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

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.

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

Source: Compustat and Goldman Sachs Global Investment Research.

Amanda Sneider, CFA (212) 357-9860 [email protected] Goldman, Sachs & Co.

David J. Kostin (212) 902-6781 [email protected] Goldman, Sachs & Co.

Stuart Kaiser, CFA (212) 357-6308 [email protected] Goldman, Sachs & Co.

Ben Snider (212) 357-1744 [email protected] Goldman, Sachs & Co.

Rima Reddy (801) 884-4794 [email protected] Goldman, Sachs & Co.

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investorsshould be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investorsshould consider this report as only a single factor in making their investment decision. For Reg AC certification and otherimportant disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed bynon-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

The Goldman Sachs Group, Inc. Global Investment Research

0%

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Sh

are

of

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Operating Income

Depreciationand Other

SG&A

Cost of Goods Sold

5%

5%

18%

67%

9%

5%

17%

66%

Interest and Taxes

5%4%

March 17, 2014 United States

Goldman Sachs Global Investment Research 2

Contents

US corporate profitability returns to record levels 3

Margins: Past, Present, and Future 4

Cost breakdown: Margins as the remainder of expenses 7

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



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.



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

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

The median S&P 500 firm’s 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 as of March 12, 2014

Exhibit 3: Median and aggregate margins by sector as of March 12, 2014

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

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

3%

4%

5%

6%

7%

8%

9%

10%

197

9

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8

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1

199

4

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7

200

0

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3

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6

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9

201

2

201

5

S&P 500 Net Profit Margin(trailing four quarters)

5.9

3.9

8.9

4.7

8.9

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

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1


Bottom-upConsensus

Forecast

Aggregate

Median

2013 MarginAggregate 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



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 as of March 12, 2014


5%

6%

7%

8%

9%

10%

11%

De

c-0

6

De

c-0

7

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c-1

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c-1

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De

c-1

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De

c-1

6


Goldman SachsForecast

Bottom-up ConsensusForecast

8.9%

8.9% 9.0%

1Q 2011 -3Q 20138.4-8.9%

2014E9.4%

2015E10.0%



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 as of March 12, 2014

Source: Goldman Sachs Global Investment Research.

Sensitivity of 2014 EPS forecast tosales growth and margin (Δ50bp ≈ $5)

2014 Profit Margin

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

201

4 S

ale

s G

row

th



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

as of March 12, 2014


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 as of March 12, 2014


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Operating Income

Depreciation and Other

SG&A

Cost of Goods Sold

5%

5%

18%

67%

9%

5%

17%

66%

Interest and Taxes

5%4%

8.3 % 8.9 % 8.9 %

2.5 %4.1 % 4.2 %

5.4 %5.0 % 4.5 %

18.3 % 16.8 % 16.9 %

65.6 % 65.2 % 65.6 %

0%

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30-Jun-07 30-Sep-11 31-Dec-13

Sh

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Operating Income


SG&A

Cost of Goods Sold

Interest and Taxes

Prior peak Recent peak Current



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




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 year’s time.

Exhibit 10: Growth in cost of goods sold vs. GSCI index


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

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2016

CO

GS

as

% o

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les

S&P 500 COGS (ex-Financials and Utilities)

Average: 66%

66%

Share ofCOGS Sector S&P 500

Sector ($Bil) Revenue COGS

Energy $1,134 78% 21%Materials 290 72 5Consumer Discretionary 957 68 18Consumer Staples 896 68 16Industrials 749 68 14Health Care 774 63 14Information Technology 516 48 9Telecom Services 121 40 2

S&P 500 $5,437 66% 100%

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ear/Year C

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)

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00 C

OG

S G

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%)

S&P 500 COGS Growth(LHS)

S&P GSCI Commodity IndexYear/Year Change

(RHS)



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




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


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

Source: Department of Labor, Department of Commerce, Compustat and Goldman Sachs Global Investment Research.

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SG

&A

as

% o

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S&P 500 SG&A(ex-Financials and Utilities)

Average: 18%

17%

Share ofSG&A Sector S&P 500

Sector ($Bil) Revenue SG&A

Information Technology $281 26% 20%Telecom Services 65 22 5Health Care 249 20 18Consumer Staples 258 20 18Consumer Discretionary 265 19 19Industrials 181 16 13Materials 45 11 3Energy 56 4 4

S&P 500 $1,400 17% 100%

(10)%

(5)%

0 %

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10 %

15 %

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

S&P 500SG&A Growth

Nonfarm BusinessUnit Labor Cost Growth

(4-qtr change ann)

(4)%

(3)%

(2)%

(1)%

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1 %

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S&

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00 M

arg

in(L

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, Yo

Y G

row

th)

S&P 500 MarginGrowth(LHS)

Core PCE vs.Unit Labor Cost

(RHS)



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 as of March 12, 2014


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 as of March 12, 2014

Exhibit 17: Companies have taken advantage of low ratesas of March 12, 2014



2%

4%

6%

8%

10%

12%

14%

16%

1980

1985

1990

1995

2000

2005

2010

2015

S&P 500 Profit Margin(trailing four quarters)

8.910.9

8.49.3

13.8EBIT

Operating 5.9

4.73.9

8.9

14.113.3

8.3

13.2

7.1

11.7

5.8

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8%

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11

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20

15

S&P 500 interest cost(ex. Financials and Utilities)

10-Year US Treasury Yield(one year average)

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ear US

Treasu

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&P

500

deb

t g

row

th

S&P 500 debt growth(LHS, ex. Financials and Utilities)

10-Year US Treasury Yield(RHS, one year average)



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 as of March 12, 2014

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.

20%

25%

30%

35%

40%

45%

50%

55%

60%

1975

1980

1985

1990

1995

2000

2005

2010

2015

Statutory

Median S&P 500 Effective

39%44%

48%

30%

US Corporate Income Tax Rate



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



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



2 %

3 %

4 %

5 %

6 %

7 %

8 %

9 %

10 %

11 %

12 %

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

EndConsumer

IntermediateGoods

RawMaterials

Bottom-upConsensus

10%7% 9%

4%

3%5%

5%

3%

7%

21%

13%

6%

61%

74% 73%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

EndConsumer

IntermediateGoods

RawMaterials

Sh

are

of

sale

s

Operating Income


SG&A

Cost of Goods Sold

Interest and Taxes



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 category’s sales but 16% of earnings. Excluding the industry

group’s 19% margin, End Consumer margins drop to 8.9% from 9.7%.

Exhibit 21: Breakdown of sales by stage of production as of March 12, 2014


Raw Materials Intermediate Goods

End Demand

Integrated Oil & Gas51%

Materialsex. Containers & Packaging

27%

Oil & Gas Exploration &

Production13%

Agricultural Products

7%

Other Energy2%

Oil & Gas Refining & Marketing

24%

Health Care Distributors

18%

Machinery12%

Transportationex. Airlines

9%

OtherHealth Care

8%

Semiconductor& Semi Eq

7%

OtherInfo Tech

6%

Food Distributors

3%

Containers & Packaging

2%

Other11%

Food & Staples Retailing

ex. Distributors13%

Retailingex. Distributors

11%

Software & Services

8%

Food Beverage & Tobacco

ex. Ag Products7%

Aerospace & Defense

6%

Computer Hardware

6%

Managed Health Care6%

Telecom Services

6%

Media6%

Pharmaceuticals5%

Automobiles4%

Industrial Conglomerates

4%

Other18%

0% 20% 40% 60% 80% 100%

Materials

Energy

Industrials

Health Care

Info Tech

Staples

Discretionary

Telecom

Share of 2013 sector revenue

Raw Materials

16%

Intermediate Goods

21%

End Demand63%



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 stock’s 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 as of March 12, 2014

Note: Degree of Operating Leverage calculated as (Sales – COGS) / (Sales – COGS – SGA – Depreciation)


2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

Deg

ree of O

peratin

g L

everage

Op

erat

ing

Mar

gin

Degree ofOperating Leverage

(RHS)

Operating Margin(LHS)



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 sector’s multiple expansion.

Apple’s 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 sector’s 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


Note: Telecom Services margins for 4Q 2013 equal 8.2% when adjusted for pension benefits.


Contribution toS&P 500 Margin

Operating Margin Sales Expansion /2Q 2007 4Q 2013 Change Growth (Contraction)

Information Technology 11.0 % 16.3 % 536 bp 39.6 % 86 bpConsumer Discretionary 4.8 6.9 208 0.0 17Consumer Staples 6.3 6.6 30 29.4 10Health Care 9.4 8.7 (69) 36.9 4Telecom Services 8.3 10.2 189 8.8 3Materials 8.7 6.9 (182) 26.1 (8)Industrials 8.8 8.9 3 14.5 (8)Energy 11.1 7.6 (349) 31.6 (48)

S&P 500 Net Margin 8.3 % 8.9 % 57 bp 22.6 % 57 bp



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 as of March 12, 2014


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



0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

197

9

198

2

198

5

198

8

199

1

199

4

199

7

200

0

200

3

200

6

200

9

201

2

201

5

201

8

202

1

Goldman SachsPortfolio Strategy

ForecastS&P 500

InformationTechnology

Bottom-Up Consensus Forecast

2015E

10.0%

9.0%

19.0%

16.8%

Net Profit Margin(trailing four quarters)

3%

4%

5%

6%

7%

8%

9%

10%

197

9

198

1

198

3

198

5

198

7

198

9

199

1

199

3

199

5

199

7

199

9

200

1

200

3

200

5

200

7

200

9

201

1

201

3

201

5

201

7

S&P 500

S&P 500 ex.InformationTechnology

8.3%

7.7%

7.9%

Net Profit Margin(trailing four quarters)

8.9%

7.9%

8.9%



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 as of March 12, 2014



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%




Operating Margin Contribution toGoldman S&P 500 Margin

Sachs Sales Expansion /2013 2014E Change Growth (Contraction)

Consumer Discretionary 6.9 % 7.2 % 28 bp 9.5 % 9 bp

Information Technology 16.3 16.6 21 6.2 3

Materials 6.9 7.2 34 7.7 2

Industrials 8.9 9.0 7 6.4 1

Energy 7.6 7.8 14 4.8 1

Health Care 8.7 8.7 (1) 5.7 (0)

Consumer Staples 6.6 6.7 1 4.5 (1)

Telecom Services 10.2 8.5 (172) (1.9) (8)


Operating Margin Contribution toBottom-up S&P 500 MarginConsensus Sales Expansion /

2013 2014E Change Growth (Contraction)

Information Technology 16.3 % 18.0 % 169 bp 1.2 % 14 bp

Energy 7.6 8.1 43 6.5 10

Health Care 8.7 9.2 52 6.3 10

Consumer Discretionary 6.9 7.2 32 7.5 9

Materials 6.9 8.0 119 4.8 6

Industrials 8.9 9.2 31 4.2 4

Consumer Staples 6.6 6.7 3 2.4 (2)

Telecom Services 10.2 10.7 46 (5.3) (2)




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


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




5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

Dec

-06

Dec

-07

Dec

-08

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Dec

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Dec

-11

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-12

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-14

LT

M P

rofi

t M

arg

in

S&P 500

Recurring

Operating

Cost of Interest Tax Depreciation OperatingGoods Sold SG&A Expense Expense & Other Margin

Information Technology 48 % 26 % 1 % 4 % 4 % 16.3 %Telecom Services 40 22 4 5 19 10.2Industrials 68 16 2 2 3 8.9Health Care 63 20 1 2 5 8.7Energy 78 4 1 5 4 7.6Consumer Discretionary 68 19 2 3 2 6.9Materials 72 11 2 2 5 6.9Consumer Staples 68 20 1 3 3 6.6

S&P 500 66 % 17 % 1 % 3 % 4 % 8.9 %

March 17, 2014

United States

Goldm

an Sachs Global Investm

ent Research

19

Exhibit 30: Consumer Staples margins


Exhibit 31: Consumer Discretionary margins




Exhibit 32: Energy margins as of March 12, 2014

Exhibit 33: Health Care margins as of March 12, 2014



5.6%

5.8%

6.0%

6.2%

6.4%

6.6%

6.8%D

ec-0

6

Dec

-07

Dec

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Dec

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Dec

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Dec

-11

Dec

-12

Dec

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-14

LT

M P

rofi

t M

arg

in

Consumer Staples

Operating

0%

1%

2%

3%

4%

5%

6%

7%

8%

Dec

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Dec

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Dec

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Dec

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LT

M P

rofi

t M

arg

in

Consumer Discretionary

Operating

4%

5%

6%

7%

8%

9%

10%

11%

12%

Dec

-06

Dec

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Dec

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Dec

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Dec

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Dec

-11

Dec

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-14

LT

M P

rofi

t M

arg

in

Energy

Recurring

Operating

8.0%

8.2%

8.4%

8.6%

8.8%

9.0%

9.2%

9.4%

9.6%

9.8%

10.0%

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

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Dec

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LT

M P

rofi

t M

arg

in

Health Care

Operating

March 17, 2014

United States

Goldm

an Sachs Global Investm

ent Research

20

Exhibit 34: Industrials margins


Exhibit 35: Information Technology margins




Exhibit 36: Materials margins as of March 12, 2014

Exhibit 37: Telecommunication Services margins as of March 12, 2014



5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

Dec

-11

Dec

-12

Dec

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-14

LT

M P

rofi

t M

arg

in

IndustrialsOperating

8%

10%

12%

14%

16%

18%

20%

Dec

-06

Dec

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Dec

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Dec

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Dec

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Dec

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Dec

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-14

LT

M P

rofi

t M

arg

in

Information Technology

Recurring

Operating

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Dec

-06

Dec

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Dec

-08

Dec

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Dec

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Dec

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Dec

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M P

rofi

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arg

in

Materials

Recurring

Operating

0%

2%

4%

6%

8%

10%

12%

Dec

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Dec

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Dec

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Dec

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-11

Dec

-12

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M P

rofi

t M

arg

in

Telecom Services

Recurring

Operating

Disclosure Appendix

Reg AC

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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