Investing In High Profit Margin Businesses

Net profit margin is one of thekey tools for determining thefinancial health of a company.The metric demonstrates acompany’s ability to convertsales into profits and alsofurnishes an insight into how wella company is run. Armaan Madhani explains how investorsmust properly analyse thevarious facets of profitability

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Stock picking is an uphill task. Especially in the currentenvironment, where investors must be wary of businesses thatare vulnerable to high levels of long-lasting inflation, supplychain disruptions, rising interest rates and incessant geopoliticalcrisis. A smart strategy for investors is to considercompanies with robust earnings’ potential that hold up betterthan others when the times get tough. These are companies thatgenerate plentiful profits on a regular basis. A neat trick toidentify such businesses is to scrutinize net profits or bottomline.To gauge the extent of profits, net profit margin is the idealmetric.

Net profit margin is one of the key tools for determining thefinancial health of a company. Net profit margin ratio iscalculated by dividing net profit by sales revenue. The metricdemonstrates a company’s ability to convert sales into profitsand also furnishes an insight into how well a company is run.Higher the net profit margin, the better is the financial health ofa company as it implies larger profits relative to revenue. Netprofit margin also, to a certain extent, determines a company’sability to pay dividends to its shareholders.

Pros and Cons of Profit Margin Ratio
Net profit margin is the most conclusive ratio, because if thereare major issues with other ratios or the company’sperformance, it will instantly impact this ratio. Ergo, it is a goodpractice to start analysis by looking at this ratio. Profit marginmeasures how much money a company squeezes from its totalrevenue or sales. Net profit margins are earnings generallyexpressed as a ratio or a percentage of sales. It allows for thedirect comparison between profit and costs at any given saleslevel. Percentage allows investors to compare the profitability ofdifferent companies.

Profit after tax is presented as an absolute number and doesn’tallow comparison. As an investment metric, net profit marginhas its own share of shortcomings. It can be influenced byone-off items such as the sale of an asset, which wouldtemporarily boost profits. The metric differs from industry toindustry due to their varying cost structures. Also, thedifference in accounting treatment of various items makes peercomparison a laborious activity. While it is a crucial criterionfor measurement in traditional businesses, it may not be asuseful while analysing financial institutions and new-agetechnology businesses.

Companies that prefer debt financing have higher interestexpenses which skews net profit margin, rendering it ineffectivewhile conducting performance analysis. Another pitfall is thatnet profit margin in isolation does not reveal the true costefficiency in realising sales. Sometimes a decrease in net profitmargin may have nothing to do with changes in cost efficiencyand hence not necessarily a bad omen. The company may haveadopted a strategy to increase its market share by temporarilyreducing prices and sacrificing margins. Ergo, the type of strategy a company adopts must also be taken intoconsideration. Sales volume should also be taken into accountwhile examining profit margin. Companies with relatively lowprofit margins but higher sales volume will be more profitableon an overall basis.

Significance of High Profit Margins

Net profit is the amount of money a business earns afterdeducting all operating, interest and tax expenses over a givenperiod of time. High profit typically denotes that a company hasrelatively low cost of goods and a sky-high selling price. Netprofit margin helps investors gain a better understanding of acompany’s business model in terms of pricing strategy, coststructure and operational efficiency. Hence, rising net profitmargins over a period of time demonstrate a company’s abilityto control its operating and overhead costs, which can assist innavigating through periods of uncertainty and unexpectedlosses.

High margins often help a company achieve steady free cashflows, thereby strengthening its balance-sheet. Companies mayalso use profit margin for price control because of the directrelationship between profit and price on a per unit basis. Oftenthese companies can also lower prices as and when required toput pressure on competitors and new entrants. A high profitmargin not only captivates the attention of investors but alsoattracts skilled employees. The profit margin ratio helpsinvestors to gain a deeper insight into the top management’sefficiency. A low profit margin suggests higher risks, implyingthat a decline in revenue might hamper profitability.

Businesses with high profit margins possess a competitive edgeover their peers. Only few companies can sustain high marginson a consistent basis. Therefore, there is a high likelihood thatthese companies are market leaders in their industry and thekey drivers of their competitive advantage could include strongpricing power, high barriers to entry, first mover advantage,long term presence, specialised resources, advanced technologyprotected by patents, and much more. High margins also reflectcorporate strengths such as a proven scalable business modeland prominent well-established brands. Businesses wheremajority of the costs are fixed benefit from operating leveragewhich leads to hefty margins.

The Winning Strategy

It is easy to simply rely on net profits to gauge future earnings,but it doesn’t always portray the whole picture of the company.Using net profit margin as a sole measure of profitability is lessthan ideal. It is best to make use of several ratios and metrics inconjunction with net profit while analysing a company. Grossprofit margin and operating profit margin are typically usedwith net profit margin in financial analysis. While analysingpast financials, consistency in margins over longer periods oftime should be a critical factor. The latest numbers of ROE andROCE should be above a given threshold level.

Companies with High Profit Margins

The high margin company being analysed should have a strongbalance-sheet with ample liquidity, regular free cash flows andlow leverage. Companies operating in under-penetratedindustries with high profit margins often face fierce competitionfrom new entrants with fat wallets. Growing competition cancoerce companies to reduce prices or increase costs to retainmarket share, thereby forgoing fat margins. Hence, thesebusinesses should either hold strong pricing power orformidable barriers of entry or defensive moats in order tosustain the profit margin and thrive in the long run. Cautionshould be exercised while investing in high margin business asthese stocks frequently tend to trade at relatively expensivevaluations.

Forward and backward integration strategies also helpcompanies to gain better control of the value chain, reducedependence on their suppliers and increase competitiveness. Ifproperly executed, these strategies can help reduce thebargaining power of suppliers and boost margins. In addition tothe above, a vigorous growth catalyst should be present for the company that will propel profits higher and maximise earnings’potential. Following is a list of some stocks that have reportedhigh profit margins on a consistent basis along with highliquidity, minimal leverage as well as ROE and ROCE above 15per cent.

Conclusion
Investors should know how to properly analyse the variousfacets of profitability. Profit margin analysis is a prominent toolthat helps investors become cognizant of and acknowledge theprofitability of companies. It can help gain insight into the wayin which effective management teams are able to generate highprofits from sales as well as how much cushion is available for acompany to stave off competition, soldier through uncertaintiesor simply as a margin of error. Well-managed firms are able tomaintain and even expand profit margins through dynamiceconomic and market conditions. Along with profit marginanalysis, investors should also consider the state of the economy,ongoing business cycle and the industry in which the companyoperates.

RECOMMENDATIONS

Caplin Point Laboratories Ltd.

CMP (₹ ): 720.00

BSE CODE: 524742
Face Value(₹ ) : 2
52 Wk High/Low (₹ ) : 1,034.00 / 577.95
Mcap Full ( ₹  Cr.) : 5,456.80

HERE IS WHY
✓ Strong pipeline for US with ANDA'sunder development
✓ Optimistic expansion plans in sixmajor markets
✓ Unique Latin American businessmodel

Caplin Point Laboratories is a fastgrowing, fully integratedpharmaceutical company with adominant presence in LatinAmerica, Francophone Africa and a growingpresence in regulated markets such as USAand the EU. The company was established in1990 to manufacture a range of ointments,creams and other external applications. Itfocused on the emerging markets of LatinAmerica, Caribbean, Francophone andSouthern Africa and is today one of theleading suppliers of pharmaceuticals inthese regions with over 4,000 product licenses across the globe.The company thrives on a unique business model of owningdistribution networks, catering predominantly to the bottom ofthe pyramid in the areas of its presence.

Caplin Point Laboratories is possibly the only mid-sizedcompany in India’s pharmaceutical sector to be engaged in theresearch and development and manufacture of finishedformulations, APIs, clinical research, front-end generic presencein Latin America, brand marketing in Francophone Africa anda USFDA and EU GMP-approved injectable facility. Thecompany’s unique business model has helped generateresources to build world-class infrastructure. Caplin PointLaboratories’ debt-free and cash surplus situation positions itattractively to address the opportunities of the future.

The company’s quarterly consolidated financials reveal that theoperating profit for Q4FY22 was ₹ 111.45 crore as compared to₹ 95.15 crore for Q4FY21, an increase of 17.13 per cent. Net salesfor Q4FY22 were at ₹ 339.24 crore, recording a rise of 17.13 per cent as compared to net sales of ₹ 278.71 crore in the samequarter last year. The net profit has improved and stands at₹ 80.83 crore as against ₹ 67.92 crore in Q4FY21. The annualperformance of net sales reported is ₹ 1,269.41 crore for FY22,which has increased by 19.61 per cent from the previous year’svalue of ₹ 1,061.29 crore. The operating profit stood at₹ 433.42 crore in FY22 as compared to ₹ 352.18 crore for FY21,which has increased by 22.67 per cent.

The cash surplus stood at ₹ 694 crore in March 2022, recordingan increase of ₹ 223 crore over March 2021. This increase wasafter capex spending of ₹ 91 crore during the year. Thecompany’s unique Latin American business model continues todrive top-line and bottom-line growth with benchmark cashflows even if there are several macroeconomic uncertaintiessuch as the pandemic, Ukraine-Russia conflict, lockdowns inChina, freight costs and other escalations. The company wontenders in two Latin America markets for USD 21 million, ofwhich USD 14 million is to be supplied in FY23 and the rest thefollowing year.

The company has earmarked Mexico and Chile as the nextimmediate avenues for growth in the Latin America region. Itsoverall pipeline for the US remains strong, comprising 55+ANDAs under development. The company has optimistic plansto grow its position in six major markets of the US, Mexico,Brazil, Europe, South Africa and CIS countries withdifferentiated strategies. In addition to the same, the companyis also forming a domestic market sales team focused on nichehospital injectables. Hence, foreseeing that the growthmomentum will mainly be driven by front-end expansion,improving product baskets, adjustments to product mix andintroduction of own brands, we recommend BUY.

HCL Technologies Ltd.

CMP (₹ ): 1083.25

BSE CODE: 532281
Face Value(₹ ) : 2
52 Wk High/Low (₹ ) : 1,377.00 / 910.85
Mcap Full ( ₹  Cr.) : 2,93,957.77

HERE IS WHY
✓ High growth prospects for IT sector
✓ Relentless focus on innovation andorganic growth
✓ Hefty profit growth recorded inQ4FY22

HCL Technologies is a nextgenerationglobal technologycompany that helps enterprisesre-imagine their businesses forthe digital age. Enterprises across industriesstand at an inflection point today. In orderto thrive in the digital age, technologies suchas analytics, cloud, IoT and automationoccupy centre-stage. In order to offerenterprises, the maximum benefit of thesetechnologies to further their businessobjectives, HCL offers an integratedportfolio of products and services throughthree business units. These are IT andBusiness Services (ITBS), Engineering and Research andDevelopment Services (ERS), and Products and Platforms (Pand P).

FY22 can be viewed as spectacular year of India’s technologyindustry. It recorded the highest-ever growth of 15.5 per cent,reaching USD 227 billion in revenue. The industry leveraged ona formula of combination of digital and innovation.Platformisation and XaaS underpinned the acceleration oftechnology adoption. The year also belonged to technologystart-ups jumping into scale-up mode. The industry doubled upon operational excellence to manage margin pressures whereasthe e-commerce sector witnessed deeper penetration of theO+O model (offline+online).

The Quarterly Results of the company for Q4FY22 show that netsales and operating income have grown by 18.95 per cent inQ4FY22 to ₹ 22,597 crore from Q4FY21 which was ₹ 19,641crore. The operating profit in Q4FY21 stood at 4,793 crore andit improved by 12.04 per cent in Q4FY22 to ₹ 5,370 crore. Thenet profit zoomed strongly beyond 200 per cent i.e., to ₹ 3,600 crore for Q4FY22, whereas previously in Q4FY21 it was₹ 1,111 crore. On the annual front, the results show net salesgrew by 13.63 per cent in FY22 as compared to ₹ 75,379 crorerecorded in FY21. The FY22 numbers show a net profit of₹ 13,524 crore as compared to FY21 which was ₹ 11,169crore, gaining 21.09 per cent. The operating profit rose 2.97 percent to ₹ 21,597 crore in FY22 as opposed to ₹ 20,975 crorein FY21.

The management of the company has charted strategicobjectives to focus on creating value for all stakeholders thatinclude the management’s focus to organically grow thebusiness along with maintenance of high capital allocation andsustainability in growth. HCLT also plans to differentiate itsofferings through innovation, cloud capabilities, integratedsolutions and accelerators. The company has been preferred asa digital partner for global 2,000 enterprises, with 70 per cent oftech spent by these entities. In order to transform brands atscale, the company will focus on these clients selectively.

The company views digital engineering, high-growth verticalsand high potential geographies (Japan, Germany and France) astheir big bets in engineering and research and development. ITservices for chip companies are also a focus area for HCL Tech,as the world moves toward chip sovereignty with countriesincluding the US, Japan and India wooing semiconductormakers to build factories. The company’s technology productsand services are built on four decades of innovation along witha world-renowned management philosophy and a strongculture of invention and risk-taking. Hence, taking intoconsideration the company’s vision of continuing to grow indouble digits and its relentless focus on customer relationships,we recommend BUY.

ITC Limited

CMP (₹ ): 264.10

BSE CODE: 500875
Face Value(₹ ) : 1
52 Wk High/Low (₹ ) : 273.10 / 200.85
Mcap Full ( ₹  Cr.) : 3,26,073.35

HERE IS WHY
✓ Healthy quarterly earnings in recentquarter
✓ Well placed than peers withimproving cigarettes businesssegment
✓ Predicted boost in volumes due tolifting up of mobility restrictions

ITC is one of India’s foremost privatesector companies and a diversifiedconglomerate with businessesspanning fast moving consumer goods,hotels, paperboards and packaging,agriculture business and informationtechnology (IT). ITC was ranked as India’smost admired company, according to asurvey conducted by Fortune India inassociation with Hay Group. ITCis the country’s leading FMCG marketer, aclear market leader in the Indian paperboardand packaging industry, a globally acknowledged pioneer infarmer empowerment through its wide-reaching agriculturebusiness, and a prominent hotel chain in India that is atrailblazer in ‘responsible luxury’.

ITC’s wholly-owned subsidiary, ITC Infotech, is a specialisedglobal digital solutions provider. Over the last decade, ITC’snew consumer goods businesses have established a vibrantportfolio of 25 world-class Indian brands that create and retainvalue in India. ITC’s world-class FMCG brands, includingAashirvaad, Sunfeast, Yippee, Bingo, B Natural, ITC MasterChef, Fabelle, Sunbean, Fiama, Engage, Vivel, Savlon,Classmate, Paperkraft, Mangaldeep, Aim and others, havegarnered encouraging consumer franchise within a short spanof time. While several of these brands are market leaders intheir segments, others are making appreciable progress.

Looking at the company’s performance in the third quarter ofFY22, the consolidated quarterly performance shows net sales andoperating income of ₹ 18,365.80 crore in Q3FY22, which is a 30.3per cent increase from ₹ 14,124.48 crore reported in Q3FY21. The operating profit also rose by 12.92 per cent in Q3FY22 to₹ 6,019.59 crore from ₹ 5,330.71 crore recorded in Q3FY21. Thequarterly net profit rose by 14.82 per cent to ₹ 4,118.80 crore inQ3FY22 as compared to ₹ 3,587.20 crore reported in Q3FY21. Theannual performance of net sales increased to ₹ 53,155.12 crore inFY21 from ₹ 51,393.47 crore in FY20. The operating profit dippedby 10.17 per cent to ₹ 19,635.26 crore in FY21 as compared to₹ 21,858.05 crore in FY20.

The net profit stood at ₹ 13,389.80 crore in FY21 as compared to₹ 15,584.56 crore recorded in FY20. ITC recorded around 12 percent YoY volume growth in Q3FY22 while cigarette EBITimproved 14 per cent due to an increase in mobility, focusedmarket intervention and product mix. The volume growth islikely to sustain backed by no tax hike in the Union Budget2022 on cigarettes, helping the company in competing withillicit cigarettes. ITC is also expected to benefit from the rise ininflation underpinned by the Russia-Ukraine conflict that hasinflated wheat prices in Q4FY22 as both countries account foraround 25 per cent of the global wheat supplies.

Its agriculture business registered robust growth due toimprovement in wheat, rice, spices and leaf tobacco exportswhich is expected to continue in Q4FY22. On the other hand,the hotels segment is likely to register attractive revenue growthand margin recovery as leisure and business travel are boostingthe occupancy rate with lockdowns having been lifted acrossthe country. Also, betterment in the end-user industries andexports will be a key driver for paperboard sales in future.Hence, considering the company’s ability to leverage internalsynergies present across its diverse businesses which can bequalified as a source of competitive advantage for its productsand services, we recommend BUY.

SJVN Ltd.

CMP (₹ ): 28.00

BSE CODE: 533206
Face Value(₹ ) : 10
52 Wk High/Low (₹ ) : 33.80 / 25.35
Mcap Full ( ₹  Cr.) : 11,003.43

HERE IS WHY
✓ Healthy project pipeline
✓ Strong fundamentals
✓ Consistently improving margins

Satluj Jal Vidyut Nigam, better knownas SJVN, is an Indian public sectorundertaking involved inhydroelectric power generation andtransmission. SJVN, a Mini Ratna, CategoryI and Schedule ‘A’ CPSE under theadministrative control of the Ministry ofPower, Government of India, wasincorporated on May 24, 1988, as a jointventure of the Government of India (GOI)and the Government of Himachal Pradesh(GOHP). The company has a total operatinghydropower capacity of 1,912 MW throughits two hydropower plants—Nathpa Jhakriand Rampur. In addition, it has an installed capacity of 97.6MW of wind power and 6.9 MW of solar power.

Beginning with a single project and single state operation i.e.India’s largest 1,500 MW Nathpa Jhakri Hydro Power Station inHimachal Pradesh, the company has commissioned sevenprojects totalling 2,016.51 MW of installed capacity and 86 km400 KV transmission line. SJVN is presently implementing oroperating power projects in Himachal Pradesh, Uttarakhand,Bihar, Maharashtra and Gujarat in India besides neighbouringcountries of Nepal and Bhutan. Its primary business segmentsinclude the generation and transmission of thermal, hydro,wind and solar power as well as consulting.

Looking at the quarterly consolidated results, net sales wererecorded at ₹ 549.14 crore in Q3FY21 compared to ₹ 493.87 crorefor Q3FY20, a marginal increase of 11.19 per cent. Theoperating profit for the third quarter of FY22 was at ₹ 444.73crore as against ₹ 381.42 crore, indicating a rise of 16.6 per centand the net profit was up by 18.97 per cent at ₹ 233.96 crore for the third quarter of FY22 as compared to ₹ 196.65 crore for thesame quarter last year. Taking into consideration the company’sannual performance, the operating profit was posted at₹ 2,865.16 crore in FY21 as compared to ₹ 2,624.17 crore forFY20.

Net sales reduced by 8.04 per cent on a YoY basis to ₹ 2,485.39crore as compared to ₹ 2,702.80 crore. The net profit for FY21was posted at ₹ 1,641.78 crore as against net profit of ₹ 1,561.18crore for FY20, a minimal gain of 5.16 per cent. SJVN hasrecently achieved a financial close for a 70 MW solar project inGujarat. The company is allocating an amount of ₹ 2.67 billionfrom its existing foreign currency term loan to fund thisproject. The project is expected to be completed later this year,leading to the start of power generation in October.

The project was awarded to the company by Gujarat Urja VikasNigam Limited (GUVNL) at a tariff of ₹ 2.21 per kWh. SThecompany has a stable revenue stream through long-term powerpurchase agreements with state electricity boards anddistribution licensees. The company has various ongoingprojects that are under construction, under pre-constructionand investment approval, and under survey and investigation.

Over the last five years, SJVN has reported strong operatingand net profit margins on a consistent basis. The company isfundamentally strong with adequate liquidity and low leverage.With the receipt of several other prominent projects in the thirdand fourth quarters of FY22 and an efficient management teamwith a proven track record, SJVN is on track to reach itsambitious targets of having 5 GW of installed capacity by2023, 25 GW by 2030, and 50 GW by 2040. Hence, werecommend BUY.

(Closing price as of May 17, 2022)

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