US CORPORATE PERFORMANCE

As we know corporates are like households de-leveraging if they can to reduce their exposure to financial markets and cut costs especially investment, to defend margins and business models, and maximise profits to restore share values or push up their shares in the current rising market, which may prove a temporary centre of a W or double-dip. But in the interests of recovery, are US profit margins unsustainably high? FT's Lex argued that US corporate profit margins are too far above their long-run average and should "return to the mean relatively quickly", implying significant risk to current earnings path. US corporate profits before depreciation, tax & interest amounted to about 35% of corporate output in 2Q '09 compared with a long-run average (since 1947) of 29% (which seems at first glance very high?)
The margins are indeed odd (spotted by Simon Ward at Henderson) in that pre-depreciation profits have been compared with net corporate output after deducting depreciation i.e. inconsistency in treatment of depreciation between numerator & denominator of the ratio. Two credible measures of profit margins are:
1) profits before depreciation, tax & interest as % of gross output, i.e. before depreciation; and 2) profits before tax & interest as % of net output.
These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series in the FT Lex column, but net margins are much less extreme relative to history – 19.4% in Q2 '09 versus an average since 1950 of 18.1%.
The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span (working life - at least in theory) of capital goods, whether or not simply for "tax efficiency", and alo pressure in many quarters of industry to replace systems (IT etc.) and processes.
If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range. Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to return rewards after costing for the erosion in value of assets (argument for using net rather than gross margins).
The FT focused on domestic profits, ignoring 25% share of total US profits accounted for by foreign earnings. The first chart (also from Simon Ward) compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession. The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.