In Part I of this article, we took a look at how margins have behaved over the past decade and determined that the recent rise in margins was the result of corporations slashing expenses rather than growing revenue. Moving on, we'll examine how exactly they were able to do so without causing their revenues to suffer.
There are several possible explanations:
- Interest rates. With the Fed holding rates near zero for the past 4 years, and for the foreseeable future, it stands to reason that corporate interest payments would have dropped. Despite this, I don't believe that interest rates are a direct contributor to high profit margins for the simple reason that the most burdensome debt is long-term in nature and the rates on these debt issues have been locked in since issuance. Payments on short-term debt, which is rolled over more frequently have likely fallen, but this type of debt generally makes up a comparatively smaller portion of company's debt structure. Low interest rates are more effective at spurring new investment (which we unfortunately haven't seen much of in this recovery) than they are at lowering interest costs on existing debt loads.
- Corporate tax cuts. Cutting the corporate rate would have a direct effect on margins; however, the vast majority of corporate tax cuts were directed towards small businesses in the hopes of reviving that area of the economy. Large corporations were not major beneficiaries, as I'll demonstrate shortly.
- Input costs. Reducing the cost of inputs is an effective way of improving margins. However, at the macro level, doing so is a question of commodity prices. Commodity prices fell precipitously in 2008, which lowered input prices throughout supply chains. This factor is subject to the inventory costing method applied by the firm. A LIFO firm (whose cost-of-goods-sold is composed of the most recently acquired inputs) would immediately realize a benefit from reduced input costs in net income. On the other hand, a FIFO firm would realize the same benefit, but on a delayed basis. Their COGS account would first run through the higher-priced inventory already on hand before benefiting from the lower-cost inventory acquired post-2008. These accounting differences reverse in time, and since the rise in input costs has generally been commensurate with the rise in the broader market, any benefits from low input costs would have been transient.
- Monetary stimulus. Monetary velocity is at a historical low and continuing to trend downwards (as seen below), meaning that money is not moving around the economic system very quickly, a detriment to corporate revenue. To compensate, the Fed has engaged several rounds of asset purchases, inflating the money supply. Velocity acts as a multiplier on the money supply, so although velocity is currently quite low, it now acts on a much larger monetary base, moderating the effects of low velocity. The net effect of the Fed's actions has been to support prices and revenues, therefore aiding margins.
- Labour force reductions. Wage costs represent a substantial portion of expenditures for any business, and as we know, there were a tremendous number of jobs lost during the recession, which have yet to be recovered.
In order to further isolate the sources of margin growth and to provide some empirical backing to my comments, I'll refer to a figure produced by Marco Lettieri at National Bank as part of a sector-by-sector breakdown of historical margins that he conducted. More importantly for our purposes, he used S&P 500 (NYSEARCA:SPY) EBIT margins as opposed to net margins, thus factoring out interest and tax effects.
Source: National Bank
Side note: The reason I included this particular ex-financials graph is because interest represents a much larger expense for financial companies, and factoring out these expenses (as an EBIT measure does), leads to distorted results. In other words, a large portion of expenditures for financial firms are pushed further down in the income statement, and these expenses are not captured by EBIT earnings, resulting in an EBIT margin which appears significantly higher.
As you can see, EBIT margins and net margins have followed a similar path in recent years (in fact, EBIT margins have risen more during the post-crisis period). If current profit margins were the result of interest or tax effects, EBIT margins would be lower on a relative basis. The fact that they are higher implies that interest and taxes have had a limited effect on corporate profit margins.
For reasons outlined above, I don't believe input costs could have had such a prolonged effect on margins, certainly not on such a broad basis throughout the entire market. Low input prices would have to cripple the margins of companies somewhere along the supply chain.
This leaves monetary stimulus and labour cuts as the major drivers of profit margins, but with one glaring issue related to labour cuts: At the macro level, a persistently high unemployment rate and high profit margins should not be able to exist concurrently. A single firm can cut its wage expense and therefore improve its margins, however unemployed people must spend less and behave in a more frugal manner out of necessity. As a result, when overall unemployment rises, a corresponding decrease in revenues is to be expected. This diminishes or eliminates any beneficial effect on margins. This effect has not been as pronounced as it likely should have been, but why not?
As mentioned, monetary stimulus has helped support revenue. In addition, another credible theory is that the large amount of transfer payments and other associated fiscal stimulus spending have helped sustain revenue while simultaneously allowing companies to cut expenses, particularly payroll, without the corresponding hit to margins & earnings that would normally occur from reduced revenue.
To highlight the effect that transfer payments have had on income, examine the following figures which contrast total real personal income with real income less transfer payments.
It is plainly apparent that real personal income ex-transfer payments are well below their pre-recession peak (which is to be expected given the persistently high unemployment we have witnessed), while on the other hand, total real personal income is notably higher and has managed to eke out a marginal new high. Transfer payments have clearly had a profound effect on income in recent years.
It is also interesting to note that total personal income has followed a path that is quite similar to that of S&P 500 revenues. In fact, the correlation between the two data sets is 95.5% with and R-squared value of 91.2%. Although it is not especially surprising to find a positive relationship between the two measures, the strength of the relationship is noteworthy, as it implies that S&P 500 revenues are very strongly linked to the level of real personal income.
Of similar importance to transfer payments, the fiscal stimulus measures enacted during the aftermath of the financial crisis included a substantial amount of personal tax cuts/refunds (roughly 37% of the total package according to the CBO). Reducing the tax burden on individuals increases their disposable income, thereby allowing them to spend money they wouldn't otherwise been able to. This means that tax incentives are tantamount to transfer payments.
Additionally, by definition transfer payments do not include tax effects, meaning that the stimulus packages have had an even larger effect on personal income than can be seen by examining the difference between the two graphs.
To sum up, it appears that we have a situation in which the recession induced corporations to slash capital budgets, and eliminate unprofitable or strategically undesirable business segments, as well as the jobs associated with these operations. This resulted in a tremendous number of jobs cuts. Normally high levels of unemployment would put a cap on revenues; however, unprecedented amounts of monetary and fiscal stimulus have allowed revenues to rebound modestly. The net effect of these two factors has been to enable corporate revenues to grow while keeping expenses subdued, thus resulting in expanding profit margins.
In Part III, we'll take a look at some of the risks related to profit margins, and their implications for margins and earnings.
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.