Not your grandpa’s aggregate demand shortfall

Andrew Smithers, of the consultancy Smithers & Co, said in December that US profit margins were at a record level and had expanded in the past three years even as output fell.

“Margins have been as good as it gets,” says Graham Secker, European equity strategist at Morgan Stanley. He adds corporate profitability over the past 20 to 30 years has gained from factors such as technological advances, falling corporate tax rates, low funding costs and declining commodity prices.

Analysts at Citigroup say operating margins at S&P 500 companies are close to the highs of 2007, partly because of the fall in unit labour costs. “A reluctance to hire more employees as well as outsourcing to lower-cost alternatives have left management teams with lean and mean companies,” they say.

Some analysts remain optimistic about prospects for the US. Gerard Lane, equity strategist at Shore Capital, says: “Even though US margins are extended, they do not necessarily have to fall at the moment.

“As a long-term trend, these businesses are gaining more of their profits from overseas. It is only when unit labour costs at S&P companies start growing at more than 2 per cent a year that margins will start to fall.”

Here is more, from the FT.


This would be consistent with a recession caused by increasing barriers to entry.

'have left management teams with lean and mean companies'
Which are utterly reliant on the companies that actually do the work - such as Foxconn for Apple, et al. What will be interesting to see is when China and Foxconn feel confident enough to get rid of the middleman eating up what Foxconn et al are likely to come to see as their profit margin. And when that day arrives, Foxconn will probably consider billions of customers in South America, Asia, and Africa as being a better market than a few million self-described elites in places like North America. Especially since those North American customers tend to pay with pieces of paper, having essentially abandoned internal high tech manufacturing during the decades of making themselves 'lean and mean.'

And in one year, their product is either obsolete, or they have developed the design capability. That's the question, isn't it?

Indeed, the value added by Apple delivering a complete solution with all the hardware and software rough edges smoothed* should not be underestimated. Plenty of companies can make a touchscreen tablet, only Apple has the iPad.

* apart from iTunes sync, which seems to be the one thing Apple users complain about

Plenty of companies can make a smart phone, only Rim has Blackberry. Well, you know, that would have been a true post 3-4 years ago wouldnt it? Technology leaders today fade, it seems inevitable. The only thing that will remain will be the fat cash reserves on the balance sheet. Google is already looking to hire investment managers for their own cash inhouse so this seems to be the natural evolution. iHedgefund.

Here is an interesting thought experiment -

Can Apple make an iphone/ipad/ietc without Foxconn? Simple answer - no, and not into the foreseeable future, as Foxconn (and its various compatriots operating in China/Taiwan) cannot be replaced in a couple of quarters. Especially since the actual equipment, the actual labor, and the actual expertise to do manufacture goods using that equipment and labor owned by Foxconn. Apple doesn't actually own any of those things - being mean, lean, and rich, why bother with actually making things?

Can Foxconn make an iphone/ipad/ietc without Apple? Well, sure - but could they make next year's Apple iphone/ipad/ietc without Apple? The simplistic answer is of course not - without Apple, it wouldn't be an i device. The not so simplistic answer - well, Samsung seems to be able to make pretty much everything Apple is able to - at least to the extent that Apple is engaged in a planetary legal battle to stop Samsum from selling what Apple considers to be iphone/ipad/ietc devices manufactured by Samsung without Apple's permission.

What happens when the actual manufacturer of both Apple's and Samsung's (though to a lesser extent than Apple - the Koreans aren't as stupid as Americans when it comes to throwing away a manufacturing base - after all, they just spent the last generation building one up from pretty much nothing) devices decides to cut out the middleman, in part because Foxconn has been wasting its money investing in the engineers and programmers that a lean and mean country like America (I'm grinning even writing lean and mean in connection with America, but let that pass) simply thinks it can always buy when needed to keep the bottom line fat?

Apple, I am sure, has patent, trade secret, confidentiality and a bunch of similar restraints tied around Foxconn such that this is unlikely.

I used to work for a design company that had most of the heavy assembly done in China. They limited how much IP any assembler saw, but they were simultaneously designing the next generation product under the assumption that an assembler would eventually be marketing their design.

I have a buddy that works with a high tech company that outsources a ton of its manufacturing to Asia.

They intentionally design the manufaturing process so that things are built by multiple companies and no manufaturer sees the entire process. I am sure Apple does the same thing.

Assuming that any one manufacturer could redesign the whole Ipad would be like assuming a line worker at GM could build his own Corvette since he knew how to make a chassis or how to assemble the final product.

Maybe if he gets it one piece at a time...

Given what Foxconn is doing for the ipad/iphone:

1. Assembly -- anyone can do that. Apparetnly, it is being done by hand.

2. metal cases -- again, just a question of scaling.

3.Foxconnn can be replaced. Other suppliers, no. Moving as much of the iphone to silicon reduced assembly costs, which is exactly what Apple is doing.

Who says these companies aren't already selling in S. America, Asia and Africa?

Also, if Apple had indeed used a "Foxconn" in ,say, Texas; you think that'd stop Asian companies from reverse engineering and competing?

Well, what I meant is about caring whether the 'Cphone' and 'Cpad' would be banned in North America due to patent infringment, for example. Leaving that little detail out was a mistake

OEMs have been around for a long time, though, and they haven't driven the brand name companies out of business. Any reason to think that Foxconn brings domething to the table that previous OEMs didn't?

Asus used to be a contract manufacturer, maybe still is. When they developed and manufactured the Eeepc line, a $400 laptop they forced Microsoft to continue selling XP. It was an upheaval in the market for the established players.

Playing a defensive action with IP protection is sign that you lost.

To think that the US is going to stay on top is foolishness. Right now in the industry I work in Japanese and Korean manufacturers are buying up US companies in the sector for access to distribution networks.

One could easily reframe this argument as, Foxconn has a handful of mega companies that it is dependent on. Jettisoning those relationships would be extremely risky, even downright foolish. Remember Acer? They pursued a similar strategy.

Foxconn is not a Chinese company (their HQ is in Taiwan, where they were founded). Are they idiots for outsourcing much of their manufacturing to the PRC?

I can think of about 5 OEMs off the top of my head that could pick up the iPhone and iPad contracts in a very short amount of time and there are many others who could quickly scale to that level of production fairly quickly (and all of them would drool over the opportunity). Foxconn is the biggest OEM electronics manufacturer, but they in no way represent the majority of manufacturing capacity.

As somebody who got into the corporate world in the recessionary early 1980s, profit margins seem ridiculously high to me these days. I can understand why Apple has a high margin, but why does P&G?

I think the answer lies partly in emerging foreign markets and partly that large parts of technological innovation being winner-take-all.

I don't think American domestic markets are what drives P&G / unilever etc. these days.

Okay, but what's the winner take all technological innovation in toothpaste?

Keep it to yourself, but they've come up with a way to put the toothpaste back in the tube! The socon wing of the Republican party is planning to announce this in an October surprise.

"Okay, but what’s the winner take all technological innovation in toothpaste?"


Same reason the Beer companies are global: Distribution networks reward scale. Even with identical technology and labor costs, the biggest distribution network has the lower per-unit cost. Add in the technical edge required to efficiently manage a large distribution network, and you've got a technical barrier to entry in addition to the scale advantage. So the largest company typically has MUCH has higher profit margins.

Unilever doesn't make better toothpaste. Through superior distribution, Unilever gets their toothpaste in front of more customers. More customers mean Unilever can pay for more advertising ( and a bit of R&D), which drives more sales through the existing channel, with increases profit margins.

Moreover, should some upstart make progress in one area -- a better laundry detergent, for example -- the incumbents can use the scale to crush (or, more likely, buy) the new entrant. cf Eagle Brand snacks vs Frito Lay.

In fact, I suspect Unilever doesn’t make almost any toothpaste (from what I saw in developing nations). Most of it gets outsourced to smaller job-work firms, packagers etc. Oftentimes, the same smaller company that made the toothpaste last year for unilever made it for P&G the following year.

You'd be surprised on how many products the "manufactured by" and "distributed by" are entirely different entities.

I'd guess two other candidates here are winning the sales and marketing arms race and some firms getting special access to closed markets.

If firms competed mostly in terms of price like they do in economic models, profit margins would be very tight. Some firms like airlines do indeed compete mostly on price and their profit margins are consequently very low. Unilever and P&G, on the other hand, appear to spend a lot of resources on marketing and on developing customer loyalty. Coca-Cola and Apple are probably two of the most successful sales and marketing firms in history and their profits show it.

Big firms also probably have significant advantages in entering highly regulated or corrupt markets. An egregious example is when Goldman Sachs got one of only two licenses granted by the Chinese government to foreign investment banks (Credit Suisse was the other, if I recall correctly). If you are the CEO of Unilever, you can get some high-ranking trade ministry official in Thailand or Indonesia on the phone pretty easily and sort out your regulation and paperwork troubles. If you are Joe Blow, Inc., forget about it.

This is yet another illustration that high unemployment, and the consequent reduction in labor cost, is in the interests of the powers that be. Is it any surprise that government policy favors this group rather than the mass of citizens?

No it's no surprise at all, especially given the fact that most of the government is bought out by the powers that be.

Right, for instance: In whose interest is it to keep importing foreign workers in a time of high unemployment? Not the "mass of citizens", that's for sure.

Not importing a foreign gynecologist cannot help an unemployed native welder.

If you include the elderly in the "Powers that Be" category then perhaps you have a case. Otherwise you are just tilting at windmills.

Hey I've always advocated getting rid of anyone over 40

Strange. I would have guessed that the powers that be would have wanted the stock market higher. They care about corporate profits but not corporate valuations?

lean, mean, and really stupid!

So why is the S&P index still 12% off its 2007 peak? Greater uncertainty?

the marginal consumer is dead, even hopium fueled stock traders realize this.

It used to be said that corporate profits were a major determinant of business cycles: when profits fall, business investment drops , the economy crashes; profits rise followed by a rise in investment, economy grows. Is this still true, and we can expect investments and the the economy to expand, or is it different this time?

Apple also can't make the i-Pad without mining and oil companies. The points above about Foxconn are, at best, irrelevant.

I wonder if--and to what degree--the increase in margins is due to survivorship bias. This is pure speculation on my part--I don't have the data in front of me--but I understand that the recession killed a lot of previously low-margin companies.

Meh, I am not sure this is the answer. But has any economist looked at where the most recent QEs from the Fed wound up. I mean when you dump a half trillion in cash on the market it has to end up somewhere. It didn't wind up in housing. It doesn't seem to be showing up in CPI. Although, I have heard arguments that it wound up in "volatile" commodities like food and energy. Maybe it just ended up saving businesses from having to lower their prices for a quarter or two and so now is showing up as corporate profits. If such is the case, it kind of undercuts the argument that businesses are doing anything special or are particlularly lean and mean.

Exactly, it's a simple effect of today's inflated revenues being higher than yesterdays costs. When QE stops and credit contraction starts, margins will go down.

For nonfarm business the deflator has been rising faster than unit labor cost since 2008.

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