Margin trend not what it seems

4/14/2008


With the first quarter of 2008 closed and investors waiting to hear about operating results over the next few weeks, the financial sector’s woes loom large.

Consensus estimates project a 12% decline in per-share profits for the S&P 500 Index in the March quarter, following a 28% decline in the December quarter. Not surprisingly, as profits fell, so did profit margins.

But the financial sector’s horrid performance is skewing the numbers. Problems in the credit markets have hit the financial sector particularly hard, sparking huge investment losses at many companies. Consensus estimates project a 60% decline in the S&P 500 Financial Sector’s per-share profits for the March quarter. Excluding the financials, the rest of the index is expected to deliver respectable per-share-profit growth of 7%.

The trailing 12-month net profit margin of the median S&P 500 stock reached 9.6% in June, its highest point in at least 13 years. The median profit margin remained well above 9% through October, but has slumped over the last five months. The median nonfinancial stock’s net profit margin also peaked in June but remains very close to peak levels.

Below, we discuss two companies with a history of rising profit margins, all of which are expected to see further margin expansion this year and next year.

While Airgas ($47; NYSE: ARG) is exposed to a U.S. economic slowdown, the dynamics of the current downturn seem to favor this supplier of industrial gases. U.S. exporters are benefiting from a weak U.S. dollar, which makes American products cheaper overseas and foreign products more expensive at home. Airgas generates 25% of sales from industrial manufacturers, many of which have so far been only modestly affected by the economic slowdown. Nonresidential construction (12% of 2007 sales) is also doing well.

Because demand for gas remains high, Airgas has been able to maintain profit margins by raising prices. Airgas is forecasting that half of its expected organic growth rate of 5% over the next three years will come from price increases. Airgas already controls 25% of the packaged-gas market and is gaining share. The large market share contributes to the company’s pricing power.

Finally, Airgas rents the cylinders that customers use to store the gas they purchase. Those rental fees represent a steady source of revenue, as most customers hold onto the cylinders even when they are not buying more gas. Airgas’ 9 million cylinders each provide revenue of about $60 per year. Rental fees alone represent more than 40% of earnings before interest, taxes, depreciation, and amortization, creating a noncyclical source of cash flow. Airgas has never posted a same-store-sales decline in its core gas and rental business, and the current economic slowdown should not endanger that streak. Airgas is a Buy.


Disney ($31; NYSE: DIS) shares have risen solidly over the last five years as the company expanded its profit margins to 11.6% from 3.3%. This year’s economic slowdown, and an expected decrease in advertising revenue, are likely to slow the margin expansion but not stop it.

Disney’s cable stations (26% of fiscal 2007 revenue) have the advantage of dual revenue streams: subscriptions and advertising. ESPN, for example, earned roughly 64% of revenue from license fees. The rest came from commercials. License fees are less susceptible to an economic downturn than advertising.

ABC broadcast stations (17% of revenue) are much more vulnerable to a decrease in advertising. In the 2001 recession, total media advertising fell 7%, but advertising on broadcast television dropped 14%. Add to that the ongoing overall decline in broadcast viewers (down 5% in the 2007-2008 season), and ABC faces not just a short-term economic challenge but also long-term industry changes. Yet hit shows like ABC’s Lost and Grey’s Anatomy and cable channels ESPN and Disney Channel helped the media division post 28% growth in operating income in the December quarter. Operating margins for both broadcasting and cable operations jumped in the quarter.

The parks and resorts division (30% of revenues) is also vulnerable to a downturn, though so far the company has not reported weakness. The company may see sales decline this year as consumers restrain vacation spending. Still, theme-park revenue rose 11% in the December quarter, and the company believes cost controls can maintain operating profit margins near 19%. Disney is a Long-Term Buy.


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