Analysts are currently counting on margin expansion to justify their earnings estimates. Looking at data from Factset (left panel below), analysts expect profit margins to expand from 9.8% in the first quarter of this year to 11.2% by the fourth quarter of 2015. Profit margins are already at record levels, so continued margin expansion would take us into uncharted territory for profitability.
There may be growing headwinds to margin expansion though. Companies are becoming more comfortable with the economic picture and are steadily taking more risk by investing in capacity (for example hiring new employees). This could mean that margins do not expand as much as analysts are forecasting.
Investing in growth negatively impacts near-term margins because when a company invests in new capacity it incurs costs up front in hopes that future demand will eventually justify the expansion. Expenses are often realized faster than sales growth.
For example, in last week’s earnings call notes I highlighted Fastenal’s most recent quarter as something important to watch. The company grew sales, but showed weak margins in part because it was investing in growth. The company is optimistic that sales growth will materialize, but until it does, the investment in capacity is a risk–one that impacts current financials.
As earnings season starts to pick up, it will be particularly important to focus on margins. If margins do not increase, and analysts don’t raise their sales forecasts, then forward estimates for the S&P 500 would look a lot different than they do currently (right panel below). Analysts are currently expecting $119 in earnings this year and $133 next year, but if margins don’t expand, then expected sales growth is only enough to take us to $115 and $120 over the next two years.
Source: Factset Earnings Insight Report