On Friday, Bank Of America Merrill Lynch and Deutsche Bank independently published their respective findings on corporate profit margins, which are currently sitting at historic highs.
“The debate on S&P 500 net margins never seems to go away,” wrote Deutsche Bank’s David Bianco.
“One of the most common bearish arguments that we hear from clients is that margins are mean-reverting,” wrote Bank of America Merrill Lynch’s Dan Suzuki.
Both Bianco and Suzuki concluded that margins were sustainable and were unlikely to collapse to historic means. This refutes the work of John Hussman and GMO’s Jeremy Grantham, both who have warned that falling margins would crush profits and hinder the long-term returns on stocks.
It’s All About Low Interest Expense And Low Tax Rates
On Saturday, we discussed the findings of Suzuki.
“Importantly, roughly two-thirds of the improvement in net margins can be attributed to changes below the operating line, specifically interest expense and taxes,” noted Suzuki regarding the increase in margins since 1995. Suzuki went on to argue why interest expense and taxes were unlikely to rise anytime soon.
Like Suzuki, Deutsche Bank’s David Bianco also decomposed gains in profit margins since 1995. While Bianco’s numbers are slightly different, his conclusions were essentially the same.
“Net margins are higher from structural factors… not cost cutting,” said Bianco.
So What Are The Bears Getting Wrong?
Margin bears have been emphasising how companies have improved profitability by laying off workers and squeezing the workers who they kept.
The bears’ thesis has been supported by the persistently high unemployment rate and stagnant wage growth.
But the findings of Bianco and Suzuki show that that the bears’ concerns are relatively small and more than offset by gains the forces of lower interest expense and taxes.
To get a better sense of this debunking, you need to look at operating margins, which are profits before interest and tax.
Bianco and Suzuki examined operating margins from different angles but nevertheless arrived at similar conclusions.
Tech And Energy Operating Margins
“S&P 500 Non-Financial operating margins are currently about 12.0% vs. their historical average of 10.6%,” writes Suzuki. “This is entirely due to increases in profitability and contribution from Tech and Energy.”
Suzuki notes that tech and energy operating margins have undergone significant structural changes.
Tech sector margins have benefitted from industry maturation. You see, young tech industries operate at losses or very slim margins as they get their companies off of the ground. Today, the once young tech companies have established themselves and built up the scale to maintain a higher level of profitability.
Energy is benefiting from massive structural changes. Back in the 80’s and 90’s, oil prices were at around $20/barrel. But thanks to emerging market demand, oil is trading around $90/barrel today. And oil prices and energy industry margins are very tightly correlated. Suzuki says that oil would have to plunge back to around $30 for margins to revert to a mean. This is unlikely.
“Excluding these sectors, operating margins of 11% are only 65bp above their historical average,” said Suzuki. “While we agree that both earnings and margins are cyclically elevated, operating margins appear in-line with historical non-recessionary periods (Chart 12).”
As you can see from the chart below, there’s nothing spectacular about operating margins today.
Another way to look at operating margins is by geography. Bianco does a nice job of this in his devastating 18-page report.
Keep in mind that it tends to be cheaper to operate overseas thanks to stuff like low labour costs and property expenses.
“Since 2000 in aggregate S&P foreign pre-tax margins have been higher than pretax domestic margins and gap is widening,” wrote Bianco. “This is because – 1) high margin businesses are the ones that are expanding abroad; and 2) their foreign operations became more profitable in the 2000s after the mostly investment stage of the 1990s. As companies with high foreign sales are becoming a larger share of the S&P, aggregate foreign operating margins are climbing.”
And we can’t forget about taxes. It’s well known that corporate tax rates are lower overseas. So the more companies expand out there, the lower their effective tax rates become.
Bianco provides another eye-opening chart aggregating the net margins of companies with high foreign sales and those with no foreign sales.
As you can see from his sample, the profit margins of U.S. companies selling to U.S. customers doesn’t seem to be anywhere close to a level that would warrant a collapse.
Neither Bianco nor Suzuki will deny that profit margins are high and are at risk of pulling back.
However, they both aim to make clear that profit margins are high due to long-term structural factors, not short-term cyclical factors.
It appears both have accomplished this very convincingly.