Notes on the Margins
Anywhere you turn on Wall Street these days, you’ll find investors worried about profit margins.
The bull run of recent years has, of course, been fed by rising corporate earnings. And one of the main forces behind those earnings gains has been steadily improving profit margins--that is, many U.S. companies have been earning more profit on each sales dollar.
But nowadays, investors fear that margins will stop growing and may even contract at many companies. If the effects of the Asian financial crisis don’t hurt margins, some analysts say, rising wages or other factors will.
Even some profit stalwarts such as Intel have warned in recent quarters that their hefty margins will recede.
In this environment, companies that continue to boast rising profit margins ought to have a leg up in attracting investors to their stocks.
To identify some potential winners, The Times ran a computer screen to search for companies that have successfully raised margins in recent years and whose growth prospects suggest they may be able to boost--or at least maintain--their margins in the near future.
We focused on “operating profit margin,” which assesses the percentage of sales a company keeps after paying the basic costs and expenses of the business, such as for raw materials, employee salaries and administrative overhead.
A company’s operating profit thus measures how well it manages the basic business. Operating profit is before financial items such as interest expense and taxes.
In our screen, companies had to have boosted operating margins in each of the last four calendar years. That in itself is an elite group: Of 8,033 U.S. companies screened, only 420 increased their margins each year in that period.
*
Because a company’s operating margin may rise for a time solely because the company is trimming costs--without growing the business--we then screened the list to identify companies whose sales and net earnings per share both have grown at a compounded rate of at least 25% a year over the last three years.
We then removed companies whose growth rates, even if faster than 25%, did not exceed their industry’s average.
Finally, we required that earnings per share over the next three to five years be forecast by Wall Street analysts to rise more than 25% annually. And more than five analysts had to be making profit estimates.
Our search turned up eight companies on the Nasdaq market and New York Stock Exchange.
How does a company consistently raise its margins? Generally, by keeping close watch on costs, by boosting productivity or by boosting prices--or some combination of those three.
But as several of the companies on our list have demonstrated, management also can raise margins by branching into more profitable business lines.
Of course, there is no guarantee that these eight companies can continue to boost margins. And many of the stocks may fully reflect investors’ high expectations. Still, the list may at least provide a starting point for investors hunting for companies with good earnings prospects.
Here are mini-profiles of the eight companies:
Abercrombie & Fitch
Teenagers in search of the latest trends are quite familiar with Abercrombie & Fitch (ticker symbol: ANF). Older investors may just wish they’d listened to those teens over the last year.
Shares of the Reynoldsburg, Ohio, apparel retailer have more than tripled in the last 15 months thanks to the surging popularity of its casual clothes aimed at teenagers and twentysomethings. Some analysts think the stock has further to go.
Abercrombie, whose annual sales last year rose 56% to $522 million, has 158 stores nationwide selling a range of casual clothing for men and women. One measure of its success: Abercrombie’s first-quarter sales at stores open at least a year skyrocketed 48%. That compares with 17% for Gap.
Abercrombie’s management is widely praised for its marketing wizardry and ability to adapt to the subtle though critical shifts in the tastes of its fickle customers.
*
The question is: Can it keep it up? Retailing stocks are notoriously volatile and Abercrombie’s has had a heck of a run. The shares are priced at 40 times the most recent four quarters’ earnings per share.
But Kindra Hix, a NationsBanc Montgomery Securities analyst, thinks management can deliver.
The company has plans for 400 stores in all, Hix said. It’s also opening 14 children’s stores that have great potential, she said.
“These guys are seeing strength in all of their categories,” Hix said.
Abercrombie’s clothes are among the priciest in its peer group, which has helped boost the firm’s margins. But if the economy weakens, or Abercrombie’s fashions go out of style, those prices could become a problem.
On the plus side, Abercrombie this month was split off completely from parent Limited. That means far more shares are now traded on the open market, which is good news for broadening the investor base and attracting institutions that couldn’t own the stock when it was less actively traded.
Ciber
One way for a company to improve margins is to segue into more profitable business lines. That’s what Englewood, Colo.-based Ciber (CBR) is doing.
Ciber’s primary business is supplying companies with skilled computer personnel. But it’s shifting from that lower-margin business into a wide range of computer-consulting and information-technology services that carry much higher margins.
About 60% of Ciber’s revenue still comes from staffing, said Moshe Katri, an analyst at UBS Securities in New York. But that’s down from as much as 80% a couple of years ago.
Part of Ciber’s growth is coming from acquisitions. Ciber, as now constituted, could boost earnings 30% a year for the next few years, Katri said. With acquisitions, that figure could be closer to 40% or 50%, he said.
The downside for investors: Information technology stocks can be very volatile. The group has recently nose-dived on concerns over what will replace the “year 2000” computer-reprogramming business when that work dries up as the millennium approaches.
*
Through Friday, Ciber stock was down 17% from its April high. Shares of many of its rivals have fallen much harder. One factor in Ciber’s favor is that only 10% to 12% of its business is year-2000-related.
The industry’s other big issue is simply finding workers. These companies usually have plenty of demand for their services but have problems hiring enough skilled
workers. Firms are hiring employees away from rivals, stoking fears that rising wages will cut into margins and earnings growth.
Still, Ciber’s earnings were up 58% in the quarter ended March 31, to 19 cents a share. In the past, “if you bought at the bottom of a correction [in Ciber’s stock], you were handsomely rewarded,” Katri said.
Diagnostic Health Services
Diagnostic Health Services (DHSM) provides services such as ultrasound and magnetic resonance imaging to rural hospitals. It loads equipment and trained technicians onto trucks that drive to hospitals too small to run such facilities on-site.
Diagnostic’s core business is growing nicely and it’s expanding through acquisitions. But the Dallas-based company’s real potential lies in the opportunity to cultivate relationships with hospitals and eventually manage their in-house radiology and cardiology departments, analysts say.
“It’s like getting their foot in the door and then expanding,” said Amy Brodsky, analyst at Vector Securities International in Deerfield, Ill.
Diagnostic often can run the units more efficiently than the hospitals themselves. And the on-site contracts are far more profitable. The average monthly revenue from a mobile contract is $2,000, Brodsky said. The average fixed contract is $18,500. Of Diagnostic’s 550 hospital accounts, only 133 are on-site deals. But they account for 55% of revenue.
Still, Diagnostic’s stock has taken a beating lately. Through Friday, it was 35% off its recent high in mid-March. The problem: Diagnostic missed first-quarter earnings estimates by a penny a share after losing two large contracts. Sales rose 37% to $14.4 million, and earnings per share rose 20% to 12 cents.
The setback is temporary, some analysts believe. “There will be growing pains,” said Vincent Colicchio of Southwest Securities.
“People are questioning the credibility of the story, but there is opportunity there,” Brodsky said. But the company, he said, “needs to not just meet but exceed expectations.”
Family Golf Centers
Die-hard golfers don’t spend every waking hour on the links. They spend some time at driving ranges practicing for when they’re actually on the course.
That’s where Family Golf Centers (FGCI) comes in. The Melville, N.Y., company is the nation’s leading operator of independent golf ranges after spending the last several years aggressively buying up small players.
“It’s primarily a mom-and-pop industry,” said Harry Katica, an analyst at Prudential Securities.
Family Golf also recently bought the industry’s No. 2 company. By year-end, it should run 85 or more golf centers.
There’s room for growth. There are 2,200 U.S. driving ranges, about 95% of which are independent. And there aren’t many big rivals left to compete with Family Golf for acquisitions, Katica said.
Because its business is seasonal, Family Golf has recently moved to buy ice skating rinks, which are counter-seasonal, and broader family entertainment centers.
The company’s operating profit margin was 27.3% last year, up from 23.7% in 1996. In the first quarter of this year, Family Golf’s sales rose 113% to $19.2 million. Earnings per share rose to 7 cents from 3 cents. Earnings for 1997 overall rose 65% to 84 cents a share.
Rexall Sundown
The aging of the baby boom generation is coming at the right time for Rexall Sundown (RXSD).
The Boca Raton, Fla.-based company, which makes a wide range of vitamins and nutritional supplements, has been helped by the growing use of vitamins and other health products by the postwar generation.
Industrywide, sales of the products in the mass retail market grew 20% in 1997 and could expand 35% this year, said Richard Fradin, analyst at William Blair & Co. And Rexall is increasing its market share in that segment, which is now 12%. “They’re taking share pretty rapidly in a business that’s growing very rapidly,” he said.
The stock has corrected a bit lately, falling from $39 in mid-March to $32.63 now. One risk in the stock is that Wal-Mart Stores accounts for 30% of Rexall’s sales. There’s no indication the giant retailer plans to cut back on Rexall products, but if it ever did, it could spell trouble.
Analysts also debate how much longer Rexall can grow at its recent pace. Sales jumped 78% to $115 million in the quarter ended Feb. 28. Earnings per share rose 67% to 20 cents.
“The company’s growth has been phenomenal,” Fradin said. “Certainly that will slow down, but it’s not slowing down yet.”
Robert Half International
Robert Half International (RHI) is a prime example of a company that has successfully branched out from its core business.
The Menlo Park, Calif.-based staffing company mainly supplies temporary and permanent accountants to outside firms. The danger in investing in staffing firms is that competition is fierce, profit margins are often slim and barriers to entry are almost nonexistent.
“You don’t need a PhD to run a staffing company,” said Jeff Silber, analyst at Gerard Klauer Mattison in New York. “Basically you need a Rolodex and a phone and you’re in business.”
But Robert Half has consistently moved beyond its roots into higher-margin lines.
Its Accountemps temporary line still made up 53% of revenue last year, while permanent placements were 8%, Silber said.
But its Office Team unit, which supplies high-end clerical workers and secretaries, kicked in 24% of revenue. Clerical staffing is a low-margin business and is growing only about 10% a year industrywide, but Robert Half has an edge because firms that use it for accountants or other specialty workers are likely to also rely on it for lower-end people, Silber said.
In 1994, Robert Half started a unit devoted to temporary staffing in the information technology industry. Competition is rabid--”Everybody and his grandmother provides IT staffing,” Silber said--but it’s been profitable for Robert Half.
Finally, Robert Half a year ago started a unit that focuses on providing top-level executives to companies. For example, if a company wants to revamp its payroll system, it needs a seasoned worker. The advantage of this unit is that billing rates are higher and project assignments are longer than at other jobs, Silber said.
Not surprisingly, Robert Half’s stock has had an extended run-up in the last two years and now is priced at 48 times annual earnings per share. But in the first quarter, sales rose 42% to $401 million. Earnings rose 48% to 31 cents a share.
“It’s an expensive stock; it always has been an expensive stock and it probably will always be an expensive stock,” Silber said. Even so, “this is not a company that’s standing still,” he said.
SpeedFam International
Some of the other stocks on this list are trading at or near record-high levels, a fact that may scare off investors looking for cheap stocks. That’s not an issue with SpeedFam International (SFAM) of Chandler, Ariz.
The stock of the semiconductor manufacturing equipment company has fallen by about two-thirds since the Asian financial crisis hit the stock market with full force in October. Trading just shy of $61 on Oct. 16, it’s now at about $21.
Many chip-related stocks have suffered because of a slowdown in orders from Asia, and SpeedFam is no exception. Nevertheless, some analysts like the stock.
To start, it can’t go much lower, they say. Cody Acree, analyst at Southwest Securities, points out that the company has $11 a share in cash on the balance sheet. What’s more, its technology represents a key step forward in the development of chips. Its products will be in demand once companies resume building chip factories, enthusiasts say.
“It’s not a matter of whether they do [need its technology] or not and will SpeedFam be a success,” Acree said. “It’s a matter of when and how long does [an investor] have to wait.”
SpeedFam makes chemical mechanical planarization technology that is used in the chip-making process. To put it simply, CMP lets makers produce denser and more reliable chips.
SpeedFam’s sales growth slowed to 15% in the quarter ended Feb. 28. Earnings fell 26% to 31 cents a share as margins contracted. Earnings are expected to be weak this quarter as well.
Staples
Staples made a name for itself with superstores that sell a vast array of office products at discount prices. It now hopes to build on that by developing a catalog business that reaches small and mid-sized companies.
Two weeks ago, Westborough, Mass.-based Staples completed a $690-million deal to buy privately held Quill, a leading catalog firm. That’s an important part of Staple’s three-pronged growth plan.
It’s also putting up stores in smaller markets where competition is limited. It’s now concentrated in the New York, Los Angeles, Philadelphia and Washington areas. Finally, Staples is developing a (currently money-losing) European operation.
Staples, the nation’s No. 2 office supply chain, has not lost a step since federal regulators last year nixed its proposed $4-billion merger with No. 1 company Office Depot, analysts say.
The only negative lately for Staples, some say, is that it settled for Quill instead of buying the larger Viking Office Products, which is now being snapped up by Office Depot. Viking has a sizable overseas operation, which would have fit Staples nicely, said Mark Mandel, an analyst at ABN AMRO.
Still, “the company is firing on most cylinders,” Mandel said. “You’ve got to be hard-pressed to find negatives here.”
Last week, Staples reported a better-than-expected quarterly earnings gain of 50%, to 12 cents a share, before one-time charges.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Growth Companies With Rising Margins: Eight Ideas
These eight companies survived some demanding stock screens The Times ran to identify fast-growing businesses with rising profit margins. To make the list, a company’s operating profit margin must have risen in each of the last four years. Also, a company must have had compounded annual sales and earnings-per-share growth rates of more than 25% over the last three years. Finally, a company’s annualized earnings growth over the next three to five years must be projected at 25% or better by analysts. The survivors:
Company: Abercrombie & Fitch
Ticker symbol: ANF
Operating profit margin (1993): --3.7%
Operating profit margin (1995): 10.1%
Operating profit margin (1997): 16.1%
Annualized 3-yr. growth / Sales: 47%
Annualized 3-yr. growth / EPS: 70%
Stock 52-week high/low: $48.00/16.88
Friday close: $41.63
*
Company: Ciber
Ticker symbol: CBR
Operating profit margin (1993): 4.1%
Operating profit margin (1995): 6.1%
Operating profit margin (1997): 9.8%
Annualized 3-yr. growth / Sales: 49%
Annualized 3-yr. growth / EPS: 68%
Stock 52-week high/low: $37.75/14.25
Friday close: $31.44
*
Company: Diagnostic Health Svc.
Ticker symbol: DHSM
Operating profit margin (1993): --8.4%
Operating profit margin (1995): 10.2%
Operating profit margin (1997): 22.0%
Annualized 3-yr. growth / Sales: 66%
Annualized 3-yr. growth / EPS: 66%
Stock 52-week high/low: $15.25/7.31
Friday close: $9.25
*
Company: Family Golf Centers
Ticker symbol: FGCI
Operating profit margin (1993): --26.2%
Operating profit margin (1995): 22.5%
Operating profit margin (1997): 27.3%
Annualized 3-yr. growth / Sales: 117%
Annualized 3-yr. growth / EPS: 86%
Stock 52-week high/low: $31.56/13.31
Friday close: $27.13
*
Company: Rexall Sundown
Ticker symbol: RXSD
Operating profit margin (1993): 11.1%
Operating profit margin (1995): 13.3%
Operating profit margin (1997): 19.1%
Annualized 3-yr. growth / Sales: 32%
Annualized 3-yr. growth / EPS: 52%
Stock 52-week high/low: $39.00/12.31
Friday close: $32.63
*
Company: Robert Half International
Ticker symbol: RHI
Operating profit margin (1993): 8.4%
Operating profit margin (1995): 10.9%
Operating profit margin (1997): 11.9%
Annualized 3-yr. growth / Sales: 43%
Annualized 3-yr. growth / EPS: 50%
Stock 52-week high/low: $54.94/28.38
Friday close: $52.94
*
Company: SpeedFam International
Ticker symbol: SFAM
Operating profit margin (1993): 1.2%
Operating profit margin (1995): 2.7%
Operating profit margin (1997): 12.4%
Annualized 3-yr. growth / Sales: 50%
Annualized 3-yr. growth / EPS: 78%
Stock 52-week high/low: $60.88/19.13
Friday close: $20.94
*
Company: Staples
Ticker symbol: SPLS
Operating profit margin (1993): 2.9%
Operating profit margin (1995): 4.8%
Operating profit margin (1997): 5.2%
Annualized 3-yr. growth / Sales: 37%
Annualized 3-yr. growth / EPS: 41%
Stock 52-week high/low: $26.13/13.88
Friday close: $24.31
Source: Market Guide Inc.
