January 2012
Corporate profit margins: Will pricing discipline hold and….
is it enough?
Tom West, CFA, CAIA, Head of Equity Research
Throughout the last recession and into the slow, grinding
recovery, corporations have shown impressive pricing and
production discipline. On the consumer side, there has
been firm pricing on cars despite slow sales, while retailers
have been careful with inventory and have been closing
underperforming stores. The pricing of capital goods
has also been solid on average. As one CFO said, “Of
course we are showing discipline; there is no incremental
business out there. We’d just be cutting prices. As soon
as there is something to aim at, we’ll all start shooting.”
While discipline is indeed holding, investors need to be
mindful that overall corporate profit margins are nearly
at prefinancial crisis highs, which were in turn at 20-year
highs. And two major sectors, health care and financials,
are by no means out of the legislative and regulatory
woods. These and other risks are certainly known to the
market, but it is worthwhile to review the major sectors
and give some thought to what may or may not be fully
“priced in.”
Exhibit 1: S&P 500 earnings
Breakdown by sector and threats to profit margins
% of S&P
500 EPS
PE 2011E
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecom Services
9.1
9.5
15.1
14.3
13.0
10.1
19.6
3.6
2.3
15.1
14.9
10.1
11.9
11.3
13.2
13.0
11.9
17.3
Caution warranted on incremental profit margins
Potential relief from raw materials but pricing is an issue
Driven by production volumes, energy prices, and the dollar
ROEs not high, but possible regulatory and rate headwinds
Drug patent expiries, reimbursement pressured by austerity
Decelerating contribution margins, but healthy environment
Normal deflationary pressures on mature products
Supply-demand dynamics vary with commodity and geography
Will bandwidth demand drive enough revenues to cover investments?
Utilities
S&P 500
Non Financial, Non-energy
3.5
100
70.6
13.6
12.7
13.4
Stable, but more power demand would help
Exchange rates, Global GDP, regulatory environment
Possible threat to profit margins
Sources: FactSet, Columbia Management estimates, October 2011
There are pockets of strength and weakness in every
subsector and industry, so the threats to profit margins
listed in Exhibit 1 on the previous page represent very much
a broad brush view. The price-to-earnings (PE) ratios
move around with the mood of the market, but are a good
barometer of how much profit risk is priced in to the stocks.
Consumer staples and consumer discretionary:
Pricing power at its limit?
Consumers have done their part in this recovery, despite
limited wage growth and inflationary pressures. In
consumer staples, it appears as though many of the
brands have pulled all the pricing levers they can pull,
and seem to be at a point where they are in danger of
losing business to “private label” or store brands. Those
companies with significant sales outside the U.S. have, in
most cases, enjoyed a profit tailwind in 2011, as overseas
revenues and profits were translated into dollars. Dollar
strengthening could turn this into a headwind in 2012.
In consumer discretionary, autos provide a good snapshot
of the pricing situation seen in other areas. Even with the
relatively low level of auto sales, discipline on the part
of manufacturers is keeping average transaction prices
and profits firm. But it is hard to see an uptick in demand
without some promotional pricing as part of the bargain. It
is also hard to maintain those prices without exciting new
models, which in turn require investment in R&D and capital
equipment. It is not so much that margins are in immediate
peril; it is that the optimists may be overestimating
incremental profits by underestimating the cost to maintain
and grow sales. Management teams in the consumer sector
seem to be using the phrase “investing in price” more often.
Exhibit 2: Financials: A mix of threats and opportunities
Total assets, November 2011
Book value
$17,080,702
$1,888,541
Return on equity (2011E earnings)
6.8%
Price to book, November 2011
0.78
P/E
11.5
Sources: FactSet, Columbia Management estimates, November 2011
Despite the recovery in earnings through 2011, return on
equity (ROE) in the financial sector is still relatively low by
historical standards. While returns may trend up, investors
should be circumspect, or at least patient. The large
investment banks may have to divest some businesses
and resize for a new regulatory and economic environment.
This may mean a “shrink to profitability” program, which,
if done well, can mean EPS growth, but not overall profit
growth. Insurers will struggle to earn money on “the float”
if low interest rates continue to moderate returns on their
fixed-income portfolios. The longer interest rates stay low,
the greater the pressure on insurance company margins.
Price increases would be the only relief.
While global investment banks and insurers are facing
pressures from rates and market volatility, traditional
commercial banks (according to our estimate only 20%
of financial sector earnings) have shown pretty good
improvements in ROE due to modest loan growth and
favorable credit trends. This reflects some of the bright
spots in the economy and, if economic momentum stays
positive, indicates there is room for continued profitability
improvement into 2012.
The tech sector: Off-income statement R&D
and the perennial profit shift
There is a subtle but important profit margin dynamic that
is visible in several of the biggest technology companies:
The need to keep buying smaller upstarts to keep their
revenue growth and margins on track. This means that
internal R&D, carried as a cost on the income statement,
is augmented by acquisitions, which come out of the
statement of cash flows. Thus, a smaller-than-usual portion
of reported earnings will turn into cash for investors.
There’s nothing too insidious here; management teams will
admit how important these acquisitions are, and “acquired
R&D” has been around for a long time. But it does seem a
bigger part of the landscape and is probably a big part of
the low PEs we see in mature tech companies.
Shifts in profit pools to better mousetraps and deflation
that comes with mature products (especially hardware) are
The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.
part of the technology sector’s landscape. Even though
technology generates more earnings than any S&P 500
sector, it is not clear that the negative forces are any worse
than usual. Sure, volumes and profit margins are very
tough in PCs and laptops. But look at the strength in tablet
computers and smartphones. No wonder one company
constitutes 40% of the net income under the hardware
section of the S&P 500. While the largest search engine
has competition, it seems unlikely that the media sector will
claw back the search engine’s projected $9 billion in annual
profits any time soon. In short, it is hard to say the profit
outlook in technology is any better or worse than usual.
Health care: The patent cliff and
reimbursement vigils
The most obvious threat to margins in health care is the
coming wave of patent expiries or “patent cliffs” among the
major pharmaceutical companies. And while these expiries
seem well-known, it pays to be cautious. Wall Street has
a way of overestimating firms’ abilities to deal with
downdrafts in revenues. Fixed costs are simply more
persistent than many investors realize.
Certainly, pharma and biotech companies will develop
new and better drugs and therapies to replace the profits
lost to patent expiries, but this remains a major threat.
According to our estimates, pharma earnings are 44% of
S&P 500 health care earnings. Across all of health care,
there is a general fear that federal budget cuts will inflict
pressure on reimbursement rates and pricing across
essentially all segments of the healthcare sector.
Industrials: Deceleration in incremental
margins, but pricing outlook looks firm
The recovery in demand for capital goods has been led
by developing markets, while North America has not
fully recovered. U.S. industrial production is still slightly
below trend and well below the prior peak in 2007. The
sharpest increases in margins came a couple years ago as
companies cut costs and volumes started to recover. But
incremental margins in 2012 are likely to remain subdued.
That said, the pricing and margin environment does seem
better in capital goods and general business-to-business
than in the consumer sector. The explanation for this is
hard to pinpoint, but several factors come to mind: supply
and production have been well-managed in capital goods;
businesses seem to have more cash than consumers;
capital expenditures receive favorable tax treatment in
the United States; and low interest rates facilitate the net
present value of capital put in place.
Conclusion
There appears to be more downside risk to profit margins
than there is upside opportunity. But the multi-year
discipline streak is unlikely to break down suddenly.
Investors should temper expectations of profit growth
through margins and be careful about paying historical
average PE multiples from times when profit margins had
more opportunity to expand.
Important disclosures
The views expressed are as of the date given, may change
as market or other conditions change, and may differ
from views expressed by other Columbia Management
Investment Advisers, LLC (CMIA) associates or affiliates.
Actual investments or investment decisions made by CMIA
and its affiliates, whether for its own account or on behalf
of clients, will not necessarily reflect the views expressed.
This information is not intended to provide investment
advice and does not account for individual investor
circumstances. Investment decisions should always be
made based on an investor’s specific financial needs,
objectives, goals, time horizon and risk tolerance. Asset
classes described may not be suitable for all investors.
Past performance does not guarantee future results and
no forecast should be considered a guarantee either.
Since economic and market conditions change frequently,
there can be no assurance that the trends described here
will continue or that the forecasts are accurate.
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