Four Angles On Efficiency

8/4/2014


We all deal with limitations, such as time, money, intelligence, or patience. Companies face similar dilemmas. The best-run firms are capable of wringing out more profits than competitors relative to the resources at hand.

Efficiency metrics rarely attract much notice during earnings season. But they can point to underlying currents that eventually lead to significant changes in sales and profit trends. Below, we explore different ways to measure efficiency and highlight companies making the most of their finite resources.

Profit margins

Many companies are benefiting from improved efficiency through new technology, low borrowing costs, and muted growth in labor expenses. Profit margins measure these gains by calculating earnings as a percentage of revenue. Gross profit margin uses earnings after removing costs related to acquiring or making products. Operating profit margin also takes into account operating expenses.

The five recommended stocks in the table below have kept costs under control, reflected by their higher gross and operating profit margins in the past 12 months.


PROFIT MARGINS

Gross Profit Margin
Oper. Profit Margin
Company (Price; Ticker)
Last 12
Months
(%)
Prior 12
Months
(%)
Last 12
Months
(%)
Prior 12
Months
(%)
Norfolk South. ($103; NSC)
38.1
35.6
38.1
35.6
Schlumberger ($111; SLB)
30.9
29.6
27.4
25.9
U.S. Bancorp ($43; USB)
87.0
83.7
56.2
54.5
United Rentals ($110; URI)
59.2
57.2
46.1
43.6
Wells Fargo ($52; WFC)
94.2
89.0
54.4
51.1

Last year, Norfolk Southern ($103; NSC) produced its highest operating profit margins since 1997. The railroad has continued to improve its profitability this year, with June-quarter gross profit margins reaching their highest level for any quarter in at least 17 years. Freight volumes jumped 8% in the June quarter, pushing revenue to a quarterly record of $3.04 billion, up 9%. Operating expenses rose just 3%, as lower compensation and benefits partly offset higher fuel usage and locomotive costs.

Pent-up demand caused by last winter's harsh weather contributed to higher June-quarter volumes. Management expects volume growth to continue in the second half of 2014, though at a slower pace. The consensus targets 15% higher per-share profits in the September quarter, followed by 7% growth in the December quarter; revenue growth should exceed 5% for both quarters. Norfolk Southern is a Long-Term Buy.

Returns on equity and assets

These metrics measure the effectiveness of management's use of assets and shareholder contributions. Return on equity, or net income divided by shareholders equity, indicates profit relative to book value of shareholders' net investment in the company. Return on assets equals net income divided by total assets. Think of these metrics as profit margins for the balance sheet. The companies below reported higher returns on equity and assets in the past 12 months.


RETURNS ON EQUITY AND ASSETS

-- Return On Equity --
--- Return On Assets ---
Company (Price; Ticker)
Last 12
Months
(%)
Year-Ago
Period
(%)
Last 12
Months
(%)
Year-Ago
Period
(%)
B/E Aerospace ($87; BEAV)
15.4
12.7
6.9
5.4
Comcast ($55; CMCSa)
14.9
14.0
4.8
4.2
EOG Resources ($114; EOG)
15.9
5.5
7.9
2.7
Manpower ($80; MAN)
13.1
8.3
5.2
3.0
Skyworks ($52; SWKS)
16.7
13.2
15.0
11.8

EOG Resources's ($114; EOG) returns on equity and assets for the 12 months ended March nearly tripled their year-earlier levels; both have also grown sequentially in each of the past five quarters. With management projecting organic growth of 29% in crude-oil production this year, EOG expects its 2014 return on equity to approach 18%, which would be its highest level since 2008. Within its peer group of 36 exploration-and-production stocks in the S&P 1500 Index, EOG ranks in the top six for returns on both equity and assets — the only company with annual sales above $4 billion to do so.

EOG reports June-quarter results on Aug. 6. The consensus estimate calls for per-share profits of $1.37, implying 31% growth, on 10% higher revenue. EOG enters the earnings report with a lot of momentum. Both Halliburton ($71; HAL) and Schlumberger ($111; SLB) described robust drilling activity in North America during the June quarter. EOG is a Buy and a Long-Term Buy.

Sales/employee

An expanding work force suggests companies are increasingly bullish on the future. A rising sales-per-employee ratio signals improved productivity from the work force. All five companies below employed more workers at the end of last year than they did a year earlier. Their sales/employee ratios also rose, meaning the larger staffs haven't come at the expense of efficiency.


SALES/EMPLOYEE

-------------- Annual Change --------------
Company (Price; Ticker)
Sales
(%)
Employees
(%)
Sales/
Employees
(%)
Alaska Air ($46; ALK)
11
2
9
Continental Resources ($152; CLR)
34
23
9
Schlumberger ($111; SLB)
7
4
3
Skyworks Solutions ($52; SWKS)
14
1
13
Union Pacific ($100; UNP)
5
1
4

In 2010 Schlumberger ($111; SLB) acquired rival Smith International for $9.8 billion in stock and the assumption of $1.8 billion of net debt. Since absorbing Smith, Schlumberger's work force has risen 4% a year, well below the pace of its 7% annual sales growth. As a result, its sales per employee set a record high last year. The company also produced its highest returns on assets, investment, and equity since 2008.

Schlumberger expects capital spending for the exploration-and-production industry to average 6% to 7% growth through 2017. Schlumberger generates most of its revenue from services and products related to wells, an area management sees growing faster than the overall industry. Solid industry growth, combined with efficiency improvements and a steadily declining share count, position Schlumberger to generate double-digit growth in per-share profits over the next few years. Schlumberger is a Focus List Buy and a Long-Term Buy.

Cash conversion

The cash conversion cycle, a gauge of operating efficiency, equals the number of days needed to sell inventory plus days required to collect receivables minus days allowed to pay bills. Declining cash conversion implies a company is accelerating the rate that sales turn into cash.

Cash conversion can vary greatly between industries, so it's best to compare this metric to industry peers or a company's historic norms. For the five companies in the proceeding table, cash conversion cycles in the latest quarter were faster than the year-ago quarter and the three-year average.


CASH CONVERSION CYCLE

--------- Cash Conversion (Days) ---------
Company (Price; Ticker)
Latest
Quarter
Year-Ago
Quarter
3-Year
Average
Cognizant Technology ($51; CTSH)
62.3
64.6
63.9
Dover ($87; DOV)
78.6
86.3
79.6
Kroger ($50; KR)
5.1
5.1
6.7
ManpowerGroup ($80; MAN)
42.6
43.7
42.8
Skyworks Solutions ($52; SWKS)
73.1
93.5
84.1

In the April quarter, Kroger ($50; KR) converted inventory investments back into cash in 5.115 days, compared to its three-year average of 6.675 days and 5.118 days in the year-ago quarter. Kroger's cash conversion rate was last this low in the June 1998 quarter. The recent improvement reflects faster inventory turnover and Kroger's ability to stretch the time required to pay its bills. Kroger's cash conversion cycle compares favorably to the average rate of 5.971 days for S&P 1500 food retailers.

The company has also accelerated the rate it transfers cash back into investors' hands. The dividend grew at an annualized rate of 16% over the past three years, exceeding its five-year growth rate of 12%. Stock buybacks have shrunk the share count by 22% in the past five years, including 17% in the last three years. Kroger is a Focus List Buy and a Long-Term Buy.


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