For the second time in 20 years, companies are reaping the
benefits of an economic scare. Back in the early 1990s, they shed
costs in the face of uncertain business conditions. Hundreds of
large companies deployed the phrase "corporate restructuring." The
downsizing, especially in terms of staff, ultimately led to a big
margins, an eventual hiring boom, and rising stock prices.
And it's happening again…
Companies shed every ounce of fat in 2008 and 2009 and are once
again sporting stunning profit margins. By some measures, corporate
profit margins are at an all-time peak. Many companies would be
glad to boast of 15% pre-tax margins (which is the profit level on
every dollar of sales before taxes are paid).
The companies in the table below go even further, generating
pre-tax margins in excess of 30%, 40% or even 50%. This is almost
unheard of in the annals of corporate America.
Some companies routinely pound out stunning margins.
has generated pre-tax margins in excess of 30% for seven straight
years. That's largely due to the Office suite of programs, which
typically cost hundreds of millions to develop but generate
billions in profits. Investors were rightly concerned when
free cash flow
-- the eventual result of robust pre-tax profits -- slumped from
$14 billion in fiscal (June) 2008 to $11.5 billion in fiscal
2009. Yet during the past two years, Microsoft has generated
an average of $18 billion in annual free cash flow. At last,
appear to be responding to the company's impressive performance,
tacking on steady gains on the heels of recent quarterly results.
The energy industry is also home to several high-margin businesses,
thanks in large part to very firm oil prices.
Diamond Offshore (NYSE:
Apache Corp. (NYSE:
Devon Energy (NYSE:
are quite pleased to have a lot of exposure to pricey oil and
lesser exposure to natural gas, which falls in price week after
week. Expectations that oil prices could rise even higher in 2012
if Middle East tensions rise or European demand rebounds would
enable these companies to post even stronger profit margins.
At first glance, you'd expect to see copper-mining firm
posting weak pre-tax margins. After all, in the fourth quarter of
2011, the cost of mining on a per pound basis rose to $1.57 from
$0.53 from a year earlier. The company's newer mines, along with
rising labor costs, are raising the cost of doing business. Yet
with copper selling for $3.80 a pound, the profit spread remains
Freeport-McMoran expects mining costs (per pound) to drop to $1.38
this year, which should help boost margins. Offsetting this benefit
is a set of investments slated for several new mines, which will
create a drag on margins and
in the next few years. The good news: these mines should make this
stock even more appealing in terms of the
net asset value
) of Freeport's base of mines. Merrill Lynch just boosted their NAV
assumption from $65 to $73, well above the current $44 stock
The research and development payoff
Technology companies often reap high profit margins -- if they are
willing to spend the money to stay ahead of the pack and on the
leading edge. That's been the approach of chip maker
Analog Devices (NYSE:
, which spends around $500 million a year on R&D. This spending
helps freshen the product lineup of its chips that go into cars,
communications equipment and industrial equipment.
Analog typically generates gross margins above 60%, and outside of
R&D, keeps a tight lid on all other costs. This has fueled
pre-tax margins above 30% for the past few years. And strong
pre-tax margins means strong free cash flow. With a steadily rising
pile of cash, which recently stood at more than $3.5 billion,
Analog has bought back more than 25% of its stock in the past five
Shares of Analog Devices have moved up off of their lows, but still
trade for a reasonable 15 times projected (October) 2013 profits.
That's closer to the low end of the stock's five-year historical
range of price-to-earnings (P/E) ratios that have swung between 11
Risks to Consider:
Don't count on pre-tax margins to remain this strong in the
future. Back in the mid-1990s, companies began rebuilding depleted
workforces and as costs rose, margins cooled. Still, those
mid-decade investments led to the profit boom of the late
Action to Take -->
As you research these stocks, take a fresh look at recent quarterly
results to be sure margins can manage to stay aloft in the
near-term. This shouldn't be a problem for the oil producers, as
prices remain firm. Technology stocks are also likely to maintain
robust margins as labor costs are a small part of their business.
As a litmus test, analyze what profit levels would be like if
margins slipped back 500 basis points (or 5%). If the stock is
still a bargain, then it's safe to invest even if the company has
investments planned for coming years, as is the case with Freeport
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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of FCX in one or more if its "real money" portfolios.
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