Category Archives: Industry Analysis

are high margins better than low ones?

October 28, 2016 By in contribution margin, margins, Retail, Uncategorized Tags: , , , 1 Comment

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.

 

 

firming oil prices: seasonal strength or something more?

October 20, 2016 By in Industry Analysis, oil, oil and natural gas, shale oil, shale oil and gas, Uncategorized Tags: , , , , Leave a comment

September through mid-January is the period of greatest seasonal strength in oil prices.  Early in this period, refineries shift from making gasoline to supply drivers to manufacturing heating oil in advance of winter in the northern hemisphere.  There’s normally some friction in the supply chain as this takes place.  But the key reason for current oil price strength, I think, is the typical behavior of wholesalers, retailers and end users accumulating supplies of heating oil for winter use as autumn commences.

This period of strength usually ends in late January–after which there’s be no time to get newly-refined heating fuel to users before the weather warms.

What follows from February through April is the period of greatest seasonal weakness for oil.

 

What to make of current firmness in crude.  Is there any evidence that the proposed OPEC production limiting agreement is exerting upward pressure on the price?

My private hunch is that, yes, there is.  At the same time, I also think there will be little lasting (meaning over six months or a year) collective discipline to keep to promised quotas once they’re seen to be having an effect.  Budget deficits are too large and the third world us-against-them cohesiveness that enabled OPEC’s remarkable past cartel success is no longer present.

 

Still, I think that prices will be strong seasonally for a while in any event, so there’s no need to have a view on whether a production agreement will stick.  That time will come early in the new year.

At that point, for 2017 investment success, having a (correct) opinion about oil will be crucial, I think.  I’m hoping–and anticipating–that I’ll be able to make that decision on other grounds, i.e., the innate cheapness (or not) of shale-related exploration stocks, even without price increases.  In the meantime, I’m content to be on the sidelines.

 

“The Dying Business of Picking Stocks”

October 18, 2016 By in Investment firms, Uncategorized Tags: , , , 1 Comment

That’s the title of an interesting article in today’s Wall Street Journal on the accelerating replacement of active investing with indexing in portfolios of all stripes in the US.

One important factor in the lagging performance of most active investment groups is being left out, however.  It’s the one no active investment organization wants to talk about.

Beginning in the 1980s and increasing in momentum in the 1990s, active investment groups began to dismantle their in-house investment research departments.

Why do this?

In my view it’s because,

–research departments are expensive.  They’re hard to run well.  Evaluating securities analysts over short periods of time, like a year, is as much an art as a science.  Because of its pain-in-the-neck character, a less tha nstellar research effort is very easy to regard as an unneeded expense rather than a valuable asset

–most money management organizations are run by the chief marketing person, with the head portfolio manager being the Chief Investment Officer.  So the ultimate decision maker on firm-wide administrative matters is typically not an expert on what it takes to have sustainably good investment performance

–in the 1980s and 1990s brokerage firms built and maintained strong research departments, whose output they offered to money management clients in return for charging a higher commission rate for trades.  So reliable–although not proprietary–third party research was available to money managers without their having to pay for it from management fees.  This added to the view that good in-house research was unnecessary

–eliminating in-house research would mean salaries “saved” that could be used to boost compensation for the professionals who remained (including the CEO and CIO, of course).

 

Not every firm used all the reasons on this list, but many found some combination of them persuasive enough that they decided to substantially reduce, or eliminate their independent research entirely.

This, of course, made these firms radically dependent on brokerage research…

…which has proved a disaster when, in their dark days immediately after the stock market collapse of 2008-09, most brokerage houses laid off virtually all their experienced researchers and pared back their for-commission research efforts to the bone.

This left money managers who had eliminate their own research high and dry.  It also meant the affected firms were faced with the prospect of rebuilding their own in-house research.  Because this would involve a substantial expansion of the professional staff, the resulting expense would pressure income for–I think–at least a couple of years.

 

I haven’t followed this issue carefully.  My experience, though, is that this is the kind of decision CEOs really don’t want to make–to admit they were wrong, and badly enough that fixing their mistake will retard or eliminate future profit growth.  As a result, a kind of paralysis sets in and the process of fixing the error never begins.

 

 

Trump’s taxes

October 3, 2016 By in real estate, Uncategorized Tags: , , , Leave a comment

Over the weekend, the New York Times published an article that contains copies of parts of Donald and Marla Trump’s 1995 income tax filings.  The pages, mailed to a Times reporter in September and verified as genuine by the accountant who prepared them, contain two items of note:

 

–during that year, the Trumps had income of about $9 million.  That was more than offset by a loss of $15.8 million generated from “rental real estate, royalties, partnerships, S corporations, trusts…”–which I take as being tax loopholes designed for the real estate industry.  If we assume that this is par for the course, it would mean that the Trumps typically pay no federal or state income tax.

 

–the Trumps also show that as of that year they had accumulated other losses totaling a stunning $909 million.   This figure is presumably the cumulative result of Donald Trump’s efforts as an investor.  Two points:

—tax losses have a current economic value, which deteriorates as time passes.  In this case, the value in 1995 of the Trump’s loss was about $350 million, and was shrinking in economic worth by, let’s say, $30 million per year.  Logically, the best course of action would have been for the Trumps to use the loss by selling, the sooner the better, something they owned and had a profit on.  The fact that they did not suggests they didn’t have any investment gains at that time–or that they used what gains they had to whittle the loss figure down to $909 million.

—Donald Trump was born into a wealthy real estate family.  He entered the family business with the advice and support of his successful father.  Falling interest rates + the development of New York City as a world financial center made the 1980s a golden age for real estate investing in the region the Trump family had expertise.  Yet the Trump 1995 tax returns suggest that on a net basis Donald not only made no profit during a time when real estate was like a license to print money; instead, he lost nearly a billion dollars.

In a recent Forbes article, John Griffin, a finance professor at the University of Texas/Austin examines Donald Trump’s investing career using publicly available data, both independent estimates and figures self-reported by Trump.  Prof. Griffin concludes that Mr. Trump has made only about half the profits of a typical real estate investor (about 40%, taking the self-reported figures), while taking on a higher than average level of risk.  Mr. Griffin concludes, ” Donald Trump is obviously a skillful presenter and a talented entertainer, but in terms of his investment skills, he is a clear underperformer.”  To my mind, the mammoth loss shown in the 1995 Trump tax return suggests that a less favorable assessment may be warranted.

 

 

 

crude oil: from shortage to surplus

September 16, 2016 By in oil and natural gas, shale oil, shale oil and gas, Uncategorized Tags: , , , , , 1 Comment

Until very recently, petroleum industry thinking about crude oil supplies has been dominated by what has been called “peak oil theory.”  Developed by geologist and Shell Oil researcher M. King Hubbert in the 1950s, the simplest statement of the theory is that world production of crude oil would peak shortly after the year 2000, and then begin an inevitable decline.  The reason?   …all the world’s oilfields would have been discovered and fully exploited by that time.

We now know that Dr. Hubbert’s hypothesis is incorrect.  In fact, it’s wildly–even directionally–wrong, done in by the incentive of high prices and the development of hydraulic fracturing.

 

Peak oil is of more than academic interest, since strong belief that the world is facing an inevitable decline in oil production has informed the capital spending budgets of all the major oil companies for the past generation.  For them, the present situation of abundant supply at around $50 – $60 a barrel was unthinkable.  As a result, the majors have poured billions and billions of dollars into locating very high-cost hazardous-environment oil prospects that may now be not economically viable.

What happens now?

 

My mind keeps going back to the late 1990s and the mad rush to lay fiber optic cable around the world to support the internet.  Corning and a few Asian suppliers made the highest-quality glass cable.  Global Crossing and others spent immense amounts of money as they raced to complete undersea cables to connect the US to the rest of the world.  Internet traffic was expanding at such a fantastic rate that, in these firms’ minds, the fact that a whole bunch of firms were all doing so made no difference.

In hindsight, a key assumption these companies all made was that each optic fiber in a cable would be able to handle only one transmission at a time.

Then came dense wavelength division multiplexing.   DWDM amounted to putting a prism at each end of a fiber, breaking the light into a number of different wavelengths and sending a separate communication over each wavelength.   First it was two wavelengths, then four, then 256…

Suddenly the looming fiber optic shortage was an actual fiber optic glut.

What happened beak then?    The fiber optic cable business fell apart.  So too equipment suppliers like JDS Uniphase.  The most aggressive fiber optic cable layers went into bankruptcy.

 

I’ve been thinking that it’s time to poke around in the wreckage of smaller US oil exploration firms, although I suspect we may not see oil price lows until the end of the winter heating season (assuming there is one) next February.  But I also continue to think that the DWDM analogy is a reasonable one.  It suggests that there’s still lots of trouble ahead for the biggest and best-known names in the oil industry.