Understanding what drives gross margins
I’m pretty new to value investing and am trying to develop intuition for the economic forces that drive gross margins. To do so I want to consider the simple example of a local, single-location laundromat.
Is it reasonable to expect that in an area like mine where there are a few laundromats situated very close to each other offering virtually identical services (pureplay washing/drying, no folding or dry clean service), the margins for such a business should be quite thin? After all, with such little product differentiation and low switching costs (as I mentioned, all three locations are very close to each other), I imagine customers are basing their decision on price alone. So intuitively economic forces would prompt a price war among incumbents until they reach the point of zero economic profit.
Is this thinking reasonable? I understand that thread of substitutes can affect margins as well in cases where the market is otherwise monopolistic or oligopolistic with product differentiation. But with how commoditized basic laundry is, I don’t imagine that playing a role.
I’d really appreciate some guidance here, thank you.
Are you referring to operating margins or gross margins? Because they're different. I'll assume you're talking gross.
In my mind, gross margins are generally correlated to how much value you can create by making a good or service and how differentiated it is.
Grocery stores & car dealerships will have low gross margins as they're pretty indistinguishable, but BioTech & high-end fashion companies will have high margins because their product is special.
In your laundromat example though, gross margins are likely going to be pretty high, as for each incremental load of laundry your only costs will be utilities.
But that being said, margins overall are going to be high. Rent will be a massive expense, as will repairs/maintenance, insurance, and cleaning.
You're right though, for a relatively undifferentiated product and few barriers to entry, margins overall will be low.
But gross margins aren't necessarily low just because competition is high.
Ok gotcha, so basically overall operating margin here will presumably be low because of the nature of the competitive landscape I outlined above, but with this particular example where cost structure leans heavily toward fixed costs, it happens to be the case that gross margins may appear high but operating margin tells the full story about competition. Thanks a lot for the insight and please correct me if I misunderstood
You’ve got it
Will echo a lot of the above post, but a really simplistic way of looking at gross margins is price + volume / cost. Price flows straight through to your gross profit / operating profit, while volume has an incremental as the post above describes. Meaning for every incremental unit you produce, there are associated fixed & variable costs. The point on competition is a very good one.
Essentially gross margins are a way to understand how expensive (or inexpensive) it is to provide a good or service, and therefore how scalable it is pre-SG&A / other OpEx / rent. If the unit economics are good, then scale makes sense. If it's fairly cheap for you to provide a good or service net of what you're selling it for (value proposition), this will result in a higher ROIC. Volume growth tends to be more valuable to businesses that have higher base ROIC because for every unit of volume output you get a better and better return. And that drives higher earnings dollars $.
In the laundromat example, the demand/mkt structure may also explain away why there's no price war. If everyone dropped price in an effort to win volume and share, at some level there's a price that doesn't cover cash costs and thereby throws the model into negative margin territory. Meaning... as a function of elasticity, there likely isn't enough volume amidst 3 laundromats next to each other to offset the decline in price needed to capture every customer across all 3. The survivor would be the one with the lowest fixed cost footprint. And then you have to also think about capacity restraints. If a laundromat tripled its customer base, could it adequately service all those additional customers? Price & volume often times are competing with one another due to laws of elasticity, to some degree.
Reminder your break-even point is fixed costs / gross margin. So if you sum your rent / maintenance / D&A / interest / taxes and divide by your GM % (let's assume 75%), that would be how many sales in $ you would need to do to achieve a total profit of $0.
Ok that makes sense, really appreciate the detailed explanation.
I want to make sure I understand that third paragraph correctly. What I’m hearing is that because a 1 cent price decrease will likely not be enough to sway every single customer to the location in question, each business may not see a benefit in any price decrease beyond its current price because the impact on margins would offset any benefit from increased volume. So if we pretend all three businesses have identical fixed and variable costs, they may still be operating above zero economic profit because none of the three see any benefit in lowering prices. Please call me out if that interpretation is wrong.
I guess I was thinking about it in more of a pure theoretical sense where if we assume the products are fully undifferentiated, any arbitrarily small price decrease will capture the whole market, meaning inevitable price war. But I suppose in reality consumers are less price sensitive (especially with this type of consumption where overall expense is so small)
I think your interpretation is correct. It's moreso if they lowered price in effect to win customers, the others would respond in lowering their prices as well and it become a circular reference, otherwise everyone would shut down (if they all had the same fixed/variable costs). Consumers aren't directly sensitive to a company's costs, however companies generally will price for value or cost. What I mean is that your point about customer sensitivity is correct, but that if expenses are higher then the company in question has to make up the shortfall somehow, often times via price.
In like... the purest of economics form, perfect competition is what you're describing where all market participants exist in a totally homogenous environment, so therefore there is no optimal need to lower prices to win more customers because it's unsustainable.
I'm getting a feeling that this could be like a case study type question - or if just for curiosity still a useful thought experiment for looking at things.
It gets easier when you start assigning ballpark numbers to these things - average rent/space cost, number of machines, number of customers/cycles per day, cost per machine install, average maintenance costs (per spins or yearly?), utilities/water/electric, etc. - you can do this pretty quickly and easily in excel and it will give you a much better sense of the unit economics here, your split between fixed and non-fixed costs, and incremental margins (which will likely be high). May be worth considering the ROIC in this analysis also - take the classic ROIC = NOPAT / SALES (x) SALES / INVESTED CAPITAL. So while common sense may say that this business has low margins because there is little differentiation, this may be a business that still generates very solid ROIC because of the second part of that equation (turnover part), where your sales to invested capital is quite high at sufficient scale. Other parts to consider is the stickiness and stability of the business because it is a necessary service, customers are unlikely to travel significantly far distances to save on an overall low cost service, etc. Probably has better pricing power than you would think. Throw in some vending machine income for fun. I would think there aren't significant operating costs over COGS - biggest fixed cost is machines/rent, biggest variable costs are water/electricity/maintenance (although maybe some of the maintenance is more "fixed" in nature?).
Just throwing out random things here - but as it relates to margins, you should probably be able to get pretty close to understanding the margin profile of the business with quick assumptions in an excel sheet, maybe even run it down to profitability per load!
looks like herzy was posting a better post as I typed mine up!
Qui perferendis rerum est non sed odit quia nihil. Omnis quibusdam autem nisi fuga soluta. Est iusto necessitatibus suscipit placeat aliquid. Qui eligendi repudiandae sequi pariatur labore culpa voluptate.
Eos alias iste et velit quod rerum minima. Quis quia tempore temporibus soluta incidunt consequatur beatae. Consequatur quaerat cumque sapiente atque.
Enim qui quia sint voluptatem quaerat quasi et. Quod animi est aut earum ipsum. Iure sunt ut rem saepe sed aliquid. Accusamus doloribus soluta ut et.
Cumque nobis quo blanditiis dolorem et. Aliquid omnis dolorum et itaque.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...