When it comes to finding good potential investments, one of the first things most investors look for is high profit margins. There is generally nothing wrong with following this process. However, one shouldn’t limit their search to companies with fat margins. A good example of this concept is Sysco Foods versus Cisco Systems. I display a comparison between these two firms to make the illustration. Despite the fact their names sound similar the businesses couldn’t be more different.
Profit margin and Return on Capital comparison:
Sysco (SYY, Financial) – 5 year Margins ROC
Gross Margin 19.2% 17.0%
Pre-tax Margin 4.7%
Net Margin 2.9%
CSCO (CSCO, Financial) – 5 year
Gross Margin 64.8% 18.1%
Pre-tax Margin 26.3%
Net Margin 20.0%
We can see that from a margin perspective, the two companies are very different. The food service distribution industry carries razor thin margin, while the router and switch market is high margin. Yet each of these businesses is equally valuable. Why is this the case?
The answer lies in the fact that profit margins are but one component of a firm’s profitability. Some of you might be familiar with the DuPont Model – which breaks down the components of return on equity. Quick side note – I tend to focus on return on total capital rather than return on equity as it takes into account profits on firm’s total capital (debt plus equity), not just equity. The primary factors in return on capital are profit margins and asset turnover. Asset turnover measures how quickly a firm can convert assets such as inventories, receivables, etc. into cash. It measures how efficiently a company utilizes its assets. These two numbers combined provide us with ROC.
Here in lies the answer to the previous question. The companies put up comparable ROC numbers because while CSCO has much higher margins, SYY has much greater asset turns.
Asset Turnover:
Sysco 3.6X
Cisco .5X
Of course, this makes perfect sense. Food distributors are able to turnover their asset base at a much quicker pace because their product and services are at a much lower price point. Selling paper napkins and soap dispenser refills move off the shelves much quicker than do expensive high-end routers. Asset turns are an important number to track over time as it provides valuable clues into how a company’s profitability is changing. For example as Cisco Systems navigates down the margin chain (i.e. the Linksys acquisition which supplies home-based routers), it will be interesting to see if improved asset turns can offset the margin erosion.
When looking at profitability - it’s more than just margins.
