How Disruption Weighs On Profit Margins by Tom West, ColumbiaManagement
- Corporate profit margins can come under pronounced pressure from various forms of disruption.
- Firms need to invest in technology and distribution systems to support customer preferences and stay competitive.
- The key question is whether a company has adequately invested in next generation products, distribution or true advances in productivity.
A mainstay of stock market appreciation over the last several years has been the ability of corporations to manage costs and maintain pricing discipline to deliver high profit margins, even amid tepid growth. While nobody is saying it explicitly, the overall state of things indicates that investors are comfortable with share count reduction supporting earnings per share (EPS) growth, and that the high profit margins that make it all work are sustainable. So it is worthwhile to ask: How is the margin story holding up? On average, pretty well. But it’s interesting to look at where the cracks have come in, and where they have not.
It is generally not as simple as excess supply touching off a cycle of price reductions. While such reductions have happened, companies have managed though them more often than not. They are often temporary phenomena, such as a retailer picking up promotional activity to work down a spike in inventory. The common ingredient for more pronounced margin pressure is some form of disruption. Technological disruption comes to mind, but we’ve also seen customer preference for a different version of the product, or a different form of delivery, or even disruption through legislative fiat.
In retail, e-commerce is turning out to be a profit margin headwind. Customers want free shipping and the ability to return items anywhere for any reason. Firms need to invest in technology and distribution systems to support this, but it is more about staying competitive than capturing incremental sales. And in the supermarket, there is a demand for more healthy foods and a shift from processed foods. So traditional packaged food companies either need to invest in new products or buy smaller, upstart competitors that are positioned for these trends.
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Regulatory fiat: Both the financial sector and the healthcare sector saw disruption in the form of legislation around pricing and offerings. Healthcare has absorbed much of the Affordable Care Act pretty well. Managed care companies have held onto profitability, and some of the providers are benefiting from the growth in utilization. The financial sector was hit with a variety of restrictions—from limits on overdraft fees on small checking accounts to the amount of capital that must be held by the largest capital markets institutions. These were and are drags to profitability, but firms are finding solutions to some of the changes.
In the technology sector, disruption and shifting requirements are part of the landscape, if not the landscape itself. Investment in corporate IT infrastructure has seen only limited growth as customers delay investment spending while they take time to consider their strategy toward the cloud and software as a service. It is interesting that almost all of the old tech giants that were once seen as the engines of innovation are presumed to be the victims of innovation.
The good news for equities is that it is hard to find many examples of excess investment and aggressive pricing just breaking out, even amid slack demand. As one CEO explained; “we’d just be lowering our revenues. You’ll see us get aggressive if things get moving and there is actually some incremental business.”
The bad news is that some form of disruption eventually comes to every industry, and discipline won’t cut it when the market wants something different than what you are selling. So, investors protect themselves by investing in the disruptors, right? Yes, but an investment diet consisting solely of prospective disruptors can have its own issues. And not every industry is disrupted by an outsider. So the key question is whether a company has adequately invested in next generation products, distribution or true advances in productivity. They can do this internally, through investment spending and R&D or externally through smart acquisitions. Either approach is ok, as is a combination of both. The important thing for analysts and investors is to asses which path a company is on, and appraise the financial statements accordingly.