CONCLUSION: When analyzed outside the vacuum of short-termism associated with quarterly reporting, US corporate profit margins appear particularly overstretched – from both an operational and a social perspective. This has potentially dire implications for corporate earnings growth over the long term.
In the note below, we explore the US corporate income statement with a long-term analytical lens. But before we dig into the graphical eye candy below, we must stress that it’s important to note that a handful of the metrics below are derived from our own calculations using a combination of BEA, BLS and Bloomberg data. In the process of compiling data for this analysis, we discovered that US corporate financial statement data is particularly scant at the macro level. That said, however, we were able to find and manipulate several readily-available data series into what we feel are decent proxies for a variety of key corporate operational metrics. As always, we’ll let you be the ultimate judge of our work; refer to the appendix at the bottom of this note for more details.
WHERE WE ARE IN THE LONG-TERM CYCLE
To say that US corporations are generating net income at historic rates would indeed be a very accurate statement. In fact, the ratio of US corporate earnings to Nominal GDP at year-end 2011 was 7.3% - good for the highest level since 1930 (data going back to 1929). Using the full data set, this ratio is 1.6x standard deviations above the long-term average. Using data from the modern/post-war period, this ratio jumps to 2.2x standard deviations above the long-term average.
From an operational perspective, US corporations have been increasingly productive; in 2011, US corporations produced an aggregated operating margin of 33% (as a percentage of gross profits; full explanation and methodology below) – an all-time high. As a result of this, and other key drivers, cash flowed through to the bottom line at a historically-elevated ratio of 12.8% of gross profit. That’s the highest ratio since 1930. Interestingly, as the chart below shows, ratios in the 10-12% range tend to be historic inflection points for rates of earnings generation.
HOW DID WE GET HERE?
Macro Drivers: The aggregated propensity of US corporations to generate earnings has benefited greatly from several key long-term macro drivers, including favorable regulation, easy money and secular weakness in the USD exchange rate(s).
From a regulatory perspective, both lower tax rates and a higher degree of tax write-offs have helped US corporations reduce their overall tax burden (27.5% in 2011) to levels unseen since prior to 1940 (with the exception of 2002). Though depreciation as a percentage of gross profits has fallen -100bps from its 2009 peak of 13.4% to 12.4% in 2011, that level of corporate write-downs is unseen outside of the Great Depression era.
From a cost of capital perspective, the following chart highlights the obvious relationship between US monetary policy and corporate interest payments. More specifically, net interest payments as a percentage of corporate EBIT have fallen to 10.5% in 2011 – down from a whopping 32.1% during the Paul Volcker era.
The following two charts highlight arguably the most important long-term trend that we think is critically important to contextualize: Weak Dollar Inflates the Inflation. The first chart highlights the strong inverse relationship between the market value of the USD and US corporations desire to chase easy revenues afforded by commodity price inflation by incrementally investing in mines, shafts and wells. Interestingly, US corporations haven’t been this addicted to US dollar debauchery since the last time we had a Federal Reserve Chairman condition market expectations for perpetual easy money (Arthur Burns). The second chart perfectly highlights this broad-based chasing of price/revenues (using commodity price data going back to 1981).
Micro Drivers: While the aforementioned long-term macro trends have all played an important role in helping US corporations generate earnings at historically-elevated ratios in recent years, we’d be remiss to ignore several key micro strategies that US corporations have implemented to buoy their bottom lines.
The first long-term trend we’d focus your attention on are the substantial cost cuts over the last ~10yrs. To that tune, US corporations have taken to paying employees less and investing less in equipment and software (as percentages of gross profit) over that duration – no doubt creating particularly lean operations in the process. At 58.7% of gross profit, the former is at an all-time low; at 13.1% of gross profit, the latter – which includes computers and software, industrial equipment and transportation equipment – has retraced to levels seen just before the DotCom Bubble.
Another trend on the labor front that has been fairly additive to US corporate profits is outsourcing – particularly in the manufacturing (think: Pearl River Delta) and service industries (think: Indian call centers). Over the last ~20yrs, US wage and salary payments to the rest of the world has tripled as a share of Nominal GDP.
Another major micro trend that US corporations have strategically pushed for and taken advantage of is economies of scale. Using BLS data for the total number of employees on nonfarm private payrolls, we were able to calculate the number of employees it takes US corporations to employ in order to generate $1B in earnings. That number has declined exponentially over time and, in 2011, reached an all-time low of 100,404 workers. While general inflation over the years has certainly played a role in this trend, the fact of the matter is that US corporations have consistently been able to squeeze out incremental profits from their existing headcount or generate new sources of earnings by acquiring human capital at perpetually slower rates.
The following chart, which shows the ratio of US corporations’ gross profit to their nominal labor expense per employee, is highly supportive of our previous claim. The plot essentially shows the number of turns US corporations are able to generate from their labor assets; as such, we find this to be an interesting way to measure worker productivity. Importantly, this metric reached an all-time high of 1.7x in 2011.
It's abundantly clear that US corporations have become quite effective at generating incremental returns for shareholders, having broadly implemented successful strategies at the micro level while also taking advantage of several noteworthy tailwinds on the macro level. That said, however, a fair amount of corporate earnings growth in recent years has come directly at the expense of the US laborer. While this is most certainly not the proper medium to discuss the morality of this trend from an ideological perspective, we will offer the following analytical thoughts on the potentially negative implications of the current setup:
Over the last ~30yrs, corporate executives, whose compensation is primarily determined by the value of their stock price, have increasingly paid out a smaller share of gross profits to employees in favor of boosting dividends (via making more cash available for the bottom line). This trend has correlated quite nicely with the dramatic ascension of the US equity market over that same duration.
As a result of increasingly heightened corporate executive pay (via dividend increases and stock market inflation), income inequality in America has widened to generational highs (data back to 1979).
What is perhaps misunderstood by consensus are the potential negative long-term political and economic implications of this trend. As the following chart from The Nation shows, domestic income inequality has surpassed levels unseen since just prior to the Great Depression. Interestingly enough, as the previous chart highlights, you'd have to go back to the pre and post Great Depression era to find US corporate dividend payout ratios that exceed the levels reached in recent years. While it would certainly be a stretch to say that income inequality was the dominant factor in bringing about the Great Depression, it would be equally as reckless to completely dismiss it as a contributing factor.
Refer to our DEC 8 note titled "SPREAD RISK: THE INVESTMENT IMPLICATIONS OF WIDENING INCOME INEQUALITY" for our extended analysis of this important political topic.
All told, when analyzed outside the vacuum of short-termism associated with quarterly reporting, US corporate profit margins appear particularly overstretched – from both an operational and a social perspective. This has potentially dire implications for corporate earnings growth over the long term.
APPENDIX: The GDP, Fixed Investment and BOP data in the charts above are rather straightforward and can be easily accessed via the BEA’s Interactive Data Tables. As mentioned before, however, we did have to make a few judgment calls to back our way into a handful of corporate operational metrics. In the following list, we attribute our calculations to their respective definitions in BEA Table 1.14:
- Gross Profit = Gross Value Added of Corporate Business (NOTE: while certainly not equivalent to corporate revenues, this was the closest L/T proxy for topline data we could find)
- EBITDA = Net Operating Surplus + Consumption of Fixed Capital
- EBIT = Net Operating Surplus
- EBT = Corporate Profits with IVA and CCAdj
- Earnings = Profits After Tax with IVA and CCAdj
- Depreciation = Consumption of Fixed Capital
- Net Interest Payments = Net Interest and Miscellaneous Payments
- Effective Tax Rate = Taxes on Corporate Income/Corporate Profits with IVA and CCAdj
Additionally, to the extent you’d like to conduct a similar analysis on your own, we found the following four guides helpful in getting us up to speed on the BEA’s definitions and data collection methodologies: