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It goes without saying that the revenue and earnings of a company are very important for investors. But don't overlook a company's profit margins. They can tell an interesting story.
The gross profit margin, which is simply a company's revenue minus the cost of producing its goods or services, divided by its revenue, can tell you a lot about a company's pricing power. In periods of rapidly rising commodity costs, companies with strong pricing power can raise their prices to offset higher costs. Those without it cannot, and margins suffer.
Additionally, companies might be able to show rather solid revenue growth on its income statement, but if its gross profit margin is declining in the process, it's likely that the company is discounting heavily to move its merchandise off the shelves. That could be a red flag for investors.
Another important profit margin to consider is operating profit. Operating profit takes gross profit and subtracts operating expenses such as selling, general and administrative costs. This, too, is expressed as a percentage of revenue.
The operating margin lets investors know how efficiently a company is being run. If its operating expenses are growing significantly faster than revenue, for instance, then this could be a signal that management isn't keeping a close eye on its costs.
Keep in mind that corporate profit margins depend heavily on the industry they're in, so it's important to compare them with their peers for an apples-to-apples analysis. Tech companies will tend to have much higher margins than retailers, for instance.
Wide Margins, Wide Moats
Expanding profit margins have been a big reason why the S&P 500 has more than doubled since bottoming in March 2009. Revenue growth has certainly helped, but expanding margins have led to substantial bottom line growth, and higher stock prices. But after more than 3 years, further expansion is unlikely.
While profit margins usually expand and contract along with the overall economy, some companies manage to consistently produce wide profit margins. More often than not, these businesses will have at least one of four types of competitive advantages:
- Consumer (control over pricing)
- Producer (proprietary production technologies)
- Economies of Scale (lower long-run average costs)
- External (i.e., government regulation)
These competitive advantages must be constantly monitored and maintained in order to fend off competition. And if a company continually generates wide margins and fat profits, you can bet it will attract competitors.
Ridiculous Margins, Reasonable Prices
Usually high-margin, wide-moat businesses will also generate strong free cash flow for its shareholders (if a company routinely reports high profits but low cash flow, then look out). This frees it up for things like share buybacks, dividends, debt extinguishment or acquisitions. But these high margin companies usually trade at premium valuations too.
There are, however, companies with fat, and expanding, profit margins and strong growth prospects trading at reasonable prices. For the long-term investor, these could be great buying opportunities.
I ran a screen for companies with 5-year average operating margins greater than 30% and net margins above 25%, along with the criteria that current margins must be greater than their 5-year averages (i.e., margins must be expanding). The stocks must also have a forward price/earnings ratio below 20.
Here are 4 names from the list:
Operating Margin (5-yr average): 44.9%
Net Margin (5-yr average): 40.9%
Forward P/E: 15.3
Check Point is a leader in securing the Internet. It's best known for its firewall and VPN products. Check Point generates over 60% of its revenue from high margin software updates, maintenance and subscription fees.
The company retains a remarkable 45 cents for every dollar of revenue it earns. And with strong cash flow and very little capital expenditures, Check Point generates very strong free cash flow, which it has been using to buyback its own stock.
Operating Margin (5-yr average): 34.2%
Net Margin (5-yr average): 32.7%
Forward P/E: 8.1
Bladex is a unique company. It was created by the central banks of Latin America and the Caribbean as a supranational bank to promote foreign trade throughout Latin America. The bank primarily provides trade financing to selected commercial banks, middle-market companies and corporations in the region.
This has proven to be a very profitable niche for the company. And thanks to its fat profit margins, Bladex is able to pay a dividend that yields a juicy 4.8%.
Operating Margin (5-yr average): 38.4%
Net Margin (5-yr average): 36.9%
Forward P/E: 16.2
IntercontinentalExchange, or ICE, operates global futures exchanges, over-the-counter (OTC) markets, derivatives clearing houses and post-trade services. Most of its trading is done electronically on three regulated exchanges and an OTC marketplace.
Because of its transaction-based revenues, ICE actually benefits from volatility in the marketplace. As you can see from its margins, it is a very profitable business. During the first six months of 2012, ICE's operating margin was an incredible 61.5%, up from 58.7% over the same period last year.
Operating Margin (5-yr average): 31.2%
Net Margin (5-yr average): 28.9%
Forward P/E: 17.0
Grupo Aeroportuario del Sureste, S.A.B. de C.V., or Southeast Airport Group, is a Mexican airport operator with concessions to operate, maintain and develop the airports in tourist-heavy southeast Mexico, including Cancún, Veracruz and Cozumel.
The company was formed in 1998 after the Mexican government decided to privatize some of its airports. Southeast Airport Group has experienced strong and relatively steady revenue and wide profit margins since then as it essentially has a monopoly on the airports in southeast Mexico.
The Bottom Line
Investors should look beyond just the top and bottom lines of the income statement and consider what's in between: the gross and operating margins. For the long-term investor concerned with competitive advantages, look for wide, and expanding, margins. These four companies all fit that criteria - and are reasonably priced.
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