One of the most remarkable stories of the recovery has been the rebound in corporate profitability from the depths of the recession. As frightened consumers cut back on everything but the most essential spending at the end of 2008, earnings for all sorts of corporations dropped precipitously. This was not terribly surprising. With less revenue coming in the door and little time for firms to adjust their cost structures, you'd expect the bottom line to be pretty ugly.
What was unexpected was that even before it was obvious that we were emerging from the recession, corporations were surprising investors on the upside during earnings season. Even though at first revenues were flat at best, firms were able to eke out an improving bottom line as margins rose. As consumer demand came back, profitability gains were even stronger.
Recent data of corporate profits as a percentage of gross domestic product (an imperfect measure for sure but one that gives us a decent snapshot of profitability) show just how sharp the upturn has been. From 1947 until today, corporate profits have averaged 9.45% on GDP. In the period from 2004 until the end of 2007 that number jumped to 11.19%. This number floated around 9.00% through 2008 before plummeting to 7.00% in the fourth quarter of that year. But by the fourth quarter of 2009, profitability was already more than the long-term average, and the most recent data peg profits at 11.29% of GDP. This is higher than the average during the upturn and close to historically high levels.
Margins Not SustainableI'm growing concerned that these levels of profitability are not sustainable and that corporations are going to have a much harder time posting impressive margin growth moving forward. To see why, I'll take a look at how firms were able to get these margins in the first place and why I think it is going to be more difficult in the future.
Labor Costs CutThis was a big one in terms of saving money and boosting profits. Firms across the board laid off armies of workers that they didn't think they needed anymore. With suddenly lower consumer demand and the prospect of a second Great Depression, management teams were understandably scared. They cut everything they thought they could in order to keep the doors open. And the workers that were left ended up taking on more tasks and working harder than they had before to make up for the massive layoffs.
Firing a bunch of workers had a hugely detrimental effect on the unemployment rate, but having fewer employees on payroll was a boon for profitability. But cutting staffing to the bone is not sustainable. Existing workers can only take on so much work, and as demand increases, businesses will need to hire to expand. As those new workers come in, it is unlikely that revenue will increase at the same rate as payroll. And as the labor market recovers, firms will be forced to raise pay and add back benefits to existing workers, thus adding further cost pressures. This will squeeze margins and bring them back closer to historical norms.
RestructuringThis is an incredibly popular corporate buzzword. Oftentimes it means nothing more than moving a few divisions, adding some new senior vice presidents in charge of widgets, and taking a big earnings charge.
But during the recession, a lot of firms actually did restructure their businesses in ways that made them work better and earn more money. The jolt of seeing seemingly untouchable firms such as General Electric or Goldman Sachs displayPTip('GS', 'GS','YTD', '', '', '', '', '', '','msg','P'); shaken to their core was the impetus and cover that managers needed in order to make sweeping changes that might have been resisted in good times.
This meant that to find more efficiencies, companies considered shutting down legacy businesses that had been laggards for years, buying a complementary business at a great price, or just changing processes that hadn't been updated in years. These changes might have provided a gain to the bottom line but they are often one-time in nature. You get the step-up once, but it is hard to improve on profitability from there. And more likely that not, inefficacies will creep into the system, mitigating some of that initial gain over time.
Input Costs FellThe price of raw materials dropped along with global demand, improving the profitability of firms which were able to keep their prices constant. This was especially evident for firms doing business in emerging markets. Demand held up better in those areas and came back faster, so there was no need to pass along lower costs to the consumer.
Even if you don't believe we are at the precipice of rapid inflation, there is no doubt that costs are starting to go up for raw materials. But the consumer still isn't strong enough to accept large price increases, so chances are a lot of those rising prices will come out of corporate profits.
What Does That Mean?In short, I don't think the recovery from the Great Recession has suddenly made firms permanently more profitable. In the coming quarters and years, firms are likely to see margins compress and revert closer to historical levels. In fact, if profits stayed this high forever, I'd think something is wrong with capitalism. Even absent the issues above, this level of profitability should attract new entrants to compete away the excess earnings.
This reversion to the mean will likely lead to some negative earnings surprises and forecasts of lower profit ahead. That isn't going to do much to support higher stock prices, and it could put downward pressure on all stocks.
Is profitability about to fall off a cliff? No. But investors should keep a close eye on margins in the months ahead.
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Input Costs FellThe price of raw materials dropped along with global demand, improving the profitability of firms which were able to keep their prices constant. This was especially evident for firms doing business in emerging markets. Demand held up better in those areas and came back faster, so there was no need to pass along lower costs to the consumer.
Even if you don't believe we are at the precipice of rapid inflation, there is no doubt that costs are starting to go up for raw materials. But the consumer still isn't strong enough to accept large price increases, so chances are a lot of those rising prices will come out of corporate profits.
What Does That Mean?In short, I don't think the recovery from the Great Recession has suddenly made firms permanently more profitable. In the coming quarters and years, firms are likely to see margins compress and revert closer to historical levels. In fact, if profits stayed this high forever, I'd think something is wrong with capitalism. Even absent the issues above, this level of profitability should attract new entrants to compete away the excess earnings.
This reversion to the mean will likely lead to some negative earnings surprises and forecasts of lower profit ahead. That isn't going to do much to support higher stock prices, and it could put downward pressure on all stocks.
Is profitability about to fall off a cliff? No. But investors should keep a close eye on margins in the months ahead.
Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.
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