Companies’ profit margins are on the way to a rebound. All it would take for it to continue is for the economy to remain stable.
Margins have diminished over the past couple of years, making it difficult for companies to boost earnings on the bottom line. While the aggregate operating profit margin for the
S&P 500
was 16.75% in 2021, according to FactSet, it dropped to about 16.1% for each of the next two years. The cause was rising costs, a result of not only of the broader inflation the Federal Reserve is trying to stamp out, but also the soaring commodity prices that resulted from Russia’s war against Ukraine.
This year, analysts except S&P 500 companies to produce a 17.1% operating margin.
The inflation data show why. The consumer price index, which measures the prices consumers pay for goods and services, has been rising at a touch over 3% year over year for the past six months. The compares with gains of about 1% in the producer price index—a measure of what companies pay for materials and services—for most of that time.
That is because commodity prices haven’t soared the way they did a couple of years ago, and companies are no longer rushing to buy new inventory as they did when supply chains were unsnarling themselves after the pandemic. The more moderate rise in the cost of goods means firms’ gross margins, the percentage of sales that companies retain after subtracting the cost of goods sold, have increased.
Walmart,
which reported its fourth-quarter earnings on Tuesday, is an example. Sales rose 5.7% from a year earlier to $173.4 billion as prices increased in many categories, especially groceries. But the cost of goods sold rose just 5.1%, boosting the gross margin to 24% from 23.5% in the same period the year before. With other expenses, such as for pay and advertising, up by only a few percent, the operating profit margin expanded to just over 4% this year from a touch above 3% a year ago. Operating profit rose by double digits.
Other consumer companies are in the same boat. The median gross margin for U.S. consumer discretionary companies has recently risen to roughly 36% from just under 35% a little more than a year ago, according to Trivariate Research.
The bottom line is that “gross margins will expand,” wrote Trivariate’s Adam Parker in a Sunday research note.
That will help operating margins, but it doesn’t guarantee that they will increase. While gross margins expand as long as the price of a product rises faster than its cost, operating margins reflect not only the cost of goods sold, but also expenses such as labor, advertising, and depreciation of equipment.
Operating margins will rise if revenue increases faster than the cost of goods, plus those related expenses. Selling a bigger volume of products can make the difference.
That depends on demand for goods and services. Consumers need to continue to increase the number of products they buy, which is something they have seemed willing and able to do of late.
If, however, the economy falters, margins may not increase so much. If price increases aren’t so robust or if sales volumes get hit too hard—two events that could happen as higher interest rates eat into people’s finances—that will hurt margins.
That’s why so much depends on the resilience of the economy and consumer spending. The key to the outlook for margins and profit growth is when the Fed will decide it has made enough process in reining in inflation to cut interest rates and keep people shopping.
Write to Jacob Sonenshine at [email protected]
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