Companies are becoming more profitable – but will it last?

With recession worries still at the fore, last month the Financial Times' Unhedged column took a close look at profit margins in the US, using data stretching back to 1990 provided by S&P Capital IQ. The findings suggested US company profitability had seen a concerted increase over the past decade, with little let-up of late.

S&P Capital’s Chris Mowbray and team have now provided Investors' Chronicle with equivalent data for the UK market. What can it tell us, if anything, about future prospects for the domestic market?

The 30-year dataset is based on results from all listed UK companies, including those that no longer exist (to prevent survivorship bias) and excluding financials, for whom profit margins aren’t a great indicator. Compared with the US results, which were compiled on the same basis, it’s a decidedly more volatile affair.

To take the most volatile period on the chart first: the idea that the dotcom crash, 9/11 and a global recession ultimately had more of an impact on UK than US companies is an interesting artefact of the data. That said, the subsequent rebound in domestic profitability, to a level well in excess of that seen in the US at the time, suggests the operating margin data for UK corporates is simply noisier.

This whipsawing may also disguise the real issue. The step change in US company profitability over the past 10-15 years, as well as the increase over the past couple of years, suggests some kind of mean reversion may be due. And UK figures follow a similar pattern, albeit slightly less conclusively.

Operating margins in the UK rose from 9.6 per cent between 1994 and 2010 to 10.5 per cent in 2011-22, in keeping with the kind of increases seen in the US.

Gross margins are different: across the pond, they were on average three percentage points higher over the past decade than they were from 1994-2010. In the UK, they’re three percentage points lower.

Is this just another quirk of the data? Have UK companies struggled to control direct costs (the cost of goods sold, which form the basis of gross margins) while simultaneously getting more efficient when it comes to total overhead expenditure (including leases and even, unlikely as it may sound, utility costs)?

If you’re thinking about the ‘B’ word at this point, that theory is a stretch. Gross margins have in fact started to rise again since 2016, when the UK left the European Union. So there's no evidence to indicate that Brexit has hampered profitability. But nor is there much indication, anecdotally, that the opposite is true. We may simply be bumping up against the limits of aggregate data’s usefulness - which is a fancy way of saying it's not clear what's caused this shift.

Without wanting to disregard that caveat, the easiest way to analyse the data is arguably by looking at the last decade in isolation. Here it’s more straightforward: in 2022, both operating and gross margins for UK companies were comfortably higher than at any point in the past decade.

For gross margins, that represents the culmination of five successive years of increases. For operating margins, it’s a rebound from a brief period of decline – but that decline was relatively shallow, so this can’t be said to be simple mean reversion.

In short, by these measures, UK companies were in good shape last year, which doesn’t indicate a recession is around the corner. Conversely, the data could also increase concerns that profit-led inflation is taking hold. One driver of this could be a drop in competition, which the Competition and Markets Authority this week identified as a factor behind supermarkets’ widening margins on fuel. The conclusion here is similar to Unhedged's own: if that's happening across other sectors, or there are other structural factors behind the increase, margins may not fall all the way back to long-term trends any time soon.