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Stocks Under $10 With SU10Team

Examining a Company's Profit Picture

By SU10 Team | 2017-07-20 08:00:00.0
Stocks in Focus: BETR

We recently shared the first five of a series of questions that you must be able to answer before you decide whether to buy a share of stock in a particular company.

To quickly recap, the first five questions are:

1. What does the company do?

2. What are its key products or services?

3. In what business unit or units does the company make most of its profits?

4. Who are the key competitors and how are they impacting the market?

5. What is driving growth at the company?

If you missed the more in-depth explanation of those questions, you can find it here. You may want to review those questions because the next five build on their answers.

The gist of those five questions is to help you understand the company you are investing in and items to pay attention to when sizing up what's on the horizon, both good and bad. After all, how do you know how to gauge a company's business and the competitive landscape if you don't have a firm understanding of what the company does and how it makes money for itself and its shareholders? These are some of the tools I use each time I look at a new opportunity.

OK, let's get to question 6.

6. What is driving the company's profit picture and, if it's not improving, why not?

The answer to this two-part question hinges on what is happening with a company's profits. I tend to look at a company's operating margin: operating profit divided by revenue. There are several parts of the income statement that come into play calculating a company's operating profit.

Operating Margin = Operating Profit/ Sales

To calculate a company's operating profit, we use the following formula:

Operating Profit = Sales – Cost of Goods Sold – SG&A

Before we get to the nitty-gritty, let's pluck a real-world example from one of our holdings and use Amplify Snacks (BETR:Nasdaq), which has been on a tear of late. We'll use the company's most recent quarterly earnings report, which you can find here.

Operating Profit = Sales – Cost of Goods Sold – SG&A

Operating Profit = $87.2 – $51.9 – $16.8 = 18.5*

*Note: All figures are in millions of U.S dollars

Now moving to its operating margin for the quarter:

Operating Margin = Operating Profit/Sales = 18.5/87.2 = 21.2%

So we have the number, but what does it mean?

Generally speaking, a company's profit picture can improve when it earns more per dollar of revenue. If Starbucks (SBUX:Nasdaq) raises its price on a cup of coffee or Apple (AAPL:Nasdaq) is benefiting from higher prices on its latest iPhone models, odds are that such a company's margins will be rising. If, however, Starbucks initiated that price increase to fend off the pain of higher coffee prices or rising wages, the company's margins may improve, but maybe not as much because the benefit of the price increase is offset by higher costs to the company.

Companies also can see margin improvement due to something called "economies of scale," which means the more a company builds a product, the more efficient it will get. Hand in hand with that robust product volume may go more favorable costs associated with key parts or ingredients that go into the product. Also look for when a company initiates a new manufacturing technology or improves its materials to lower its production costs.

This is not rocket science, but using some basic math mixed with some finance. Another way a company can see its profitability improve is through lower costs. Take the Starbucks example above. If coffee prices drop and Starbucks keeps its coffee prices intact, its operating margin should benefit from the fall in coffee prices. If Starbucks was enduring the pain of higher coffee prices, then hiked prices on its coffee drinks and incurred a fall in coffee prices, that situation would bring a one- two benefit to Starbucks. The benefits of a price increase and falling coffee or input costs equals cha-ching for Starbucks!

Of course, coffee is one input among many at Starbucks. But that's why you need to read the company's financial filings to determine which inputs are critical. The same goes for other companies and other parts and ingredients. As it relates to Amplify Snacks, the key input we are watching is corn, but as it brings more products to market, odds are the influence of corn prices will dip as others rise.

One of the things I am fond of saying is context and perspective are critical. This means understanding how a company's operating margin compares to the prior few quarters as well as the year-ago quarter and what a company's guidance means for the coming quarters. That context allows us to understand if operating margins are expanding, standing still or contracting. Generally speaking, expanding operating margins lead to rising EPS and declining operating margins deliver falling EPS.

A quick example can be had as we compare Amplify's March 2017 operating margin of 21.2% with its December 2016 quarter (the figures to calculate this can be found here) that came in at 24.5%. Recall that Amplify is not only expanding its product portfolio both in the U.S. and Europe, but it's also bringing more products to market. We also saw a step down in product sales, which is seasonal in nature from the holiday-filled December quarter. That combination led to the quarter-over-quarter drop in Amplify's operating margin.

Our next question will deal with understanding a company's balance sheet.

Regards,

Christopher Versace

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Stocks Under $10 Holdings

Holdings 1

Stocks we would buy right now

Symbol % Portfolio
Weighting
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ATRS 0.029168920062971265 Health Services
AXTI 0.028907566539207043 Electronics
BETR 0.043494640105930314 Food & Beverage
TLGT 0.03171711691967243 Drugs
USAT 0.027189517147498034 Computer Software & Services
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ACRX 0.021876690047228448 Health Services
AUY 0.042462363692469786 Metals & Mining
ENZ 0.010706160419912973 Health Services
HDSN 0.004074314754395826 Industrial
IWM 0.17231775212074385 Financial Services
PXLW 0.023078449553822863 Electronics
SIRI 0.010192787426804678 Media
ZIXI 0.018491928563121263 Computer Software & Services