Great Company - Shitty Margins
Hi all,
I was recently asking myself the following question.
Why do have some great companies very low margins?
Let's talk a leading manufacturer of machines as an example. EBITDA around 10% and EBIT around 7%. Machines are typical quite sophisticated which should imply a high degree of differentiation.
Shouldn't they be able to have higher margins in this case? I understand that capital intensity dilutes the margins. But differentiation should in theory at least also justify higher gross margins due to higher prices right?
Any thoughts?
Looking forward to your input.
What do you mean with capital intensity? Capex?
There's 2 likely answers:
It's not that 'great' of a business in the sense that it may make highly technical products, but despite that perceived complexity, there are other players in the market that can compete the price (and margin) down. As a rule of thumb, truly differentiated businesses (those with high barriers to entry, offer a differentiated product or service, and exist in a disciplined monopolistic / oligopolistic landscape) command high margins because they have pricing power. For example, Apple and P&G both have 30% EBITDA margins and even better free cash flow profiles (capex light businesses) - both Apple and P&G's products have brands that command a premium in the market.
There may also be a cost issue. Some companies accumulate a lot of corporate overhead / fat over time or over-invest in infrastructure as they anticipate that growth will follow. If the company is doing that, then their EBITDA margin will also get compressed.
For most mature companies. EBITDA margin is a great proxy for how attractive an underlying industry is, and how well that business' positioning within that industry is. More attractive industry + better market position = higher margins and vice versa.
I think Gross Profit Margins / COGS is a better place to start. a fabulous company can be completely screwed by overspending on SG&A. GPM varies in accounting treatment but once you get that consistent, it's a better barometer. Every industry operates on a GPM range for a variety of reasons - that are NOT controllable by the company itself. SGA costs are controlled company to company and are little (less) determined by industry. GPM is where my eyes always go first because it tells me most of what I need to know about the company, quality, pricing, efficiency, etc.
Great companies are defined more by high returns rather than high margins. Would you rather sell one widget for $100 profit or 50 widgets for $10 profit each? It's important to look at not only how much profit is generated but also how much investment is required to achieve these profits as well as the inventory turnover, etc. Look at a business like Cardinal Health or Pool Corp - low margin but very high returns and great companies.
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