How to Protect Your Margins in a Downturn
Given the barrage of bad economic news over the past 18 months, you would think that the profit margins of U.S. companies would have withered away to nearly nothing. But though it's true that bottom lines have been hammered over the course of the recession, something promising has begun to happen: Profit margins are ticking back up.
The net margins of privately held U.S. companies grew more than a full percentage point in the second quarter of 2009. In some industries, the growth appears especially robust. Information and professional services firms saw net profit margins increase more than 3 percentage points; the finance and insurance sector saw a gain of 6 percentage points.
That's the result of an analysis of private company profits by Inc. and Sageworks, a maker of financial software and a leading provider of data about closely held businesses. In an effort to determine just how the tough economic climate has affected entrepreneurs, we looked at three key indicators -- gross profit margins, net profit margins, and change in revenue -- for companies in 12 economic sectors over the past eight quarters. In all but three of those sectors -- health care, wholesale trade, and real estate -- net margins strengthened in the second quarter of 2009 (the most recent period for which data are available). The data can be found on the pages that follow. We also asked top executives in each sector to describe how their industries are faring and to share some insights into how they strive to maintain their profits.
It's tempting to view the good news about margins as evidence that a recovery has begun. But it's not that simple. Stronger margins are undeniably a good thing. But they do not exist in a vacuum. Indeed, the generally encouraging news about the bottom line is offset by the fact that the top line -- that is, sales -- continues to be anemic in almost every industry sector. Retailers saw revenue fall 3.5 percent in the second quarter. Sales in the information industry dropped some 1.5 percent. "Since sales remain down and consumer spending fell in the second quarter, these increases in profits result mostly from cost cutting," says William Dunkelberg, chief economist of the National Federation of Independent Business. Unfortunately, at this point in the downturn, there's not much left to trim. Dunkelberg also cautions that many may have cut too deeply. "The reduction in costs, especially in labor, has been dramatic -- and perhaps overdone," he says.
It's also instructive to look at the difference between gross and net profit. Gross profit reveals how much a company earns after accounting for the cost of producing the product or service it sells; when gross profit margins fall, it generally means that a company has little to invest in non-income-generating activities, like marketing or tapping new markets. Net profit, or the bottom line, shows how much a company actually keeps after subtracting all expenses, such as taxes, interest paid on debt, and other nonproduction costs.
The problem is that although net profit margins are strengthening, gross margins are falling or flat in six of the 12 industries we examined. That means that even though businesses have been able to cut costs, they don't have much pricing power. "Wherever you see reductions in gross profit margin, that suggests firms are still reducing prices," says Doug Tatum, co-founder of Tatum, an Atlanta-based consulting and executive search firm.
Still, the surprisingly robust net profit margins are cause for at least some optimism. Brian Hamilton, CEO of Sageworks, is encouraged by recent activity in the retail sector, which ramped up net profit margins in the second quarter despite an ongoing drop in revenue. "When retail trends up, that's typically good news for everyone," Hamilton says. "It means that people are starting to spend again." And if companies have been cut to the bone, it also means they are lean and mean and could be ready to pounce once demand in general does pick up -- something Dunkelberg expects to happen in the fall. "When sales finally do go up," he says, "we could look forward to a rapid increase in profits."
A Silver Lining, and a Cloud
All that cost cutting appears to have paid off. Both gross profit margins (the orange line, in the top graph) and net profit margins (the pink line, below) at private companies improved in the second quarter of 2009. Does that mean the recession is over? Not so fast. See that blue line? The one plunging perilously downward? That represents sales.
KEY: Gross Profit Margin | Net Profit Margin | Sales % Change | Graphs represent industry averages
Accommodation + Food Services
"We've learned from past recessions to thrive on repeat customers by delivering good value. Even if my cost of goods goes down, I'm inclined to put those savings back on my customer's plate rather than trying to increase my margins."
-- Roger Berkowitz, president and CEO, Legal Sea Foods
Administrative + Support Services
"Last year was only the second time in our history that we didn't grow profits. But we still try to reserve some of our resources to invest in new projects or expansions that will pay off three to five years down the line."
-- Jon Judge, CEO, Paychex
"The most common way to make money in construction is to drive revenue as high as you can by taking on bigger projects, then getting them done as efficiently as you can. In this economy, that's hard to do. Fortunately, we have always focused on niche markets that require expertise for which we get paid high margins."
-- Jim Ansara, chairman, Shawmut Design and Construction
Finance + Insurance
"The collapse of the economy hit financial companies, of all sizes, more quickly than those in other sectors. So we've seen the industry make dramatic changes in head counts. And while I am cautiously optimistic about a recovery, it is not going to be immediate."
-- Larry Zimpleman, CEO, Principal Financial Group
"We get paid a set amount per customer, so our profits are determined by how well we manage the costs of the medical expenses incurred by our customers. Our success depends on our ability to manage those costs without our customers feeling constrained by their available options."
-- John Baackes, CEO, Senior Whole Health
"Our people drive our success, so we're focused on increasing the efficiency and productivity of how they work. In our sales team, for example, we make sure that our people are spending the bulk of their time working on the most profitable deals and keeping our most profitable customers happy."
-- Evan Goldberg, founder and chairman, NetSuite
"We're looking to trim labor costs in an agile way. Rather than laying people off, we've cut costs by bringing jobs in-house that we used to outsource. That way we capture all the benefits of the increased productivity of our workers."
-- Jake Nichol, CEO, Leatherman Tool Group
"Rents across most markets are down, and there is a lot of space available. We're helping clients take advantage of the situation by renegotiating leases if they got stuck paying market rates two to three years ago."
-- Roger Staubach, executive chairman, Jones Lang LaSalle
"Our goal is to turn over our inventory four times a year. We're working more closely with our manufacturers to shrink our development time and buy closer to the market. We're also taking advantage of falling prices for materials and production."
-- Lexy Funk, CEO, Brooklyn Industries
Professional, Scientific + Technical Services
"Our biggest cost by far is the cost of our people. That's why I pay close attention to the ratio of total compensation to total revenue. If that number gets below 50, then we're working people too hard, and they'll start quitting. If the number gets to 60 or above, we're not making any money."
-- Chuck Porter, co-chairman, Crispin Porter + Bogusky
Transportation + Warehousing
"The biggest asset for a trucking company is its vehicles. So how a driver treats that asset can determine profits. But with the drop in rates and tonnage caused by the recession, companies are having a hard time making any money at all. In 2008, more than 3,000 trucking companies filed for bankruptcy."
-- Doug Clark, CEO, AmeriQuest Transportation Services
"To make money, we have to manage our variable costs, such as shipping and trucking. When gas prices spiked, we had to suddenly get very creative with our routes. We also ask our buyers to pay in advance. That way, we can take our interest-rate spread out of the mix."
-- Jeff Hoffman, CEO, Enable Holdings
Darren Dahl is a contributing editor at Inc. magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, North Carolina.