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13/12/2022
5
min read

Where next for profit margins in 2023?

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Rosemary Banyard
Rosemary Banyard

Fund Manager

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In 1912, an explosives salesman working for the large US chemicals company DuPont invented a framework to measure internal efficiency, which became famous as the DuPont analysis or formula. This formula breaks down the important investment metric of return on equity into its constituent parts. One such constituent is net profit on sales, or net margins, which can in turn be broken down into a tax element, an interest element (if any), and an operating profit margin on sales.  

Profit margins vary enormously between industries and between competitors in the same industry, depending on their pricing power, efficiency, scale and sales strategy. In the past year, which has seen strong inflation in raw materials, energy, freight and labour costs, corporate margins have been under pressure, depending on how quickly, if at all, companies can pass on these higher costs to their customers. Although freight costs have recently fallen significantly, as has the oil price and some commodities such as copper, there is continuing pressure on wage inflation and staff retention, and a new threat to margins is emerging in the form of the central banks warnings of recession. If volumes drop, which a recession implies, then the recovery of indirect overheads such as administration, sales & marketing and distribution costs, is usually reduced in the short run. This can produce a nasty margin contraction. 

In this environment, can any business expect margins to improve in 2023?

There are some good reasons to think so.

  • One example is any business experiencing a structural reduction in its costs of going to market, perhaps because of the digitalisation of previously manual processes or a new distribution model. This year, promotional products company 4Imprint saw its revenue per marketing dollar (a key performance indicator) leap 50% from $5.46 to $8.19, and its marketing costs reduce from 18.3% of revenues, to 12.2%.  The company was able to replace some expensive pay-per-click advertising via Google with increased direct marketing of its own brand. 
  • A second reason could be a reduction in ongoing pension costs for companies with defined benefit pension schemes where the liabilities are bought out by an insurance company, relieving the sponsor of regular contributions. A recent example here was TT Electronics, where a pension buyout is set to save £6m initially, and an equivalent annual improvement in future years. (For context the company reported £34.8m of adjusted operating profits in 2021). We confidently expect more DB pension scheme buyouts to come as the discount rate for calculating the pension liabilities (based on long bond yields) has recently risen, reducing liabilities in some cases faster than any fall in asset values and eliminating any funding shortfall.  
  • A third source of margin improvement could come from a change in business mix. The most dramatic example here is the introduction of new income streams arising from royalties, which reflect close to 100% profit margin, as little if any costs are usually attached to the income received (the licensee typically bears all the production costs). In recent years of this is miniature table-top war games company Games Workshop, where royalty income from licensing its intellectual property to computer games publishers has risen from £1.5m in 2015 to £28m in 2022. This represents 7.2% of revenues versus 1.3% in 2015, and operating margins attributable to the rising royalty element have put on 530 basis points. 

A company which could surprise on the upside in this regard is disinfectant manufacturer Tristel, which has licensed its proprietary formula for the production of chlorine dioxide to Parker Laboratories for the US market. Royalty income will  start to flow, initially from surface foam disinfectants already launched in most states, but then hopefully also from high level disinfectants used on outpatient medical devices, if the FDA (US Food and Drug Administration) approves their use. Either way, we see a rising royalty stream emerging in this business, which explains the more positive commentary from directors and is not as dependent on a binary regulatory ruling as some may think. 

A common but often riskier way to increase margins is through acquisition. This can come about because the acquisition is inherently more profitable, but also because costs of overlapping services can be removed and sometimes better buying power can lower costs too. In October 2020, value-added distributor Diploma made a significant and high-quality US acquisition in its controls division: Windy City Wire reported adjusted operating margins of 22.7% in its first year in the group, a positive enhancement to group margins which were 16.2% in the previous year. 

Further down the profit and loss account, pre-tax margins could start to widen for companies sitting on net cash balances, which have for years earned near zero in interest but could now start to generate a positive return. Examples here could include AJ Bell, even though much of the increased investment income will be passed through to clients.  

It is vital for companies to generate improved operating and pre-tax margins if possible, because corporation tax rates in the UK are set to rise from 19% to 25% in the next two years, a huge increase in the slice of the pie taken by the UK government.  

So, despite the challenging economic backdrop, there are several sounds reasons why margins for some UK companies could improve significantly in 2023. 

Find out more information on the VT Downing Unique Opportunities Fund.

Risk warning: Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein. 

Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies.  

Important notice: This document is intended for retail investors and their advisers and has been approved and issued as a financial promotion under the Financial Services and Markets Act 2000 by Downing LLP (“Downing”). This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. This document contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified.  Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.


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