Why GAAP Matters: Real Profit Margins Tumble To 10 Year Lows
Over the past several months, the topic of GAAP vs non-GAAP number (and specifically the near-crisis gap that has formed between the time series) has gotten increasingly prominent attention by both regulators and the mainstream media. But while attention has focused on the difference between GAAP and non-GAAP earnings, and EPS, few have paid attention to intermediate financial data, such as profit margins. Perhaps this is a substantial oversight, because as the following charts from Deutsche Bank show, on a GAAP basis, trailing 12 month GAAP margins have now tumbled to the lowest level since before the global financial crisis; in fact the last time GAAP net margins were here was some time in 2006, when the S&P was trading about 700 points lower.
In other words, profit margins are not only sliding on a non-GAAP basis, they are crashing if observed on an unadjusted, "unaddbacked", un-proforma GAAP basis. This is important because as we first wrote last October, five of the past six times corporate margins dropped by a similar amount, the US ended in a recession. Conveniently, in the past week, Barclay's Joanthan Glionna issued a note reminding readers of precisely this. Here is what he said.
Late-cycle rallies that last are supported by expanding profit margins. This was clear in 1988, 1998, and 2006. So where do profit margins go from here? We see 40bp of upside, but not much more than that and certainly not a new record. We expect margins will recover over the next two quarters because oil prices are now above $40 per barrel and that should alleviate operating distress and impairment charges from the energy sector. Our upside case envisions S&P 500 profit margins increasing from 8.8% back to 9.6% in a scenario of $55 oil.
But outside of the energy sector we see scant improvement forthcoming. It is true that economic conditions are stable and the fears of a recession that prevailed during the first few months of the year are gone. The dollar rally has stalled and even manufacturing data looks healthier. But there are a few convincing reasons to believe we are past the cyclical peak for profit margins. First, top-line growth is too slow. Second, wages are rising. Third, margins in the all-important tech sector are falling.
Slow growth hinders possible margin expansion. When modeling earnings, revenue growth and changes to profit margins are often considered separate. They are not. Because of operating leverage the best predictor of the direction of profit margins is top-line growth. When growth is strong, margins expand. Costs just need to be contained. In contrast, when growth is absent margins must be boosted through cost cuts, which are more difficult to enact. Global economic data are providing a strong indication that top-line growth for America's largest and most international companies will remain subdued. We forecast 2% revenue growth for the S&P 500 in 2016.
The biggest secular change in profit margins has been the decline in labor costs in relation to revenue. We have discussed this frequently in prior reports but the portion of gross value added paid out in compensation expenses by non-financial corporations have declined from 66% to 60% over the last 15 years. This trend is unlikely to continue. Wage growth has picked up. The Bureau of Economic Research’s data show that compensation costs at nonfinancial corporations are increasing significantly faster than sales. Considering that labor is the largest aggregate expense, a continuation of this mismatch would surely lead to lower profit margins. To be sure, we do not expect compensation costs to continue growing faster than revenue, but it is a risk.
Lastly, we would highlight the declining profit margin of the technology sector as a downside risk for the profit margin of the S&P 500. Recall, the technology sector is responsible for 19% of the S&P 500's net income. Over the last few years the profit margins of technology companies have soared to great heights. The profit margin of the sector reached almost 18%, which is double its long-term average. But, the future may be less bright as the net profit margin of the sector has been declining for more than a year.
Finally, putting it all in visual context:
It is important to note that profit margins climbed to a new high during each of the prolonged late-cycle rallies we analyzed. This is shown in Figure 8. We believe this additional expansion in margins played a critical role in extending the bull markets of these periods. But we do not envision the profit margin of the S&P 500 reaching a new high again during this business cycle. The contraction has been too severe and even with a recovery in the energy sector we believe a rational upside case for margins is 9.6%, which remains below the peak of 9.9% reached in 2014.
Now the punchline: all of the above assume non-GAAP margins. If one uses "real" data, which factors in actual revenues and costs, what one gets is a profit margin of just over 8%, or a drop of nearly 200 bps from the recent highs, back to a level last observed when the S&P was some 700 points lower. More importantly, there has never been a GAAP margin drop as steep as this one, without a recession following immediately after.
As for Barclays' contention that margins rebounding to sub all time high of 9.6% (non-GAAP), the only way that can feasibly happen is if the price of crude returns to $80 or higher, or companies lay off millions to cut overhead and boost margins, both outcomes that would have a substantially adverse impact on the broader consumer economy.
So stocks or the economy: Pick your non-GAAP poison.