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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Why Falling Gross Margins Don't Always Spell Trouble

When comparing income statements, many investors focus on gross margins (which is a measure of gross profits divided by sales). They assume that as long as gross margins are expanding, then the company must be on the right track.

It ain't necessarily so.

In fact, companies may have a very good reason to sacrifice gross margins. If a company lowers its prices a bit, giving up a bit of gross margins, it may still generate higher profits thanks to a higher volume of goods sold.

And that's just how Walmart (NYSE: WMT) approaches business. The mega-retailer has decided to lower the prices on many items to boost store traffic. Gross margins, which had been steadily rising over the years, are actually likely to fall by a modest amount this year to around 24.6%.

But that's OK. Walmart figures that it can make it up on volume. Sales are likely to grow around +4% and gross profits are still growing, around 3.5%. And as long as overhead costs stay in check, those higher gross profits will more readily flow to the operating income line. So Walmart's operating margins are likely to actually rise a bit, despite the lower gross margins. (Net profits should also be higher, and when coupled with a smaller share count thanks to a share buyback, EPS should grow at a more robust 9%).

Walmart is lucky. It controls so much of the retail market that it can afford to set the tone on prices. But other companies may not be so lucky. Falling prices and falling gross margins could spell real trouble if it is being done in response to market conditions. That’s why it pays to see what’s behind the change in gross margins.

For example, Ford Motor (NYSE: F) had to idly stand by a few years ago and watch rivals produce far too many cars and trucks. With a glut of unsold vehicles piling up on dealer’s lots, gross margins fell from the mid-teens in the first half of the last decade to 6-10% in 2007, 2008, and 2009.

 

Those gross margins were too low for the auto maker to earn money, so massive profits quickly turned to large losses. Ford eventually slashed overhead. Now, gross margins are creeping back up, and the auto maker is finally back in the black. If industry output can stay restrained as demand rises, Ford might see a nice rebound in gross margins -- and a strong surge in EPS.

[Read here for a look at Ford Motor and potential profit opportunities.]

Of course, the best kind of company to buy is one that manages to squeeze more gross profits out of every dollar of sales while keeping overhead in check. That allows operating margins to expand at a nice pace as well. Apple (Nasdaq: AAPL), Archer Daniels Midland (NYSE: ADM), Priceline.com (Nasdaq: PCLN) and Salesforce.com (NYSE: CRM) have all been able to boost gross and operating margins for at least the last three years. (This is not to imply that these companies will continue to do so, but instead highlights the ideal income statement.)

Action to Take: When looking at a company's quarterly press release, management will always seek to highlight the positives and ignore the negatives. Be sure and calculate if margins are expanding before considering an investment. There may be a good reason for a short-term hit to gross margins (as is the case with Walmart), but the company should still be on track for further margin gains down the road.

You can also get a sense of margin trends by listening to the company’s conference call. Is the company raising or cutting prices? Is overhead in check, or are overhead costs rising too quickly? Those factors help determine the future direction of profit margins.

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If you want to learn more about how to use margin analysis in your investment research, check out these related article from InvestingAnswers:  4 Ways You Can Spot a Healthy Company and How to Use Margin Analysis as an Investment Tool.