Goldman Sachs is out with a new research report on the big debate about profit margins. We will have more coverage tomorrow, but we wanted to focus on one section in particular (and we saved the best for the end of the post) – how sensitive S&P 500 EPS forecasts are to changes in profit margins. See what Amanda Sneider, CFA, David J. Kostin, Stuart Kaiser, CFA, Ben Snider and Rima Reddy.
S&P 500 EPS (.INX) Margins: Past, Present, and Future
US corporate profitability is at record levels. A secular trend of higher margins has driven record S&P 500 earnings despite an environment of sub-trend economic growth and modest sales. During the last 30 years margins have roughly doubled, trending higher on the back of technological advances, cheaper and more productive labor, expansion to emerging markets, declining taxes and interest rates, and aggregate index sector composition that has shifted towards higher-margin industries.
S&P 500 EPS: Margins are the key reason earnings have rebounded so quickly in the recent cycle.
Net margins for the S&P 500 (ex-Financials and Utilities) hit a low of 5.9% in 2009. By 3Q 2010, margins had already returned to the previous 2Q 2007 peak of 8.3%. They continued to rise during the next year, reaching a cyclical and historical peak of 8.9% in 3Q 2011.
The median S&P 500 firm’s margin has been 100-150 bp above the aggregate S&P 500 margins since 4Q 2008. The top 20 firms by 2013 revenues account for one third of aggregate S&P 500 sales, yet 13 of 20 (65%) reported margins less than 5%. This compares to 17% of the other 367 ex-Financials and Utilities companies in the S&P 500.
For the past three years, trailing four-quarter margins have remained essentially flat, ranging from 8.4% to 8.9%. Firms found varying degrees of success supporting margins by adjusting pricing, costs and business mix. Some companies prioritized sales growth at the expense of margins.
While index-level operating margins have been under pressure in recent quarters, atypical operating items recorded in the second half of 2012 increased the severity of the contraction. These included pension charges and write-downs to continuing operations (see page 18). S&P 500 margins rebounded in the second half of 2013 as trailing four-quarter earnings anniversaried these items.
S&P 500 EPS Operating margins equaled 8.9% at the end of 2013, just 8 bp below the previous peak level.
S&P 500 EPS Conflicting views on the potential for further margin expansion
Looking forward, the forces that influence margins are equally balanced between upside and downside, and we expect margins will remain nearly flat through 2015. In the near term, economic acceleration should drive revenues and support margins through modest operating leverage. Additional efficiency gains and cost controls combined with subdued commodity costs should offset an uptick in wage inflation.
In conference calls during the 4Q 2013 earnings season, companies presented mixed outlooks for margins. Many indicated that expansion will be difficult, consistent with our forecast. Managements highlighted difficult pricing and higher input costs as key factors offsetting operating leverage, efficiency gains, and continued cost controls. See S&P 500 Beige Book: Four key themes from 4Q 2013 earnings conference calls (February 11, 2014) for more information.
Looking further out, labor costs will present more of a headwind to margins as the output gap shrinks. Corporate profit growth at the expense of personal income has made margins a topic with important social and political ramifications, in addition to financial considerations.
Our Economics team sees a favorable environment for corporate profits with a significant pickup in US GDP and productivity growth in 2014 with only a modest pickup in wage growth. Further out, they expect a reversion to higher wages and lower profit margins. Assuming that labor productivity grows 2% and price inflation converges toward the Fed’s 2% target, hourly labor costs would need to grow more than 4% to systematically impact margins. See US Daily: The Telling Strength of Corporate Profits (January 22, 2014) for more information.
S&P 500 EPS are highly sensitive to small changes in profit margins, as each 50 bp shift in margins represents roughly $5 in EPS. Exhibit 5 shows the sensitivity of our 2014 EPS forecast to various margin assumptions. For example, our estimate of $116 assumes an 8.9% net margin, but an increase to 9.4% would imply EPS of $121. The roughly 45 bp gap between our margin forecast and the consensus estimate of 9.4% more than explains the upside between our 2014 EPS forecast and bottom-up consensus expectation of $118. However, our sales growth and Financials EPS forecasts are higher than consensus.