Productivity is Leading to Margin Expansion

A Comment on Today’s Inflation Print

Consumer prices in January rose more than expected with the headline reading up 3% y/y and the core (ex-food and energy) up 3.3% y/y. There is some noise in the numbers: January is typically a seasonally stronger month, the wildfires in California, Bird Flu impact to double-digit increases in egg prices, and a likely pull ahead of goods before tariffs get implemented (if they get implemented). On the positive side, rents and medical costs posted declines. Overall, the data is going in the wrong direction, and while a lot of the inflation we are seeing is tied to higher GDP growth, this will likely keep the Fed data dependent and less likely to ease rates anytime soon.

It is important to keep in mind that GDP is growing above trend and is currently at 2.9% (trend is 1.5%). This is leading to upward pressure on inflation. From an investment point of view, we would prefer stronger growth with a little more inflation because it will lead to stronger earnings. In fact, 60% of S&P 500 companies have already reported four quarter results, with earnings up 12% y/y.

A Theme with Upside Surprise

In 2025, we see the U.S. GDP growing between 2-3%. An economy with this type of growth is often coupled with mid-single-digit revenue growth and 11-12% earnings growth, both of which are a tailwind for stock prices. A recurring theme we have experienced slightly through the mid-point of fourth quarter earnings is margin expansion; companies are beating top- and bottom-line estimates while keeping costs down. We think this is a result of many factors, such as increased productivity through technology, the integration of artificial intelligence in the workplace, cost efficiencies in supply chains, and improved workforces. An encouraging sign is it is not industry-specific; this is a trend we are noticing throughout the entire economy. As technology and AI become more mainstream, we think margins can continue expanding and help companies become more efficient.

Charts 1: Companies We Follow That Reported Expanding Operating Margins in the Previous Quarter: META, GE, SLB, ROK, AMZN, & EMR^[1]

Operating income is a company’s profit after subtracting operating expenses. Operating expenses consist of naturally recurring costs incurred to run a company, such as employee salaries, marketing expenses, and costs of goods sold. Operating income divided by revenue equals operating margin; when margins increase, that is a sign that the company is effectively controlling costs while increasing revenues, likely as a result of technology, management decision making, or other factors.

Margin Expansion Stories from the Fourth Quarter

Last quarter, Schlumberger (SLB) reported the highest EBITDA (earnings before interest, taxes, depreciation, and amortization) margins since 2015 at 25%. This was due to its fastest-growing division, digital and integration (D&I), also having the greatest margins. The D&I division provides digital solutions and services to SLB’s clients, with the goal of enhancing operational efficiencies. D&I offers AI and cloud computing technologies to exploration and production energy companies, with nearly 40% margins. On its most recent earnings call, CEO Olivier Le Peuch stated, “As we remain focused on cost optimization and process enhancements, leveraging digital transformation to become a more efficient organization, this will support a margin expansion journey.”^[2]

We enjoy discussing GE Aerospace (GE) given its superb management team, and they demonstrated that again last quarter. Margins expanded by 450 basis points to 20.10% through strength in its commercial engines and services (CES) business, which is approximately 70% of GE’s total revenues, a large part of which is services driven. CES margins expanded 250 bps y/y to 26.2% attributable to a favorable mix and pricing, alongside increased services volume. CEO Larry Culp’s focus on improving GE’s supply chain has resulted in improved margins – their focus on supply chain management has led to improvements in material inputs, which increased by 26% across priority supplier sites from the first half to the second half of 2024.

Amazon (AMZN)’s North American and International segments have seen y/y margin improvements for eight consecutive quarters. The North American segment’s operating margin was 8%, up 190 bps y/y, while the international segment’s operating margin was 3%, up 400 bps y/y. Management stated that AWS operating margins are volatile – given the early stages of AI, margins are suppressed due to high levels of investment. But CFO Brian Olsavsky stated that “over the long term, we feel the margins will be comparable in non-AI businesses as well,” indicating further improvement in margins to come following the investment-heavy phase of the cycle.

Chart 2: Three Improving Margin Stories, But One Has Not Performed Like the Others^[3]

Altogether, improving margins is a product of many factors, such as strong management teams, efficiencies, increased use of technology, and business synergies. Margin expansion is an attribution we look for during company analysis and believe it is a leading indicator of company performance. In a world with 2-3% GDP growth, we believe company revenues can grow 5-7% with 11-12% earnings growth – all of which equate to further margin expansion across the U.S. economy.

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Sources:

^[1] Source: Bloomberg. As of February 10, 2025.

^[2] Source: SLB. As of January 17, 2025.

^[3] Source: Bloomberg. As of February 10, 2025.

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