Why are investors attracted to companies that report losses year after year? Why do they buy into these loss-making companies, which include the NZX-listed Orion Health, Pushpay, Wynyard and Xero?


These companies have a combined sharemarket value in excess of $4 billion compared with total operating revenue of $318 million and losses of $159 million for their latest financial years.


This column looks at the reasons why a number of loss-making companies have high sharemarket valuations but it doesn’t attempt to assess the individual merits of these four NZX companies.


A key figure for every commercial organisation is its net profit margin, which is the net profit after tax as a percentage of revenue.


Companies with a high net profit margin are usually more attractive than those with a low profit margin, particularly if the former have strong revenue growth prospects.


The accompanying table contains the net profit margin of the United States S&P 500 Index companies.


Goldman Sachs, which compiles these figures, reveals that the total net profit margin has increased from 5.9 per cent in 2009 to 9.0 per cent for the December 2014 year. The information technology sector, which has experienced a net margin gain from 9.7 per cent to 17.4 per cent, has accounted for 48 per cent of the S&P 500 Index margin expansion over this five-year period.


Apple, which has a net profit margin of 22.8 per cent, has been responsible for 18 per cent of the market-wide margin increase since 2009.


Goldman Sachs expects the overall net profit margin to fall to 8.6 per cent in the current year and pick up to 9.1 per cent in the 2016 calendar year. This year’s contraction will be due to the energy sector, where margins are expected to fall from 7.9 per cent to 2.2 per cent.


Information technology is the standout as far as margins are concerned, with the sector’s net margin expected to expand from 17.4 per cent last year to 18.2 per cent in the current year and 19.0 per cent in 2016.


A large number of technology or internet oriented companies have net margins in excess of 20 per cent, including Google with a net margin of 23.3 per cent and Facebook with 23.5 per cent.


One of the attractions of loss-making technology companies is their potential to grow rapidly and generate huge profit margins if they achieve economies of scale.


Loss-making companies can also attract very high valuations.


Uber, which is not listed, has an estimated value in excess of US$50 billion and Airbnb, the home rental site, has a US$24 billion valuation. Earlier this year Snapchat had a valuation of US$16 billion and a workforce of only 330. This represents a valuation of more than US$48 million for every Snapchat employee.


No NZX-listed companies operate in the same areas as Apple, Google, FacebookUber, Airbnb or Snapchat, but the new breed of internet and technology companies have the ability to grow much faster and achieve higher net margins than New Zealand’s more traditional companies.


For example, Fonterra reported a net profit after tax of $506 million for its latest financial year, on revenue of $18,845 million, giving it a net profit margin of just 2.7 per cent.


Technology, internet and cloud-based companies have huge potential if they obtain customer traction because they have world-wide markets and the potential to achieve net profit margins in excess of 20 per cent.


However, they usually have to raise a large amount of equity during their development stage and there is an extremely high failure rate amongst these technology/internet based startups. The vast majority of these companies never achieve their forecast revenue and profitability figures.


Investing in loss-making companies is risky but there is a place — albeit a relatively small one — for these investments in high-risk portfolios.


The aggregate net profit margin of these nine large NZX companies is 8.9 per cent, compared with 9.0 per cent for the S&P 500 Index companies. However, there is a massive variation in New Zealand between Ryman Healthcare, which has a net profit margin of 40.2 per cent, and Fletcher Building, with only 4.6 per cent.


It is important to note that the New Zealand figures are based on underlying or normalised profits.


Auckland International Airport has a net profit margin of 34.7 per cent, which is higher than Christchurch International Airport and Wellington Airport.


The Auckland based airport is in a strong position because it is the hub port for New Zealand and has a huge land bank. Although it has high net margins, it doesn’t have the revenue growth potential of a technology company.


The airport operator is particularly attractive to long-term oriented pension and superannuation funds because it accounts for nearly three-quarter of all New Zealand’s international arrivals and departures by air.


Contact Energy has a net margin of 5.4 per cent, which is below Meridian Energy’s 7.2 per cent. These companies have limited growth prospects but they have high potential dividend payout ratios, particularly if they don’t have major capital expenditure programmes.


Fisher & Paykel Healthcare has been one of the NZX’s most successful companies in recent years. The company’s above average net profit margin and global growth prospects have contributed to its recent impressive sharemarket performance.


Fletcher Building is a disappointing performer, with a net margin of only 4.6 per cent. This compares with net margins of 5.8 per cent and 17.6 per cent for Boral and James Hardie respectively, two comparable ASX building supplies companies — although they don’t have distribution and construction businesses.


This column has previously expressed the view that our largest listed company should have had more focus on the domestic retirement village sector instead of purchasing a large number of diverse overseas assets, most of which have not delivered their expected returns.


Fletcher Building would have been far better advised to have made a takeover offer for Ryman Healthcare years ago, instead of purchasing Australia’s Laminex Group, Tasman Products and Crane, three largely fragmented and unrelated businesses.


Chairman Sir Ralph Norris and CEO Mark Adamson are redirecting the group’s focus on New Zealand, and an increase in Fletcher’s net margin from 4.6 per cent to 7.0 per cent will raise its net profit after tax from $399 million to over $600 million.


Ryman Healthcare, with a net profit margin of 40.2 per cent, is the most profitable top 10 NZX company by a wide margin. This figure includes realised profits on new and existing retirement village units but excludes unrealised property revaluations. A minimal tax bill makes an important contribution to Ryman’s high net profit margin.


Sky City, Sky Network Television and Spark New Zealand have above average net profit margins and would probably attract far more investor interest if they had greater revenue growth prospects.


Net profit margins don’t fully explain share price movements, but they are a useful guide. Companies with high net profit margins and strong revenue growth prospects are clearly more attractive than companies with permanently low profit margins and limited revenue growth potential.


Brian Gaynor

Portfolio Manager

Disclosure of interest: Milford Funds Ltd. holds shares in most of the companies mentioned on behalf of clients. 

Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.