One of the hottest ongoing debates in the stock market is about the
sustainability of historically high profit margins.
High profit margins have allowed companies to amplify modest sales growth into impressive earnings growth.
However, the debate often gets confused when people don’t make the distinction between the operating profit margin and the net margin.
The operating profit margin is generally measured as earnings before interest expenses and taxes, or EBIT. This margin reflects the operating efficiency of a company.
The net profit margin is the profit after all operating, interest, and tax expenses are subtracted. It’s the bottom line. Unlike the EBIT margin, the net margin is impacted heavily by financial planning decisions.
“The margin story continues to be far less about efficiencies than smart tax and balance sheet planning,” said Citi’s Tobias Levkovich in a note to clients this week. “While there is much discussion about companies being able to manage their businesses wonderfully and thus even small revenue gains can generate more impressive bottom-line increases, this mindset is ill- founded, in our view. The broad data shows that overall S&P 500 operating margins have been flat to down for more than six quarters and the true story behind net margins has been lower effective tax rates and interest expense.”
Levkovich argues that the earnings surprises we’ve seen so far during this reporting season have been of low quality because of the nature of these margin trends.
Below is a chart of the EBIT margin and a chart of interest as a percentage of sales. The latter chart reflects the low interest rate environment.
Many people often argue that corporations have been able generate increasing levels of profits by laying off workers and squeezing the workers they keep. However, employee costs are included in the EBIT margin, which has been trending lower for the S&P 500.
“The most disturbing issue is the view that EBIT margins have been so good and that companies have been incredibly efficient running their operations,” added Levkovich. “Figure 10 should dissuade anyone from believing that misperception. After-tax margins on the other hand have been solid but that reflects lower effective tax rates and lower interest expense as a per cent of sales due to low interest rates (see Figure 11). In this context, management teams have been far better at tax planning and balance sheet engineering which is not as impressive as running their underlying businesses but that is not the current talking points for many misguided market observers.”