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What Happens if Corporate Profit Margins Start to Decline?

Factors that support sustained high margins are slated to reverse

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John Kinsellagh
Apr 05, 2019
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Before 2018 drew to a close, those analysts not mesmerized by the steady and considerable rate of profit margin growth were already adjusting their first-quarter and annual 2019 margin projections downward. After record-setting increases in 2018, several factors will coalesce to break the favorable decade-long trend that has supported historically high margin levels.

Some of these factors are already working their way to the corporate bottom line, crimping profits. Unprecedented low unemployment has increased the bargaining power of employees — this is despite the long-term decrease in the number of employees that are union members. The past several years have seen wages rise on a percentage basis that is the highest in 30 years. According to the U.S. Labor Department, average hourly wages in February were 3.4% higher than a year earlier, sparked by low and declining levels of unemployment. The February figures represent the fastest rate of wage growth in over a decade. The trend had already started to pick up speed in 2018. That is one reason why analysts slashed their forecasts for earnings growth this year.

Analyst are anticipating another strong month of wage gains when the Labor Department releases the March jobs report on Friday. This cost increase, in and of itself, will have a negative impact on margins. The reality is employees tend to be the biggest beneficiaries during the tail end of a long economic expansion.

Energy costs have increased as crude oil prices have rebounded substantially from their lowest levels. The rise in prices has been rapid and steep. U.S. crude oil futures increased 32% in the first quarter, logging their largest one-quarter percentage gain since 2009. A combination of continued wage growth, low unemployment and diminishing revenue due to a slowdown in economic growth would impact labor-intensive corporations, such as consumer discretionary and industrial companies, especially hard.

Many investors fail to realize the heady and unprecedented growth in corporate profits over the past two years was possible only because companies had a strong tailwind at their backs: lower tax rates, increasing market share, relatively stable labor costs and low interest rates. Although first-quarter profit margins have decreased from their inordinately high levels of 2018, according to data from FactSet, net margins for of the S&P 500 companies hit 10.7% in the fourth quarter—their highest level on record since 1999. Surging corporate profits have been responsible for the decade-long bull market run.

Corporations have already squeezed out all the benefits that will inure to their bottom lines from favorable trends. According to the U.S. Commerce Department, taxes came to about 11% of pretax corporate profits in the first three quarters of 2018. By comparison, in 2000, the tax burden was approximately 32%. It seems highly unlikely corporate taxes will go any lower; should Democrats capture the presidency and Congress in 2020, it is almost a certainty that rates will go up as concerns about growing income inequality become more heightened.

Will companies be able to pass these increased costs on to consumers? The growing presence of the online (and increasingly, brick and mortar) Amazon (

AMZN, Financial) will crimp many companies' ability to transfer these increased expenses to their customers. This will be particularly difficult for some companies in certain sectors, such as the large wholesale food sector. Amazon currently continues to disrupt the market by establishing base services, product and pricing standards to which consumers have now grown accustomed.

Amazon began offering delivery to customers as well as in-store pickup, setting off a chain reaction as other food companies in the notoriously thin-margin business were forced to offer similar services to retain their existing customers as well as lure new consumers. Currently, the cost of providing delivery services to customers is expensive; securing reliable drivers on a sustained basis is difficult due to the, at times, paltry sums earned by some drivers in some geographic areas. Few grocers are slated to eliminate this service, though, as the Whole Foods-Amazon giant always looms in the background.

This state of nature, dog-eat-dog environment is going to undoubletly impact margins in this sector. How many grocers have the ability to sustain losses on these tertiary services like the $900 billion market cap Amazon?

Ever-rising margins have helped fuel the bull market over the past decade. Going forward, coroporatons will no longer be operating in the benign environment of low taxes, increasing market share, relatively low labor costs and stable transportation costs.

That favorable trend is at its apogee and profit margins can head in only one direction only. As Heraclitus said, “All flows, nothing abides.” Investors should brace themselves for the dramatic changes ahead that will create a more challenging market environment.

Disclosure: I have no positions in any of the securities referenced in this article.

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