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If Producer Price Inflation Continues, Company Earnings Will Suffer


Companies will likely be unable to pass the increased costs of commodities onto consumers.

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Today I'm following up on my comments from last week about my portfolio allocation with thoughts on the April US Producer Price Index report. Plus, I'm investing in a company that stands to benefit from the adoption of active-matrix organic light-emitting diodes (AMOLED).

1. As I mentioned last week [subscription required], while I remain long on select stocks, I put on some inflation hedges and I'm actively trading volatility (in small size, as this segment can wipe out gains quickly) in conjunction with Treasuries as downside protection. Today's US Producer Price Index (PPI) report for April is an example of why I put on these positions. The report stated that producer prices increased more than estimates at a seasonally adjusted 0.6%. The economy is still muddling along, but persistently high commodity prices combined with flat wages imply that corporate margins may be getting squeezed by rising input prices, which can't be passed through to consumer prices. The chart below graphs the year-over-year percentage change in the PPI minus the year-over-year percentage change in the Consumer Price Index (CPI). It's a way to measure inflation pass-through.
Click to enlarge

When PPI can't be passed through to consumer prices costs, it must be cut elsewhere or margins get squeezed. The flood of liquidity from QE is slowly being turned off, and while companies continue to swim in an ocean of liquidity, cutting off the flow should begin to challenge those companies that have used the flow of cheap capital to augment returns above sustainable levels. In other words, earnings-per-share growth rates are above sustainable levels, and investor expectations will correct once companies fail to meet those elevated expectations.

2. I bought some Universal Display Corporation (NASDAQ:OLED) this morning to put in a drawer and revisit in a couple of years. The company licenses technology and supplies materials for the production of the aforementioned active-matrix organic light-emitting diodes, which have been gaining increased attention since Samsung (KRX:005930) first committed to the display technology when it introduced the Galaxy S3 two years ago. Universal Display's stock is trading well off its highs as Samsung recently delayed an expansion of OLED television lines until 2015, and Universal Display is facing price competition on the commodity material side of the business just as the industry is set to meaningfully expand installed AMOLED capacity.

I liken this investment to the one I made in SanDisk (NASDAQ:SNDK) in 2008. Flash technology, like OLEDs now, had significant advantages over incumbent technology, but it was too expensive to meaningfully penetrate all of the potential end markets. I don't know when it will happen, but as installed capacity is increased and costs come down, OLEDs will both replace old technology and enable new end markets. The display business is just beginning to move down the cost curve, and as Samsung's delay indicates, the inflection point may be further away than investors currently assume -- but I'm using these diminished expectations to gain exposure. A point will come when costs are competitive, and when this point arrives, the quality, flexibility, lower power, and simplicity of AMOLED solutions will replace LCDs, just as flash drives are replacing mechanical HDDs. The beauty of Universal Display's stock is that Universal's primary growth driver is licensing income. Much like Qualcomm (NASDAQ:QCOM), it should grow as use of its technology grows.

Twitter: @Honest_T
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No positions in stocks mentioned.

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