Como se combate o populismo? "Com eleições", responde Fukuyama

[Karamba]

United States: Margin Myths

Richard Berner (New York)

Less-than-buoyant earnings reports are triggering disappointment in an equity market that was priced for good news following a fourth-quarter stock market rally, and, so far, these downbeat results contradict Wall Street’s expectations for margin gains in most sectors and earnings growth double that of the economy. However, the apparent deceleration in earnings fits to a tee my script and that of my colleague Henry McVey: Profit margins will flatten and earnings growth will slow significantly during 2005 despite a healthy economy. This disconnect suggests that there’s still enormous confusion surrounding the earnings outlook and the forces driving profit margins.

In fact, I think three related myths regarding profit margins permeate the bearish side of the earnings debate: First, some think that Corporate America hiked margins solely and thus temporarily through cost cutting. In addition, they believe that costs rising faster than inflation will squeeze margins. Finally, some bears believe that a world awash in capacity will limit pricing power and compress margins. As with all myths, these have grains of truth. Superficially, moreover, they seem to support my view that margins will flatten. But in my view all three are mostly wrong. Here’s why, and why it matters.

Myth #1 is that aggressive cost cutting underpinned a temporary surge in profit margins, and when the string ran out on further cost cuts in a world of slow growth, margins began to flatten. In my view, however, Corporate America’s ability to exploit operating leverage was the key to the explosion in margins over 2002-04, not cost cutting. Operating leverage increases when companies can spread their (high) fixed costs, such as depreciation, over the wider base of recovery.

Now, courtesy mostly of fading operating leverage, I think that margins are flattening, and convergence between earnings and economic growth will occur even if the economy reaccelerates and the dollar resumes its decline. Compared with a year ago, I think earnings growth by any measure likely will slow to about 4½–5% by the end of 2005 (see “Critical Investment Themes for 2005,” Global Economic Forum, January 3, 2005). A smaller tailwind from the dollar's decline, rising interest expense, an increase in the effective corporate tax rate, and increased healthcare, pension and options expense all will likely contribute to flatter margins. Importantly, however, I also believe that corporate discipline in capital spending will help to sustain margins by limiting growth in capacity that would undermine returns.

The second myth is that companies lack pricing power, so in a world of soaring materials costs, margin compression is the inevitable outcome. In my view, however, costs rising faster than inflation aren’t the key culprit for shrinking margins, although they may be important for some companies. To begin, materials costs are 10-20% of all costs, higher for goods producers but far less so for services producers. So a 10% jump in materials costs might add 1-2 percentage points to the cost tally. But collectively, unit depreciation and labor costs are far larger, with depreciation costs comparable to those of materials, and labor costs triple materials costs.

Nonetheless, faster growth in unit labor costs — either through accelerating compensation or decelerating productivity or both — doesn’t account for the margin compression. Operating leverage could either be an offset if it is rising, or a factor reinforcing the influence of costs on margins if it is falling. Paradoxically, in addition, as hours expand and productivity decelerates, growth in compensation per hour may at first slow. That’s because high fixed health and pension costs per worker add operating leverage; when companies expand hours rather than headcount, those costs per hour shrink.

Finally, pricing power is a determinant of profit margins, but only to the degree it determines the markup over costs as companies set prices. Using that markup pricing model, some Fed officials noted last year that firms had room in margins to absorb rising costs before raising prices. But in my view, in many industries the markup model doesn’t apply, and margins are flattening even as pricing power improves. That’s because dwindling operating leverage and rising operating rates are going hand in hand.

To shed light on the forces driving this disconnect, we asked analysts this month whether unit costs have risen faster than prices charged at the companies they cover over the last three months. Half of the analysts reported that unit costs have not risen faster than prices charged during that period. That fortunate group mainly includes IT and industrials; not surprisingly, Wall Street’s analysts are extrapolating healthy margins for both groupings into 2005. Conversely, only 28% of analysts reported that unit material costs have increased faster than prices charged, consistent with the margin squeeze reported at most consumer staples and materials companies and at some consumer discretionary firms.

The last myth completes the circle among prices, costs and margins: Many think that a world awash in capacity, especially in rapidly-growing China and Asia generally, will continue to limit pricing power and compress margins. But in my view, the change as well as the level of US operating rates has imparted a cyclical boost to both pricing power and profit margins. In manufacturing excluding high-tech industries, operating rates have jumped by 5 percentage points over the past 21 months; such a better balance between supply and demand has underpinned firmer pricing. That’s not entirely the product of booming demand. Indeed, Corporate America’s capital discipline has limited the growth in capacity, at least so far.

For investors, the message is clear: Margins are flattening and earnings growth is converging to that of the economy. The search for alpha in such an environment might well begin with high-quality companies that maintain a disciplined approach to expansion, and that grow their dividends to signal their commitment to sustain high returns on invested capital. Conversely, undisciplined capacity expansion would quickly reverse those fundamentals. Increasingly, therefore, investors will likely discriminate between the best and worst allocators of capital.