The concept of “margin” has numerous forms, but its essence captures the portion of revenue a company gets to keep after it deducts costs to produce a good or a service. The higher, the better. Margins and the direction in which they move are strong indicators of a company’s financial health. Expanding margins bode well for the future and vice versa.
Corporate margins in the US have been in a secular rise since the 1980s and on an uninterrupted ascent for the last decade.
Below we focus on some of the main contributors to this trend.
- Technology and automation have perhaps been the largest factors to this expansion, as human labor is gradually being replaced by automation. This has suppressed costs due to overall technology cost deflation, improved processing capacity, reduced propensity for human error, and elimination of costs associated with human labor (benefits, pensions, insurance, etc.).
- Lower overall level of government intervention in business has allowed for consolidation of power, with bigger companies getting bigger and amassing more financial, political and bargaining power. Perhaps with the exception of banks, most sectors have benefited from lower levels of oversight, less M&A/antitrust scrutiny, and more business-friendly governments both in the US and abroad.
- Reduced impact of organized labor and collective bargaining power in the last three to four decades has made it easier for companies to control labor costs. The US, having some of the most flexible labor laws in the world, drives this trend, allowing companies to squeeze an even greater benefit from labor compared to peers.
- In an attempt to stimulate the global economy after the Global Financial Crisis (GFC), a variety of policy maneuvers have created easy and inexpensive access to capital to expand corporate balance sheets, fund investments, reduce share count through repurchases, acquire high-growth peers, keep debt service costs low, and increase sales and margins.
The net effect of these trends has been an extended bull market and strong margin expansion, most prominently observed in the US. Not only have margins consistently expanded since the GFC, they have also surpassed prior peaks to reach new highs.
Revenues and costs are the two main inputs to margins. In a strong economic environment backed by a healthy consumer and a robust demand for goods and services, most companies can grow sales faster than costs because not all costs grow proportionately to sales. That is because some costs are fixed and stay stable regardless of sales. When that happens a company has positive operating leverage, which results in higher margins. The bigger the fixed portion of costs, the more operating leverage a company enjoys when it grows, as it spreads growing sales over fixed costs. However, operating leverage works the same in the opposite direction. When sales slow, a large fixed cost base becomes a burden, as it has to be spread over fewer units sold. Thus, in a weak macro/demand backdrop with slowing sales, the higher the operating leverage, the more pain a company has to endure.
While the degree of operating leverage varies across industries and companies, all companies have both fixed and variable costs and thus some exposure to this dynamic. As a result, in a decelerating sales environment, few will escape the adverse effect of shrinking margins.
At this point in the business cycle, it is prudent to ask whether the current ascent can continue and outline some factors that may interfere with the secular rise of corporate margins.
Confidence levels of various economic constituents combine to form the most important driver of sales. Confidence in the future is what drives consumers to spend, businesses to hire and invest, and governments to undertake large infrastructure projects. At the end of 2018, US consumer and small business confidence, two key measures of demand strength, both reached historic highs, supported by a strong economy, low energy costs, corporate and individual tax cuts, and one of the lowest interest rate environments in history.
The ISM non-manufacturing survey, another reliable macro indicator, set an all-time high at the end of the year. The US economy is near full employment with record lows in the unemployment rate and jobless claims. All the while inflation remains benign. It is hard to envision economic activity getting much better. A potential slowdown in the US is bound to have a pronounced effect on global demand and sales growth. Since the start of the year and as the boost from tax reform wears off, the economic picture has become less robust. Confidence levels have retreated modestly. Construction spending, auto sales, and composite PMIs have weakened. The bond market has flashed several warning signs with flattening of the long end of the curve, while the middle of the curve inverted, a historic precursor to slowdowns. Government and corporate debt levels stand at all-time highs, while central banks remain accommodative with global rates not far from zero. With substantial stimulus already in place, there is little slack in the system and fewer tools to sustain growth through additional intervention. In the meantime, the US is engaged in trade wars with long-term partners, clouding business confidence and economic outlook.
Outside the US, the economic picture has not been quite so robust. We have seen a prolonged slowdown in China due to deleveraging, which has affected trading partners like Japan and Europe. The rise of protectionism has expanded outside of the US, with Brexit in the UK, unrelenting protests in France, extended budget battles in Italy, and consolidation of power in Turkey, all potential detractors to synchronized global growth.
While none of these factors is imminently indicative of a material downturn, they are highly suggestive that the best times might be behind us, and corporate revenues may be a much smaller contributor to margin growth.
- De-globalization – The movement towards globalization is grounded in the theory that global trade benefits all partners involved. The principle of comparative advantage holds that if a country is able to produce a good at a lower relative opportunity cost versus others it will benefit both itself as well as its trading partners by doing so. This underlying foundation of free trade is being questioned by protectionist movements around the world calling for production and labor to retrench back within national borders without regard for costs and efficiencies. This can have positive effects on job creation within national borders. However, shifting production to sub-optimal locations is likely to increase costs. Higher costs can be absorbed by companies, thus hurting margins, or be pushed to consumers in the form of higher prices, which lowers sales. The net cost of such shift could exceed any benefit created by employment growth.
- Tariffs – Government imposed tariffs are typically borne by the end consumer of imported products as they eventually increase the final price. For instance, if country A makes and exports widgets to country B, and B imposes tariffs on A, then the final price of widgets in country B is higher. Consumers in country B are now faced with higher prices and will likely buy fewer widgets, thus hurting sales. The manufacturer may choose to absorb the tariff cost so the price to the consumer is unchanged but in that case, margins will shrink. Tariffs are usually implemented to increase government revenues or as retaliatory measures, albeit at the expense of higher consumer prices and/or lower sales. Recently the US implemented tariffs of 10% on $200 billion and 25% on $50 billion worth of Chinese goods, with the potential to do so on imported German and Japanese goods. A potential escalation of tariffs on China will be a hit to US GDP of roughly -0.5% annually according to Strategas Research, while the Taxpayers Union estimates that such escalation will offset ~25% of US taxpayers’ savings expected from the 2017 tax law between the years 2019 and 2023.
- Labor – While historically a strong labor market has been positive for the economy, it goes hand in hand with rising wages. Wage growth is positive for consumer confidence and spending, but it is an added burden to corporate margins. Wage inflation currently stands at 3.4%, while unemployment rate is at 3.6%, the lowest in nearly five decades. As unemployment falls, wages will eventually need to increase to supply companies with qualified labor, a relationship known as the Phillips Curve. The tight labor market has a disproportionately negative impact on small businesses, which employ nearly 50% of the private workforce in the US. In the Q4 2018 NFIB survey, one-third of respondents indicated labor costs or labor quality as the single most important problem affecting their business.
- Capital Expenditures (Capex) – Capex is critical spending that reinvests money back in the business to sustain growth, to improve products/services, to boost productivity, and to invest in promising new initiatives. In the last two decades, as part of vast sweeping corporate cost cutting efforts to enhance margins and bottom lines, capex has shrunk as a percentage of cash flow and currently stands at a historic low as a percent of corporate cash flows.
Underinvestment in capex can have negative implications for sales growth, market share, and ability to compete effectively in a rapidly changing market. Companies that have fallen behind on the investment curve and are starting to see the adverse effects of restrained capex will need to step up spending.
- Regulation – Recent years have seen a more relaxed regulatory environment and less intervention across industries with technology being a prominent example. The resulting consolidation of power has served to boost pricing power and limit competition as best exemplified by the FAANG cohort, which seems destined for increased oversight. In the aftermath of its Cambridge Analytica scandal, Facebook has dramatically reduced its margin expectations as its costs have skyrocketed due to heavy hiring, fines, and potential regulatory costs. Similarly, Alphabet (Google) has been in the crossfire of privacy issues in Europe. After political pressure, Amazon recently implemented a companywide minimum wage and is likely to get much closer antitrust scrutiny. Apple has repeatedly been in the headlines with anti-competitive app store practices and rates.
The Outlook for Margins
Given the rather complex inputs to corporate margins, both magnitude and direction from here are hard to pinpoint. However, given the current data regarding the state of the consumer and the economy, it seems it will be difficult for these indicators to continue to improve from current peaks in real terms.
As discussed, these historic highs were not achieved without abundant help from fiscal and monetary stimulus worldwide, including record low interest rates, ongoing quantitative easing through central bank asset purchases, a net decline in oil prices and corporate and consumer tax cuts. It then stands to reason that the fading of these support factors may signal the end of revenue momentum as growth will be harder to generate going forward.
The cost side of the margin equation is less straightforward because of the role of technology and automation. While outsourcing benefits have declined due to trade tensions, rising global labor costs, and lower taxes in the US, technology continues to bring improved efficiencies. New technologies, heavier reliance on industrial robotics, and ever more prevalent deployment of automation and artificial intelligence (AI) across value chains, logistics, and distribution networks have served to suppress cost inflation.
If we are directionally right on sales slowing, this will leave cost reduction as the sole contributor to margin growth. Considering the cost pressures discussed above, technology will have to shoulder an even larger burden going forward relative to the past. This may well turn out to be feasible and a needless worry. However, we struggle to find compelling evidence that technology and automation benefits will ramp up fast enough to fully offset a potential slowdown in sales and an acceleration in some key cost inputs. Lastly, such impacts will not be distributed equally across industries and companies with areas like autos and manufacturing likely to benefit disproportionately versus the more service-heavy educational/healthcare space.
We think it will be hard for most companies to expand margins from current peaks. At least in the near term, the revenue outlook is not likely to improve materially from current levels on an inflation-adjusted basis. At the same time, the total cost input to our margin framework should continue to escalate as it absorbs some new pressure points discussed earlier. Barring a major increase in the ability of technology and automation to hold down cost inflation, it is difficult to envision further material margin expansion across market constituents.
Despite this more challenging market environment and the mounting margin threat, we remain sanguine, albeit watchful on equities. One aspect that offers comfort is that valuations remain broadly in line with history. More importantly, this environment presents unique opportunities to differentiate our stock selection approach by carefully studying secular themes, margins, and cost structures across various companies and industries and to select the long-term winners.
 This paper will focus on operating margins since those are the most reflective of core business health and are less subject to manipulation by non-core business or accounting items.
 The survey began in 1997.
 FAANG = Facebook, Apple, Amazon, Netflix, and Alphabet’s Google