It goes without saying that the revenue and earnings of a
company are very important for investors. But don't overlook a
. 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
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:
Check Point Software Technologies Ltd.
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
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.
Grupo Aeroportuario del Sureste, S.A.B. de C.V.
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
Todd Bunton is the Growth & Income Stock Strategist for
and Editor of the
Income Plus Investor service
GRUPO AEROP-ADR (ASR): Free Stock Analysis
BANCO LATINOAME (BLX): Free Stock Analysis
CHECK PT SOFTW (CHKP): Free Stock Analysis
INTERCONTINENTL (ICE): Free Stock Analysis
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