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Good morning. Yesterday was quiet in stocks. But Wall Street’s verdict on the Thursday and Friday mini-rally, or at least that of a few big-name strategists, is in: not convinced. “One swallow doesn’t make a summer,” sniped JPMorgan’s equities team, feeling lyrical. Send us your market metaphors: [email protected] and [email protected].
Margins: back to normal or impending doom?
It’s been clear for a while that swollen margins are getting pinched. This earnings season, which is nearly wrapped up, drove home the point. This chart of S&P 500 operating margins is something to behold. They’ve dropped two percentage points in no time at all:
As striking as the chart is, it is also a little hard to interpret. Does it suggest that profitability is normalising after a series of shocks? Or crashing in the face of persistent cost inflation and softer demand?
By all appearances, market valuations imply that margins are merely normalising. Stocks are not cheap, and if anything are a bit expensive. And it makes sense that margins might be normalising, because supply chains already have. For the first time since the pandemic began, the New York Fed supply-chain pressure index, updated yesterday, shows conditions a smidgen looser than the historical average:
Optimistically, you could imagine more limber supply chains lowering inflation while raising output, the opposite of a stagflationary shock. As a result, cost growth should fall. Operating margins might settle back to something like the post-2000 average of 12 per cent, but no worse.
Ryan Grabinski at Strategas isn’t so sanguine. He figures that margins are indeed normalising, but that this is just the prelude to a fundamentals-driven margin crunch. Grabinski calculates that on a trailing 12-month basis, S&P cost growth has outstripped revenue growth for the fourth month in a row. He writes:
When this occurred in 2020 into 2021, much of the rise was due to an increase in external factors (shortages, bottlenecks, etc), which resolve over time. However, today’s occurrence appears to be due to internal factors (higher wages, etc), which often prove stickier . . .
Should the growth in costs exceed the growth in revenue for an extended period of time, there could be significantly more margin compression ahead of us. The “labour hoarding” we are seeing will only last for so long if margins continue to fall. The first 160bp decline was likely a normalisation of margins, the next decline will be related to weakening outlooks.
If costs stay sticky, revenue growth will become the crucial swing factor for margins. To that end, here’s one troubling data point. According to Bloomberg, bottom-up consensus estimates of S&P 500 sales for the next 12 months have just started falling:
We wouldn’t want to exaggerate this. Revenue is usually measured as year-over-year growth for a reason; little sales wobbles do not a recession make. But it’s notable that sales estimates are starting to follow earnings estimates down. Remember the danger of negative operating leverage: since many costs are fixed, small downturns in revenue growth become a big drag on margins and profits. If revenue contracts outright, sell everything and board up your windows.
In the bigger picture, markets have been mired in a (volatile) holding pattern for nine months. Even after pricing in much higher rates, stocks haven’t broken below their October lows. If anything is going to change that, it will be earnings. And if Grabinski is right that costs are sticky, companies will need to juice sales to keep us out of an earnings recession. Markets seem to think they can do it. (Ethan Wu)
Salesforce and stock-based compensation
Last week, I wrote something enthusiastic about Salesforce. The gist was that the gaggle of activist investors who have bought the stock are on to a good thing, because (a) the company has lower margins than peers and should be able to fix that, (b) it still looks relatively cheap on free cash flow yield, given its high growth and (c) Salesforce has promised to stop doing acquisitions, which it appears to have been bad at.
Several readers wrote in to argue that I had not thought hard enough about Salesforce’s habit of issuing employees tons of shares. Having reflected on this over the weekend, I think they’re right.
Salesforce’s share count has risen 84 per cent since year-end 2011, a compound annual growth rate of 6 per cent:
This increase, of course, dilutes earnings per share. But one might argue this is not too important. Adjusted EPS is up 330 per cent since then, despite the dilution. But there is the little matter of those adjustments. The biggest one of them, by far, takes out share compensation expenses.
The most popular justification for ignoring share-compensation expense is that it is a non-cash item, and its economic effect already appears in EPS by way of the higher share count that results. Dave Zion, who runs the accounting analysis shop Zion Research Group, explained the problem with that argument to me.
Suppose that instead of issuing shares to employees, a company issued shares to the public for cash, and then paid its employees with that cash. In that case, the diluted share count would rise, just as with employee share or option grants. It would be absurd, however, to exclude the cash paid to employees from expenses. But economically, there is no difference between the two cases, except for who the new shares are issued to.
This is a bit hard to grasp, because in the share compensation case, no cash goes out the company’s door. Zion has a nice way of making the case clearer. However you want to conceptualise share issuance, he says, you have to take account of two things: the dilution that has happened in the past, and the dilution that will happen in the future. The company’s diluted share count does a good job of capturing past dilution: all the options and restricted shares that have already been issued will eventually become regular shares. The stock-based compensation expense line captures the dilution that will happen in the future. Paying employees, whether in cash or stock, is after all an ongoing expense.
So, in the future, a company that now pays its employees by handing them billions of dollars worth of shares will either (a) increase its share count still further, (b) have to switch to paying those employees in cash or (c) spend cash buying shares from the public to limit dilution.
Now, you might think that I avoided this whole messy question last week, because I valued Salesforce and its peers on free cash flow, which is not affected by adjustments to earnings. But this is not so.
Here is the problem. Free cash flow, as I calculated it, is operating cash flow minus capital expenditures. This excludes cash raised by selling shares or cash spent to buy them back. Yet eventually, fast-growing tech companies stop growing quite so fast, at which point the dilution from employee stock issuance becomes annoying to investors. The company then starts spending cash to buy back shares to offset that dilution (these transactions appear, for the geeks in the audience, in financing cash flow, not operating cash flow). That spending absorbs shareholders’ capital.
Here is a chart of the net cash outlay for share repurchases by the four biggest US software companies by market cap:
Consider Microsoft (a company which, honourably and unlike the other three companies depicted, does not exclude share compensation expense from its adjusted earnings). It generated an astonishing $65bn in free cash flow in its past fiscal year; $31bn of that went to repurchases. But Microsoft’s share count fell by less than 1 per cent this past fiscal year, implying that about half of the $31bn went to offset dilution from issuing shares to employees. Anyone using free cash flow as a metric for valuing Microsoft should adjust for this fact.
And the same must go for Salesforce, which just began buying back shares ($4bn last year). A lot of its future cash flow will probably go to repurchases to offset dilution. Determining whether Salesforce is likely to spend proportionally more or less of its cash on this than peers would take some fiddly analysis and imprecise assumptions. But it is fair to say that when I praised Salesforce for its free cash flow yield, I was oversimplifying badly. To value Salesforce and its peers, you have to think hard about share issuance. (Robert Armstrong)
One good read
At CPAC with Tim Miller.
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