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.

 

 

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.