Profit Margins: How They Got Here And Where They Are Going, Part I

Includes: SPY
by: Closing Time

It's no secret that profit margins and indeed corporate profits as a whole have risen to record levels as the economy emerged from the depths of the financial crisis. This has led to a fair degree of skepticism regarding how such a situation transpired given the fragile nature of the recovery, and an even greater degree of debate over the future direction of earnings and margins. How have margins arrived at where they are today, and what specifically led them here? Can the current trend be expected to persist? What are the implications for earnings moving forward? Over the course of this article, I'll use some data on the S&P 500 (NYSEARCA:SPY) as proxy for answering some of these questions.

To start, how does a company go about increasing its profit margins in the first place, technically speaking? In the most basic sense, there are two different avenues:

  1. They can increase their top-line revenue. This assumes that the associated expenses increase by a smaller percentage than does revenue. For example, if a company starts off with 1,000 in revenue and 600 in expenses, they then have 400 in income and a profit margin of 40%. If revenues grow by 5% (to 1,050) but expenses grow faster at 6% (to 636), then their income is 414 (1,050 - 636) and their profit margin is 39.43 % (414/1050). In other words, their margins have fallen despite growing revenues because expenses increased at a higher rate. Conversely, if expenses had grown at slower rate than revenue, say 3% (to 618), then income is 432 and their profit margin would rise to 41.14%. Or, the second method:
  2. They can cut expenses. By the same logic, this assumes that doing so does not reduce revenue by a greater percentage than the expense reduction.

That's it. There are many different ways to go about doing each of them, but in order for earnings to increase, at least one of these events must occur. And they are both subject to different limitations:

At the macro level, revenue growth is governed by the broad economic environment rather than the actions of individual companies. A company can, for example, increase its advertising efforts in an attempt to increase revenues, but if the economic picture is not conducive with end-user demand, this strategy will be less effective at increasing revenues than it otherwise would be. Also, bear in mind that increasing advertising/sales efforts represents an expense and as mentioned above, if expenses grow at a faster rate than revenue, margins will contract. On the other hand if times are good, revenues can exhibit large, sustained growth rates, a precursor for healthy and sustainable profitability.

Expenses can be reduced via productivity and efficiency gains, which are both vital aspirations of any company hoping to achieve long-term profitability. However, a strategy of reducing expenses to improve margins is ultimately limited by the fact that there is an implicit floor on operating expenses. Below this level, things such as product quality, order fulfillment, and service standards will begin to suffer. Eventually this will lead to a larger decline in revenues than in expenses, causing margins to contract. As a result, for a given level of revenue, reducing expenses to increase profit margins follows a path of diminishing marginal returns, ultimately rendering this method of margin expansion untenable in the long-run.

As Jeremy Grantham has argued in the past, profit margins for the market as a whole are mean-reverting. With the exception of a few outliers which are extremely well insulated from competitors and thus able to protect and maintain strong margins (AAPL being a good example of this), high profit margins should attract competition. This competition ultimately brings margins back to an equilibrium level. This effect has likely been slowed by the unwillingness of large corporations to unleash their cash reserves into new investment and/or lever back up to enter new markets, and also by the inability of small businesses to obtain financing. These conditions will not last forever, suggesting that unusually high margins will not either.

Let's take a look at some data from the S&P 500 over the last 10 years. Specifically, revenues, earnings, their respective annual growth rates, and associated profit margins:

Some interesting things to take note of:

  1. Margins actually expanded from 2008 to 2009 despite a near 13% drop in revenue (highlighted above). This seems counter-intuitive at first glance, but can be explained rather easily by applying the same logic used above when I discussed how margins grow in the first place:

    Profit margins are calculated as Net Income divided by Revenue. Net income is equal to Revenue minus Expenses, so substituting in, we get:

    PM = (Revenue - Expenses)/Revenue.

    Therefore, it is entirely possible for profit margins to grow despite falling revenue, as long as expenses are falling at a faster rate. Apparent from this is that there was a sudden and substantial reduction in expenses from 2008 to 2009.

  2. More importantly, examining the trend in revenues since the pre-recession peak reveals that over that period of time, revenue was just barely able to recover by the end of 2011. In spite of this, margins (and by extension, profits) have more than doubled from their pre-recession levels.

Based on these observations, we can conclude that the rise in profit margins was due to expense cutting rather than organic revenue growth.

Although this is an important distinction, saying that expense reduction is responsible for these record profit margins is a bit of a general statement. In order to understand how long they can be expected to persist for, we need to examine exactly where businesses have shed the bulk of their expenses. And perhaps more importantly, what has allowed them to do so without significantly eroding their revenues? In Part II, I'll examine some of these questions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.