The Importance of Gross Margins

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In my opinion, the gross margin generated by a firm is one of the most important ratios you can use to determine the future of the investment.

The gross margin is the profit produced by the firm, after the cost of sales has been subtracted from revenue. The higher the gross margin, the stronger the free cash flow. A high cash flow can be returned to shareholders or re-invested into the business, allowing the business to expand, without having to lean on debt.

Companies with a higher gross margin usually demand a higher premium because of their higher earning potential.

Although gross margins are important, I believe net margins weigh equally in determining the quality of earnings. The difference between the net margin and the gross margin shows the efficiency of the firm. For example; a firm with a high gross margin and low net margin can indicate there are inefficiencies in the business. This is usually a result of poor management, high administration costs and high financing costs.

Gross Margin = Gross Profit/Revenue
Net Margin = Net Profit/Revenue
For example:

The Ugly

<table> <tbody> <tr> <td> <p>$US Millions</p> </td> <td> <p>Revenue</p> </td> <td> <p>Gross Profit</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Net Profit After Tax</p> </td> <td> <p>Net Margin</p> </td> </tr> <tr> <td> <p>Avon Products <span class="ticker" data-id="202886">(NYSE: <a href="">AVP</a>)</span></p> </td> <td> <p>10,129</p> </td> <td> <p>7,150</p> </td> <td> <p>70.5%</p> </td> <td> <p>516.7</p> </td> <td> <p>5%</p> </td> </tr> </tbody> </table>

Avon Products has a large gross margin of over 70%, but huge administration costs absorb most of the company's income. Selling/General/Admin costs account for over 54% of revenue. These high costs resulted in a tiny 5% net margin, leaving almost no cash available for reinvestment or return to shareholders.

In fact looking deeper into Avon's cash flow, it turns out the company has a negative cash flow and was forced to issue debt to support itself.

The Bad

<table> <tbody> <tr> <td> <p>$US Millions</p> </td> <td> <p>Revenue</p> </td> <td> <p>Gross Profit</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Net Profit After Tax</p> </td> <td> <p>Net Margin</p> </td> </tr> <tr> <td> <p>Abercrombie & Fitch Co.<span><span class="ticker" data-id="202820">(NYSE: <a href="">ANF</a>)</span></span></p> </td> <td> <p>4,160</p> </td> <td> <p>2,280</p> </td> <td> <p>55%</p> </td> <td> <p>126.9</p> </td> <td> <p>3%</p> </td> </tr> </tbody> </table>

Abercrombie & Fitch has the same problem. Despite having a large 55% gross margin, the company has large staffing costs resulting in a tiny net margin of 3% of total revenue.

Although the company reported last quarter margins had improved - up to 9.5%.

Abercrombie & Fitch actually had a negative cash flow for the full year 2012. Although unlike Avon, they brought back debt rather than issued it. The negative cash flow was paid for with existing cash assets.

The Good

At the other end of the scale we have fiscally prudent Apple (NASDAQ: AAPL

<table> <tbody> <tr> <td> <p>$US Billion</p> </td> <td> <p>Revenue</p> </td> <td> <p>Gross Profit</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Net Profit After Tax</p> </td> <td> <p>Net Margin</p> </td> </tr> <tr> <td> <p>Apple</p> </td> <td> <p>155.97</p> </td> <td> <p>68.2</p> </td> <td> <p>44%</p> </td> <td> <p>41.73</p> </td> <td> <p>27%</p> </td> </tr> </tbody> </table>

With low operating costs and high gross margins, Apple’s net margin comes out to 27%!

This large net margin has allowed Apple to generate a huge cash balance, with over $100 billion burning a hole in its balance sheet that it could return to shareholders or reinvest. This cash pile is still growing at an alarming speed.


<table> <tbody> <tr> <td> <p>$US Billion</p> </td> <td> <p>Revenue</p> </td> <td> <p>Gross Profit</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Net Profit After Tax</p> </td> <td> <p>Net Margin</p> </td> </tr> <tr> <td> <p>Philip Morris International <span class="ticker" data-id="210565">(NYSE: <a href="">PM</a>)</span></p> </td> <td> <p>31.1</p> </td> <td> <p>20.3</p> </td> <td> <p>65%</p> </td> <td> <p>8.54</p> </td> <td> <p>28%</p> </td> </tr> </tbody> </table>

Finally, an analysis on margins would not be complete with looking at a tobacco stock. One of the best sectors for shareholder returns is tobacco. 

For all the controversy that surrounds tobacco stocks, they are one of the best cash generative businesses around, with an average net margin of approximately 20%. 

This allows the group as a whole to maintain a high level of cash return to shareholders, with the average dividend yield about 4% and share buybacks increasing every year!

Philip Morris has one of the best cash flows in the sector. With a cool 28% net margin, the company is rolling in cash. In 2011 alone, the company returned $10 billion to shareholders on revenues of $19 billion.

Share Performance

<img src="/media/images/user_14485/gross-margins_large.png" />

The strength of the net margins can be seen in the performance of the companies over a 5 year period. Both PM and Apple have strongly outperformed the S&P 500, Abercrombie, and Avon.

Although the size of the margins produced is not the only factor that has allowed these companies to outperform the market, it has been a significant contributor. The free cash flow generated through wide margins has allowed Apple and PM to reinvest to improve sales, and buy back stock to improve EPS.

A stock with high margins and a strong cash flow can be the signal for a future market winner.

RupertHargreav has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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