Surging inflation in raw materials, energy, freight and labour have put pressure on profit margins over the past year, but many companies have been able to pass these higher costs on to customers by raising prices.
Now, another threat to profit margins is emerging in the form of a recession. If revenues drop, as is likely, this makes it more difficult to recover indirect overheads such as administration, marketing and distribution costs.
However, Rosemary Banyard (pictured), manager of the VT Downing Unique Opportunities fund, said there are several reasons why many UK companies could significantly improve their margins in 2023 despite the challenging economic backdrop.
Below, the manager provides five examples.
Reducing distribution costs
First up, Banyard pointed to businesses that can structurally reduce the cost of going to market, such as through a new distribution model or digitalising processes that were previously performed manually.
As an example, she cited promotional products company 4Imprint, where revenue-per-marketing dollar leapt 50% from $5.46 to $8.19 this year, and its marketing costs reduced from 18.3% of revenues to 12.2%.
“The company was able to replace some expensive pay-per-click advertising via Google with increased direct marketing of its own brand,” the manager explained.
Offloading pension liabilities
Next up, Banyard said businesses with defined benefit pension schemes can reduce costs by offloading their liabilities to insurance companies, relieving them of the obligation to make regular contributions.
A recent example was TT Electronics, where she said a pension buyout is set to save £6m initially, and an equivalent annual amount in future years. For context, the company reported £34.8m of adjusted operating profits in 2021.
“We confidently expect more defined benefit pension scheme buyouts to come as the discount rate for calculating the pension liabilities (based on long bond yields) has risen, reducing liabilities faster than any fall in asset values in some cases, and eliminating any funding shortfall,” the manager explained.
Changing the ‘business mix’
A third source of margin improvement could come from a change in the ‘business mix’, meaning a company’s range of products, services and customers.
Banyard said the most dramatic example here is the introduction of new income streams arising from royalties, which reflect a profit margin of close to 100%, because little if any of the costs are usually attached to the income received (the licensee typically bears all the production costs).
One of the most obvious examples of this in recent years has been table-top war games company Games Workshop. Royalty income from licensing its intellectual property to computer games publishers rose from £1.5m in 2015 to £28m in 2022.
“This represents 7.2% of revenues versus 1.3% in 2015, and operating margins attributable to the rising royalty element have put on 530bps,” said Banyard.
Another company she said could surprise on the upside in this regard is disinfectant manufacturer Tristel, which has licensed its proprietary formula to Parker Laboratories to allow it to produce chlorine dioxide for the US market.
“Royalty income will start to flow, initially from surface foam disinfectants already launched in most states, but then hopefully also from high-level disinfectants used on outpatient medical devices, if the US Food and Drug Administration (FDA) approves their use,” she added.
“Either way, we see a rising royalty stream emerging in this business, which explains the more positive commentary from directors and is not as dependent on a binary regulatory ruling as some may think.”
Acquisitions
A common, but often riskier, method of increasing margins is through acquisitions.
Banyard said these can drive higher margins because the acquisition may be inherently more profitable, costs of overlapping services can be removed, or better buying power lets the business lower costs.
As an example, she pointed to distributor Diploma, the controls division of which acquired Windy City Wire in the US in October 2020.
“Windy City Wire reported adjusted operating margins of 22.7% in its first year in the group, a positive enhancement to group margins which were 16.2% in the previous year,” she added.
Benefiting from interest rate rises
Some companies don’t need to do anything at all to see profit margins increase. While rising interest rates restrict economic growth and increase the cost of borrowing, they provide a net boost to financial companies that hold a lot of cash.
“Examples here could include [investment platform] AJ Bell, even though much of the increased investment income will be passed through to clients,” Banyard finished.