Not all profits are made equally. Some businesses have to reinvest an awful lot of profit into heavy equipment, manufacturing or supply chain management to keep on operating. These capital-hungry businesses, in my experience, tends to produce lower returns for shareholders in the long run.
I’m in good company because dynamic duo Warren Buffett and Charlie Munger also favour capital-light businesses. Here’s the latter explaining why: “We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a cheque at the end of the year.”
I believe profits should explode at Auto Trader (LSE: AUTO) and Craneware (LSE: CRW) as revenue growth outpaces reinvestment requirements.
Tripling that year-end cheque
Auto Trader is the UK’s largest online pool of car buyers and dealers. The sheer size of this network means there’s little reason for customers to go elsewhere when looking to make a car purchase. It is much like ASOS, Amazon, or Spotify – a one-stop shop with clear advantages derived from the critical mass it has reached. As a seller, you’d be foolish to side-step it too, because you’d be voluntarily turning down a massive market.
Upwards of 65% of UK used-car sales are completed through its portal, including 8.2m cars sold in the 12 months to March 2017. New car sales have been falling recently, which could place near-term pressure on Auto Trader as fewer people replace old cars. But over the long term, I believe its exceptional economics will drive solid returns.
The virtual marketplace itself doesn’t require much capital to host, which facilitates the company’s incredible 65% operating margin. This wonderful profitability supported a more-than-tripling of the dividend in 2017, from 1.5p in per share to 5.2p. The company generated over £170m in free cash flow last year, leaving the shares trading at only 20 times free cash flow. This might not sound that cheap, but given the company’s pricing power and high margins, I believe this to be a fair price for a great business.
Deeply embedded technology
Craneware is another business with low capital requirements. It supplies cost-saving software to US Hospitals and recorded a 27% operating margin in the first half of this year. The company’s software is deeply embedded in many areas of hospital management and switching to a rival could result in major disruptions to mission critical functions.
Trump’s repeated failure to repeal and replace Obamacare has removed some of the uncertainty hanging over the company’s products. This, combined with generous free cash flow and a market-dominating competitive position means Craneware is well-placed to generate exceptional shareholder returns.
The low-cost nature of the business means that incremental revenue growth largely falls through to the bottom line, so I expect margins to expand over the next few years. The company’s dollar renewal value, which more often than not comes in at over 100%, indicates that there is little client churn and that the company has enduring pricing power.
Craneware expects to report full-year revenue growth of 16% and EBITDA of $18m. The market cap of £350m is definitely on the expensive side, despite the company’s $50m cash pile, so the company might best be watched for now.