Musing About Margins

When the global meltdown began a couple of years ago now, analysts all over the world agreed that the financial sector, particularly in the United States, had simply become too big. Whether measured by percent of GDP or percent of the S&P's capitalization, the lubricant of our economic system had become bigger than its wheels. We then tried to make this into slogans, "Too big to fail," or "To big to save." Reading the news in the current earnings season, the financial sector continues to live large.

Cleveland-based Eaton Corporation (NYSE: ETN) reported outstanding results for a global leader in power management systems, hydraulics, automotive and aerospace. My former colleague, Norm Klopp of Midwestern Investment Management, always liked this stock. Core revenues were up 18% for this global leader, and operating EPS rose 32 percent year-over-year. Segment operating margins increased to 13%. Good company, with good management and a business model leveraged to strong volume increases, and it's as good as it gets.


Now move over to medical devices, a sector with which I'm familiar first hand. This sector offered great demographics, unmet clinical needs, technological innovation, and proprietary technologies. Multiples were in the ozone years back. St. Jude Medical (NYSE: STJ) reported an 11% revenue increase for their fiscal third quarter, and operating EPS up 5% year-over-year. Operating margins increased to 26%. That is a pretty nice margin for a manufacturing business, and it reflects characteristics of the device business. St. Jude is selling at 13x this year's projected operating EPS, reflecting uncertainty about reimbursement and healthcare reform. Remember, STJ's operating margins are twice those of the more industrial Eaton.


So, what made me wring my hands this morning? BlackRock (NYSE: BLK) reported a 74% increase in third quarter earnings, besting all analyst estimates, driven by its acquisition of Barclay's Global Investors, the leader in indexed fund products. Current operating margins were 33.8%, projected by the CEO to move to 40 percent, which will be driven by asset inflows into indexed equity and fixed income funds. I don't mean to single out BlackRock, because the large banks would also be poster children, but it was the absolute value of the operating margin that drew my attention.


In the funds business, there's no metal bending, no R&D, no product development risk, no product liability, no price controls, no FDA regulation, and no accountability for poor performance, since indexed products mimic the market risk. Goldman Sachs is reported to be ready to redeem Berkshire Hathaway's $5 billion convertible because, among other things, it has $1 trillion in excess liquidity with the Federal Reserve Bank. Something is wrong with this picture, and it could be that some numbers, particularly for banks as opposed to asset managers, are illusory.


We've written before about this issue. Simon Johnson takes a stab at guesstimating the unrecorded bank portfolio write downs as being $50-$100 billion, with a ten percent probability of losses being multiples of his estimated range. Really, really big in other words. Even if we careen to this scenario, there will be no reform and no accountability. Former CEO Angelo Mozilo of Countrywide Financial, one of the great enablers of Fannie who poured jet fuel over the early flames of the mortgage crisis, walks away with no life style changes, while the housing sector is beginning yet another episode of cardiac arrest. I took a Rolaids with my coffee.