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Analyzing Special Businesses: When Margins Matter

Geoff Gannon

Geoff Gannon

407 followers
Someone who reads my blog sent me this email:

Hello Geoff,

About your latest article on Analysis Paralysis.


You show an example of using 10-year average FCF margin to calculate P/S. Calculating this way, you assume that the margin will revert to the normalized margin. However, margins tend to decline over time as competition works its magic.

Don't you think that instead of using average FCF/average S divided by price/sales, it would be better to use average FCF/Price to get the FCF yield? The calculation is easier and you get the normalized yield based on the current price without assuming that the CF margin will revert to the average.


Best Regards,

Dimitar

Great question.

In my Analysis Paralysis article, I didn’t do a good job of explaining why I was using the free cash flow margin to value a stock like Omnicom (OMC).

Omnicom is a special business. And you should only use long-term average margins when valuing special businesses.

Personally, I’m most interested in two kinds of stocks:

1. Stocks that are special businesses. Islands of unique business ecology.

2. And net-nets.

That’s it.

Why?

Because buying safe, quality net-nets means you are getting liquid – rather than stuck – capital at a discount. If returns on capital tend to even out across the economy, you will do very well in net-nets.

So why special businesses?

Special businesses are companies with unique assets. These assets are usually – but not always – intangible. Dreamworks (DWA) has a library of unique movies. Dun & Bradstreet (DNB) has a unique database of 188 million business records. That asset’s replacement cost is…

…Not gonna happen.

No one will ever replicate D&B’s DUNS numbering system. The barrier to entry in that particular line of business is insurmountable. D&B has managed to cut that part of its business off from the rest of the economic universe. It has opened a portal to another economic plane where it enjoys whatever profits its customers are willing to pay. Competitors – actual or potential – have no role in setting D&B’s prices or determining its profits.

Let’s look at Fair Isaac (FICO). Operating margins in its scoring business are north of 60%. That translates into about 40% after-tax. Certainly not the normal margins for the economy as a whole.

FICO's only competition is VantageScore. Which was created by FICO's customers (the credit reporting bureaus) to try to replace – or at least commoditize – the FICO score. VantageScore is shamelessly based on the FICO score. It’s an attempt at commercial confusion – profiting from someone else’s good name. VantageScore even tries to get the scores to fall into a similar range so a VantageScore kind of looks like a FICO score. This is despite the fact that the FICO score range is counterintuitive. You would think credit scores would be presented as letter grades, one through 10 number scores, one through 100 number scores, or one through 1,000 number scores. Nope. Because FICO uses a 300 to 850 range – imitation credit scores will use similar ranges.

Aside from VantageScore, FICO has no real competition in its credit scoring business. The credit scoring business has three-year average operating margins around 67%. The economics are very similar to Moody's (MCO). This is obscured by FICO's other businesses which are inferior to the company’s crown jewel: credit scoring.

So, why should we look at FICO’s long-term average margins?

Forces of Opposition

Profits – even where there is no competition – are still set by costs and customers.

Profit-seeking businesses have to overcome opposition. That’s how they get to keep their profits.

Forces of opposition include:

· Competitors

· Suppliers

· Employees

· And Customers

A business’s long-term profits depend on how well it overcomes these forces of opposition.

Many bad businesses resort to price competition. This is their method for dealing with competitors. However, price competition weakens the position of all competitors in the industry versus their customers.

Competitors are on opposite sides of the table when it comes to individual customers. However, competitors are on the same side of the table when it comes to customers as a group. To the extent competitors undermine each other on price, they are breaking ranks and betraying their industry. Competitors – whether they realize it or not – are always in a position where they can both cooperate and compete with other industry players.

Investors tend to focus too much on a business’s position versus its competitors and too little on a business’s position versus its customers.

Having a superior position relative to your customers is very important. And it’s very hard to gain such a position in industries characterized by price competition.

How do you gain a strong position relative to your customers?

Off the top of my head, I can think of five ways:

· Satisfaction

· Routine

· Alignment

· Identity

· Dependence

Satisfaction

A satisfied customer is a customer who will not search for alternatives. If you are selling infrequently purchased, high-priced items – satisfaction will not be sufficient to prevent price competition. Even customers who are satisfied with their current refrigerator will compare prices on new refrigerators when they need a replacement. And comparison shopping is a business’s worst nightmare.

Routine

For cheap, frequently purchased products – routine may be enough to ensure decent profits. However, this approach requires both familiarity and availability. As a result, companies that depend on routine purchases for their profits often get squeezed by the retailers that sell their product. Nonetheless, companies like Berkshire Hathaway’s Fruit of the Loom and Hanesbrands (HBI) depend heavily on customer routine.

Alignment

Sometimes your interests and your customers' interests align. This works well in industryies where there’s a gentleman’s agreement of some sort. For example, “don’t poach” or “don’t poach on price.” Customers are expected to pick from among the industry’s competitors. And competitors are expected – in theory – to wait for a customer to break off their existing relationship before wooing them. It’s especially important that competitors do not try to poach each others' clients using price. The most profitable alignment industries tend to be those with customary fees like 10%, 15%, or 2 and 20. These industries work well when the entire industry holds the line on price. Almost all of these industries depend on presenting themselves as a fraternity of experts. Maintaining the image of the industry is important. An aura of professionalism can be cultivated to amp up the mystique.

Identity

This is where your customer stops being rational and starts being honest. Instead of saying: “Pepsi tastes better than Coke,” they now say, “Coke tastes fine. Pepsi tastes fine. But I’m a Pepsi drinker.” Each product is treated as unique. Even the rejected product. The pie is divided. Profits pour in.

A lot of Tom Russo’s investments fall into this category.

Dependence

Exactly what it sounds like. It’s no accident that the English world “client” is really just ancient Roman for “dependent.” This is where a customer surrenders more and more control to you. You are invited into their business. Your products and services are integrated into their critical, daily routines. They can’t function without you. If they stopped paying for your product, they’d go through a painful period of withdrawal.

Information has the highest risk of dependency. Once a customer starts using your database, formula, etc. – there’s a decent chance they’ll get hooked. Over time, they will build their routines without regard to the fact that the information they are using is not homegrown. It’s imported. Finally, their business will depend on continuous importing of your data. The result: You get a perpetual royalty on their sales.

Often, complexity is touted as a competitive virtue. The more complex your product is – the harder it is for others to copy it. True. But the more complex your product is – the harder it is for a customer to become dependent on it.

Theoretical discussions of competition tend to omit counterexamples like WD-40, Arm & Hammer, and Tabasco – all of which benefited from having multiple uses. The customer could and did repurpose them.

The ideal product is one that is complex to make but simple to integrate.

If your customer doesn’t further customize the product you sell them – it’s very hard to make them truly dependent on that product.

Repurposing information is very common. When you sell information to customers, you don’t know how they are going to use it. And each customer may integrate your information into their routines in a different way.

I can relate to this. I expect anyone who uses financial information can. I’m dependent on EDGAR, Morningstar, Sharelockholmes, Stockscreen123, Excel, etc. None of these products were created with a clear idea of how I would use them. I can assure you that I use every one of them a little differently than anybody else out there.

Lack of Price Competition

The first rule of business is to find an alternative to price competition. If you must compete – find a way to compete on something other than price.

Which brings us back to Omnicom.

Four advertising conglomerates control most of the industry. Advertising is a relationship based business. Clients do not compare agencies day-to-day. They stay with the same agency until they fire that agency. Some clients switch frequently. A couple never switch agencies. Advertising agencies generally compete aggressively on everything but price. Price competition is minimal. If run right, Omnicom should always convert 10-15% of its revenue into pre-tax profits.

Stable Margins

There’s a way of measuring a company’s margin stability. You can either look at operating margins or free cash flow margins. For companies without a lot of cash or debt, the free cash flow margin works fine.

You’ve seen me do this before. Basically, I look at a company’s 10-year average free cash flow margin. And I compare that to the standard deviation of the company’s 10-year average free cash flow margin. Standard deviation divided by mean gives us the (arithmetic) coefficient of variation. Or what I just call “variation.” A company like Omnicom could have pretty low free cash flow margin variation. Something like 0.30.

Some people have emailed me asking what an acceptable level of margin variation looks like. I wouldn’t think that way.

The number is meant to describe rather than prescribe. Calculate the free cash flow margin variation for every company you analyze. Then rank them from most stable to least stable. You’ll see patterns.

Generally – and this is just me speaking anecdotally here – you’ll find that stable margins correlate really strongly with a lack of price competition. Basically, if competitors have a hard time winning business from this company by lowering their prices – margins will be stable. If competitors have an easy time doing that – margins will be wobbly.

Margin stability isn’t necessarily correlated with market share. I don’t have market share data – so I can’t tell you how the two numbers relate. Relative market share (No. 1’s market share/No. 2’s market share) can give you hints that margins will be stable. Here’s how relative market share works. If you have a 50% share of the market and your nearest competitor has a 15% share, your relative market share is 3.33 (50%/15% = 3.33).

Relative market share can offer some clues about margin stability. But I’ve always wondered how much the connection between market share and profitability is really about market share leading to profits.

Profits are a pretty good indicator you are doing something right. And a profitable company gaining market share is hardly a surprise.

Japanese companies really got enamored with the idea that high market share leads to high profits. But do high profits lead to high market share?

Or more accurately, do some of the same things that cause high profits also cause high market share?

And stable margins.

I don’t know.

But I do know that some of the most stable margins come from companies that are in oligopolies. They are not necessarily the market share leader. And they are often one of about four companies who control anywhere from 50% to 95% of the market.

My own hunch is that the ability to maintain and gain market share without resorting to price competition is probably the best predictor of both long-term profitability and long-term market share. At least in industries where price competition is not intense.

Return on Equity

A wide moat and huge market share is no guarantee of extraordinary profitability.

Carnival (CCL) has 50% market share in the world cruise industry. Its nearest competitor - Royal Caribbean (RCL) - has 25%. And this understates the barriers to entry somewhat as Royal Caribbean uses much bigger ships. In other words, even if you wanted to challenge the No. 2 guy in the industry – he’s spending up to $1 billion or more on his biggest ships. Cruising is not an industry where it’s easy to make a small bet. Barriers to entry in the cruise business are insurmountable. The problem is not competition from new entrants. It's the ability to earn decent returns on capital. A problem that has plagued transport companies for hundreds of years.

Capacity is the question here. Carnival is not a great business. Probably never will be. But it is a wide-moat business. The question is whether the moat is protecting anything of value. But there's no question the moat will hold.

The question with Carnival – which has a lot of tangible assets – is whether the prices charged will be enough to earn a decent amount on the massive amounts of tangible capital employed.

This is why wide moat businesses with intangible assets are easier to analyze.

Companies like Dun & Bradstreet, Moody’s, FICO, and Omnicom don’t have to worry about their prices being high enough to justify their low asset turnover ratios.

Carnival has to worry about prices relative to assets and assets relative to prices.

When you consider how long some of those assets are in service – you can see how miscalculations regarding capacity can hurt you for a long, long time.

I don't believe in using margins to analyze companies in normal industries. Margins should be used when analyzing special businesses. Businesses that have managed to become islands of profitability separate from the economic mainland.

When a company has a history of extraordinarily high and stable free cash flow margins (as measured by the free cash flow margin itself and its 10-year, or longer, coefficient of variation) I think you can use margins. But only then. And it should be backed up with qualitative data.

Historical margins should only be relied on when analyzing wide moat stocks.

I would start with the idea of special. Meaning hard to replicate. Then I’d move on to the issue of moats. And finally to whether or not this is a good business.

But, if it’s not a special business, it’s not a business where you want to pay for sales.

For normal businesses, you only want to pay for tangible book value. Or better yet – net current assets.

Companies like Omnicom, FICO, Dun & Bradstreet, Moody's, Carnival, Nintendo (NTDOY), and Dreamworks are special. They can't be easily duplicated.

If you look at Nintendo's 30-year record, it has extraordinarily low operating margin volatility. This doesn't mean the industry economics can't change tomorrow and destroy the value in Nintendo. It just means that Nintendo mostly controls its own destiny within the world of video games provided the soft side of the industry is quite profitable. That last statement is what drives Nintendo's profitability, because ultimately it is the games and the profits on those games (made by Nintendo or royalties paid to Nintendo) that drive Nintendo's profits directly and its hardware sales indirectly. Again, this doesn't assume a dominant position. Nintendo is at best part of an oligopoly shared by Microsoft and Sony. However, historically, the video game business (not consoles, but the games themselves) have - like movies - been a place without much price competition. You compete on having hits. Not on pricing games. This applies only to the soft side of the business. In hardware, prices matter. So a company like Nintendo is a mixed breed.

Now, when I say wide moat I do not mean the company is in any way dominant in its industry. This is not necessary. I would consider Dreamworks to be a special business you can analyze along the lines of a wide moat business because it only engages in a specific entertainment niche where price competition is irrelevant. The business is hit driven. Not price driven. You try to beat your competitors on attendance – not on price.

The use of historical margins is appropriate only in situations in which a company can safely ignore a competitor's price cut. Nintendo is a complicated example. They can't ignore hardware price cuts. But the hard and soft sides of the business are inextricably intertwined. And it is the lack of price competition on the games themselves that has supported high returns on capital in the business.

If a company is subject to normal price competition, liquid assets (NCAV) or tangible equity should be used instead.

I vastly prefer the use of net current assets to tangible book value. I think tangible book alone is not very helpful except in situations where it is obvious an above average business is selling for below book. For average companies, it's sometimes hard to tell whether or not they should sell below book value. So price-to-book is a hit or miss strategy.

It works well in groups. But price-to-book is most useful when analyzing individual companies that you know are above average companies trading below book value. Those are obvious bargains.

I do agree with you, however, that where it is necessary to take competitor actions into consideration – where a company does not control its own destiny – it is a bad idea to rely on historical margins.

In those situations, I would use net current asset value or tangible book value to analyze the stock.

The price-to-sales ratio approach is meant for special businesses.

Not normal businesses.

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About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.0/5 (29 votes)

Comments

onthefringe
Onthefringe - 2 years ago


I say this as an investment novice... But I've really liked these posts as of late.
onthefringe
Onthefringe - 2 years ago
Revisiting this article. Love this article. May post print it out and hang it on a plaque next to my desk. Two sections in particular:

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