A Golden Age For Corporate Profits

Includes: DIS, UTX, WMT
by: Jason Tillberg

Inflation averaged 3.16% in 2011. While American workers are seeing negative real rates of return in their savings accounts, which yielded next to nothing last year and negative real earnings increases in their paychecks, as total compensation increased only 1.3%, there has been one major beneficiary of our rather one-sided economic recovery: Corporations

Corporate America has seen a boom in profits this past decade and even more so, these past 2 years. I have the charts to prove it.

First, let's just look at corporate profits after taxes since 1947:

(Click charts to expand)

The Fed has reduced the value of the dollar since its founding in 1913, so to better give justice to what I am calling a "Golden Age of Corporate Profits," it's better to see how profits compare as a percentage of various data points of our economy.

Let's start with corporate profits after tax as a percentage of gross domestic product:

Clearly a huge jump in corporate profits as a percentage of GDP since around 2004 up to now, with the exception to the plunge in profits in 2009.

How about corporate profits after tax as a percentage of compensation of employees, which includes wages and salary accruals?

Here is a chart of wages and salary accruals:

Here is corporate profits after tax as a percent of wages and salaries:

Another huge jump in profits as a percentage of wages and salaries.

How about corporate profits after tax as a percentage of total assets on the balance sheet of nonfarm non financial corporate business?

Here is the chart of total assets on the balance sheet of nonfarm nonfinancial corporate business:

Here is the percentage of corporate profits after tax as a percentage of total assets on the balance sheet of nonfarm, nonfinancial corporate business:

Not surprising, we can see corporate profits after tax as a percentage of total assets on the balance sheet is also close to record highs.

So I've demonstrated, corporate profits after tax, as a percentage of our GDP, as a percentage of wages and salaries and a percentage of the total value of assets on balance sheets are all at or near all-time highs.

What could be contributing to these high profits?

One factor is the low corporate taxes being paid.

Corporate taxes as a percentage of pretax corporate income I get by taking federal tax receipts on corporate income and adding that to corporate income after tax and then dividing the corporate tax by the total pretax corporate income.

Here is a chart of federal tax receipts on corporate income:

Here is a chart showing the % of federal income tax receipts on corporate income as a percentage of pre tax corporate income:

Note: This Chart goes up to 2010

Record low corporate taxes continue to contribute to helping with Corporate America's golden age of corporate profits. Tax policy is why corporate taxes as so low. While we are running trillion $+ deficits, again in 2012 for the 4th year in a row now, if Congress ever decides to get serious about cutting the deficit, it's hard to see how corporate tax policy doesn't get attacked on helping to raise revenue.

Wages of workers is another reason for helping corporate America have such high profits. Wages haven't risen much these past 2 years.

Wages could also be the factor that causes margins to fall back to mean levels again.

Output per hour is the gain in productivity and the main reason for why standards of living rise. Graphed as an index, we can see that over the long term, it has always risen. It's also a way for a company to not have to hire more workers if it can grow 5% per year and figure out how to get its employees to be 5% more productive. But, if the company can no longer generate a rate of productivity gain that is equal to growth in the sales of the business, it'll need to hire more workers.

Here a long-term chart of output per hour as an index:

Here is a chart of the year-over-year percentage gain in out put per hour for the last 5 years, calculated quarterly:

The gains have slowed and that means companies are going to have to hire more workers if they are to grow. That might well factor into reduced net profit margins if the company is unable to pass along the higher labor costs to their customers. In essance, the company will just have to eat the higher cost of labor.

At the same time, given that the average compensation only grew 1.3% last year, in a year with a 3.16% cost of living increase, companies may well feel pressure to have to give raises too.

Here is a chart of the year-over-year increase in the cost of compensation to workers:

So either companies have to be able to pay their workers higher wages, which should cut into profits, or, if they don't and we get more years of negative real income growth, then demand for goods and services will fall and that may well prove to cause a recession in the real economy.

Take a look at this chart of gasoline deliveries from refineries. Are we all just driving the bare minimum these days or does everyone have a Prius?

Given that I believe this a golden age of corporate profits, I am biased to think that in the quarters and years ahead, we will see year-over-year declines in corporate profits after tax.

I think it is dangerous to believe that we're in some kind of a "high plateau" of corporate profits.

I am reminded of home building stocks, one that I referenced in my book, pg. 57, D.R. Horton (NYSE:DHI). I put the Value Line Investment Survey page there. In its report on Jan. 10th, 2003, D.R. Horton had completed fiscal 2002 with net profit margins of 6.0%. D.R. Horton was selling at about 1x book value and a P/E of 5.3. It forecasted net profit margins would be 6.7% in the following 3-5 years, between 2005-2007. That was frankly, reasonable and prudent. Prior net profit margins at D.R. Horton, going back to 1995 up this 2002, were never lower than 4.0%. Net profit margins of 6.0% in 2002 were the highest yet.

What happened during 2003- 2005 was the booming home building industry, which gave D.R. Horton stellar earnings. Net Profit margins were 7.2% in 2003, 9.0% in 2004 and 10.6% in 2005.

In Value Line's January 6, 2006 report, right at the peak of this "Golden Age in Profit Margins," predicted a so-called "Permanent Plateau" in super high net profit margins. It predicted net profit margins would be 10.7% in the years 2008-2010.

Big mistake! D.R. Horton suffered losses in the years 2007, 2008 and 2009.

Here is a 10-year chart of D.R. Horton and shows what happens when companies exceed their earnings estimates and what happens in the years when they don't come close to meeting them.

Estimates for S&P 500 earnings are expected to continue to grow according to bloomberg. The forecasts for earning to grow:

+0.3% in Q1 2012 (y/y)
+1.7% in Q2 2012 (y/y)
+7.0% in Q3 2012 (y/y)

I think that investors need to be careful now. Look at margin of safety, like price to book value or price to net tangible asset value. Also guage the industry the company is in to see if that industry has been prone to wild swings in net profit margins in the past.

For example, Walmart (NYSE:WMT) has had incredibly stable profit margins averaging between 3.3% - 3.6% since 2002 and have been 3.5% since 2009.

Meanwhile, companies like Disney (NYSE:DIS) and United Technologies (NYSE:UTX) have seen great increases in their net profit margins over the last 10 years. Forecasts also call for even higher net profit margins in the future.

Here is Disney's net profit margins since 2002:

2002 4.4%
2003 5.0%
2004 7.4%
2005 8.5%
2006 9.8%
2007 11.3%
2008 11.6%
2009 9.4%
2010 10.6%
2011 11.5% Est
2012 12.9% Est

Est for 2014-2016 14.4%

Source Value Line

Here is United Tech net profit margins since 2002

2002 7.9%
2003 7.6%
2004 7.4%
2005 7.5%
2006 7.8%
2007 7.7%
2008 8.0%
2009 7.2%
2010 8.0%
2011 9.2%
2012 9.6% Est

Est for 2014-2016 10.0%

Source Value Line

I think the decling profit margins could prove to be the biggest risk factor in stock valuations today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.