Modeling Peak Profitabiliyt

March 17, 2014
Writing in the margins:

Analyzing peak profitability
Portfolio Strategy Research
Expect high but flat profit margins for the S&P 500 in 2014
US corporate profitability is at record levels
Amanda Sneider, CFA
Higher margins drove record S&P 500 earnings despite an environment of

sub-trend economic growth and modest sales. Margins are the key reason
earnings have rebounded so quickly in the recent cycle. Operating margins
equaled 8.9% at the end of 2013, a return to the previous peak. Looking
forward, the forces that influence margins are equally balanced between
upside and downside. We forecast trailing four quarter net margins will
remain at peak levels in 2014 before rising to a new peak of 9.0% in 2015.
Cost management is the main driver of margin growth

Firms have enjoyed a secular increase in the productivity of labor and
capital as well as technological innovations such as real-time inventory
management, reducing both fixed and variable costs. Low inflation in
terms of commodity inputs and labor costs have been tailwinds. Taxes and
interest rates have never been more favorable for the profitability of firms.
(212) 357-9860 amanda.sneider@gs.com

Goldman, Sachs & Co.
David J. Kostin
(212) 902-6781 david.kostin@gs.com
Stuart Kaiser, CFA

(212) 357-6308 stuart.kaiser@gs.com
Ben Snider
(212) 357-1744 ben.snider@gs.com
Rima Reddy
(801) 884-4794 rima.reddy@gs.com
Stage of Production: Intermediate-stage margins squeezed

Companies on either end of the production chain have been able to
support margins due to letting commodity prices flow through on one end
and pushing through pricing to the consumer on the other. Intermediate
companies have been caught between the two, and aggregate margins for
these companies contracted during the past two years. Cost of goods is a
higher portion of sales for raw and intermediate stage firms while SG&A is
a higher share of expenses for end-demand companies.
Breakdown of costs and profits for S&P 500 ex-Financials and Utilities
40%
35%
67%
66%
Cost of Goods Sold
18%
17%
SG&A
25%
20%
5%
10%
5%
5%
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
Interest and Taxes

Depreciation
and Other
9% Operating Income
5%
0%
5%
4%
2013
15%
2012
Share of Sales
30%
Source: Compustat and Goldman Sachs Global Investment Research.
Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors
should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors
should consider this report as only a single factor in making their investment decision. For Reg AC certification and other
important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by
non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
The Goldman Sachs Group, Inc.
Global Investment Research
March 17, 2014
United States
Contents
US corporate profitability returns to record levels
Margins: Past, Present, and Future
Cost breakdown: Margins as the remainder of expenses
Stage of Production: Intermediate company margins squeezed
12
Operating leverage: Limited benefit to index-level margins in 2014
14
Sectors: Margin trends vary, but Information Technology is key
15
Disclosure Appendix
21
Goldman Sachs Global Investment Research
March 17, 2014
United States
US corporate profitability returns to record levels

A secular trend of higher margins has driven record S&P 500 earnings despite an
environment of sub-trend economic growth and modest sales. During the last 30 years
margins have roughly doubled, trending higher on the back of technological advances,
cheaper and more productive labor, expansion to emerging markets, declining taxes and
interest rates, and changes in aggregate index sector composition. Operating margins
equaled 8.9% at the end of 2013, just 8 bp below the previous peak margin level.
1.
Looking forward, the forces that influence margins are equally balanced between
upside and downside, and we expect margins will remain nearly flat through
2015. Economic acceleration should drive revenues and support margins. Companies
remain focused on efficiency gains and cost controls, but labor costs will present more
of a headwind than has been the case in recent years. We forecast trailing four quarter
net margins will remain at peak levels in 2014 before rising to a new peak of 9.0% in
2015.
2.
Bottom-up consensus estimates imply further margin expansion to new peak

levels in 2014 and 2015. Consensus expects aggressive margin expansion to 9.4% in
2014 and to 10.0% in 2015. Expectations for the Information Technology sector are a
key difference between our forecast and consensus.
3.
Cost management has driven margin growth in the long term more than any
other factor. S&P 500 companies lowered both cost of goods sold and selling, general
& administrative expenses as a share of revenue during the last 20 years. For both
COGS and SG&A, low inflation in terms of commodity inputs and labor costs have
been tailwinds. We expect commodity prices will remain controlled, but labor costs
should eventually rise as slack is removed from the labor market.
4.
Taxes and interest rates have never been more favorable for the profitability of
US firms. S&P 500 firms have taken advantage of the recent low interest rate
environment to increase debt to boost current margins and lock in future support. But
potential changes to the tax code have recently garnered significant political and
media attention and would have meaningful implications for corporate profitability.
Excluding the impact of lower tax and interest rates, EBIT margins hover near peak
levels but have not exceeded the highs reached in 2007.
5.
Raw Material and End Demand companies have been able to support margins
through pricing. Firms selling intermediate goods were less able to push through
costs and experienced more pressure on margins. Consensus sales and EPS estimates
imply expansion in all three groups during 2014.
6.
Operating leverage will provide limited benefit to S&P 500 margins as GDP
growth accelerates. As the economy improves and revenues grow, fixed costs
become a smaller portion of total costs and margins expand. But already low operating
leverage means the accelerating US economy will provide only a modest boost to S&P
500 margins. Although index-level upside from leverage is limited, stock-level
opportunities exist. Firms that can leverage increased sales should be able to grow
margins despite headwinds.
7.
Information Technology matters to index-level margins. Information Technology is

the only sector with margins above the index-level, and margins for the sector are
nearly double that of the S&P 500. Because of their high margins and large sales
weight in the index, Info Tech margins typically have a large impact on the S&P 500.
Information Technology margins contracted in recent quarters, although they are now
trending upward. We expect limited margin expansion during the next few years.
March 17, 2014
United States
Margins: Past, Present, and Future

US corporate profitability is at record levels. A secular trend of higher margins has
driven record S&P 500 earnings despite an environment of sub-trend economic
growth and modest sales. During the last 30 years margins have roughly doubled,
trending higher on the back of technological advances, cheaper and more productive labor,
expansion to emerging markets, declining taxes and interest rates, and aggregate index
sector composition that has shifted towards higher-margin industries.
Margins are the key reason earnings have rebounded so quickly in the recent cycle.
Net margins for the S&P 500 (ex-Financials and Utilities) hit a low of 5.9% in 2009. By 3Q
2010, margins had already returned to the previous 2Q 2007 peak of 8.3%. They continued
to rise during the next year, reaching a cyclical and historical peak of 8.9% in 3Q 2011.
Exhibit 1: S&P 500 net margin, 1979-2013
as of March 12, 2014
10%
S&P 500 Net Profit Margin

(trailing four quarters)
9%
8.9
8.9
8%
7%
6%
5.9
5%
4.7
4%
3.9
2015
2012
2009
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
3%
Source: Compustat, FirstCall, I/B/E/S and Goldman Sachs Global Investment Research.
The median S&P 500 firms margin has been 100-150 bp above the aggregate S&P 500
margins since 4Q 2008. The top 20 firms by 2013 revenues account for one third of
aggregate S&P 500 sales, yet 13 of 20 (65%) reported margins less than 5%. This compares
to 17% of the other 367 ex-Financials and Utilities companies in the S&P 500.
Exhibit 2: S&P 500 median and aggregate margins
Exhibit 3: Median and aggregate margins by sector
12%
Aggregate

11%
10%
Median
9%
8%
7%
6%
Aggregate
5%
Bottom-up
Consensus
Forecast
4%
Source: Compustat, FirstCall, I/B/E/S and GS Global Investment Research.
2021
2018
2015
2012
2009
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
3%
2013 Margin
Median
Difference
Health Care
8.7 %
14.2 %
551 bp
Consumer Staples
6.6
10.1
351
Energy
7.6
10.2
259
Consumer Discretionary
6.9
8.3
142
Materials
6.9
7.9
103
Industrials
8.9
8.7
(15)
Information Technology
16.3
13.9
(245)
Telecom Services
10.2
5.5
(476)
S&P 500
8.9 %
10.2 %
132 bp
Source: Compustat, FirstCall, I/B/E/S and GS Global Investment Research.
March 17, 2014
United States
For the past three years, trailing four-quarter margins have remained essentially flat,
ranging from 8.4% to 8.9%. Firms found varying degrees of success supporting margins
by adjusting pricing, costs and business mix. Some companies prioritized sales growth at
the expense of margins.
While index-level operating margins have been under pressure in recent quarters,
atypical operating items recorded in the second half of 2012 increased the severity of
the contraction. These included pension charges and write-downs to continuing
operations (see page 18). S&P 500 margins rebounded in the second half of 2013 as trailing
four-quarter earnings anniversaried these items.
Operating margins equaled 8.9% at the end of 2013, just 8 bp below the previous
peak level.
Exhibit 4: S&P 500 net margin, 2006-2015E
11%
Bottom-up Consensus
Forecast
2015E
10.0%
2014E
9.4%
10%
8.9%
9%
8.9%
8%
Goldman Sachs
Forecast
1Q 2011 3Q 2013
8.4-8.9%
7%
6%
9.0%
Dec-16
Dec-15
Dec-14
Dec-13
Dec-12
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
5%
Dec-11

March 17, 2014
United States
Conflicting views on the potential for further margin expansion

Looking forward, the forces that influence margins are equally balanced between
upside and downside, and we expect margins will remain nearly flat through 2015. In
the near term, economic acceleration should drive revenues and support margins through
modest operating leverage. Additional efficiency gains and cost controls combined with
subdued commodity costs should offset an uptick in wage inflation.
In conference calls during the 4Q 2013 earnings season, companies presented mixed
outlooks for margins. Many indicated that expansion will be difficult, consistent with our
forecast. Managements highlighted difficult pricing and higher input costs as key factors
offsetting operating leverage, efficiency gains, and continued cost controls. See S&P 500
Beige Book: Four key themes from 4Q 2013 earnings conference calls (February 11, 2014)
for more information.
Looking further out, labor costs will present more of a headwind to margins as the
output gap shrinks. Corporate profit growth at the expense of personal income has made
margins a topic with important social and political ramifications, in addition to financial
considerations.
Our Economics team sees a favorable environment for corporate profits with a
significant pickup in US GDP and productivity growth in 2014 with only a modest
pickup in wage growth. Further out, they expect a reversion to higher wages and lower
profit margins. Assuming that labor productivity grows 2% and price inflation converges
toward the Fed's 2% target, hourly labor costs would need to grow more than 4% to
systematically impact margins. See US Daily: The Telling Strength of Corporate Profits
(January 22, 2014) for more information.
S&P 500 earnings are highly sensitive to small changes in profit margins, as each 50
bp shift in margins represents roughly $5 in EPS. Exhibit 5 shows the sensitivity of our
2014 EPS forecast to various margin assumptions. For example, our estimate of $116
assumes an 8.9% net margin, but an increase to 9.4% would imply EPS of $121. The
roughly 45 bp gap between our margin forecast and the consensus estimate of 9.4% more
than explains the upside between our 2014 EPS forecast and bottom-up consensus
expectation of $118. However, our sales growth and Financials EPS forecasts are higher
than consensus.
Exhibit 5: EPS sensitivity: 50 bp shift in margins = $5/share in EPS
Sensitivity of 2014 EPS forecast to

sales growth and margin (50bp $5)
2014 Profit Margin
2014 Sales Growth
6.9 %
7.4 %
7.9 %
8.4 %
8.9 %
9.4 %
9.9 %
10.4 %
10.9 %
9.0 %
98
103
108
113
118
123
129
134
139
8.0
97
102
108
113
118
123
128
133
138
7.0
97
102
107
112
117
122
127
132
137
6.0
96
101
106
111
116
121
126
131
136
5.0
96
100
105
110
115
120
125
130
135
4.0
95
100
105
109
114
119
124
129
134
3.0
94
99
104
109
113
118
123
128
133
2.0
94
98
103
108
113
117
122
127
132
Source: Goldman Sachs Global Investment Research.
March 17, 2014
United States
Cost breakdown: Margins as the remainder of expenses

Rather than one major factor pushing margins to record levels, over the last 20 years
almost every component of the income statement has shrunk relative to sales.
Exhibit 6: Breakdown of costs and profits for S&P 500 ex-Financials and Utilities
40%
35%
67%
66%
Cost of Goods Sold
18%
17%
SG&A
25%
20%
15%
5%
10%
5%
Interest and Taxes
4%
Depreciation and Other
9%
Operating Income
2013
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1994
0%
1996
5%
2012
5%
2011
5%
1995
Share of Sales
30%
Cost management has driven margin growth in the long term more than any other
factor. S&P 500 companies have seen the cost of goods sold (COGS) as a share of revenue
fall by 1 percentage points since 1994 (67% to 66%). Lower selling, general &
administrative expenses (SG&A) have contributed another point. Firms have enjoyed a
secular increase in the productivity of labor and capital as well as technological innovations
such as real-time inventory management, reducing both fixed and variable costs.
Only depreciation and other expenses increased as a percentage of sales since the
2007 peak. Depreciation remains low historically but has risen relative to recent cycle lows.
Exhibit 7: Breakdown of sales and profits for S&P 500 firms ex-Financials and Utilities
40%
35%
65.6 %
65.2 %
65.6 %
Cost of
Goods Sold
18.3 %
16.8 %
16.9 %
SG&A
5.0 %
4.5 %
4.1 %
4.2 %
Share of sales
30%
25%
20%
15%
5.4 %
10%
2.5 %
5%
8.3 %
8.9 %
8.9 %
30-Jun-07
30-Sep-11
31-Dec-13
Prior peak
Recent peak
0%
Interest and
Taxes
Depreciation
and Other
Operating
Income
Current
March 17, 2014
United States
For both Cost of Goods Sold and Selling, General & Administrative Expenses, low
inflation in terms of commodity inputs and labor costs have been tailwinds. We
expect commodity prices will remain controlled. Labor costs should rise as the output gap
narrows and slack is removed from the labor market. The question is whether efficiency
gains can outpace the increase in labor costs. Both are below their long-term averages and
have been cyclical but generally trending down for the past decade.
Cost of Goods Sold (COGS)

Cost of Goods Sold includes expenses directly allocated to production, such as
material. Unsurprisingly, sectors in earlier stages of production, such as Energy and
Materials, report higher COGS as a share of sales (78% and 72%, respectively).
Exhibit 8: Cost of goods sold as a share of sales
Exhibit 9: Cost of goods sold by sector
72
S&P 500 COGS
(ex-Financials and Utilities)
COGS as % of sales
71
70
69
68
Average:
66%
67
66
66%
65
64
63
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
62
Share of
S&P 500
Sector
Revenue
COGS
Sector
COGS
($Bil)
Energy
Materials
Consumer Staples
Industrials
Health Care
Telecom Services
$1,134
290
957
896
749
774
516
121
78%
72
68
68
68
63
48
40
21%
5
18
16
14
14
9
2
S&P 500
$5,437
66%
100%
Our commodity strategists forecast a -4% return for the S&P GSCI Enhanced
Commodity Index over the next 12 months. They expect oil prices to decline, with Brent
crude reaching $100 in a years time.
Exhibit 10: Growth in cost of goods sold vs. GSCI index
20
15
60
10
40
20
(5)
(20)
S&P GSCI Commodity Index
Year/Year Change
(RHS)
(10)
(15)
(40)
S&P GSCI Commodity Index

Year/Year Change (%)
S&P 500 COGS Growth (%)
80
S&P 500 COGS Growth

(LHS)
(60)
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
(80)
1994
(20)
Source: Haver, Compustat and Goldman Sachs Global Investment Research.
March 17, 2014
United States
Selling, General & Administrative Expenses (SG&A)

Selling, General & Administrative Expenses represents expenses not directly related
to the manufacture of products. During the downturn, SG&A growth declined sharply as
companies cut costs. Selling, general & administrative costs as percentage of sales fell to
16.8% from 18.3% in mid-2007.
Pensions are included in SG&A spending, so some of the recent rise and decline in
margins is due to pension adjustments.
As with COGS, Selling, General & Administrative spending varies by sector. SG&A
accounts for over 25% of Information Technology costs but just 4% of Energy costs.
Exhibit 11: SG&A expense as a share of sales
Exhibit 12: SG&A expense by sector
Share of
S&P 500
Sector
Revenue
SG&A
20
SG&A
($Bil)
SG&A as % of sales
Sector
19
Telecom Services
Health Care
Consumer Staples
Industrials
Materials
Energy
Average:
18%
18
17
S&P 500 SG&A
(ex-Financials and Utilities)
17%
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
16
S&P 500
$281
65
249
258
265
181
45
56
26%
22
20
20
19
16
11
4
20%
5
18
18
19
13
3
4
$1,400
17%
100%
Our Economics team sees a favorable environment for corporate profits in 2014 with
a significant pickup in productivity growth but only modest wage growth. The gap
between the productivity and labor growth rates is associated with margin growth (see
Exhibit 14). Further out, they expect a reversion to higher wages and lower profit margins.
However, they believe this is at least a couple of years off.
Exhibit 13: Nonfarm labor cost and SG&A growth
Exhibit 14: Price-Cost gap associated with profit growth

60 %
50 %
40 %
Source: BLS, Compustat and Goldman Sachs Global Investment Research.
1%
0%
0%
(2)%
(30)%
(3)%
(40)%
(4)%
2016
(1)%
(20)%
2014
(10)%
2012
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
(10)%
10 %
2010
Nonfarm Business
Unit Labor Cost Growth
(4-qtr change ann)
2%
2008
(5)%
20 %
2006
0%
3%
2004
5%
4%
30 %
2000
S&P 500 Margin

(LTM, YoY Growth)
10 %
5%
S&P 500 Margin

Growth
(LHS)
Core PCE vs. Unit Labor Cost

(4-qtr avg, YoY Change)
S&P 500
SG&A Growth
6%
Core PCE vs.

Unit Labor Cost
(RHS)
2002
15 %
Source: Department of Labor, Department of Commerce, Compustat and

Goldman Sachs Global Investment Research.
March 17, 2014
United States
Taxes and interest rates have never been more favorable for the profitability of US
firms. The efficiency gains and cost controls put in place by most S&P 500 firms in recent
decades have brought EBIT margins to record highs. However, the historical upward trend
in EBIT margins is less extreme than that of net profit margins, highlighting the role
government policy and effective management have played in elevating corporate profits.
Exhibit 15: EBIT margins are also at historical highs but less extreme than profit margins
16%
S&P 500 Profit Margin

14%
13.3
EBIT
13.2
14.1
13.8
8.9
8.9
11.7
12%
10.9
10%
9.3
8%
8.3
7.1
8.4
5.8
6%
Operating
4%
5.9
4.7
3.9
2015
2010
2005
2000
1995
1990
1985
1980
2%
Interest rates
By increasing debt with interest rates near historical lows, S&P 500 firms have taken
advantage of the opportunity to boost current margins and lock in future support.
While 10-year Treasury yields have risen from their bottom at 1.4% last August, interest
costs have continued to fall, reaching new all-time lows as firms issue debt and extend
maturities.
Exhibit 16: Cost of debt is at historical lows
Exhibit 17: Companies have taken advantage of low rates
8%
20 %
7%
S&P 500 interest cost
7%
(ex. Financials and Utilities)
10-Year US Treasury Yield
15 %
6%
(RHS, one year average)
S&P 500 debt growth
5%
4%
3%
10 %
5%
5%
4%
0%
3%
2%
(5)%
(one year average)
1%
6%
2%
S&P 500 debt growth

(LHS, ex. Financials and Utilities)
(10)%
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
1%
2000
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
0%
10
March 17, 2014
United States
Taxes
Effective US corporate tax rates have steadily declined for decades despite statutory
rates that rank among the highest in the world. The United States has the highest
statutory corporate income tax rate among OECD countries, at 39%, combining federal and
weighted average state corporate income tax rates. Meanwhile, the S&P 500 median
effective rate of 30% is almost 10 percentage points below the statutory rate. Over the last
10 years, fewer than 10% of S&P 500 firms have paid the statutory rate or higher.
Exhibit 18: Falling corporate tax rates have boosted profits
60%
US Corporate Income Tax Rate
55%
50%
48%
45%
40%
44%
Statutory
39%
35%
30%
30%
Median S&P 500 Effective

25%
2015
2010
2005
2000
1995
1990
1985
1980
1975
20%
Source: OECD, Compustat, and Goldman Sachs Global Investment Research.
The tax preferences that create the gap between effective and statutory rates will
likely receive scrutiny from policymakers as they attempt to reform the tax code. By
closing the gap between effective and mandated tax rates, the government could raise
revenues while lowering the statutory rate, thus presenting the change as a tax cut.
Looking forward, changes to tax rates could have meaningful implications for
corporate profitability. Since 1975, tax rates have had the largest cumulative contribution
of the five DuPont factors to S&P 500 index ROE (ex-Financials). The majority of this
contribution was generated in the 1980s when President Reagan cut statutory rates from
50% to 39%. In the last decade, taxes have had a positive but much smaller impact. Higher
effective rates would be a headwind for margins.
Energy pays the highest effective tax rate among S&P 500 sectors in part due to excise
taxes on the sale of oil products.
See US Equity Views: Higher corporate tax rates represent a risk to earnings and valuation
(February 5, 2013) for more information.
11
March 17, 2014
United States
Stage of Production: Intermediate company margins squeezed

Interestingly, the companies on either end of the production chain have been able to
support margins due to letting commodity prices flow through on one end and pushing
through pricing to the consumer on the other.
Intermediate companies have been caught between the two. Aggregate margins for
these companies contracted by over 100 bp since the previous peak in 3Q 2011. Over the
past two years, the cost of goods sold increased to 74% of sales from 73%.
Consensus sales and EPS estimates imply 50 bp of expansion in all groups during 2014.
Exhibit 19: Firms in intermediate stages of production reported lower margins
12 %
11 %
10 %
9%
8%
7%
6%
5%
4%
3%
2%
End
Consumer
Raw
Materials
Intermediate
Goods
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
Bottom-up
Consensus
The cost of goods is a higher portion of sales for firms in the raw and intermediate
stages of production while SG&A is a higher share of expenses for end consumer
companies. Due to a higher mix of fixed costs, intermediate- and end-stage firms benefit
more from operating leverage than raw materials firms.
Exhibit 20: Firms in intermediate stages of production reported lower margins
45%
40%
61%
Cost of
Goods Sold
Share of sales
35%
30%
21%
74%
25%
20%
15%
10%
5%
6%
SG&A
7%
Interest and
Taxes
3%
3%
5%
Depreciation
and Other
7%
9%
Operating
Income
Intermediate
Goods
Raw
Materials
13%
5%
4%
10%
73%
0%
End
Consumer
12
March 17, 2014
United States
We classify 63% of S&P 500 revenues in the End Consumer category. The Consumer
Staples and Consumer Discretionary sectors account for half of end demand sales. The
Software & Services industry group lifts margins for the end-stage group. Software &
Services represents 8% of the categorys sales but 16% of earnings. Excluding the industry
groups 19% margin, End Consumer margins drop to 8.9% from 9.7%.
Exhibit 21: Breakdown of sales by stage of production
Raw
Materials
16%
Telecom
Discretionary
Staples
Info Tech
Intermediate
Goods
21%
End Demand
63%
Health Care
Industrials
Energy
Materials
0%
20%
40%
60%
80%
100%
Share of 2013 sector revenue
Raw Materials
Agricultural
Products
7%
Intermediate Goods
Other Energy
2%
Food
Distributors
3%
Oil & Gas

Exploration &
Production
13%
Containers &
Packaging
2%
Other
11%
Oil & Gas

Refining &
Marketing
24%
Other
Info Tech
6%
Integrated Oil
& Gas
51%
Semiconductor
& Semi Eq
7%
Health Care
Distributors
18%
Other
Health Care
8%
Materials
ex. Containers
& Packaging
27%
Transportation
ex. Airlines
9%
Machinery
12%
End Demand
Other
18%
Industrial
Conglomerates
4%
Food & Staples

Retailing
ex. Distributors
13%
Retailing
ex. Distributors
11%
Automobiles
4%
Pharmaceuticals
5%
Software &
Services
8%
Media
6%
Food Beverage
& Tobacco
ex. Ag Products
Telecom
7%
Services
Aerospace &
Managed Health Computer
6%
Defense
Care
Hardware
6%
6%
6%
13
March 17, 2014
United States
Operating leverage: Limited benefit to index-level margins in 2014

Companies with high fixed costs tend to experience margin contraction in downturns
and margin expansion in recoveries. As the economy improves and revenues grow, fixed
costs become a smaller portion of total costs and margins expand.
In addition to incremental sales growth, our models suggest that margins expand by 16 bp
for every 1 pp increase in real US GDP growth. Despite this, we expect limited margin
upside in 2014 even though we expect real US GDP to grow above-trend.

Low aggregate operating leverage means the accelerating US economy will provide
only a modest boost to S&P 500 margins. Firms cut fixed costs during the great
recession in an attempt to protect earnings in a period of slow growth, bringing the S&P
500 degree of operating leverage (DOL) to the lowest level in at least 30 years. We measure
operating leverage through each stocks degree of operating leverage (DOL), the ratio of
revenue after variable operating costs to revenue after variable and fixed operating costs. A
high DOL indicates more fixed costs and high operating leverage while a low DOL indicates
more variable costs and low operating leverage.
The S&P 500 degree of operating leverage troughed at 2.5 in 2Q 2011. The DOL rose
over the last few quarters as COGS growth outpaced sales growth. We estimate the S&P
500 degree of operating leverage will decline to 2.4 by the end of 2014 from 2.7 in 3Q 2013.
Although index-level upside from leverage is limited, stock-level opportunities exist.

Firms that can leverage increased sales should be able to grow margins despite headwinds.
We recommend investors buy our High Operating Leverage basket (Bloomberg ticker:
<GSTHOPHI>) against our Low Operating Leverage basket (<GSTHOPLO>). We expect
strong sales growth will benefit the earnings of high operating leverage stocks more than
their low leverage counterparts, and high operating leverage stocks to outperform on
stronger earnings growth. See US Thematic Views: Buy high operating leverage firms
ahead of expected sales growth (August 6, 2013).
Exhibit 22: Operating leverage near all-time lows
4.0
10.0
Operating Margin
9.0
3.8
3.6
8.0
3.4
7.0
3.2
3.0
6.0
2.8
5.0
2.6
2.4
Operating Margin
(LHS)
4.0
2.2
2.0
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
3.0
Degree of Operating Leverage
Degree of
Operating Leverage
(RHS)
Note: Degree of Operating Leverage calculated as (Sales COGS) / (Sales COGS SGA Depreciation)
14
March 17, 2014
United States
Sectors: Margin trends vary, but Information Technology is key

Technology margins have exceeded 16% since early 2011. This is almost double the
index-level aggregate (8.9%). Information Technology margins are flat relative to the 3Q
2011 peak but remained the highest margins of any S&P 500 sector.
Apple (AAPL) significantly contributes to the Info Tech sectors multiple expansion.
Apples trailing four-quarter revenues grew by over 600% between 2Q 2007 and 4Q 2013
($174 billion from $23 billion) and its margin expanded to 21% from 14%. Excluding Apple,
Info Tech margins still expanded by 450 bp.
Margins for the Industrials and Health Care sectors are in line with index-level
margins. Strong sales growth in Health Care positively contributed to index-level margins
even though the sectors margin declined. Health Care margins fell to 8.7% in 2013 from
9.4% in mid-2007 but grew sales faster than the market (37% vs. 23%).
Pension adjustments cloud margin changes in the Telecom Services sector. Excluding
these adjustments, margins have improved slightly over the past year (see exhibit 37).
While Consumer Discretionary margins are up over 200 bp since 2007, there has been
little change in the past three years. Both our forecast and consensus expect modest
margin improvement for the sector in 2014. We expect expansion to 7.2% by year-end 2014
from 6.9% in 2013, in line with consensus.
Not all sectors are near peak margin levels. Four out of eight sectors reported margins
below mid-2007 levels. Margins for the Energy and Materials sectors contracted at least
20% since then. The Energy sector has been the largest drag on index-level margins. Sector
margins fell to 7.6% from 11% in 2007.
Margin movements during the recent quarter are mostly positive. Trailing four-quarter
margins for Information Technology, Consumer Staples, Industrials, and Telecom Services
all expanded versus 3Q 2013 while Materials and Health Care margins are flat. Only Energy
and Consumer Discretionary margins declined.
Exhibit 23: Half of sector margins below 2007 levels
Consumer Staples
Health Care
Telecom Services
Materials
Industrials
Energy
S&P 500 Net Margin
2Q 2007
11.0 %
4.8
6.3
9.4
8.3
8.7
8.8
11.1
8.3 %
Operating Margin
4Q 2013
Change
16.3 %
536 bp
6.9
208
6.6
30
8.7
(69)
10.2
189
6.9
(182)
8.9
3
7.6
(349)
8.9 %
Contribution to
S&P 500 Margin
Sales
Expansion /
Growth
(Contraction)
39.6 %
86 bp
17
0.0
10
29.4
36.9
4
8.8
3
26.1
(8)
(8)
14.5
(48)
31.6
57 bp
22.6 %
57 bp
Note: Telecom Services margins for 4Q 2013 equal 8.2% when adjusted for pension benefits.
15
March 17, 2014
United States
Information Technology margins matter to index-level margins

Only Info Tech margins are above the aggregate index level. Because of their high
margins and large sales weight in the index, Info Tech margins typically have a large
impact on the S&P 500.
Exhibit 24: High Info Tech margins contributed to S&P 500 margin expansion
22%
20%
18%
2015E
19.0%
Bottom-Up Consensus
Forecast
Net Profit Margin

16.8%
Information
Technology
16%
14%
12%
10.0%
10%
9.0%
8%
6%
4%
Goldman Sachs
Portfolio Strategy
Forecast
S&P 500
2%
2021
2018
2015
2012
2009
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
0%
Excluding Information Technology, S&P 500 margins peaked at 7.9% in both 3Q 2011
and 2Q 2007. Positive contributions by Consumer Staples and Health Care were cancelled
out by declines in Energy and Industrials.
Exhibit 25: Excluding Info Tech, S&P 500 margins have not exceeded 2007 highs
10%
Net Profit Margin
9%
8.9%
8.9%
8.3%
7.9%
8%
S&P 500
7.7%
7.9%
7%
6%
5%
S&P 500 ex.

Information
Technology
4%
2017
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
3%
16
March 17, 2014
United States
Info Tech is a key difference between our forecasts and consensus

We forecast Information Technology will be of little benefit to index-level margins in
2014. We forecast modest margin expansion for the Info Tech sector from 16.3% in 2013 to
16.6% in 2014. Our sales growth forecast is slightly above the market level (6.2% vs. 6.0%).
Exhibit 26: We forecast margins of 8.9% and 6.0% sales growth in 2014
Materials
Industrials
Energy
Health Care
Consumer Staples
Telecom Services
S&P 500 Net Margin
Operating Margin
Goldman
Sachs
2013
2014E
6.9 %
7.2 %
16.3
16.6
6.9
7.2
8.9
9.0
7.6
7.8
8.7
8.7
6.6
6.7
10.2
8.5
8.9 %
8.9 %
Change
28 bp
21
34
7
14
(1)
1
(172)
Contribution to
S&P 500 Margin
Sales
Expansion /
Growth
(Contraction)
9.5 %
9 bp
3
6.2
2
7.7
6.4
1
1
4.8
(0)
5.7
4.5
(1)
(8)
(1.9)
6 bp
6.0 %
6 bp
Bottom-up consensus expects the Technology sector results will benefit margins.
Consensus forecasts further margin expansion to a new high of 18.0% in 2014 but with
slower sales growth than the market aggregate (1.2% vs. 4.5%). The sector accounts for
almost one-third of the consensus margin expansion forecast in 2014.
Based on these margin and sales differences, our 2014 Information Technology EPS
forecast is $0.90 below bottom-up consensus.
Exhibit 27: Consensus expects margin expansion to 9.4% but slower sales growth of 4.5%
Energy
Health Care
Materials
Industrials
Consumer Staples
Telecom Services
S&P 500 Net Margin
Operating Margin
Bottom-up
Consensus
2013
2014E
Change
16.3 %
18.0 %
169 bp
7.6
8.1
43
8.7
9.2
52
6.9
7.2
32
6.9
8.0
119
8.9
9.2
31
6.6
6.7
3
10.2
10.7
46
8.9 %
9.4 %
Contribution to
S&P 500 Margin
Sales
Expansion /
Growth
(Contraction)
14 bp
1.2 %
10
6.5
10
6.3
7.5
9
4.8
6
4.2
4
(2)
2.4
(2)
(5.3)
50 bp
4.5 %
50 bp
17
March 17, 2014
United States
Atypical operating items skew index & sector margin movements

While index-level operating margins have been under pressure, atypical operating items,
such as pension charges and write-downs to continuing operations, increased the severity
of the contraction. Recurring margins, which exclude atypical operating items, show a
smaller margin decline over the previous ten quarters.

Exhibit 28: Recent S&P 500 margin decline partially due to atypical operating items
9.5%
LTM Profit Margin
9.0%
8.5%
8.0%
Recurring
7.5%
7.0%
Operating
6.5%
S&P 500
6.0%
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
5.5%
Source: Compustat, Factset, FirstCall, I/B/E/S, and Goldman Sachs Global Investment Research.
Previous atypical operating items cloud margin trends in certain sectors. Info Tech
operating margins show a steeper decline and rebound during 2012 and 2013 due to prior
write-downs. The Telecom Services operating margin contracted from pension charges
reported by Verizon and AT&T in 4Q 2012. Later, pension-related gains reported in 4Q 2013
increased margins.
Exhibits 30-37 show trailing four-quarter margin charts for S&P 500 sectors. Recurring
and operating margin series are shown when large discrepancies exist.
Exhibit 29: Breakdown of sales and profits for S&P 500 sectors
Cost of
Goods Sold
SG&A
Interest
Expense
Tax
Expense
Depreciation
& Other
Operating
Margin
Telecom Services
Industrials
Health Care
Energy
Materials
Consumer Staples
48 %
40
68
63
78
68
72
68
26 %
22
16
20
4
19
11
20
1%
4
2
1
1
2
2
1
4%
5
2
2
5
3
2
3
4%
19
3
5
4
2
5
3
16.3 %
10.2
8.9
8.7
7.6
6.9
6.9
6.6
S&P 500
66 %
17 %
1%
3%
4%
8.9 %
18
Exhibit 31: Consumer Discretionary margins
6.8%
8%
7%
6.6%
Operating
LTM Profit Margin
6.4%
6.2%
6.0%
5.8%
Consumer
Staples
Operating
6%
5%
4%
3%
2%
Consumer
Discretionary
1%
Exhibit 32: Energy margins
Exhibit 33: Health Care margins
12%
10.0%
11%
9.8%
9.6%
10%
9%
LTM Profit Margin
Recurring
8%
7%
Operating
6%
9.2%
9.0%
8.8%
8.6%
8.4%
Energy
5%
Operating
9.4%
Health Care
8.2%
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-08
19
United States
Dec-07
8.0%
4%
Dec-06
LTM Profit Margin
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-06
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-08
0%
5.6%
Dec-07
LTM Profit Margin
March 17, 2014
Exhibit 30: Consumer Staples margins
Exhibit 35: Information Technology margins
9.5%
20%
9.0%
Recurring
18%
8.5%
LTM Profit Margin
8.0%
7.5%
7.0%
6.5%
Operating
14%
12%
10%
Industrials
Operating
6.0%
16%
Information
Technology
Exhibit 36: Materials margins
Exhibit 37: Telecommunication Services margins
10%
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-06
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-08
8%
5.5%
Dec-07
LTM Profit Margin
March 17, 2014
Exhibit 34: Industrials margins
12%
9%
10%
7%
LTM Profit Margin
Recurring
6%
5%
4%
3%
Operating
2%
6%
4%
Operating
Telecom
Services
2%
Materials
1%
Recurring
8%
0%
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
20
United States
Dec-14
Dec-13
Dec-12
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
0%
Dec-06
LTM Profit Margin
8%
Disclosure Appendix
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We, Amanda Sneider, CFA, David J. Kostin, Stuart Kaiser, CFA, Ben Snider and Rima Reddy, hereby certify that all of the views expressed in this
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Modeling Peak Profitabiliyt

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March 17, 2014

Writing in the margins:

Amanda Sneider, CFA

Higher margins drove record S&P 500 earnings despite an environment of

Cost management is the main driver of margin growth

(212) 357-9860 amanda.sneider@gs.com

Stuart Kaiser, CFA

Stage of Production: Intermediate-stage margins squeezed

Cost of Goods Sold

Interest and Taxes

Source: Compustat and Goldman Sachs Global Investment Research.

The Goldman Sachs Group, Inc.

Global Investment Research

March 17, 2014

Margins: Past, Present, and Future

Cost breakdown: Margins as the remainder of expenses

Stage of Production: Intermediate company margins squeezed

Operating leverage: Limited benefit to index-level margins in 2014

Sectors: Margin trends vary, but Information Technology is key

Goldman Sachs Global Investment Research

March 17, 2014

US corporate profitability returns to record levels

Bottom-up consensus estimates imply further margin expansion to new peak

Information Technology matters to index-level margins. Information Technology is

Goldman Sachs Global Investment Research

March 17, 2014

Margins: Past, Present, and Future

S&P 500 Net Profit Margin

Exhibit 3: Median and aggregate margins by sector

as of March 12, 2014

as of March 12, 2014

S&P 500 Net Profit Margin

Source: Compustat, FirstCall, I/B/E/S and GS Global Investment Research.

Goldman Sachs Global Investment Research

Source: Compustat, FirstCall, I/B/E/S and GS Global Investment Research.

March 17, 2014

S&P 500 Net Profit Margin

Goldman Sachs Global Investment Research

March 17, 2014

Conflicting views on the potential for further margin expansion

Sensitivity of 2014 EPS forecast to

2014 Sales Growth

Source: Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research

March 17, 2014

Cost breakdown: Margins as the remainder of expenses

Cost of Goods Sold

Interest and Taxes

Depreciation and Other

Source: Compustat and Goldman Sachs Global Investment Research.

Source: Compustat and Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research

March 17, 2014

Cost of Goods Sold (COGS)

Exhibit 9: Cost of goods sold by sector

as of March 12, 2014

as of March 12, 2014

Source: Compustat and Goldman Sachs Global Investment Research.

Source: Compustat and Goldman Sachs Global Investment Research.

S&P GSCI Commodity Index

S&P 500 COGS Growth (%)

S&P 500 COGS Growth

Source: Haver, Compustat and Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research