One of the biggest — but most under-reported — business stories of the last few years has been the stunning recovery in Net Margins.
The economy has remained sluggish, and that has meant that revenue growth has been slow. In 2009, for the S&P 500 as a whole, revenues fell by 6.75%, yet total earnings actually increased slightly. Of course, most of the improvement in earnings came from the Financials not going bankrupt at quite the pace they did in 2008, particularly in the fourth quarter of 2008.
In 2009, revenue growth again turned positive, and it looks like for the year as a whole, revenue growth will come in at 4.65%. That, however, pales by comparison to the awesome recovery we have seen on the bottom line. Total net income for the S&P 500 is expected to be 41.2% higher in 2010 than 2009, according to the bottom up consensus.
For 2011, the current expectations are for revenues to increase by 5.91%, while income grows another 15.9%. In other words, net margins are going to be higher again, but that the growth rate in them is expected to slow. More specifically, the net margin for the S&P 500 as a whole (total net income/total Revenue) is expected to rise from 5.91% in 2008 to 6.43% in 2009 to 8.82% in 2010 to 9.49% in 2011.
Much of that improvement, however, comes from the financial sector, and let’s face it, a big part of the revenues in the financial sector are flakey. When interest rates fall, so does the amount of interest received, but interest expense also falls. The income statement of a bank or an insurance company looks significantly different from that of an industrial company.
Certainly the recovery in financial net margins is impressive, rising from a negative 8.51% in the disaster that was 2008, to an expected 15.44% next year, and trailing only the tech sector in terms of net margins. A better sense of what is going on can be found if we exclude the financials.
Ex-financials
In that case, the story changes a little bit, but not that much. While the economy was in recession for all of 2008, the wheels didn’t really start to fall off until the fourth quarter, after the Lehman meltdown. Clearly the effect of the meltdown was felt as much on Main Street as it was on Wall Street (arguably much more, as Main Street did not go back to paying outrageous bonuses right away; then again, it didn’t get the same level of federal largess that Wall Street did).
There was a bit of a lag between the total freeze-up of the financial system and earnings dropping sharply for Main Street. While the financials posted their biggest losses/drops in net income in the fourth quarter of 2008, it was in the first half of 2009 that Main Street saw the biggest hit to earnings.
Thus, net margins excluding the financials dropped from 7.68% in 2008 to 6.49% in 2009. However, the damage is now being healed extremely rapidly. This year, net margins are expected to be 9.07%, comfortably exceeding the 2008 level, with a further climb to 9.88% next year.
Ten of the 16 Zacks sectors saw their net margins decline in 2009. The sharpest drop in net margins came from the energy sector, where net margins dropped from 9.13% in 2008 (when gasoline prices were over $4.00) to just 6.09%, a drop of 3.04 points.
Close on its heels was the materials sector, where margins dropped from 7.20% down to 4.47%, a decline of 2.73 points. There the story was much the same, falling commodity prices in the last half of 2008 and very low commodity prices (oil is a commodity, after all) in 2009, particularly in the first half.
While energy net margins are expected to recover this year and next, they are not expected to come close to matching their 2008 level. The same is not true of materials, where net margins are expected to hit 7.57% in 2011, comfortably above the 7.20% level of 2008.
Strength Throughout
All of the sectors are expected to have higher net margins in 2011 than in 2010, while 13 are expected to post higher net margins in 2010 than in 2009. In 2009, seven sectors had higher net margins than in 2008. Overall, 11 of the 16 sectors will have higher net margins in 2011 than in 2008.
The second table shows the percentage of total revenues the sector comprises of the overall S&P 500. It is noteworthy that the decline in net margins for the energy industry came as its share of total revenues declined dramatically in 2009, falling from 17.22% to 12.10%. While by next year energy’s share of total revenues is expected to rebound to 14.78%, that is still well below its 2008 revenue share.
The same pattern is evident for materials. Tech continues to have the highest net margins, as they have for each of the four years, and they have grown in each year. Business service also has high net margins that have grown each year.
While the economy might still be sluggish, corporate earnings are not. The improvement on the bottom line has been much better than that of the top line. Business has been able to cut costs by more than enough to make up for the sluggish revenues.
Of course, a big part of those costs have been payroll, and there has been a reluctance on the part of businesses to hire (at least here in the U.S.), even when revenue has picked up. They have also not been doing much in the way of giving raises. Why should they, when the labor market is so soft and employees have so little bargaining power? As a result, almost all of the gains to productivity have accrued to the owners of capital, rather than being shared with labor, as has historically been the case.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
