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US corporate margins threatened as growing economy pushes operating costs up

A jump in day-to-day business costs that pushed expenses for U.S. companies to above pre-pandemic levels so far has not chipped away at margins. But rising cost pressures as the economy gathers pace threaten to erode corporate profits.

Businesses cut costs in the first half of 2020 to maintain their margins as the spread of COVID-19 caused the country to lock down and revenues collapsed. Quarterly operating expenses among non-financial investment-grade rated U.S. companies fell to a low of $1.938 trillion in the second quarter of 2020 from $2.285 trillion at the start of the year, according to data compiled by S&P Global Market Intelligence.

By the fourth quarter of 2020, as the economy reopened and revenues improved, companies were financially secure enough to expand their operations, increasing costs such as rent, wages and physical stock to $2.346 trillion — an increase of 2.7% year over year.

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The balance of both slightly higher costs and revenues meant that the median operating expenses-to-total revenue ratio — an important metric for measuring a company's margin — for investment-grade rated nonfinancial U.S. companies was 83.6% in the fourth quarter of 2020. This was barely changed over the course of the pandemic from 83.5% a year earlier.

Across-the-board increases in costs, however, could eat into corporate margins, and the ability to retain those profits depends on how companies respond, experts say.

"We've already seen some companies' margins narrow, and their ability to restore them will largely depend on whether they can increase prices," Michael Hewson, chief market analyst at CMC Markets, said in an email.

Cost pressures set to rise

As the economy reopens, revenues will recover with households well placed to ramp up demand. But with increased sales come increased operating costs as demand for materials, energy and labor rises, which could put pressure on margins.

"[First quarter] results will reflect some of the sharpest year-over-year increases in transport, commodities and raw materials, gasoline prices, etc., in modern history," said Sean Darby, global chief equity strategist at Jefferies, noting that higher interest costs and labor wages will also rise in the coming quarters.

The U.S. import price index for goods excluding food and fuels rose to the highest point since April 2013, according to data published by the U.S. Bureau of Labor Statistics, on the back of increased demand and supply bottlenecks.

The price of Brent crude oil, a price benchmark for international oil trade, has climbed as well. A barrel now fetches $66, up from a low of $19 in April 2020, resulting in higher energy costs for businesses. Meanwhile, unemployment has fallen to 6% after climbing to 14.8% at the peak of the economic crisis in 2020. The declining supply of labor should increase the bargaining power of workers, experts say.

"There will be winners and losers from a margin point of view as the economy reopens," said Mark Sherlock, head of U.S. equities, at the international business of Federated Hermes, an investment bank with over $600 billion of assets under management.

"Certain businesses will face notable margin pressure," Sherlock said, noting, "rising gas prices would be an obvious example within the transportation sector or skilled labor within the construction industry."

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Energy companies slashed costs

One sector that welcomes rising oil prices and a recovering economy is energy.

At the worst of the economic crisis in 2020, the median operating ratio for investment-grade rated energy companies rose to 104.8% from a pre-pandemic level of 90.2%, meaning companies were making an operating loss. That ratio returned to 90.4% in the fourth quarter of 2020.

While most sectors improved their margins in the fourth quarter with stronger revenues, the recovery in profitability in the energy sector was built upon significant cost-cutting.

Operating expenses for investment-grade energy companies totaled $186.7 billion in the fourth quarter of 2020, a reduction of 40.7% year over year.

The oil company Chevron Corp. is a prime example. The group reduced its operating ratio to 90% in the fourth quarter of 2020 from a peak of 143.8% in the second quarter. With revenues still on the floor in the fourth quarter, down some 33.8% year over year, the company improved its margin by hacking away at its costs, laying off between 4,500 and 6,750 of its 45,000-person workforce.

By contrast, the investment-grade healthcare sector improved its margin over the course of 2020.

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The median operating margin for healthcare companies was lowered to 78% in the fourth quarter of 2020 from 81.9% a year earlier. That was achieved despite a 13.6% increase in operating expenses over the same time period, indicating strong revenue growth.

Abbott Laboratories improved its operating ratio to 76.3% in the fourth quarter of 2020 from 81.8% a year earlier, with net sales rising 28.7% in that time as a result of demand for its COVID-19 diagnostics tests.

For most other sectors, the year-over-year rise in median operating costs for investment-grade rated companies has been much more modest. In the consumer discretionary, industrials and materials sectors the increases were 0.8%, 1.5% and 1.9%, respectively.

Cost savings could be achieved by trimming excess office space and reducing travel costs, Sherlock said, noting the potential for a further squeeze on costs in a post-pandemic world.

"For some of these businesses, even small increases in turnover could have quite a dramatic effect on operating margins," Sherlock said.