QUALIPORT
Profiting From High Margins

By Maynard Paton (TMFMayn)
July 7, 2003

Want a quick way of determining whether a company is a possible 'franchise'? Check out its operating margin.

The formula for calculating a company's operating (or trading) margin is shown below:

                         Operating Profit
Operating Margin =     --------------------
                             Sales

You see, by making more profit from every £1 of sales, the firm could well have some sort of pricing power over its customers. Such power could stem from limited competition or a strong operational advantage, both of which are attractive features of any long-term share.

On the other hand, a low operating margin traditionally indicates the firm contends with plenty of competition. Customers are usually free to shop around on price, which puts a constant pressure on the top line and thus margins too -- and generally isn't amenable to the buy and hold shareholder.

But how do you judge what is a 'high' margin?

Excluding the 17 financial organisations whose accounts do not lend themselves to the above formula, the average operating margin within the FTSE 100 is presently 16.2%. The following tables highlight the top and bottom ten companies:

Top ten FTSE 100 margins

Share                                      Operating Margin (%)

British Land (LSE: BLND)                         84.6
Liberty International (LSE: LII)                 61.5
Land Securities (LSE: LAND)                      44.4
Kelda (LSE: KEL)                                 37.0
Imperial Tobacco (LSE: IMT)                      36.6
Shire Pharmaceuticals (LSE: SHP)                 31.9
GlaxoSmithKline (LSE: GSK)                       31.7
Vodafone (LSE: VOD)                              31.1
BAA (LSE: BAA)                                   30.4
United Utilities (LSE: UU.)                      29.8

Bottom ten FTSE 100 margins

Share                                       Operating Margin (%)

Johnson Matthey (LSE: JMAT)                       4.8
Safeway (LSE: SFW)                                4.6
Exel (LSE: EXL)                                   4.6
Rolls-Royce (LSE: RR.)                            4.5
Reuters (LSE: RTR)                                4.3
J Sainsbury (LSE: SBRY)                           4.2
Alliance Unichem (LSE: AUN)                       2.5
Schroders (LSE: SDR)                             (0.4)  
mm02 (LSE: OOM)                                  (2.0)
Cable & Wireless (LSE: CW.)                      (4.4)

The top ten fall into three distinct groups: property companies, regulated monopolies (e.g. water suppliers, airport operators) and consumer 'franchises' aided by patents, brands and market dominance.

Watch list

How does the Qualiport's watch list measure up to the 16.2% blue chip mean?

Share                                      Operating Margin (%)

Associated British Ports (LSE: ABP)              38.5
Imperial Tobacco                                 36.6
London Stock Exchange (LSE: LSE)                 36.2
Johnston Press (LSE: JPR)                        30.9
Ulster Television (LSE: UTV)                     30.6
Gallaher (LSE: GLH)                              23.9
Capital Radio (LSE: CAP)                         23.4
Halma (LSE: HLMA)                                18.0
Scottish Radio (LSE: SRH)                        17.1
Emap (LSE: EMA)                                  17.0

Metal Bulletin (LSE: MTLB)                       15.7
Carpetright (LSE: CPR)                           14.0
Games Workshop (LSE: GAW)                        12.9
Renishaw (LSE: RSW)                              12.7
DFS Furniture (LSE: DFS)                          9.6

Not too badly. Of the fifteen shares, only five fall below the 16.2% benchmark.

During the 1990s however, Metal Bulletin and Renishaw did consistently record margins above the 16.2% level, though it's fair to assume the FTSE 100 would have had a higher average margin during those buoyant years, too. 

The three others with margins below 16.2% (Carpetright, Games Workshop and DFS) all have retail operations. Certainly for Carpetright and DFS, keen pricing and a low cost base are used as competitive weapons. Not ideal of course, but few Wal-Mart (NYSE: WMT) investors have complained about its low pricing manifesto and sub-5% margins.

And Games Workshop? When the Qualiport met Games Workshop earlier this year, the question "If you're the dominant force in table top wargames, why aren't your margins higher?" was asked. "You mean why don't we charge our customers more?" was the reply. Pricing out their customer base (financially limited teenage boys) was cited for the below-average mark-up.

Three points to watch

When evaluating companies and their operating margins, consider these factors:

1. Property 'moats': Due to the nuances of accounting, property companies tend to have very high operating margins. The table below outlines the operational costs incurred by British Land during 2002:

British Land                        2002 (£m)

Gross rental income (turnover)       449.4
Rents payable                         (2.1)
Other property outgoings             (29.1)
Profit on property trading             0.6
Other income                           4.2
Administrative expenses              (42.6)

Operating profit                     380.4

Nearly 85p in every £1 of rent is thus regarded as profit. However, because land and property tend to rise in value over time, the costs involved in buying and building new sites can be accounted for solely in the cash flow statement and do not -- like other fixed assets -- incur an operational charge in the form of depreciation. For example, British Land spent £371m on the 'purchase of development properties and development expenditure' during 2002. The depreciation charge that year: £0.6m.

(What investors should realise though is that most property companies fund their expenditure through significant debt. So for British Land, its net interest charge for 2003 amounted to £326m, equating to a massive 65% of the firm's total profit before interest.)

2. Additional turnover: Accounting standards oblige some companies to include certain 'external' costs as turnover. Tobacco firms are good examples. The next table shows how Imperial Tobacco's sales are boosted by the excise duty levied by governments on cigarettes:

Imperial Tobacco            2002 (£m)

Turnover                     6,544
Duty in turnover            (4,899)
Costs and overheads         (1,043)

Operating profit               602

Taking the profit and loss statement at face value, an operating margin of 9% is derived. However, including excise duty in the sales figure is somewhat contentious. Excise duty technically is a cost of doing business in tobacco, but it's a tax slapped onto a product in a manner not dissimilar to VAT, which the consumer also has to pay and also goes to government coffers, yet is excluded in all turnover calculations.

The margin Imperial actually makes on the money it receives (i.e. turnover less duty, £1,634m in 2002) comes to a far more respectable 36.6%.

3) Phantom margins: Beware the transitory high margin. Many high margin businesses have significant operational gearing, which means any movement in sales will have a substantially amplified affect on profits.

Lonmin (LSE: LMI) is a good example of this phenomenon, the miner benefiting from a doubling in the platinum price over the past five years. With the cost of digging holes in South Africa remaining relatively stable, operating margins have jumped from 13% in 1998 to 48% in 2002. A fall in the price of platinum will quickly see those margins eroded.

Of course, some businesses with high margins just don't have the staying power to keep them up. For instance, former Qualiport share MMT Computing (LSE: MMT) recorded 20%-plus margins in the 1990s. After various troubles, the margin for 2002 was reported at just 1%.

So the lesson here is simple: if you're attracted by high margins, ensure the company has the wherewithal to maintain them in the good times and the bad.

The author owns shares in Carpetright, DFS Furniture, Games Workshop, GlaxoSmithKline, Halma, Johnston Press and London Stock Exchange.