The Economy

Damn the Economy: Company Profitability Full Speed Ahead

What&spamp;rsquo;s the Catch? As corporate profitability &spamp;#8212; as measured by EVA momentum &spamp;#8212; soars companies will have to rely ...
Al EhrbarJanuary 17, 2012

The limping economy and last year’s lackluster stock market have masked a stunning fact about corporate profitability:  It is the best it has been in at least 15 years, and possibly the best ever. The aggregate EVA margin (economic profit as a percentage of sales) of the 1,702 companies in the CFO EVA Momentum Ranking was more than 3% during the four fiscal quarters ended last September. 

That was up from just under 2.5% a year earlier, and less than 2% back in the four quarters ended in September 2006, near the peak of the last business cycle. For most of the time since 1995, the aggregate EVA margin was 2% or less, sometimes much less. The CFO ranking covers all nonfinancial companies in the Russell 3000 Index (other than oil and gas companies) with sales of more than $100 million and stock prices above $5.

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A record-high EVA profit margin is a great achievement, of course, but one that presents a special challenge going forward. With margins so high, there would seem to be little opportunity — in the aggregate, that is — for growing economic profits via continued improvements in operating efficiency or fine-tuning business models. This means that companies will have to rely increasingly on profitable sales growth for improvements in economic performance. 

 

Many companies still have ample room for profitability improvement, of course. Some 671 companies in the CFO ranking posted negative EVA over the latest four quarters. And, as we shall see, several industries are severely EVA challenged even now.  But taking all companies as a whole, EVA margins appear to be about as high as they are likely to go. 

A margin of 3% might not sound record-breaking, but bear in mind that we’re talking economic profits, which are measured after deducting a charge for the opportunity cost of all the capital that companies employ. That is a much tougher measure than earnings calculated under generally accepted accounting principles, which include no charge at all for the cost of equity capital. An aggregate EVA margin of more than 3% means that the companies in the CFO ranking produced more than 3 cents of residual income on each dollar of sales after covering all costs and after providing a minimally acceptable return for shareholders. 

The EVA margin is every company’s true bottom line, because it captures the overall profitability of a company’s business model, spanning income efficiency and asset management, and is quite different from the usual operating or cash profit margins. It is the most important profit margin because it shows precisely how much wealth a company is creating (or destroying if EVA is negative) with each dollar of sales. It also happens to be the only margin that investors can sensibly and confidently compare across companies and across industries.

Other margin measures omit some or all capital costs. As a result, they are distorted by the varying degrees of capital intensity. This creates obvious problems for making comparisons across industries. Semiconductor companies need to post EBITDA and EPS margins that are way above average (which they do) because they tie up huge amounts of capital. Internet and catalog retailers, in contrast, can and do get by with below-average EBITDA and EPS margins because they employ less capital than the average company. By comparison, EVA margin gets to the root of the matter.

The most profitable industry by far is tobacco (see table, here), with a median EVA margin of 23.6%. Fittingly, No. 2 and No. 3 are biotech and pharmaceuticals, which get a fair portion of their business from treatments for tobacco’s customers. Their median margins are 9.5% and 8.8%. Somewhat surprisingly, the No. 4 industry is gas utilities, at 6.7%, and electric utilities come in at No. 7 with a median EVA margin of 4.3%.

In comparing industries, the median margin is more representative than the aggregate. That’s because just one or two highly profitable companies can distort the overall picture of how most companies in an industry are faring. The software industry, for example, has an aggregate EVA margin of 13.3%, but that’s due entirely to the results of Microsoft and Oracle, both of which are fabulously profitable. Excluding those two, the aggregate software margin drops to minus 0.2%. The median margin in software is 0.8%, which is No. 36 among the 48 industries in the ranking. Or consider internet software & services, which has an aggregate EVA margin of a whopping 8.9%. But if you strip out Google’s revenues and EVA profit, the aggregate margin in the industry is a negative 2.2%. The median EVA margin for the 38 internet companies is even worse, at minus 4.2%, or No. 44 among all of the industries. 

The poorest performing industry of all, no surprise, is homebuilders, with a median EVA margin of minus 9.7%. The gap between homebuilders and internet services is filled entirely by communications companies, with wireless telecomm services at minus 4.9%, diversified telecomm services at minus 4.4%, and communications equipment at minus 4.3%. The communications revolution clearly is great for consumers, but distinctly less so for investors.

The CFO ranking is based on improvements in profitability, as measured by EVA momentum, rather than levels of profitability. EVA momentum, which is the change in economic profit divided by sales in the prior period, captures the rate of growth in a company’s economic profit. It shows in directly comparable terms how each company’s profitability has improved or deteriorated. The 48 industries stack up quite differently when it comes to profitability improvement. Tobacco, for example, drops to No. 12, and pharmaceuticals to No. 15. 

The industries with the best recent performance on EVA momentum are a mixed bag, spanning a number of economic sectors. Eight stand out, with median EVA momentum over the most recent four quarters of 2% or more. They are, in order, energy equipment and services, biotech, metals and mining, life sciences tools and services, semiconductors, conglomerates and machinery, leisure equipment and products, and media. Only one industry, airlines, had a negative median EVA momentum, at minus 1%. 

Al Ehrbar, chief operating officer of EVA Dimensions LLC, writes a regular column based on the EVA Momentum Ranking for CFO.

 

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