Healthy profit margins are one sign of an attractive company. But low margins don't automatically herald a bad investment. Businesses constantly make decisions that push their margins higher or lower over time. What matters for us investors is how those margins generally affect both profitability and the health of the overall company.
Speaking of profits
It's hard to beat companies with beautiful, high-margin business models, given the prodigious profits they can produce. Google (Nasdaq: GOOG) doesn't require huge amounts of capital to generate relatively large amounts of revenue, but it sports gross margins of 63% and net margins of 28%.
Of course, it doesn't take high margins to earn healthy profits. Waste Management requires a lot of equipment, land, and labor to collect and recycle trash and waste products. That brings its gross margin down to 38% and its net margin to just 9% -- but it still earned more than $1 billion over the past 12 months.
Ch-ch-ch-changes
As companies grow and develop, their business models often change, sometimes for the better, and sometimes seemingly for the worse. Expanding in new directions can grow or shrink profit margins.
Lower margins aren't always as bad as they seem. Google has been entering the smartphone business, and eyeing a move into laptops. That might worry some investors; most of the businesses Google might expand into, such as computer hardware, will have lower profit margins than it has now, which could drag down its overall profitability. Even Apple, with its amazing brand loyalty, can't generate margins as high as Google's. But if Google ends up delivering more revenue and earnings from these initiatives, despite the lower margins, investors' worries may prove unfounded.
Profit matters
It is valuable to examine a company's profit margins -- especially to see whether they're trending upward or downward. But actual profits are far more important. Successful retailers, among other companies, generate a lot of money by compensating for low margins with high volume.
Sometimes lower-margin business lines can help a company's overall efforts. Apple added retail stores to its offerings back in the early 2000s, and its profits have grown steadily since then, perhaps in part because the stores have given more people a place to see and try out its products firsthand.
More recently, Coca-Cola (NYSE: KO) and PepsiCo (NYSE: PEP) have embarked on the path toward vertical integration by buying their respective bottlers. Selling syrup to bottlers to prepare and distribute has long been considered a superb business model, so some investors might worry about the companies' decision to add considerably more capital-intensive bottling businesses. Yet both companies argue that having bottling operations back under their roofs will cut costs and make it easier and faster to develop new product lines. That could help overall profits, even if it does cut margins.
The principle applies to all kinds of business models. Under the new health-care laws, insurer Coventry Health Care (NYSE: CVH) will now market to and serve more individual consumers; before, the company sold its services mostly to other businesses. That change in its business model could bring lower profit margins. However, if it boosts the number of overall customers Coventry serves, and the revenue they bring in, overall profits could rise.
Remember that great businesses can take different forms, and those forms can change over time. As companies shift and grow, their profit margins matter -- but plain old profits matter more.
