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 upturn in profit 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. Microsoft (Nasdaq: MSFT) 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 Microsoft's 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, shares appear to be responding to the company's impressive performance, tacking on steady gains on the heels of recent quarterly results.
At first glance, you'd expect to see copper-mining firm Freeport-McMoran (NYSE: FCX) 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 quite robust.
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 cash flow in the next few years. The good news: these mines should make this stock even more appealing in terms of the net asset value (NAV) of Freeport's base of mines. Merrill Lynch just boosted their NAV assumption from $65 to $73, well above the current $44 stock price.
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: ADI), 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 years.
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 and 34.
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 1990s.
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 McMoran.
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