By Amy Tsao When revenues are rising and costs falling, companies end up in a sweet spot, with profit margins expanding year after year. Not many can pull it off, however, especially in the current prolonged economic slowdown, so the few that can manage the trick are well worth considering as solid, long-term investments. A recent Standard & Poor's computerized stock screen turned up 10 outfits that have consistently increased profit margins over the last 5 years (see BW Online, 9/18/03, "A Premium on Pricing Power").
True, it's always possible that some of the names on the list might stall. But for investors prepared to take a risk, these may be stocks to consider. All are rated either 4 STARS or 5 STARS (buy or accumulate, in S&P's stock-ranking system) by S&P's equities analysts, and each has a top rating from its quantitative analysts -- an indication that these shares may be undervalued.
Three on the list are in health-care businesses: Accredo Health (ACDO), Patterson Dental (PDCO), and Henry Schein (HSIC). Another trio is tied to the housing sector: Pulte Homes (PHM), Lowe's (LOW), and Bed Bath & Beyond (BBBY). The rest represent something of a grab bag: P.F. Chang's China Bistro (PFCB) chain, women's apparel retailer Chico's FAS (CHS), and continuing-educating outfits Corinthian Colleges (COCO) and Career Education (CECO).
NICHE PLAYERS. Some common themes are at work here. For one, nearly all these deal directly with consumers: clothing for baby boomer women, eateries, affordable higher education, and housewares. All of them -- including dental-supply outfits Henry Schein and Patterson, and Accredo, a specialized contract pharmacy that dispenses biotech drugs -- provide products and services that are in high demand. "These are niche players in subindustries that have terrific secular growth stories," says BB&T Asset Management analyst Cary Nordan. Notably, no technology outfits are on S&P's list, and few boast large market caps.
It helps too, to be one of the few players consolidating a fragmented sector. Homebuilder Pulte Homes makes a good example. "These guys will do what regional banks did: [Increase market] share and make acquisitions," predicts Nordan. And the unrelenting demand for new housing, spurred in part by interest rates that remain relatively low, has allowed homebuilders to raise prices at a time when pricing power elsewhere has been virtually nonexistent.
Pulte's sales will rise again this year, as it increases prices an average of 5%, figures S&P analyst Michael Jaffe. Even as today's low rates start to tick higher, Jaffe also sees wider margins for Pulte, due in part to cost savings stemming from its recent acquisition of Del Webb.
NO PRICING POWER. In some other cases, the task of improving margins may present greater challenges. At P.F. Chang's, margins have expanded as the chain has added more units and spread fixed costs over a wider base. That, coupled with the mass appeal of higher-end Chinese food and plenty of room for more restaurants, has made P.F. Chang's a Wall Street favorite, says Raymond James analyst Bryan Elliott. While Elliott sees the distinct possibility of higher margins in the long term, he expects them to contract a little in 2004 -- from 9.3% to 9 -- as a result of higher food costs and investment in 16 Pei Wei outlets, a new fast-food chain.
At P.F. Chang's and retailers Lowe's, Bed Bath & Beyond, and Chico's, the ability to boost prices has been nil. Instead, those outfits rely on their basic concepts to lure increasing numbers of customers. Acquisitions also help. Chico's recent purchase of retail chain White House makes a good example. While it will pull down margins -- to 19.1%, from the current 19.3% -- in coming quarters, says Brean Murray & Co. analyst Margaret Whitfield, "it will help them become more profitable some time next year." (Whitfield doesn't own the stock, and her firm doesn't do any banking with Chico's.)
Some of these companies have an edge because they're in an earlier stage of growth than competitors. Lowe's, Home Depot's (HD) main competitor, enjoys growing profit margins as it begins to open stores in areas previously dominated by its larger rival. Lowe's has plans to add 140 to 150 new stores in the next two years -- equal to square-footage growth of 13% to 15%. "That's among the highest in retail," says Sara Henry, an analyst at Sovereign Asset Management. Home Depot, on the other hand, is paying for its maturity, with stores opened in recent years cannibalizing its existing base, Henry notes. (Henry doesn't own Lowe's shares personally, but Sovereign holds the stock in various accounts.)
TEETH AND BIOTECH. Patterson Dental and Henry Schein have been enjoying solid growth in the unsexy business of dental supply-and-equipment distribution, says Dave Nolan, senior vice-president and portfolio manager for BB&T's midcap growth fund. (Nolan owns neither, but Patterson is a holding in the fund.) As leaders in their niche, each has been ratcheting down expenses as a percentage of sales over the last few years, while the top line has enjoyed a boost due to tax-law changes that speed equipment depreciation. Notes Nolan: "They've seen significant increase as dentists have been trying to take advantage of the [tax benefits]."
Accredo is the top player in the field of specialty pharmacy services, mailing expensive biotech drugs for diseases like hemophilia and multiple sclerosis. Many of the medications it delivers are breakthrough treatments for chronic conditions, so demand won't abate. That fact, plus the increasing numbers of biotech treatments gaining Food & Drug Administration approval, benefits Accredo over the long term, analysts say.
For-profit education providers Career Education and Corinthian are tapping into strong fundamentals, says Ken Duca, vice-president and analyst at TimesSquare Capital Management, who notes the increased demand from workers for the additional certifications and degrees that can help advance their careers. The companies' margin expansion has come from buying underperforming schools and improving their operations.
GOOD SIGN. "They've been able to drive better growth and also put some financial discipline in these schools," Duca says. Putting more resources into marketing the schools also has improved enrollment, which essentially goes straight to the bottom line. (Duca does not own the stocks, but TimeSquare holds both in its small-cap fund.)
Professional investors will continue to watch these companies because "stocks can move based on margins," Nordan says. The pros know that a few points of margin improvement every year is a good sign of a solid business with cost-conscious management. In all likelihood, the odds appear good that some of these companies -- and maybe even the majority -- are in for a healthy run. Tsao covers the markets for BusinessWeek Online in New York