| More
Profitable Than Microsoft |
Published: April 3, 2006
More Profitable
than Microsoft:
Three promising companies that are delivering better profit margins
than one of the world’s most dominant monopolies
No ordinary company can turn a $5,000 investment into a $3.0 million
investment in just over a decade. But that’s exactly what Microsoft
stock did between 1986 and 2000; no company in U.S. financial history
has been responsible for creating so much wealth and so many
multi-millionaires in such a short period of time.
What’s even more amazing is
the consistency of Microsoft’s performance over the years.
Specifically, you didn’t have to jump into Microsoft when it was first
publicly traded in 1987 to make stellar returns. By the end of 1991,
Microsoft sported an enterprise value of more than $12 billion and was
already a dominant player in the PC industry, with its Windows or MS-DOS
(Disk Operating System) installed in more than 80% of all PCs worldwide.
The stock was also already a component of several major large-cap
indices in the U.S. and was a household name to many investors.
In
other words, MSFT was by no means a speculative small-cap play. But as
you can see in our chart, the stock still returned more than +3,800%
between 1992 and 2000 -- a return of more than +52% annualized.
Perhaps even more amazing than Microsoft’s stock market performance is
its total domination of the desktop software market. Microsoft quite
literally went from an insignificant tech startup in the mid 1980s to
holding a near monopoly in the global desktop software market by the mid
1990s.
The company’s Windows operating software is currently installed on
more than 90% percent of all computers worldwide. Meanwhile, its word
processing, spreadsheet and presentation products enjoy similarly high
market share. In fact, Microsoft is so dominant in the PC software
business that it has repeatedly run into trouble with regulatory
authorities in both the U.S. and Europe. Governments are actually afraid
that the company is simply too powerful and is abusing its dominance to
push new products on consumers and to drive other firms out of the
market. Whether you like Microsoft’s software or not, this type of
market share and market power is definitely something that most
companies -- and most investors -- can only dream of.
But while Microsoft is a truly iconic success story and its dominance is
rare, it’s not unique. A small cadre of companies -- most of which
operate under the radar screen of most investors -- actually enjoy many
of the same advantages that Microsoft has benefited from over the past
two decades. To identify these undiscovered millionaire-makers, we first
looked at the key advantages that set Microsoft apart from its
competition, and we then searched for companies with similar
characteristics.
Profitability is Key
What exactly sets Microsoft apart from most other publicly-traded
stocks? When looked at strictly from a financial standpoint, the answer
to that question is surprisingly simple -- the most striking aspect of
the software giant is its high and consistent profitability.
But when I mention profitability, I’m not talking about how many
dollars Microsoft earns in a given year or how fast its earnings are
growing. Rather, I’m referring to the company’s profit margins.
Although there are many different ways to measure profitability, they
all address basically the same issue -- out of every dollar of sales,
how much does a company keep as profit? In other words, after all labor,
raw material, and overhead costs are accounted for, margins measure the
percentage of sales that drop to the bottom line. By looking at margins
instead of total dollar profits, we’re better able to compare
companies of different sizes.
Here are some of the profitability metrics that my staff and I watch
most closely:
Net Profit Margin -- This most basic measure of profitability is
calculated by dividing a company’s total net income by its total
revenues. This number is then expressed in percentage terms.
Operating Margin -- Operating margins are calculated almost
exactly like net profit margins -- the only difference is that operating
profits are substituted for net profits. The advantage of this measure
is that net profits are often skewed by one-off events -- such as the
sale of real estate or gains on stock or bond investments -- that
aren’t part of a company’s normal business. These types of one-time
events can skew the net profit margin figure. However, by looking at
operating margins, investors can greatly reduce this problem.
Cash Flow Yield -- Cash flow yields are calculated by dividing a
firm’s total cash flow by its total sales. (For the same reasons
outlined above, analysts will often substitute operating cash flows in
this calculation.) Basically, this ratio measures how much cash a
company generates out of each dollar of sales. Because accounting
profits often include many non-cash charges and payments, net income
doesn’t necessarily reflect how much a company is making from its
operations. Furthermore, larger companies routinely use accounting
gimmicks and tricks to dress up their numbers for Wall Street. Cash flow
data measures the actual flow of money and is tough (and illegal) to
fabricate. As such, it often provides a more accurate picture of a
company’s underlying profitability.
Free Cash Flow Yield -- This measure is exactly like the cash
flow yield, except free cash flow is substituted for cash flow. The
difference is that free cash flow is the figure left over after a firm
pays interest, taxes, dividends and makes capital investments.
Basically, free cash flow represents the excess cash a company does not
need to meet financial obligations or invest in future growth; it’s a
more accurate measure of the actual cash available to shareholders.
Return on Equity (ROE) -- Calculated by taking a company’s net
income and dividing that figure by total shareholder’s equity, this
measure is known as one of the favorites of billionaire investing legend
Warren Buffett. Because shareholder’s equity is a rough measure of how
much stockholders have invested in a firm, this ratio tells us how much
how much money a company makes in relation to shareholders’ collective
investment.
In practice, it’s important to understand that none of the metrics
shown above are perfect. To get a full picture of a particular
company’s profitability, the best course of action is to use a mixture
of these metrics. In Microsoft’s case, the software giant ranks among
the top 25 firms in the S&P 500 based on every single one of these
metrics -- any way you slice it, Microsoft is one of the world’s most
profitable firms.
In
my chart I’ve highlighted Microsoft’s operating margins since 1987.
Since that time, Microsoft has delivered average operating margins of
more than +37%. Even better, the chart shows just how consistently
profitable Microsoft has been over the years. In only one year did the
firm’s operating margin figure drop below 30%, and in the boom years
for technology in the late 1990s, margins climbed as high as 57%.
Of course, these figures mean little in isolation. In order to really
get a sense for just how profitable Microsoft is, this chart also
includes the operating margins for several prominent U.S.-based
technology firms. Not one of these well-known firms showed the
consistent, sky-high profitability of Microsoft.
The Many Advantages of High Profitability
Why exactly has Microsoft’s profitability been such a major advantage
for the company over the past two decades? The most obvious answer is
that more profitable companies generate higher earnings and profits for
their shareholders. This cash can, in turn, be used to finance
acquisitions or expansion into new markets. Or, when growth
opportunities are exhausted, companies with high profitability can
afford to perform shareholder-friendly maneuvers like paying out high
dividends or buying back stock.
In Microsoft’s case, thanks to its consistently high earnings and
profitability, the firm never had to tap the equity or debt markets to
garner additional capital needed for expansion. The firm never had to
take on any debt or dilute the stake of existing shareholders with a
secondary offering of shares. Instead, Microsoft financed all of its
expansion efforts using internally generated funds.
But what’s even more important about keeping an eye on profitability
metrics is that high margins are symptomatic of companies with strong
competitive advantages. In other words, companies with consistently
high margins tend to sport high market share and attractive business
models. These are just the sort of companies that could become the next
big winner -- the next Microsoft.
The reason Microsoft’s dominance has translated into profitability is
simple. When several rivals battle it out in a particular market, they
usually attempt to outcompete one another on price. In addition,
companies in competitive markets often have to spend heavily on
advertising and new product design in an effort to differentiate their
product from the competition. Both moves have the potential to reduce
margins -- falling prices obviously cut sales and earnings, while rising
marketing costs can eat into profits.
Some of the weakest profit margins can be found by looking at
commodity-based companies. These firms sell products -- such as steel,
groceries, gold or memory chips -- that can’t be differentiated from
competitors’ products. While temporary shortages can certainly cause a
spike in prices and industry profit margins, these spikes tend to be
short-lived. Once the shortage is past, competitors will compete
viciously on price, driving margins lower. That’s why most commodity
companies operate on razor thin margins.
By contrast, Microsoft operates in a market with few real competitors.
The benefit of this dominance is that Microsoft doesn’t have to
compete on price with another powerful competitor. Over the years the
prices of most technology products -- such as personal computers, memory
and even mobile phones -- have dropped drastically. PC prices, for
instance, have fallen by as much as -90% since the 1980s even as
computing power and use has grown exponentially. But this isn’t the
case for Microsoft -- the company has been able to maintain its prices
over the years, helping it to sustain margins even during the recession
and tech crash of 2001/02.
Here are some of the main factors that contribute to Microsoft’s high
profitability and competitive advantages:
Brand Name -- Microsoft was one of the first major tech brands.
The firm’s name is well-recognized and largely trusted by consumers.
The company has even branched out into non-traditional products, such as
its Xbox game console, as well as hardware like wireless networking
equipment. The benefit of the brand is that it gives Microsoft instant
recognition when the company enters a new market. Moreover, the company
can charge more for its products than a generic competitor because
consumers trust the brand.
Switching Costs -- Millions of consumers worldwide have learned
to use a computer with a Windows operating system. And most have been
using Microsoft’s Word, Excel and Internet Explorer software for
decades -- it takes time and effort to learn how to use a totally new
program. Moreover, most corporations worldwide have Windows and
Microsoft Office installed on their corporate systems. As a result,
switching software would be an extremely expensive proposition, both in
terms of up-front costs and in terms of the new training that would be
required.
Finally, the various components of Microsoft’s desktop software --
word processing, Internet browsing and e-mail, for example -- are
designed to be inter-compatible. In other words, it’s easy to cut and
paste text, graphics and tables from Excel to Word and vice-versa. This
makes it advantageous to use many of Microsoft’s products. All of
these factors make it difficult and time-consuming for consumers to use
competing products, thereby enhancing Microsoft’s dominance.
The “Network Effect” -- Nowadays a tremendous amount of
information travels throughout the world via e-mail and the Internet.
For example, you can send a spreadsheet document via e-mail anywhere in
the world almost instantly. However, because more than 90% of consumers
globally use Microsoft’s Word and Excel programs, these have become
the de-facto standards -- it can be tough to convert files from Word to
another word processing program. Therefore, most users simply use Word,
Excel and other Microsoft products in order to avoid this problem. The
beauty of this networks effect is that as Microsoft’s base of users
becomes larger, this advantage continues to grow.
With these points in mind, my staff and I spent countless hours scouring
our database of more than 9,000 companies in search of stocks that
exhibit higher profit margins than Microsoft based on many of the
various measures outlined above. We further trolled through this list to
identify a handful of firms that have cultivated dominance in a
particular market niche and have developed competitive advantages
similar to those enjoyed by Microsoft. In the table that follows I offer
a long list of stocks that fit the bill. And in the text that follows, I
highlight a few of my favorite highly profitable stocks . . .
Editor's
Note:
Throughout the remainder of this article, StreetAuthority.com founder
Paul Tracy and his staff provide a table of specific companies that are
more profitable than Microsoft. In addition, they provide readers with
an in-depth profile of three of their favorite stocks from that table.
However, the remainder of this article is available exclusively to paid
subscribers. To view the remainder of this article, you'll need to
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visit one of the following links to continue...
Good investing!
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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Paul Tracy
founded StreetAuthority and became Chief Investment Strategist in 2001. Prior to
that he spent several years as Managing Editor at a multi-million dollar
financial publishing firm with over 150,000 subscribers. In addition to
his role as managing editor and lead financial writer, he was also
responsible for equity research and managing a team of seasoned
professional financial writers, researchers and market commentators.
Paul's previous experience
includes a position at Robert W. Baird & Co.'s full-service
brokerage operations as well as economic research work on a Money and
Banking project funded by the National Bureau of Economic Research. He
has also spent time doing outside consulting and research for the
University of Virginia, has appeared as a guest expert on several
prominent financial radio shows, and has been a featured speaker at
various investment conferences across the U.S.
Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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