Friday, June 19, 2009

Can you rely on increasing Margins?

Many renowned investors including Buffett, Philip Fisher prefer buying companies with high margins over low margins and companies with increasing margins compared to decreasing margins. But how good this measures are in the short run? Let's understand this with examples. Britannia had an operating profit margin of 10% and net profit margins of around 5.5% (excluding extraordinary items) in FY2001 and FY2002. This improved to 12.2% and 9.3% in FY2005. But the entry of newer players like Surya Agro (PriyaGold fame) and ITC took this down again to 8.3% and 5.8% in FY2009.

Contrary to this, Nestle had a permanent expansion in profit margins between CY1998 when its net profit margin was around 5.5% and CY2003 when its margin became 12.5%. During these five years, the revenue of Nestle increased from INR 1612 Crore to INR 2160 Crore, i.e. by 34% or 6% CAGR but net profits rose from INR 86.2 Crore to INR 263.08 Crore, i.e. by 25% CAGR. Since then margin expansion has stopped and revenue and net profits are almost in sync. Revenues rose to INR 4358.13 Crore in CY2008, i.e. by 100% or 15% CAGR and net profits rose to INR 534.08 Crore, i.e. by 103% or 15.2% CAGR.

We can conservatively say that Nestle has almost reached a saturation for margin expansion. Conservatively since The Coca Cola Company in the US has net profit margins near high teens, i.e. 17-19%. Britannia's counter part in the US, the Kraft Foods Company also suffers from low net profit margin of around 6-7%.

We can conclude that investors must remain cautious when relying on margin expansion.
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