Companies around the world enjoyed especially high profit
margins in late 2012. But can this trend be maintained or is
profitability poised for a collapse that might threaten stocks
Toward the end of 2012, net profit margins of U.S. companies
reached historic peaks of 7 percent, about 140 basis points
above the 15-year average. International companies also posted
high margins of about 6 percent. Globally, net margins are
about 24 percent higher than the annual average over 15 years.
However, questions are being asked after margin expansion
stalled during the third quarter of 2012.
recent blog, I explained why weak pricing power if
it persists could make it harder for global companies to
meet earnings expectations this year. Despite meeting lowered
consensus estimates in recent reporting seasons, pricing power
remains scarce and companies have generally lowered their
earnings guidance for 2013.
Still, profit margins are complex. To solve the
profitability puzzle, we dissected global data on net profit
margins to find out whether they are predestined to revert from
record highs to long-term averages and to identify vulnerable
sectors or regions. This is the most important issue affecting
future earnings growth and it determines whether equities are
attractive in the longer term.
First, we looked at ebitda (earnings before interest, taxes,
depreciation and amortization) margins, which capture the
pre-tax benefits of pricing, leverage, productivity and
outsourcing. We found that the increase in ebitda margins for
nonfinancial companies accounted for only 20 percent of the
higher profitability. Most of the higher net margin came from
lower depreciation, lower taxes and lower interest costs
Historically, ebitda margins were adversely affected by a
collapse in demand, higher labor costs and prices of raw or
intermediate materials. Generally, we dont expect
developed economies to face a recession or significant
inflationary labor pressures in 2013 that would undermine
Interest rates are also unlikely to cause problems. Even if
rates increase from extreme lows in response to a stronger
economic recovery, it also means stronger sales are likely to
offset the burden of higher financing costs. Furthermore,
corporations have close to $2 trillion of cash, much of which
is invested in short-term fixed-income instruments, while debt
tends to be longer-dated. So higher rates would initially
Depreciation is the weak link in the profit margin chain.
This risk is really a function of capital spending, which
surged to $2.4 trillion in 2012. Industrial commodities and
energy accounted for half of the total, while the share of
consumer cyclicals and telecom declined. This mix is remarkably
similar to capital spending in 1983 the last cyclical
peak for natural resources (figure below).