U.S. public companies responded to the economic shock caused by the COVID-19 pandemic by cutting costs in the first half of 2020, but the reductions in areas such as payroll and rent have not been enough to prevent operating expenses rising as a percentage of revenue.
Among U.S. companies with a credit grade from S&P Global Ratings, excluding financials, revenues fell by 3.7% in the first half of the year, while operating expenses fell just 2.2%. That pushed up the average operating expense ratio in the second quarter to 86.8% from 85.3% in the final quarter of 2019, according to an analysis by S&P Global Market Intelligence.
Having increased operating expenses in the first quarter of 2020 by 3.9%, efforts to protect balance sheets resulted in companies reversing course in the second quarter with an 8% cut in expenses, meaning in the first half of the year expenses were down 2.2%. But as revenues reversed a 3.2% gain in the first quarter into a 10.3% fall in the second quarter, the ratio rose from 85.9% to 86.8%.
"If you can’t keep costs under control it has a huge impact on earnings," Peter Dixon, senior economist at Commerzbank, wrote in an email. "The operative word here is control — you have a lot more direct control over operating costs than revenue growth, and can vary them relatively quickly."
For some sectors, the impact of the coronavirus could have lasting impacts that require structural changes to businesses. For others, a recovery in revenues as economies rebound from the effects of the coronavirus will mean significant cost-cutting operations will not be required.
"The ratio can be misleading at times like this when revenue growth is impacted by one-off factors, so companies will not necessarily react to a rise in the cost ratio if they expect revenues to recover," Dixon said.
In the first half of the year it was energy companies that did the most to cut costs.
No fat to trim
Investment-grade energy companies slashed operating expenses by 6.7% in the first quarter and a further 46.5% in the second quarter to leave day-to-day cost of operations 47% lower than at the end of 2019.
The cost reduction was not enough to stop the operating ratio rising to 105.2% at the end of the second quarter from 90.6% at the end of 2019.
Shale oil and gas producers had already undertaken significant cost reductions in recent years to be more competitive and had little fat left to trim. Instead costs were cut by lowering production with more than 100,000 jobs cut in the U.S. oil field services sector, leaving the total number of employees in August down 15.5% year over year at 660,770 people.
"In 2015-2016 energy companies, in shale at least, really cut costs and they did this through squeezing supply chains, improving drilling techniques and drilling their best, most efficient acreage. This time around they don't have a lot of room to do that," Thomas Watters, sector lead for oil and gas at S&P Global Ratings, said in an interview.
The industry's struggles have occurred despite a supportive regime in the White House, and the prospect of a Democratic victory in the Nov. 3 presidential election race would likely be another pressure point for the struggling sector.
"A [Democratic presidential nominee Joe] Biden administration could mean a higher cost profile for many of these producers. There would be tighter methane regulation and Biden has talked about no new leasing on federal acreage," Watters said, noting that when companies have to tap lower quality oil fields, margins will be squeezed further. "They're running as thin as they can. We'll probably see productivity go down and costs go up as they will get less bang for their buck."
Consumer discretionary companies also saw a rise in their operating expense ratio in the first half of 2020 of 6.8 percentage points in the investment-grade segment and 5.5 points among non-investment-grade companies to 97% and 97.4%, respectively.
Non-investment-grade-rated communications services companies saw their average operating expense ratios rise 8.6 points to 94% while high-yield real estate companies saw their ratio rise 7.7 points to 88.6%.
Utilities was the only sector to experience a broad reduction in the ratio, with cuts in operating expenses of 12.7% among investment grade-rated companies and 16.6% among non-investment-grade-rated companies contributing to a fall in the respective ratios of 4 percentage points and 4.1 percentage points to 79% and 78.4%.
Ratios also fell for non-investment-grade-rated consumer staples groups by 3.1 points to 89.0% and 2 points for non-investment grade-rated materials companies to 93.1%.