Quality Businesses Part 3: Analysing High Margins
"Companies with consistent high profit margins usually have some combination of great products, efficient production, and strong customer loyalty." – Phillip Fisher
Welcome to part 3 of our mini-series on identifying “Quality” companies.
In our previous instalments we covered:
The key drivers of shareholder value creation
We then looked a how we build these into our filtering process by looking for quality companies with growing free cash flow and high Returns on Invested Capital (ROIC)
It is now our job to try and dig deeper into the numbers causing some businesses to have higher ROIC than others. This is very instructive and will help us later on when we start to look at the business more qualitatively.
This mini-series will progress as follows:
Part 3 (this section): A focus on profit margins.
Part 4: A deep dive into invested capital.
Part 5: Wrapping it all up with qualitative analysis.
What drives ROIC?
Return on invested capital is the probably the most important metric when looking at quality companies.
ROIC can be thought of as the interest rate of the company. Higher is always better!
Return on Invested Capital (ROIC): Represents the return a company earns on each dollar invested in the business and is expressed as a percentage %.
As a reminder the formula for ROIC is:
Where:
Net Operating Profit After Taxes (NOPAT) is the profits generated from the company’s operations after subtracting income taxes. (Margin)
Invested capital is the cumulative dollar amount the business has invested in its operations. This includes working capital and fixed capital (Property, plant, and equipment)
This can be visualised as follows:
ROIC encompasses both the fundamentals of the business as well reflecting the quality of the management team. Businesses and their management have 4 key levers they can pull to try to increase their ROIC:
Revenue: Increase total revenue per unit of invested capital (drive growth efficiently).
Costs: Increase profit margins by decreasing costs per unit of revenue.
Working Capital: Decrease working capital requirements without reducing NOPAT.
Fixed Capital: Decrease fixed capital requirements without reducing NOPAT.
A detailed exploration of these levers requires qualitative analysis, but for now we are interested in looking purely at the numbers and the effect they have on ROIC.
NOPAT and Profit Margins
"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business." – Warren Buffet
High profit margins are always better than low profit margins.
A high profit margin indicates the business has a level of pricing power (Quality) and can also withstand temporary periods of difficulty (Safety). A company with a 20% profit margin can easily absorb a 5% drop in the margin whereas a business with a 3% margin would be loss making.
There are multiple types of profit margin, and it is worth looking at each to get a better picture of the business. Luckily, they are easy to calculate from the income statement.
The below Sankey diagram provides an overview of a typical business and how each margin is calculated:
Gross Profit: This is the profit a company makes after subtracting the direct costs of producing its goods or services (like materials and labour) from revenue. It shows how efficiently a company produces its goods. The gross profit margin in this example is $30M/$50M = 60%
Operating Profit (or EBIT): This is gross profit minus operating expenses such as rent, utilities, and wages, but before interest and taxes. It reflects the profitability from core operations. The operating profit margin in this example is $15M/$50M = 30%
Net Profit / Net Income: This is the final profit after all expenses, including interest and taxes, have been deducted from total revenue. It represents the company's total earnings and is often called the "bottom line." The Net profit margin in this example is $10M/$50M = 20%
Note: It is also important to look at the Free Cash Flow Margin. Ideally this is close to, if not the same as net Profit, when the operating cash conversion ratio is close to 100%.
Key takeaways from Margin Analysis
When analysing margins, there are several things we look for:
High Margins: We are looking for overall net profit margins of at least 10% to indicate some level of pricing power as well as provide a level of safety. Ideally margins would be higher than this!
Positive Trends: We are also interested in identifying trends. In some cases, a growing margin may lead to accelerated FCF and ROIC. We also want to watch out for margin decline as this could indicate a loss of pricing power.
Margin Breakdown: To support our qualitative analysis, it is worth looking at the differences in Gross, Operating and net profit margins as this highlights where the costs of the business lie.
Again, I find it useful to plot this out on a graph over at least a 10-year period. Below you can see the graphs for Visa and General Electric.
For Visa we can see that all 3 margins are remarkably high.
This starts out with a gross margin of 95%+! This indicates that the direct costs of their services are marginal. After all other expenses, interest, and tax the net profit margin ranges from 35% to 52% which is also very healthy. We can also see there is a general increasing trend over the period with low volatility each year. All good stuff.
Given the conversion of net income to free cash flow for visa is close to 100% we can state that the FCF margin for the business is also very healthy. Remember Free Cash Flow is the driver of shareholder value and therefore more important than accounting earnings.
We can therefore confidently state that the high margins are contributing to a high ROIC. This is an area we should investigate further and explain qualitatively. But for now, though let’s look at General Electric.
Here you can see a completely different story. The gross margins are all sub 25% which is below the net profit margin of Visa! If we then consider other expenses, interest, and tax, we are looking at a net profit margin which fluctuates between -23% to 13%.
This indicates that General Electric does not have any level of pricing power. There is also some volatility in the results which we would need to explain. Low margins are a significant contributing factor to General Electric’s low ROIC.
So that is Margins (The Numerator of ROIC) accounted for and we can see they are important for both Visa and GE.
In the next part of the quality mini-series, we will explore Invested Capital (The Denominator of ROIC) in more detail.
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