The strongest companies on the UK stock market

Do high profit margins make them invincible?
Thursday 18 May 2017 Author: Tom Sieber

One way of discovering the strongest companies on the UK stock market is to look at profit margins.

Companies which are left with lots of money after deducting costs from sales have a stronger position from which to fight competition than someone with very low profit margins, for example. They also have strength in terms of being able to consider reinvesting money into their business.

Some investors might think high profit margin businesses are invincible. We’d certainly argue they are better placed to cope with challenges, but none of them are guaranteed to be the last man standing in difficult times.

Let’s now take a closer look at the topic of profit margins and discuss some of the higher margin stocks on the market.

COVER2

A quick lesson on profit

It is important to understand the difference between profit and profitability. Supermarket Tesco (TSCO) posted an operating profit of £1.28bn in its February 2017 financial year which towers over the £170m generated by online second hand car marketplace Auto Trader (AUTO) in the 12 months to 27 March 2016.

However, Auto Trader achieved this profit on revenue of £281.6m while Tesco’s was derived from sales of nearly £50bn. In other words, Auto Trader has a much better operating profit margin than the much larger supermarket.

Asset light model

The big difference between the margin achieved by Auto Trader and Tesco is easy to explain.

While Tesco incurs myriad of costs relating to energy, transportation, staffing and other expenses associated with its large store estate, Auto Trader is effectively just a website and its costs are mainly limited to investment in technology. It has what is sometimes described as an asset light model.

A similar example is online property site Rightmove (RMV) which posted an operating
profit of £161.6m on revenue of £220m for 2016, making it one of the highest margin companies on the UK stock market.

Rightmove is rewarded by the market for its high margins with a premium valuation, trading on forward price-to-earnings ratio of 26.5 times.

Different types of margin

There are different ways of measuring profit and equally there are different types of margin which can be more appropriate when looking at different sectors.

Gross margin: Gross profit (revenue minus cost of sales) divided by revenue multiplied by 100.

This is probably the most intuitive measure of profitability. If it costs you £5 to make a handbag which you sell for £20, your gross margin is calculated as follows: ((20 -5) ÷ 20) x 100 = 75%.

Operating margin: Operating profit (revenue minus cost of sales and operating costs) divided by revenue multiplied by 100.

Businesses of any scale have expenses beyond manufacturing and paying staff. These could include marketing, research and development and administration and are likely to expand in line with the growth of the business.

The operating margin therefore gives a fuller picture of profitability, and is almost always lower,  than the gross margin. Returning to the handbag example if you spend a further £5 marketing each individual handbag then this cuts your 75% gross margin down to a 50% operating margin.

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Net margin

Most businesses incur other costs not related to their day-to-day operations but which still need to be taken into account. These could include interest payments and tax.

Subtracting these from operating profit helps you arrive at net profit which, in turn, can be used to calculate the net margin.

There are plenty of other measures of margin including the EBITDA (earnings before interest, tax, depreciation and amortisation) margin which is heavily used in the software sector and the cash flow margin which shows how efficient a company is at converting sales into cash.

However, the operating margin is the measure which can probably be best applied across industries and our table shows the London-listed stocks with the highest five-year average operating profit margins.

When margins are at risk

Identifying a company with a high operating margin is just the start; it is important to also look at the sustainability of margins.

In the short-term a company could drive up profitability by stripping out costs. This would eventually impact sales as the quality of its product or service could suffer.

A high margin would quickly be eroded if sales start falling faster than costs.

There are several factors which can put pressure on margins. We now discuss four of them:

1. Competition

A company operating in an area with high margins will inevitably attract a competitor who also wants to enjoy the financial benefits of doing that line of business.

Unless there are significant barriers to entering the market in the form of technology, scale or regulation then the incumbent firm may have to cut prices in order to compete.

Moneysupermarket (MONY) was a trailblazer in the price comparison space for some time. Sadly competition has now intensified which has necessitated Moneysupermarket spending more money on marketing to remain at the forefront of consumer’s minds.

Liberum analyst Ian Whittaker comments: ‘This has manifested itself in declining gross margins at MoneySupermarket which fell by 520 basis points in 2016 and we estimate that gross margins will decline a further 150 basis points in 2017 to 73.4%.’

2. Increase in input costs

Another space which has seen the established players threatened by emerging competition is supermarkets, where discounters Aldi and Lidl have disrupted the market.

The pressure on margins in this sector has been exacerbated by rising input costs thanks to the collapse in sterling which followed the Brexit vote.

On 10 May 2017, Sainsbury’s (SBRY) shares were marked down as it reported a decline in its already skinny full year operating margin from 2.74% to 2.42% as it had been unable to fully pass on higher costs to its customers.

3. Regulation

This is a particular risk for consumer-facing businesses. On 9 May 2017, shares in energy companies Centrica (CNA) – which owns British Gas – and SSE (SSE) fell sharply after prime minister Theresa May pledged an end to ‘rip-off’ energy prices with a cap on bills, something which would clearly hit profitability.

4. Operational problems

Sausage skin manufacturer Devro (DVO) issued a terrible profit warning in November 2016 which caused the shares to lose nearly a fifth of their value.

Among the problems it faced were technical issues around the supply of product from its facility in the Czech Republic and difficulties in getting new plants in China and the US up to full capacity.

This translated into a drop in its operating margin from 8.3% in 2015 to 6.3% in 2016. The company has launched a strategic development programme to improve margins focused on enhancing sales capabilities, increasing the efficiency of manufacturing and launching differentiated products.

Margin improvement machine

Legacy software infrastructure company Micro Focus (MCRO) is a useful case study in margin improvement for investors.

The FTSE 100 firm has a great track record in extracting value. It is currently in the middle of its biggest challenge: integrating the $8.8bn reverse takeover of the software bit of Hewlett Packard Enterprise, also known as HPES.

Micro Focus supplies a range of application and infrastructure management tools used to build, manage, test and modernise applications built on a wide range of platforms, such as COBOL, Novell and SUSE Linux.

Many mature companies’ IT systems run on these platforms, including many of the world’s financial institutions.

Micro Focus has typically generated adjusted operating margins in the mid-40% range (43% in its last reported year to 30 April 2016).

HPES’ equivalent margins were about 21%, a level at which they’ve been stuck for several years. Micro Focus is confident of improving HPES’ margins within three years of the acquisition closing. Cross-selling products, stripping out overheads and streamlining internal processes are some of the ways it could achieve this goal.

David Toms, analyst at broker Numis Securities, anticipates HPES will have operating margins of circa 40% over the next few years. On HPES’ last reported revenue of $3.13bn, margins of that magnitude would double operating profit from the business to more than $1.25bn. (SF)


THREE STOCKS TO BUY

We have identified a trio of companies whose profitability arguably does not face any of the aforementioned threats in the near-term. They all have a consistent track record of delivering high margins.

We believe these are genuinely high quality names with a strong competitive position which gives them pricing power.

They offer products or services which are either of such superior quality, are so reliable, better than competitors or scarce. Or they enjoy such a dominant market share, that they can increase their prices without losing market share or impacting overall demand for what they do or what they produce.

Auto Trader (AUTO) 407.4p

Shares in second hand car website Auto Trader have stalled year-to-date amid waning sentiment to the car market.

Investors have been concerned about the strength of the UK domestic economy, the pressures facing consumers and the introduction of the Vehicle Excise Duty (VED).

AUTO TRADER GROUP - Comparison Line Chart (Rebased to first)

Don’t be put off by these negative factors. Take a long term
view and buy at 407.4p.

Auto Trader is reliant on the used car market (around 85% of the stock on its website) which could see some near-term benefit as buyers opt for used cars to avoid the hefty VED tax on some new cars.

The company is the market leader with a 75% share which should help protect its extremely healthy margins. Auto Trader’s website is the one most visited by prospective car buyers because it has the most listings. Car retailers are therefore compelled to use its products, reinforcing its position. It has a 59.9% operating margin.

COVER4

There are four key areas of operation – selling, buying, marketing and managing – and each one is broken up into different levels with price points moving progressively higher.

By cross-selling and upselling to existing clients, the company can increase average revenue per retailer (ARPR) and further bolster its margin performance.

According to Liberum’s forecasts, which are ahead of the consensus estimate, the stock trades on a prospective price-to-earnings ratio of 21.4 times. That is a material discount to the average of 26 times seen since its March 2015 IPO (initial public offering). The broker has a 530p price target on the shares.

Risks to consider include a possible tightening in the availability of car finance. (TS)

The solemn transfer the key the buyer of a new car


Craneware (CRW:AIM) £11.95

Scotland’s Craneware (CRW:AIM) supplies innovative financial analysis tools to hospitals. It is fast growing, generates lots of free cash flow and is a consistently high margin company.

Nearly all of its business is in the US despite the company being based in Edinburgh. That curiosity stems from the private healthcare system across the pond.

CRANEWARE - Comparison Line Chart (Rebased to first)

Founded in 1999, Craneware provides cloud-based technology solutions that help hospitals and other healthcare providers more effectively price, charge, code and retain earned revenue for patient care services and supplies.

Craneware has been busy adding extra tools and services to its platform which should help bolster already sticky customers – about 85% of annual revenue is recurring.

That implies about $46m of recurring revenue this year to 30 June 2017 ($57.8m forecast in total) and operating profit of approximately $15m, on a 25.9% forecast operating margin.

The future of the US healthcare system is not clear under president Trump’s administration yet market drivers for value-based care look set to stay in place, in our opinion.

Craneware has mapped out how it can address the five-point healthcare reform plan trying to be pushed through by Trump.

With excellent cash generation, $45m of net cash on its books plus a $50m untapped funding facility, the company has the flexibility to build in-house products or obtain them via acquisition.

Analysts forecast annual growth of 15% a year through to 2020 in organic terms.

There is scope to do even better when you consider its bulletproof balance sheet and plenty of growth options to explore. That appears to justify Peel Hunt’s £14.50, 12-month target price for the share price, even in the face of the stock’s premium price to earnings (PE) ratio of 30-times. (SF)


Playtech (PTEC) 963p

Many people consider Playtech as one of the quoted gambling firms such as William Hill (WMH) or Paddy Power Betfair (PPB). In reality, it is a software firm and should be benchmarked against technology stocks.

It owns the infrastructure used to supply gambling company back-end operations. Playtech also creates content such as slot machines, live dealer games, poker and bingo.

Last summer Morgan Stanley calculated Playtech was among the fastest growing businesses in the technology sector and growing ‘far faster’ than the gambling sector.

PTEC - Comparison Line Chart (Rebased to first)

Most of its income comes from revenue share fees. It enjoys increasingly long-term business-to-business contracts with high levels of recurring revenue. It generates high margins and has limited capital expenditure requirements. Canaccord Genuity estimates Playtech will be sitting on a €330m net cash position at the end of 2017.

Analysts point out that gambling firms rarely switch technology back in-house, meaning Playtech should have a sticky client base once it has persuaded them to use its technology.

Financial data provider Stockopedia calculates that Playtech has enjoyed an average 47.8% operating profit margin over the past five years. Investors may wish to also look at the EBITDA margin which is more closely related to net profit margin.

Net profit provides the base number from which EBITDA is calculated; importantly, it includes all of a company’s costs and expenses which aren’t included in the calculation of operating profit.

Morgan Stanley forecasts that Playtech’s EBITDA margin will be 41.2% in 2017 and 41.6% in 2018 – both very healthy numbers. The gaming division (which accounts for c87% of group revenue) EBITDA margin is in the region of 43% to 44% but the headline figure is pulled down by Playtech’s financial division being sub-30% margin.

It is worth touching on the financial division as its performance has been fairly lacklustre over the past year while it restructured operations. A few years ago it pulled out of two financial sector acquisitions worth more than £500m amid regulatory concerns.

The more recent purchase of CFH seems to have reignited interest in how its financial arm could grow.

CFH is one of the top interbank straight-through-processing venues in the world, claims Playtech. It sees a ‘significant opportunity’ with CFH’s customer base having access to Playtech’s proprietary trading platform and technology, ‘effectively mirroring (our) B2B offering in the gaming division’. (DC)

tablet pc with a poker app and poker chips coming out by breaking the glass, concept of online gaming (3d render)

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