Power of Gross Profit Margins

Investors are mostly concerned with the net profit after tax (NPAT) margins when they are analysing companies. However, gross margins are underappreciated by most analysts. To me, high gross margins are always a strong signal of pricing power.

To illustrate the point across, we will use two companies namely Profitable Goods and Weak Gross.

There will be term which may be unfamiliar. It is called Selling, General & Administration (SG&A) expenses, in short, it is known as operating expenses (opex). It is the costs of maintaining the business. It’s like rentals, depreciation, salaries, utilities, insurance, travels, listing fees, audit expenses, advertising, etc.

Profit & Loss (Income) statement for Profit Goods would look like:

Using the table above, here is the margins for Profitable Goods:

• The gross profit margins is 60% ($6,000 divided by $10,000)
• The opex cost is around 30% ($3,000 divided by $10,000)
• The net profit margins is 23.2% ($2,324 dividend by $10,000)

Below, we are looking at Weak Gross’s income statement:

Using the table above, here is the margins for Profitable Goods:

• The gross profit margins is 40% ($4,000 divided by $10,000)
• The opex cost is around 30% ($3,000 divided by $10,000)
• The net profit margins is 6.6% ($664 dividend by $10,000)

While both companies have identical sales and SGA costs, why are their net profit so different? Profitable Goods has a net profit of $2,324 as compared to Weak Gross’ net profit of $664.

The answer lies with…… their gross margins. 

Gross margin measures the profitability of the products/services of the company. It measures what is left after deducting the costs of producing the products/services. When a business does not have a high enough gross profit margin, after deducting opex, it is very difficult to produce a reasonable amount of net profit margin.

In my experience of analysing companies, I realised companies find it hard to control their gross profit margin because there are several factors such as pricing of similar goods or services from their competitors and changes in raw materials prices. As for opex, companies can find innovative ways to streamline operations without affecting the level of business performance. For example, a company may implement software from Intuit or SAP to reduce the amount of manual accounting work required. Or it can remove duplicate positions or hire from other countries.

In short, when it comes to controls, the management usually find it easier to manage opex compared to gross profit. Therefore, I would use gross margins as a starting point for any analysis. A high gross margin over the years indicates the business has a strong competitive advantage or a moat to prevent other competitors from entering their profit zones.

Using an example of SodaStream International (figures from Morningstar):

The gross margins improved from 49.45% to 53.34%, a net improvement of 3.89%. For SG&A, it improved from 43.43% to 38.01%, a net improvement of 5.42%. Due to these two improvements, the operating margin expanded. This means that the company is earning more per product sold and its operations supporting the product sales are more efficient as a percentage of sales.

(source: Google Finance)

Looking at the price chart, it was a good return from US$20-30. After this realisation, for companies with high gross profit margins but low net profit margins, it’d be something that I would spend a lot of time investigating. Are there initiatives by the management to weed out redundant costs and drive operational efficiency? When executed, it would boost up the net profit margins considerably. Yahoo! Stock Screen which is a free tool which enabled me to spot SodaStream earlier.

Part 2: Double Edged-Sword of Low Net Profit Margin

Gross profit margin measures the profitability of the goods / services sold. For net profit margin, it indicates the profitability of the business.

For this example, we have two companies called Miserable Co. and Happy Co separately:

You can see that, despite the same amount of revenues earned, Miserable Co. earns $1m as compared to Happy Co’s 5m. Having a low net profit margin is extremely disadvantageous, Miserable Co. must run its business for 5 years just to earn 5m – which is the profit Happy Co. earns… just in a year!! Isn’t that crazy? Imagine how slow Miserable Co. is earning profits for its shareholders. There is no prize for guessing which company can grow faster. There are exceptions of excellent companies with low net profit margins such as Costco, though.  

A low net profit margin is also very dangerous. Firstly, it indicates that the business is operating in a very competitive market or its costs of business is extremely high. When an aggressive competitor launches a price attack on it or costs are not managed well, a 1% net profit margin could be driven down to negative profit margins even. However, when a business has a profits margins of 30% or above, 1 or 3% drop would not affect the margins too much.

Despite the obvious risks of a low net profit margin, it creates opportunities for a capable CEO to turn things around.

A CEO could look at the cost structures to weed out unnecessary costs and drive efficiency. The effect could raise the margins by 1%. A small increase in 1% have huge impact to the bottom line.

As above, you can see the net profit jumped from $1m to $2m – an increase of 100%. For companies who can do that, its share price would react positively.

Look at an example of Japan-listed Bourbon Corp:

(source: numbers are from annual reports, accessible via ufocatch.com)

It would be a real steal if the share price does not move with the fundamental earnings of the company. But guess we are not so lucky.

Once in a while, I do come across such companies and their share price can move up quickly when the correct actions are being executed with a management team. But I have always placed a strong reminder that these are stocks for the short-mid term. I prefer companies with strong “owner-mentality” culture, led by original founders, great model and great numbers at reasonable prices. It is known as growth at reasonable prices (GARP).

Part 3: Summary

• Look out for companies with high gross profit margins as a starting point.
• Companies with high gross profit margins but low net profit margins are interesting candidates to analyse.
• Low net profit margin is a double-edged sword, depending on whether it is facing a serious decline or going through an improvement.
• Gross profit margin measures the profitability of the goods / services sold.
• For net profit margin, it indicates the profitability of the entire business.