Corporate profit margins - sustainable?

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Corporate profit margins - sustainable?

Postby dmcmahon » Wed May 01, 2013 4:58 pm

I thought the following article might be of interest. I've been concerned that corporate profit levels (and therefore stock market valuations) might be at unsustainable levels, yet I've had a nagging feeling that the raw profit/GDP ratio was bound to be misleading due to globalization. The author attempts to tease out this effect.

http://seekingalpha.com/article/1390601 ... ustainable
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Re: Corporate profit margins - sustainable?

Postby Frugal Al » Wed May 01, 2013 5:56 pm

Very interesting article. The magnitude of foreign profit growth coincides closely to an overall weakening of the dollar which accelerated around 2002.
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Re: Corporate profit margins - sustainable?

Postby larryswedroe » Thu May 02, 2013 10:26 pm

keep in mind that margins are way up also because of the cost of debt is way down, and for those that refinanced to low long term debt it will stay down for quite a while, this fact seems to be ignored by all those that talk about margins at high levels (note I did not read the article)
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Re: Corporate profit margins - sustainable?

Postby Rick Ferri » Thu May 02, 2013 10:57 pm

S&P earnings growth may slow, but earnings per share will not slow at the same pace. Companies are finding that leverage is a good thing because it keep earnings per share climbing. This week Apple is borrowing money at very low rates to buy back stock. Mircosoft did the same thing last week.The borrowing cost for both companies is lower than the dividend they're paying on common stock. Thus, issuing debt to buy stock increases cash flow while increasing EPS. Thank you Uncle Ben.

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Re: Corporate profit margins - sustainable?

Postby swaption » Fri May 03, 2013 10:32 am

Thanks, this is interesting. The article mentions Hussman's analysis, which I had linked in a prior post:

http://www.bogleheads.org/forum/viewtopic.php?f=10&t=115040

Much has been written about valuations, which may be reasonable when viewed based on the current PE, but less so if earnings are smoothed through Shiller's use of CAPE. Ultimately, it all boils down to the topic of this thread. I agree with Larry regarding low borrowing costs, but theoretically competition should render the margin benefit unsustainable. However, I can't find any holes in this analysis as presented. The traditional view is that equity appreciation is constrained by earnings growth, which in turn is constrained by GDP growth. This article is basically saying that GDP is the wrong metric, and that there can be substantial growth outside of GDP through global profits. I'm not sure if continued growth in this manner is sustainable, but that doesn't necessarily imply that the recent growth to the current level of earnings needs to be reversed.
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Re: Corporate profit margins - sustainable?

Postby nisiprius » Fri May 03, 2013 10:41 am

Rick Ferri wrote:...Companies are finding that leverage is a good thing...
Why do I not find that reassuring? Yes, I understand that leverage isn't good or bad in itself, it's a question of OK or too much; bubbles necessarily involve increases in leverage, but increases in leverage don't necessarily mean a bubble. But it is not reassuring. And, from the original article:
...this change may have permanently shifted up the mean for corporate profits...
"This time it's different?" Profits have reached a new and permanently high plateau?
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Re: Corporate profit margins - sustainable?

Postby Grt2bOutdoors » Fri May 03, 2013 11:38 am

Rick Ferri wrote:S&P earnings growth may slow, but earnings per share will not slow at the same pace. Companies are finding that leverage is a good thing because it keep earnings per share climbing. This week Apple is borrowing money at very low rates to buy back stock. Mircosoft did the same thing last week.The borrowing cost for both companies is lower than the dividend they're paying on common stock. Thus, issuing debt to buy stock increases cash flow while increasing EPS. Thank you Uncle Ben.

Rick Ferri


Let us know what will happen when the "punch bowl" goes away. This is just one form of financial engineering, the last time we had this kind of game playing it involved the wholesale financing of real estate. I see we collectively have still not learned our lesson. BTW, Apple is borrowing here because most of their corporate cash is held overseas and it is prohibitively expensive to bring it back home. If they really wanted to get creative, they'd issue a form of preferred stock on a one to one basis registered in their overseas location, use it to pay the dividends - foreign taxes would likely be lower than borrowing costs and net tax expense to shareholders. Wonder why the IB community hasn't thought of that one yet?
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Re: Corporate profit margins - sustainable?

Postby swaption » Fri May 03, 2013 1:33 pm

Rick Ferri wrote:S&P earnings growth may slow, but earnings per share will not slow at the same pace. Companies are finding that leverage is a good thing because it keep earnings per share climbing. This week Apple is borrowing money at very low rates to buy back stock. Mircosoft did the same thing last week.The borrowing cost for both companies is lower than the dividend they're paying on common stock. Thus, issuing debt to buy stock increases cash flow while increasing EPS. Thank you Uncle Ben.

Rick Ferri


Rick,

Your examples are merely anecdotal. Is corporate leverage systematically increasing? If so, to a level that is out of historic norms?

As well, there is no free lunch. With leverage comes increased earnings volatilty and risk.
Last edited by swaption on Fri May 03, 2013 1:47 pm, edited 1 time in total.
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Re: Corporate profit margins - sustainable?

Postby swaption » Fri May 03, 2013 1:46 pm

nisiprius wrote:And, from the original article:
...this change may have permanently shifted up the mean for corporate profits...
"This time it's different?" Profits have reached a new and permanently high plateau?


Ok, let's say for a moment that tomorrow GE acquires Seimens, Apple acquires Samsung, and Ford acquires VW. Obviously an extreme example, but how relevant would it then be to compare profits at US corporates as a % of US GDP relative to past levels? This is basically the thesis. Sometimes, things really are different.
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Re: Corporate profit margins - sustainable?

Postby leonard » Fri May 03, 2013 2:00 pm

This doesn't make any sense. Let's ignore costs for a second - and look just at forecasting top line sales. How can someone possibly forecast all sales across all industries in all markets - and come up with a reasonable number?

Then, how is someone going to model all the cost structures across companies and come up with reasonable cost numbers.

Internal experts within companies get these forecasts wildly wrong all the time. I would view any consolidated "corporate profit margin" forecast with extreme skepticism.
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Re: Corporate profit margins - sustainable?

Postby Rick Ferri » Fri May 03, 2013 2:09 pm

Rick, your examples are merely anecdotal. Is corporate leverage systematically increasing? If so, to a level that is out of historic norms? As well, there is no free lunch. With leverage comes increased earnings volatilty and risk.


When you''re borrowing money to buy stock, paying 0.8% net interest expense for ten years and saving 2.8% cash dividend on the amount you buy back, how is this adding to earnings volatility and risk? Seems like smart business to me.

There is an optimal weighted average cost of capital (WACC) at every firm. Large companies are shifting to more debt and less equity because it's cheaper and pushes earnings per share higher. I would too. It's basic corporate finance.

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Re: Corporate profit margins - sustainable?

Postby swaption » Fri May 03, 2013 2:57 pm

Rick Ferri wrote:
Rick, your examples are merely anecdotal. Is corporate leverage systematically increasing? If so, to a level that is out of historic norms? As well, there is no free lunch. With leverage comes increased earnings volatilty and risk.


When you''re borrowing money to buy stock, paying 0.8% net interest expense for ten years and saving 2.8% cash dividend on the amount you buy back, how is this adding to earnings volatility and risk? Seems like smart business to me.

There is an optimal weighted average cost of capital (WACC) at every firm. Large companies are shifting to more debt and less equity because it's cheaper and pushes earnings per share higher. I would too. It's basic corporate finance.

Rick Ferri


Not really sure where to start here. I guess I could try to explain how leverage increases volatility and risk, but I'm kind of at a loss in terms of how to approach that and a bit taken aback that it would even be necessary. Would it be clearer if I gave an analogy of a margin loan equal to 10% of my porfolio with an interest rate of 0.8%?

But since we are on the topic of corporate finance basics, call me crazy, but I'm relatively certain that this debt cheaper than equity thing has been going on for quite a number of years now. In fact, absent some sort of market dislocation, I think we're supposed to assume that's pretty much always going to be the case, particularly after taking into account tax benefits.
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Re: Corporate profit margins - sustainable?

Postby Valuethinker » Fri May 03, 2013 3:24 pm

swaption wrote:But since we are on the topic of corporate finance basics, call me crazy, but I'm relatively certain that this debt cheaper than equity thing has been going on for quite a number of years now. In fact, absent some sort of market dislocation, I think we're supposed to assume that's pretty much always going to be the case, particularly after taking into account tax benefits.


An interesting case of theory driving real life.

Generations of young MBAs have now learned Modigliani Miller in corporate finance classes, and learned to apply it.

First in the junk bond boom of the 1980s, and the first LBO boom. Since then in the maturation of the LBO/ PE industry.

An active market for corporate control (read: threat of hostile takeovers) plus increased incentivization of executives by share options (ie your preference is then for buybacks over dividends, as dividends lower the value of the underlying shares and your options) has meant that companies are far more likely to buy back shares than they were say 25-30 years ago.

Good news: less wasteful corporate investments and acquisitions. Bad news: more leverage, making companies more vulnerable in the downturn. Certain industries have been badly damaged by the attention of leverage-- I am thinking of the US mattress industry in particular. At one time, I think all the main mattress makers were the subject of LBOs.

The banking crash has of course pushed back on leverage and indeed US companies, from memory, were not as highly leveraged as they were going into the 2000 recession BUT the return of the high yield bond market is again pushing up leverage.

The highest levels of leverage pre Crash were, of course, in the financial services industry. Lehman, from memory, was levered (Total Assets divided by Equity) 32:1, ie the level of a hedge fund.
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Re: Corporate profit margins - sustainable?

Postby Rick Ferri » Fri May 03, 2013 3:35 pm

Rick, call me crazy, but I'm relatively certain that this debt cheaper than equity thing has been going on for quite a number of years now.


Yes it has. This conversation was started because the OP linked an article that asked, "Are Corporate Profit Margins Abnormally Elevated Or Sustainable?" The answer is sustainable because of low interest rates and balance sheet reshuffling.

So, what happens next? Borrowing and buy-backs cause the stock market valuation to rise - perhaps over 22- 23 times earnings. When this occurs, financing with stock becomes cheap again. Companies then issue more stock at higher PE multiples that they helped propel and use this cheap currency to pay off debt when it comes due (assuming refinancing of debt is at a higher interest rate).

So, what should YOU be doing now, buying corporate debt or buying corporate equity? I know what I'm doing.

Rick Ferri
Last edited by Rick Ferri on Fri May 03, 2013 3:43 pm, edited 1 time in total.
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Re: Corporate profit margins - sustainable?

Postby richard » Fri May 03, 2013 3:40 pm

Rick Ferri wrote:S&P earnings growth may slow, but earnings per share will not slow at the same pace. Companies are finding that leverage is a good thing because it keep earnings per share climbing. This week Apple is borrowing money at very low rates to buy back stock. Mircosoft did the same thing last week.The borrowing cost for both companies is lower than the dividend they're paying on common stock. Thus, issuing debt to buy stock increases cash flow while increasing EPS. Thank you Uncle Ben.

Apple's borrowing appears more about tax policy than leverage.

Apple has net current assets of about $30 billion as of March 30. From reports, a large part of its cash is overseas and the tax costs of repatriating the cash would be much higher than the cost of borrowing. The usual tax issue with leveraging to pay dividends is that interest costs are deductible to the corporation, while dividends (or buy backs) are not. That's been going on for quite a while.

Presumably Apple is buying back stock because it doesn't have enough useful projects to invest in compared to the cash flow benefits of a buy back. I'm not sure that's the most bullish sign.

Where would you expect interest rates to be with inflation trending towards 1%, not very good GDP growth and unemployment at 7.5%?
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Re: Corporate profit margins - sustainable?

Postby Rick Ferri » Fri May 03, 2013 3:46 pm

Let's look down the road and assume that interest rates are higher when all this corporate dept comes due.

Borrowing and buy-backs cause the stock market valuation to rise. When this occurs, financing with stock becomes cheap relative to debt. Companies then issue more stock at higher PE multiples that they helped propel and use this cheap currency to pay off debt at maturity.

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Re: Corporate profit margins - sustainable?

Postby swaption » Fri May 03, 2013 4:02 pm

Rick Ferri wrote:Yes it has. This conversation was started because the OP linked an article that asked, "Are Corporate Profit Margins Abnormally Elevated Or Sustainable?" The answer is sustainable because of low interest rates and balance sheet reshuffling.


No, this conversation started because the original poster provided a link to an article putting forth a rationale for elevated profits (elevated as a percentage of GDP, which is prone to mean reversion historically). I thought the rationale, which relates to international earnings (i.e. those outside of GDP), was plausible. All that you have put forth is evidence that, like Larry, you have chosen to comment without actually reading the article.
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Re: Corporate profit margins - sustainable?

Postby Rick Ferri » Fri May 03, 2013 4:18 pm

The OP made the comment because of concern stocks are becoming overvalued. But We'll go you're direction. Stocks are valued based on earnings per share, not earnings margin. The global equity market is reflecting more earnings from high margin services and less from low margin manufacturing. Tech, comm and finance companies have higher margins than industrial companies and as such more earnings per $1 of GDP. What catalyst would change this in the future so that there is regression to the mean? I have no idea.

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Re: Corporate profit margins - sustainable?

Postby grayfox » Fri May 03, 2013 10:22 pm

Let's say that top line sales equals GDP. And let''s say that real GDP will grow at 2.5% p.a.
Top line sales for the aggregate economy should not be too hard to forecast.

Image

Of course there will be the occasional recession that interrupts the uptrend, but after the recession, GDP and Sales should go back to trend.

Net Profit After Taxes is just sales after you subtract out all the costs and expenses.

Image

Net Profit Margin is just Net Profit After Tax divided by Sales, or GDP. Profit Margin is the wild card. Right now it is 11%. Average has been 6%

Image

Some of the costs and expenses must have fallen a lot in order for for profit margins to be up from 5% around 2000 to 11% now.

Isn't labor cost the biggest expense for corporations? Reducing labor costs offers the biggest opportunity for reducing expenses and increasing profit margins. [I think outsourcing began on a small scale about 1990 and really took off since 2000. Both CPAT and NPM start taking off about 2000.]

Image

How to keep labor costs down?
1. Reduce the demand for labor through automation. Have 1 machine + 1 operator do what used to take 100 workers.
2. Increase the supply of available labor, so that many workers are chasing that one job. Find large pools of ready, willing and able workers.

Until Chinese workers start making $20 an hour, I would not hold my breathe waiting for mean reversion in Profit Margin.
Last edited by grayfox on Fri May 03, 2013 10:27 pm, edited 1 time in total.
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Re: Corporate profit margins - sustainable?

Postby umfundi » Fri May 03, 2013 10:27 pm

richard wrote:
Rick Ferri wrote:S&P earnings growth may slow, but earnings per share will not slow at the same pace. Companies are finding that leverage is a good thing because it keep earnings per share climbing. This week Apple is borrowing money at very low rates to buy back stock. Mircosoft did the same thing last week.The borrowing cost for both companies is lower than the dividend they're paying on common stock. Thus, issuing debt to buy stock increases cash flow while increasing EPS. Thank you Uncle Ben.

Apple's borrowing appears more about tax policy than leverage.

Apple has net current assets of about $30 billion as of March 30. From reports, a large part of its cash is overseas and the tax costs of repatriating the cash would be much higher than the cost of borrowing. The usual tax issue with leveraging to pay dividends is that interest costs are deductible to the corporation, while dividends (or buy backs) are not. That's been going on for quite a while.

Presumably Apple is buying back stock because it doesn't have enough useful projects to invest in compared to the cash flow benefits of a buy back. I'm not sure that's the most bullish sign.

Where would you expect interest rates to be with inflation trending towards 1%, not very good GDP growth and unemployment at 7.5%?

+1

Richard beat me to making the comment about offshore cash and taxes.

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