Outrageous Margins

Outrageous Margins

By Tim Beyers

 

Every now and again we like to roll back the curtains on how we Rule Breakers pick stocks. In October we revealed that outrageous sales growth often drives our decisions. That's still the case, of course. But triple-digit sales growth alone can't be enough to call a stock a Rule Breaker. It's what the company does with the extra moola that matters. If it's being used well, the result will be an ever-expanding gross margin.

 

And I'm not talking about margin that grows a few percentage points here and there. I'm talking about get-me-the-elastic-waistband-because-these-jeans-are-too-tight margins. They're expanding faster than a blowfish in a shark tank.

 

When sales growth meets fixed costs

The reason, you see, is that the best Rule Breaking businesses have a way of turning out meaningful innovations that have relatively meager fixed costs. That doesn't mean they're instantly profitable, of course. Some, such as Intuitive Surgical and Akamai Technologies (Nasdaq: AKAM), had capital investment requirements that stalled profits for years.

 

Yet each stock gave investors clues as to their quality long before the market began rewarding their excellence. Akamai, for example, realized huge gains in gross and operating margin a full 18 months before I bought shares. That's what happens when double-digit sales gains meet moderating operating costs. Accordingly, the shares are up nearly 60% since my recommendation for the May issue of Motley Fool Rule Breakers.

 

So when our team of analysts embarks on the search for new Rule Breakers, we like to include companies that boast a minimum 60% gross margin and that have grown gross profit by at least 40% annually over the past three years. There are several tools that will help you reveal candidates that meet this criterion. 

 

Capital IQ found 50 firms that met our criteria this go-round. Some were frighteningly high, such as the Central Fund of Canada (AMEX: CEF) at a 100% gross margin. (To be fair, it's a holding company.) Others, such as Natural Health Trends' (Nasdaq: BHIP) 78.3% margin and 88% average growth, didn't seem sustainable. Three, however, really stood out:

 

1. Harris & Harris (Nasdaq: TINY)

Gross margin: 80.6%

Three-year gross profit compound annual growth rate (CAGR): 112.1%

 

Rule Breakers subscribers will be intimately familiar with Harris & Harris, which is essentially a venture capital (VC) firm that has the vast majority of its assets invested in nanotechnology start-ups. Fellow Fools John Yelovich and Carl Wherrett recommended the stock for the March issue.

 

Unfortunately, the shares are down roughly 5% over the past 52 weeks. But that doesn't mean the investing thesis -- that investing in VC is a low-risk and cost-effective way to capitalize on the nanotech revolution -- won't be realized. Far from it. I'd even argue that, in some ways, Harris & Harris is the ultimate Rule Breaker, because it's a stock that practically demands to be held for decades. And that is how VC tends to work, after all. Venture capitalists take on additional risk by providing early-stage funding and management expertise. This can go on for years, till the firm is a mature, profitable business capable of entering the public markets. It's at that point the VC gets to liquidate some of its holdings -- sometimes for multibagger returns. (Of course it wasn't at all like this during the dot-bomb years, when built-to-flip businesses were going from zero to IPO in six months, but stay with me.)

 

There's risk inherent in laying money on a company whose private investments will take years to pay off. But insiders own a big stake in the firm, and they're still buying. For example, Dr. C. Wayne Bardin, a company director, bought another 1,655 shares at $14.38 on Dec. 9. And he's not alone. Since January 2004, there's been a grand total of one insider sale. That at least suggests management is confident in the growth.

 

2. Align Technology (Nasdaq: ALGN)

Gross margin: 69.1%

Three-year gross-profit CAGR: 98.2%

 

I first stumbled across Align, which is trying to revolutionize orthodontics, when it was the subject of some serious insider buying at the hands of investor Gordon Gund, former owner of the Cleveland Cavaliers basketball team.

 

There's no way to know exactly why Gund likes Align, especially after seeing how badly it has mistreated his portfolio over the past year. What we do know is that, despite a net cash balance near $80 million, Align is embroiled in litigation with OrthoClear, whose CEO also founded Align. The dispute shows no signs of ending soon, which may be depressing the shares.

 

But that's also not all that's wrong with Align. According to Yahoo! Finance, earnings were negative for 2002 and 2003 but found their way into the black last year. Fourth-quarter earnings are expected to run negative, however. That would be the second quarter in a row and could put all of 2005 into the red. Not good, especially since the Street is expecting another net loss for 2006. Fat margins aside, it's probably Foolish to steer clear of Align till the company figures out a way to straighten out its earnings momentum.

 

3. Exact Sciences (Nasdaq: EXAS)

Gross margin: 95.4%

Three-year gross profit CAGR: 99.6%

 

And this, dear Fool, may be the most interesting stock of them all. Exact Sciences makes a DNA-based test called PreGen-Plus, which screens for colorectal cancer. Laboratory Corp. of America (NYSE: LH) has partnered with the firm to bring the tests to patients.

 

As interesting as that is, more intriguing to me is the firm's balance sheet. Exact Sciences' enterprise value -- that is, market capitalization plus debt and minus cash -- is a mere $13 million. Nearly all of Exact's value is cash in the bank, which means ongoing operations are trading for just 25% of the market cap.

 

A quick read of the risks section of the most recent 10-Q may reveal why. It seems Exact is almost entirely dependent on LabCorp as its distribution partner and that PreGen-Plus is still having to earn converts among physicians. Those, indeed, are big risks. But you also can't get much cheaper than Exact is right now.

 

Thin is most definitely not in

The truth is that the next ultimate growth stock is likely to have far more than one redeeming feature. Outrageous sales growth is likely to be on the list. So is a deep competitive advantage. Superior management, too. Such attributes in combination are what lead to multibagger returns.