Low-Margin Companies Are Still Compelling

There's more to profit margins than meets the eye. Sure, all things being equal, the higher the margin, the better. But all things are not equal. Plenty of companies can be quite attractive, despite not-so-attractive margins.

Let's back up a bit, though, to review margins. You can calculate them via the income statement. For the gross profit margin, you simply subtract the cost of goods sold (what it takes to produce a product) from revenue. That's a top-line margin. To calculate net margin, divide net income by total revenue. That shows you what's left over as ultimate profit from each dollar of revenue.

Industry matters
It's important to understand that margins generally vary by industry. When a company has an intensive and costly production process, its gross and net margins will tend to be low. Automakers such as Ford (NYSE: F), for example, purchase lots of raw materials, buy many components from suppliers, and employ thousands (many of which are unionized). Its net margin is 5%, and even though that looks low, it's a lot better than it has been for much of the past decade.

In contrast, a software specialist such as Microsoft simply has to write code and make it available on inexpensive discs or downloads. Each additional copy sold doesn't cost much more to produce. Meanwhile, companies like Qualcomm (Nasdaq: QCOM) make much of their income by licensing their technology to others, while an REIT like Annaly Capital Management (NYSE: NLY) borrows money (at today's low rates!) and invests in mortgage-based securities. Thus, it's not so surprising that Microsoft's net margin is 33%, while Qualcomm's is 29% and Annaly's is 89%. A company's industry and business model make a big difference.

Volume, volume, volume
Now that you've seen how high net margins can go, a company such as Wal-Mart (NYSE: WMT), with net margin of roughly 4%, will surely seem unattractive. But hold on: there are some other factors to consider. For starters, there's volume. Qualcomm's hefty margin is attractive, and in the past year, it has raked in close to $14 billion. That translates to net profits of roughly $4 billion. That's terrific, but ... Wal-Mart raked in about $430 billion, so its seemingly puny profit margin delivered a net profit of almost $17 billion. Volume matters.

Turn, turn, turn
Inventory turnover, which reflects how frequently a company sells out its stock of goods, is one way to get a handle on how busy and efficient a company might be. (Obviously, this doesn't apply to companies that don't have stocks of goods.) For any given period of time, you can calculate it by dividing the cost of goods sold by the average inventory level. A high inventory turnover ratio can help make up for a company's low profit margin.

It can be instructive when looking for exciting candidates for your portfolio to compare a company's net margin and inventory turns with those of its competitors. Check out some sets of rivals:

Data: Capital IQ, a division of Standard & Poor's. *Excludes real estate and land in process of development and/or for sale.

On the measures above, Weyerhaeuser is the clear winner, with a higher net profit margin and items moving off its shelves more rapidly. Whenever the housing bust turns into a housing boom, both of these companies should see business pick up as housing construction starts to increase and lumber demand grows.

Data: Capital IQ, a division of Standard & Poor's.

General Motors might seem more attractive here, with its significantly higher net margin, but Ford is far more impressive when it comes to churning through its inventory. Ford has been reporting very strong sales growth abroad in places like China and India.

Data: Capital IQ, a division of Standard & Poor's.

Finally, a look at the discount retailers above reminds us of one reason why Wal-Mart has grown so big: Its inventory turnover far exceeds its peers.

There's a lot more to look at in a company than just gross and net profit margins, but they can tell you a lot. If you find promising companies with robust profit margins, great! But whenever you run across an otherwise attractive company that sports some slim margins, give it a chance. Take a closer look.