Four Wildly Profitable Reasonable Prices

The top and bottom lines of the income statement — sales and net income — get all the attention these days. But what about the "middle" lines — gross and operating profits? Much like a middle child, these often get overlooked. However, they can tell a very important story.

Gross profit is simply a company's revenue minus the direct costs of producing its goods or services. Among other things, this can signal whether or not a company is able to raise its prices along with its input costs.

This is especially important in today's environment where soaring commodity prices are dramatically raising production costs for many companies. Companies with strong pricing power can raise their prices to offset the higher costs. Those without it cannot.

The other middle line to consider is operating profit. Operating profit takes gross profit and subtracts operating expenses such as selling, general and administrative costs. This lets investors know how efficiently a company is being run. If its operating expenses are growing significantly faster than revenue, for instance, this could be a signal that management isn't keeping a close eye on its costs.

Gross and operating profits are often expressed as a percentage of total revenue, giving you gross and operating margins. The bigger the margins, the better.

Wide Margins, Wide Moats

Corporate profit margins are heavily influenced by the industry they're in, so it's important to compare them with their peers. Technology companies will tend to have much higher margins than retailers, for instance.

However, some companies manage to consistently produce wide profit margins. More often than not, these businesses will have at least one of the four types of competitive advantages: Consumer (control over pricing); Producer (proprietary production technologies); Economies of Scale (lower long-run average costs); and External (government regulation).

These competitive advantages must be constantly monitored and maintained in order to fend off competition, and if a company continually generates wide margins and fat profits, you can bet it will attract competitors.

Ridiculous Margins, Reasonable Prices

More often than not, high-margin, wide-moat businesses will trade at premium valuations. There are, however, companies with durable competitive advantages and strong growth prospects trading at very reasonable prices. For the long-term investor, these could be great buying opportunities.

I ran a screen for companies with 5-year average operating margins greater than 25% and net margins above 20%, along with the criteria that current margins must be greater than their 5-year averages (i.e., margins must be expanding). The stocks must also have a Price/Earnings/Growth (PEG) ratio below their industry average.

Here are four of my favorite names from the list:

Oracle (ORCL - Analyst Report)
Operating Margin (5-yr average): 29.6%
Net Margin (5-yr average): 23.6%
PEG Ratio: 0.9

Oracle is the world's largest enterprise software company and also provides computer hardware products and services since acquiring Sun Microsystems in January 2010. Its software segment, which still represents around 68% of total revenue, has seen strong margin expansion over the last few years due in large part to growth in its wildly profitable Software License Update and Product Support division.

After paying the government its cut through taxes, Oracle keeps almost 24 cents in net profit for every dollar of revenue it takes in. The company also has very low capital expenditure requirements, and thus generates tons of free cash flow. In fiscal 2011, for instance, Oracle produced $10.8 billion in free cash flow, up 27% year-over-year. This allowed it to repurchase a whopping $1.2 billion in shares.

Earnings estimates have been steadily climbing higher over the last several months. It is a Zacks #2 Rank (Buy) stock. Shares seem like a bargain at just 13x forward earnings.

Visa (V - Analyst Report)
Operating Margin: 33.2%
Net Margin: 30%
PEG Ratio: 1.0

Visa is a global payments technology company and one of the most recognized brands in financial services. The company doesn't actually issue credit cards to consumers; it simply acts a payment processor. When a cardholder swipes a credit card, Visa processes the payment by facilitating the authorization, clearing, and settlement of the transaction on its proprietary networks.

Thanks to the financial crisis and knee-jerk government regulation (never waste a good crisis, right?), Visa's stock price has whipsawed since it went public in early 2008. While the company faces regulatory headwinds, fears may be a bit overblown. Analysts have been steadily raising their earnings estimates over the last several months due in large part to better clarity over the regulation's impact.

In the meantime, Visa continues to do what it does best: making piles of money. Revenue has been soaring both domestically and abroad as more and more consumers migrate away from cash and checks. Moreover, the actual cost of processing those payments is relatively small compared with what it charges in revenue. As a result, Visa has kept an average of 30 cents of every dollar it takes in after all expenses, including taxes, over the last five years. Over the last 12 months, this has increased to 40 cents.

The company also has very little capital expenditures and thus generates exceptionally strong free cash flow. It spent $2.8 billion in the first ninth months of fiscal 2011 buying back stock. Shares trade at just 15.3x 12-month forward earnings, well below its historical average of 19.7x.

PotashCorp (POT - Analyst Report)
Operating Margin: 26.6%
Net Margin: 26.5%
PEG Ratio: 1.1

Potash Corporation of Saskatchewan Inc. produces potash, phosphate and nitrogen fertilizer nutrients. Surging demand in the emerging markets is driving prices and volumes for PotashCorp's products higher. For being in the commodity business, the company posts remarkably high-profit margins. This is mostly due to the fact it is the world's largest potash producer and has significant pricing power over the product.

For the first six months of 2011, the company's potash segment earned an incredible 68.9% gross profit. Potash accounts for about 50% of the company's total revenue. What's also impressive is that total operating expenses represented just 4.9% of sales. As a result, every dollar in revenue that PotashCorp earns becomes 35 cents in net profit. That's about three times the industry average.

With earnings estimates surging after better than expected second quarter results, shares seem very reasonably priced at 15.9x forward earnings. PotashCorp is a Zacks #1 Rank (Strong Buy) stock.

Google (GOOG - Analyst Report)
Operating Margin: 27.0%
Net Margin: 25.9%
PEG Ratio: 1.1

Google is a search engine giant that derives 96% of its revenue from ads placed on its websites. Companies continue to shift away from traditional advertising sources and towards Google's popular pay-per-click AdWords program.

Google's high margins and low capital expenditures make for substantial free cash flow. Over the last 12 months the company generated nearly $8 billion in free cash flow and currently has over $39 billion in cash and marketable securities on its books. Hopefully it makes good use of that money.

Valuation seems very reasonable at 19.4x forward earnings. Three and a half years ago, Google was trading around $715 per share and had trailing earnings of $4.2 billion. Today, it's trading around $605 per share and has trailing earnings of $9.0 billion.

The Bottom Line

Investors should look beyond just the top and bottom lines and consider what's in between: the gross and operating margins. For the long-term investor concerned with competitive advantages, look for wide and expanding margins. These four companies all fit that criteria — and are reasonably priced.

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks or Intellisphere will assume any liability for losses from investment decisions based on this information.