Starbucks and the Lower-Margin Trend

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With the silver bullet of productivity disappearing (its growth is at a nine-year low), corporate pricing power at a two-year low and unit labor costs at a 16-year high, corporate profit margins are vulnerable to mean reversion. They are now elevated to 50-year highs, but they've already fallen for three quarters.

Last night's Starbucks (SBUX Quote - Cramer on SBUX - Stock Picks) report is further evidence of this; it slipped nearly 10% after it guided to flat profit margins for next year.

This drop in corporate margins forms one of the core arguments to the bearish case for equities. As a result, the bottoms-up forecasts for 11% corporate profit for 2007 are a pipe dream. The forward price-to-earnings ratios anticipated by optimistic participants are overstated.

Although bulls rave about third-quarter earnings growth, their optimism might be misplaced. The third-quarter comparisons were easy against the depressed Hurricane Katrina quarter, one of the weakest periods of profitability ever, which saw corporate profits plunge by 17%.

As well, reported profits were inflated by corporate buybacks. Adjusting for those buybacks and seasonality, the most recent third-quarter earnings slowed to only an 11% growth rate, as compared to 15%, 17% and 20% in the previous three quarters.

Starbucks specifically cited higher labor costs as the culprit for its soft margin guidance.

If this world-famous purveyor of $4 lattes is finally reaching price elasticity as it can't raise prices enough to offset labor costs, how does this bode for corporate America's profitability (and margins) when appliances, homes, personal computers, flat-panel televisions and apparel are for sale?

The answer is that the mean reversion in profit margins will be sharp and swift as the economy downshifts to slower growth.