It's no secret that investors place a premium on lofty margins. If one business squeezes $0.15 in earnings from each dollar in sales and another manages just $0.10, the first company clearly has a big advantage.
Hansen Natural (Nasdaq: HANS) is a prime example. Powerful margin expansion enabled the drink maker to turn a 10-fold increase in sales into a jaw-dropping +4,000% surge in net income. There's a similar story with Blackberry manufacturer Research In Motion (Nasdaq: RIMM), whose operating income has consistently climbed about +90% per year during the past decade.
These companies have created tremendous wealth for their shareholders, with Hansen returning +1,075% during the past five years while RIMM has returned a modest, but respectable +170%.
For a more recent example of what rising margins can do to a firm's earnings, let's peek inside the recent year-end results from consumer products maker Clorox (NYSE: CLX).
|Fiscal 2008||% of Sales||Fiscal 2009||% of Sales|
|Cost of Goods Sold||$3,098||58.8%||$3,104||57.0%|
Thanks to an impressive 180 basis point increase in gross profit margins (from 41.2% to 43.0%), it only took a modest +3.3% uptick on the top-line to produce a much stronger +16.5% increase on the bottom.
In this case, rising prices for Clorox's products at the retail level deserve most of the credit. While this can provide a nice bump (and is reflective of powerful brands), prices can only be hiked so far before scaring away customers and pinching volume.
That's why my staff and I typically look for the rarest breed of margin expansion -- the type built into the business model itself.
If a widget maker gets $1.00 for a product that costs $0.90 to get out the door, it will always have a profit margin of 10% -- regardless of whether it sells 1 unit, 1,000 units, or 1 million units.
On the other hand, there are companies with high fixed expenses, but minimal variable costs -- a structure that allows margins to rise along with sales. Think of a video game company that spends $1 million in upfront costs to develop a new game. That initial outlay for the first copy may be high, but the expenses to produce additional copies are negligible (maybe a few pennies for a blank DVD and packaging).
If the game retails for $50, then it will take about 20,000 units to reach the breakeven point. But from then on, the next sale represents almost pure profit -- and the one after that, and the one after that...
So if the company sells 30,000 units, its gross margins rise to 33%. And if it manages to sell 40,000, then margins expand to 50%. In other words, each incremental dollar in sales is more profitable than the one preceding it. Said another way, the higher the revenues, the stronger the margin -- a stark contrast to the widget maker.
My staff and I have looked for the companies with the largest growth in net income, operating income, and profit margins. Here's what we found:
|Company (Ticker)||1-Year Net Income Growth||1-Year Operating Income Growth||Profit Margin|
|Discover Financial (NYSE: DFS)||+220.7%||+70.8%||34.4%|
|Genzyme Corp. (Nasdaq: GENZ)||+169.6%||+189.9%||15.3%|
|Goldman Sachs (NYSE: GS)||+64.6%||+77.6%||22.6%|
|Apollo Group (Nasdaq: APOL)||+44.6%||+50.6%||19.1%|
|Red Hat (NYSE: RHT)||+36.9%||+28.7%||15.8%|