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Company margins exceed pre-pandemic levels as revenues rebound faster than costs

U.S. companies are learning to do more with less.

After slashing expenses in the first two quarters of 2020 in an attempt to mitigate slumping revenue, S&P 500 companies began hiring again as they reopened premises in the third quarter. However, costs rose more slowly than revenue in the third quarter, helping push margins for investment-grade-rated companies to their widest since the third quarter of 2018.

The median operating expenses-to-total revenue ratio for investment-grade companies in the S&P 500 excluding financials fell from 84.7% in the second quarter to 83.0% in the third quarter. The ratio was 0.9 percentage point lower than it was before the pandemic made itself felt in U.S. balance sheets.

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Non-investment-grade companies improved their operating margins in the third quarter by even more than their investment-grade peers. Their median operating expenses-to-total revenue ratio fell to 91.8% in the third quarter from 95.0% in the second quarter, still slightly above the third quarter of 2019's 90.9%.

The question for many investors is whether this represents a permanent shift to leaner operations or whether spending will eventually catch up with earnings as the recovery accelerates.

"Margins look poised to be fairly strong in 2021 for the average company. In fact, in the third quarter, the net profit margin for the median company in the S&P 500 was slightly higher than the level in third quarter of 2019," David Lefkowitz, head of Americas equities at UBS, wrote in an email.

"While these trends are encouraging, it may be a bit too early to know for sure if some of the cost reductions are sustainable."

Cost cutting has been the main driver of the improved margins for investment-grade companies, which slashed operating expenses by 9.1% in the first quarter and a further 8.2% in the second quarter, to $1.94 trillion.

Even after they increased in the third quarter, by 9.8% to $2.13 trillion, they were still 1.2% lower than a year earlier. Non-investment-grade companies relied more on increased revenues to balance a 6.7% year-over-year increase in operating expenses in the third quarter to $590.17 billion.

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Business travel savings

"Cutbacks in business travel are clearly supporting margins right now but some of these costs will likely come back as the economy normalizes," said Lefkowitz.

"But also bear in mind that many consumer-facing businesses such as retail and restaurants have incurred higher expenses during the pandemic in order to operate more safely. Many of these costs will fall off this year."

There may be more cost reductions in the pipeline too, according to Michael Kelly, global head of multi assets at PineBridge.

"During this period most companies had taken a pledge not to really reduce staff and I think that pledge more or less runs out at year-end. I wouldn't be surprised to see some moderate trimming of staff," Kelly said in an interview, noting that companies in certain sectors will also seek to reduce their office space.

Energy revenue lags

Non-investment-grade utilities have done best at improving their margins, cutting the expenses ratio by 4.8 percentage points in a year to 76.9%. Investment-grade healthcare companies were the next best, cutting 4.7 percentage points to 78.4%, while the average ratio for non-investment-grade-rated consumer staples companies dropped 2.6 ppts to 89.5%.

There were also significant declines in the ratio for the consumer discretionary, investment-grade materials, non-investment-grade IT and investment-grade industrial sectors.

Energy stands out as the sector that has found it hardest to balance the books.

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Oil was among the first asset classes to take a major hit to prices as the virus emerged in China, with shutdowns reducing demand from the world's largest importer of oil heaping misery onto a sector already struggling with oversupply.

In the face of collapsing revenues, U.S. investment-grade-rated energy companies cut hard, shutting down operations and laying off employees. Operating expenses fell from $266.31 billion at the end of the fourth quarter to $233.28 billion by the end of the first quarter, and were slashed further to $128.4 billion in the second quarter as the pandemic hammered economies across the world. Further cuts were made in capital investment, which is accounted for separately from the day-to-day running costs.

As the economic recovery took hold in the third quarter and demand for oil increased, operating expenses rebounded to $179.04 billion, still 29.2% lower than they had been a year earlier, while the ratio of costs-to-revenues fell from 105.2% in the second quarter to 95.6% but remained 9.5 percentage points higher than a year earlier.

The situation was worse in the non-investment grade-rated energy sector where companies were unable to cut costs in fact they rose 2.9% in the 12 months to the third quarter of 2020, contributing to an 11-percentage-point increase in the ratio to 100.7%, the highest of any sector at the end of the third quarter.

But with oil prices on the rise as the economy recovers that ratio is likely to fall, while longer term Kelly expects companies will be able to continue squeezing costs.

He said: "We've been looking for a peak of margins and profitability for about 30 years now and it just never happens. There's a long graveyard of people predicting a peak."