October 14, 2009
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.
But there's one thing even better than a healthy profit margin
-- an expanding one. If the firm does manage to boost revenue as
well, then earnings growth will be even more dramatic.
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
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).
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.
You can also find cost-cutting
initiatives (whose impact can be
seen lower down on the income
statement) to be another common path
toward margin expansion. But again,
while certainly welcome, cost
cutting can only run so deep before
there's no fat left to trim.
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
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
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
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
-- Nathan Slaughter
StreetAuthority's Market Advisor
P.S. Some of the most profitable investments of all time have
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