high margins vs. low

Many traditional growth investors characterize the ideal investment as being a company with substantial intellectual property–pharmaceutical research or computer chip designs or proprietary software–protected by patents.  This allows them to charge very high prices, relative to the cost of manufacturing, for their products.

Some go as far as to say that the high margins that this model generates are not just the proof of the pudding but also the ultimate test of any company’s value.

As I mentioned yesterday, the two issues with this approach are that: the high margins attract competition and that the price of maintaining this favorable position is continual innovation.  Often, successful companies begin to live the legend instead, hiding behind “moats” that increasingly come to resemble the Maginot Line.

In addition, high margins themselves are not an infallible sign of success.  Roadside furniture retailers, for example, invariably have high gross margins, even though their windows seem to be perpetually decorated with going-out-of-business signs.  That’s because furniture is not an everyday purchase.  Inventories turn maybe once or twice a year.  Margins have to be high to cover store costs–and, in normal times, to finance their inventories.

Although I am a growth investor, I’ve always had a fondness for distribution companies–middlemen like auto parts stores, or pharma wholesalers, or electrical component suppliers, or Amazon, or, yes, supermarkets (although supermarkets have been an investment sinkhole that I’ve avoided for most of my career).  My experience is that the good ones are badly misunderstood by Wall Street, mostly, I think, because of a fixation on margins.   In the case of the best distribution companies, margins are invariably low.  So that’s the wrong place to look.

Where to look, then?

the three keys to a distribution company:

–growing sales, which will leverage the fixed costs of the distribution infrastructure,

–rapid inventory turns, measured by annual sales/average inventory.  What a “good” number is will vary by industry.  Generally speaking, 10x is impressive, 30x is extraordinary,

–negative working capital, meaning that (receivables – payables) should be a negative number   …and getting more negative as time passes.  Payables are the money a company owes to suppliers, receivables the money customers owe to the company.  For a healthy firm, its products are in high enough demand that customers are willing to pay cash and suppliers are eager enough to do business that they offer the company generous payment terms.

A simple example:  all a company’s customers pay for everything (cash, debit or credit) on the day they buy.  Suppliers get paid 90 days after delivery of merchandise.  So receivables are zero; payables will end up averaging about 90 days of sales.  This means the company will have a large amount of cash, which will expand as long as sales increase, available to it for three months for free.

not just cash generation

The best distribution companies will also have a strategically-placed physical distribution network of stores and warehouses.

They’ll have sophisticated inventory management software that ensures they have enough on hand to meet customers’ needs + a small safety margin, but no more.  It will also weed out product clunkers.

They’ll have stores curated/configured to maximize purchases.

Monday

…the curious case of Whole Foods.

 

 

margins

A regular reader asked me the other day to explain why I said I thought the margins of Whole Foods (WFM) are too high.  Here goes:

what they are

Margins are ratios, usually some measure of profits (gross profit, operating profit, pre-tax profit…) divided by sales. (Yes, in cost accounting contribution margin is a plain old dollar amount, not a ratio.  But it’s an exception.  I have no idea why the misleading name.)

when high margins are bad

At first thought, it would seem that the higher the margins, the better off the seller is.  Buy the item for $1, sell it for $2.  That’s good.  Raise your prices and sell it for $5, that’s better.

The financial press encourages this notion with articles that talk up high margins as a good thing.

At some point, however, other people will work out how much you’re making and start doing the same thing.  They’ll typically go for market share by undercutting your prices.  So now you’ve got a competitor who wasn’t there before and you’re facing a price war that will at the very least undercut your brand image.

Creating what analysts call a price umbrella below which competitors can price their products and be protected from you as a rival is one of the worst mistakes a firm can make.

In my experience, it’s infinitely better to build a market more slowly by yourself than to have to try to dislodge a new rival who has spent time–and probably a lot of money–to enter.

One potential exception:  patented intellectual property (think:  Intel or drug companies). Even in this case, however, there’s the danger that once-successful firms become lazy and fail to continue to innovate after initial success.  The sad stories of IBM, or of Digital Equipment, or INTC for that matter, are cautionary tales.

More tomorrow.

are high margins better than low ones?

This post is indirectly about Amazon’s retailing business, although it has much wider implications.

My answer:  not necessarily.  It depends on what kind of company we’re talking about.  Note, also, that this is a topic that’s badly misunderstood, particularly in the financial press, which clings to the simple assumption that high margins, of themselves, are better than low ones.

 

The apparent virtue of having high margins is clear.  Companies that have, for instance, essential intellectual property protected by high patent/copyright/manufacturing-knowhow walls, can achieve selling prices that are much greater function of the usefulness of their products/services to customers than of their production costs (this latter is the functional definition of a commodity company).  Software firms can easily achieve 50%–or maybe 80% or 90%–operating margins for their wares.

 

Most distribution companies–both wholesale and retail–don’t work this way, however.  They thrive through low margins, high inventory turnover and careful working capital management to achieve superior financial results.  In fact, for these companies high margins are a threat, not a boon.  Why?    …because high margins attract competition.

the low-margin model

Here’s a (highly simplified) account of how the low-margin model works:

the simplest case

A warehouse holds inventory of $1 million.  It constantly replenishes its stocks, and pays cash immediately for new supplies, so that it always has $1 million invested.  It marks items up by 5% over its costs.

Let’s say the company generates an average of $525,000 in sales per month.  That means it turns over about half its inventory (a turnover ratio of 6x/year) each month, earning operating income of $25,000.  $25,000 x 12 = $300,000 in operating profit per year.  Applying a 1/3 income tax rate, it produces $200,000 in net income.  That’s a 20% return on invested capital. Not bad.

a more favorable one

Let’s now imagine that the company can turn its inventory once a month (turnover ratio = 12).  This means it earns operating income of $50,000/month, or $600,000 per year. This translates into $400,000 in net income. That’s a 40% return on capital.

nirvana

Let’s say the company turns inventory once a month but is large enough or important enough to suppliers that they no longer ask for payment on delivery.  Instead, they are willing to wait for 30-45 days.

Now the company has zero/negative working capital, i.e., no capital invested in inventory.  It’s return on investment is now infinite.

 

Yes, this third case is probably too good to be true.  But it illustrates the enormous, badly-understood, power of high inventory-turnover companies.

 

A post on potential troubles in paradise on Tuesday.

 

 

operating margin

operating margin

The financial ratio that professional investors focus on more than any other is operating margin, or operating income ÷ revenue.

The major categories of expenses subtracted from revenue to get to operating income are:  direct costs of creating a product/service (cost of materials, wages, power, water…) plus depreciation and SG&A (sales, general and administrative) expenses.  SG&A includes things like the cost of top management, sales force and corporate headquarters.

the higher, the better?

Most people assume that the higher the operating margin is, the more attractive a company is as an investment.  The idea is that the company in question must have spectacular offerings to be able to charge high prices that exceed the cost of creating them by a lot.  But that’s only true in very specific circumstances.

value and sustainability

The two big questions are whether current high margins are valuable and whether they are sustainable.

value

The first point sounds weird but is actually an important special case.  Some companies (think:  fine jewelry or furniture) have high margins–high profits on each sale–because to do business they have to maintain large inventories that don’t turn over very frequently.  Unlike candy in the checkout aisle, where the starting inventory may be sold several times a day, it may take six months or longer to sell a brooch or a sofa that’s on the showroom floor.  So, yes, the margins are high.  But a good part of that is to compensate for the expense of holding inventory (not such a concern in a 0% interest rate world) and the risk that items may go out of style (or never have been in style) before they’re sold.

sustainability

Most of the time, however, sustainability is the key issue.  That’s because high margins draw competition.  Personally, I think very high margins are never sustainable forever.  So for me the question is how quickly, and how publicly, they’ll be eroded.  I’m willing to believe that there’s an enduring  value to intellectual property like patents.  So I’m happy to buy tech companies.  There’s also a value to intangibles, like a strong brand name, an efficient distribution network and good customer service.  However, intangibles are not the no-brainer it used to be.  The internet has eroded that value badly from what it was twenty years ago–much to the consternation of people like Warren Buffett, whose career was built on his superior understanding of intangibles.

In any event, the holder of high-margin firms has to be alert to possible threats to the franchise.  Often the threat comes in the form of what are initially thought to be inferior products.  The $3000 PC replaced the $100,000 mini-computer, not because the former was better than the latter but because you could get 30 of them and make do for less than a single machine from DEC.  Same thing with mp3 players vs. stereos.  The sound is inferior but the machines are cheaper and portable.

the beauty of low margins

distribution

Again, personally, I find myself attracted to distribution companies, which have high operating income despite low operating income margins, because they have high inventory turnover.  The ones I find most compelling send to sell a product long before they have to pay their supplier for it.  Also, they’re badly understood by devotees of high margins.

broken companies

A final note:  value investors begin to salivate when they find a firm with much lower margins than is the norm for the industry.  Typically, the stock will be very cheap and, they believe, it’s just a matter of time before either the board of directors takes corrective action or the company is taken over.  Normally not my cup of tea but I’ll dabble on occasion.

margins, not quite what they seem

There’s a persistent belief among investors that companies with high margins are better than those with low ones.  To a limited extent, this is true, but the issue is much more nuanced than is commonly thought.  In fact, in many cases, a high-margin firm in a given industry is in an inferior position to one with lower margins.

I’ll be writing about this over the rest of this week, after my Keeping Score analysis of the sector performance of the S&P 500 for May tomorrow.

What are margins?

They are ratios.  They’re ratios of profits to sales, usually expressed as percentages.  The most commonly used are:

–gross margin, which is the based on profits after deducting direct costs of providing goods or services

operating margin, which is based on profits after deducting both direct and indirect costs

pre-tax margin, which is based on profits after all costs ex tax (the main added item is interest expense), and

net margin, which is based on profits after all costs, including income tax.

 

another topic

I received an email a while ago explaining that I might be one of a large number of Twitter users whose account might have been hacked in 2012.  The email suggested I change my password   …which, of course, I failed to do.

Last night I got another email noting possible suspicious activity in my account.  For anyone who might be interested, no, I am not the scantily clad woman whose picture appeared on my account yesterday.  Nor am I touting her sex site.

I have since changed my password and removed all (I think) the offending material.  A weird experience.

 

Jim Paulsen on the US stock market

Yesterday’s Financial Times contains a guest column by Jim Paulsen, strategist for Wells Capital, a part of Wells Fargo.  I find Mr. Paulsen’s work to be orignal, thoughtful and, for me, thought-provoking.  On the other hand–a warning–he and I share the same generally optimistic view on markets and have tended to agree on most basics.

Here’s what he has to say:

–the current market swoon may have been triggered by worries about the Chinese economy, but its real cause is to be found in the dynamics of the US economy/stock market

–US stocks were, and still are, trading at an unsustainably high price-earnings multiple.  The final bottom for stocks in this correction will be around 1800 on the S&P 500, or about 3% below the low of a few days ago.  That’s where stocks will be on a more reasonable 15x PE

–full employment in the US, i.e., where we are now, creates a series of problems for the economy and stock market.  Employers wishing to expand are forced to find new workers by bidding them away from other firms.  Since inflation in advanced economies is all about wage increases, poaching creates inflation.  In the short term at least, a higher wage bill means lower margins–and therefore lower profit growth.  The Fed responds to the inflation threat by raising interest rates, which exerts downward pressure on PEs

–investors don’t get this yet.  They’re “more calm and confident than at any other time in this recovery.”

–the combination of high PE, higher interest rates and slowing growth mean that equity investor focus will shift from the US to more fertile fields abroad.  These areas are more prospective because, unlike the US, they don’t face the need, caused by achieving full employment, to rein in the pace of domestic economic growth. I presume, although Mr. Paulson isn’t more specific, that this means the EU (it may also mean US stocks with high exposure to non-US economies).

my thoughts

Mr. Paulsen is in touch with institutional equity investors every day.  So he has a much better sense of the current thought processes of US professionals than I do.  He seems to feel his customers are only beginning to believe that the set of issues that come with full employment are at our doorstep–and are only now starting to discount them into stock prices.  Hence the correction.  While it’s risky to think you know more than the other guy–in this case, that the other guy slept through his elementary economics classes–I’m willing to go along and say it’s true.

Mr. Paulsen has previously made the point that interest rates are going to rise in an economy that doesn’t have much business cycle oomph left in it.  Therefore, he argues, past instances of cyclically rising rates, during which stocks generally were flat to up, may not be good guides to what will happen today.  I look at the situation in a different way.  If we ask where long Treasuries will be at the end of Fed tightening, the answer is that they’ll likely be yielding less than 4%.  If we think that the yield on Treasuries and the earnings yield (1/PE) on stocks should be roughly equivalent, then the implied PE on the S&P is 25x.

One might argue that the idea of the equivalence of earnings yield and interest yield arises from a long period in which Baby Boomers preferred stocks to bonds.  As Boomers have aged, that preference has reversed itself, meaning that yield equivalence between stocks and bonds may be too rosy a view for stocks.  If we assume that stocks trade at a 20% discount to this yield parity, however, the implied PE at the end of rate hikes is still 20.

Both results are a long way from the 15x that Mr. Paulsen proposes for the S&P.

It’s often the case that a significant drop in stocks often signals a leadership change.  I think it makes a lot of sense to reverse portfolio polarity away from an emphasis on earnings coming from the US to profits generated abroad.  How exactly to carry this idea out is the key, though.

 

 

why does Wall Street care about sales gains and not just earnings gains?

…after all, what ultimately matters is how much profit a company’s management is making for its shareholders, isn’t it?

Yes, and no.

two special cases

Let’s deal with two special cases before getting to the main topic.

–Investors who focus a lot of their attention on startups that are not yet making money will typically use sales growth as their major metric.  There are no profits yet.

–Value investors will be drawn to mature companies with lots of sales and little or no earnings because of their turnaround potential.  This is especially true if they can see other firms in the same industry who are comfortably profitable with similar levels of sales.

Neither is an example of the phenomenon we are now seeing as some companies report 3Q12 results.

strong earnings, weak sales

When earnings meet/beat the consensus estimates of brokerage house analysts–and sales don’t, the stock in question often goes down, sometimes by a lot.

Why?

it’s all about recurring earnings

1.  Investors typically look for recurring gains when they buy stocks, not one-off profits.

Consider this oversimplified example:

A company reports earnings per share of $1 for the current quarter.  If you know that this is all the profit the firm will ever make, then–assets (if any) aside–you won’t pay more than $1 for a share of stock.  (In fact, you’d probably pay less, since the $1 of profits is in the hands of management, not in yours.)

On the other hand, if you thought the company would earn $1/share every three months for the next ten years, you could be willing to pay up to $40 for a share of stock.

So there’s a huge difference between the value to investors of recurring and non-recurring profits.

2.  If a company reports higher earnings without what analysts consider an appropriate increase in sales, investors assume that the firm has achieved its profit target through cost-cutting of some type.  They argue, correctly in most cases, that the profit increase isn’t sustainable.

More than that, they view the slower sales increase as a leading indicator of slowing profit growth that will emerge in subsequent quarters.  They can see the train coming at them, as it were, so they don’t wait to get off the track.  They sell now.

Their picture is this:

Suppose the company has been spending $1 million a quarter on marketing up until now, but cuts the budget to $500,000 for the just-reported quarter.  That produces just enough extra margin that the company reports $1/share in earnings instead of $.90, thus meeting consensus eps expectations.

The worst case is that the reduced marketing is a mistake that will negatively affect sales and profits in coming quarters.  But even in the best case–that this is a true savings–the company can only cut marketing expense once.  

Yes, the company will also report an extra $.10 in eps for the next three quarters.  But that’s it.  This is really no longer a company earning $1 a share per quarter for as far as the eye can see.  It’s a company that’s earning $.90 a quarter + a non-recurring $.10 now and for the next three reports.

If you were previously willing to pay $40 for $1 a share in quarterly earnings, you should (at most) pay $36 for $.90 a quarter profits.  Add (at most) $.40 for the non-recurring earnings.

The main point is that cost-cutting has to end relatively quickly–and should not be mistaken for a permanent element of a company’s profitability.

3.  Some managements won’t be inclined to call attention to this information and will just show it somewhere in the financials (in the hope analysts won’t bother to read the fine print).  The cost-cutting could also be a bunch of little things, significant in the aggregate but not big enough individually to require disclosure.   If so, the slowdown in sales is the only clue to what’s really going on.

4.  For multi-line companies, the situation isn’t so simple. Sometimes, a firm may be phasing out a line of business where it earnings little or no profit, so it’s sales growth sags while profits advance smartly.  Here, “Shoot first, ask questions later,” may be the wrong strategy.  But it’s what short-term traders always do.  And, in my experience, “Shoot first…” is right more often than not.