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What Gross Margins Can Tell You About a Company’s Economic Moat

April 17, 2014 | About:

Value Investors love to quote Saint Warren about “Economic Moat” (moat).

In business, I look for economic castles protected by unbreachable ‘moats’.

The simplest way to think about the company’s moat is to ask how easy it would be for another company to steal business from them.

You keep a knockin’ but you can’t come in

Companies with a moat do have competition. However, try as they might, the competition just can’t break through. This can happen for a variety of reasons:

  • Geography: We have our stuff in the right places and you don’t.
    • Example: Union Pacific Railroad
  • Infrastructure: We move our stuff faster, cheaper and more reliable than you.
    • Example: Visa (V) or MasterCard (MA)
  • Patents: Even if you wanted to, you legally can’t do what we do.
    • Example: Apple (AAPL)
  • Branding: We are trusted to do the job and you’re not.
    • Example: Coke (KO)
  • Economies of Scale: We’re so big, not using us will cost you.
    • Example: Wal-Mart (WMT)

A company with a moat has a combination of these traits.

That doesn’t mean that these companies can do whatever they want. It also doesn’t mean their moats are impenetrable.

  • Union Pacific Railroad still has to compete with trucks.
  • Visa and MasterCard compete against cash, PayPal, Bitcoin etc.
  • Apple’s patents are constantly challenged and becoming obsolete at a rapid pace.
  • Coke can easily fall out of favor. Remember New Coke?
  • Wal-Mart is in a constant price war with Target and other retailers.

But it still makes life easier when you have a moat. So as an investor, how do you figure out who has a moat and who doesn’t?

The first place I look at is Gross Margin.

Quick Look at Gross Margin

The formula for gross margin is simple:

Gross Margin = Revenue – Cost of Sales

To be able to compare companies, we prefer to use a percentage. The formula becomes:

Gross Margin % = Gross Margin / Revenue

What does Gross Margin Tell us?

I see gross margin as being the economic value added by a company. It is the increase in value a company created by taking inputs into its processes.

Think about what companies do.

They take a bunch of materials and worker’s time, mix it up and resell the finished product.

Apple takes parts such as microchips, glass, metal casings, employee time, and puts them together to create something worth more than they were worth before.

The price you pay for the inputs (COS) is Apple’s economic value. On the flip side, the price the very same inputs are sold (revenue) for is the new economic value.

All you did was mix them up.

The higher the revenue, the more economic value the outputs have.

The higher the gross margin, the higher the amount of economic value is added.

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What Does This Have to Do with Moats?

A company with higher gross margins is been able to do two things:

  1. Create value for their customers
  2. Keep that value away from their suppliers

A company only charges a premium price if the customer is willing to pay it. The customer has to feel that they are better off with the product than they are with the cash.

Additionally, that value has to be special. If a competitor can replicate the value added, then the product becomes a commodity and it becomes a price battleground.

On the other side, if the company in’t a strong player in the market, suppliers can have a stronger position. In the world of business, you see suppliers pick and choose who they sell to which can raise prices for their own benefit.

When Apple was the only smartphone game in town, it could dictate to suppliers how much they would pay to have their iPhones made. Now, it’s easier for suppliers to ditch Apple and switch their business over to making Samsung phones.

It isn’t very easy, but easier.

Go look up AAPL’s margins since 2012 and you’ll see what I mean.

Apple Gross Margin

Margins are starting to erode as competition arrives | Source: Old School Value

What to look for:

When I look at gross margins, the first think I look for is consistency.

I usually value consistency even more than I value high margins. A high margin attracts competition and with competition comes smaller margins. The stability of the margin shows that the company is able to withstand competition and economic cycles and maintain itself.

Ask yourself: Do the margins look pretty close year over year?

Look at Wal-Mart (WMT) using the OSV Stock Analyzer tool. Click on the image to enlarge.

Wal-Mart Consistent Gross Margins

Wal-Mart Consistent Gross Margins | Click to enlarge

There is only a 1.7% swing between the high and low gross margin value. That is a VERY tight range.

This indicates that Wal-Mart is able to maintain its relationships with its customers and its suppliers (remember the input output image above?).

Consistency also means predictability.

A company that is predictable earns a lower discount rate in my valuations. Thus, I’m willing to pay more for the company’s cash flows.

On the contrary, a company with wild swings in cash flow requires a much larger discount rate.

See what I mean with Walter Energy (WLT).

Walter Energy Gross Margin

WLT has some wild swings in its margins. When you look at their business, they are price takers for the most part. They cannot dictate the prices they charge.

There is no moat.

Such a Simple Measure that Gets Overlooked

Gross Margin is a powerful tool in determining how strong a company’s Economic Moat is. It shows you whether the company is creating value for society and whether it’s able to reap the benefits of that value.

Key Point: Consistency is key with gross margins.

Stable margins = stable business.

Disclosure

Long AAPL. No other positions at the time of this writing

About the author:

Jae Jun
Founder of Old School Value (http://www.oldschoolvalue.com) dedicated to offering the most complete and detailed stock valuation and analysis spreadsheet. Investing made easy by importing 10 years of financials and 5 quarterly statements directly to excel for your analysis needs. Save time, make smarter decisions and make more money.

Visit Jae Jun's Website


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Comments

batbeer2
Batbeer2 premium member - 3 months ago

I see gross margin as being the economic value added by a company. It is the increase in value a company created by taking inputs into its processes.

McLane, the largest subsidiary of Berkshire Hathaway, has razor-thin margins. For the sake of this discussion I'll assume McLane slaps a 10 cent charge on a $2 bottle of Coca-cola for delivering it to a retail location. That's a 5% gross margin.

McLane recently acquired Kahn ventures. That company distributes liquor. Let's say McLane also slaps a 10 cent charge on a bottle of whisky with a wholesale price of $50. In case you thought 5% gross margin was bad, we're now talking 0.2% gross margin.

Because they now distribute whisky too, McLane's gross margins are lower. Do McLane's delivery trucks add less value now that they also carry whisky?

Has Berkshire eroded its moat by acquiring Kahn Ventures?

Not everything that can be counted counts. - Einstein

swnyc2
Swnyc2 - 3 months ago

Batbeer2,

I thought the article made a lot of sense -- until I read your comment!

So, is your point that this metric is not helpful at all?

Or, are you trying to show it's usefullness is limited? If so, how do you use it?

batbeer2
Batbeer2 premium member - 3 months ago

>> Or, are you trying to show it's usefullness is limited?

Yes

>> If so, how do you use it?

I've been trying to figure that one out for years.

So far, I've come to think it is important to spot differences between margins of competing companies (say McLane and Sysco). Not only the gross margin but also operating margin etc. If you could somehow isolate the amount of money Sysco spends on fuel for their trucks and you could do the same for McLane, then I think that will tell you which one is more efficient. To do that, the first thing you would want to do is "throw away" COGS. It is such a large chunk of the cost that it smothers all the other information.

For now I use anomalies in margins as a starting point to figure out if a specific company has some advantage.

Take Progressive. It has 18% cost of underwriting (overhead). For auto insurance, overhead is a relatively large fraction of cost (many small transactions as compared to say life insurance).

Allstate runs at 25% or so. That's interesting. At first glance, it seems Progressive could undercut Allsate by 7% and still make a profit. There are other differences but it seems like an interesting starting point for further analysis.

Michelin's margins are more stable than Goodyear's. If you look into it, you'll find Michelin sells more tyres to drivers while Goodyear sells more tyres to factories. The former is less cyclical. This alone does not mean the one is better than the other. They're different.

In short, after years of pondering this problem, all I can say is that differences in margin are an interesting starting point for further analysis. It doesn't seem like a lot of progress but I think I have some ideas about what gross margin doesn't tell us.

Thanks for some good questions! You made me think.

Gammastyle
Gammastyle - 2 months ago

I think you make the point. What is McLane's moat? If they are driving stuff around, what makes them so special that anyone couldn't do it? That is why thier margins are so thin. They don't have much of a moat around what they do.

The other point is that you have to look a consistency of the margins. If margin are small and stable, then you can be protected by being a low cost provider. Margins that swing wildly are subject to outside forces and cannot be controlled by the company. That is an indication of not having a moat.

batbeer2
Batbeer2 premium member - 2 months ago

>> If they are driving stuff around, what makes them so special that anyone couldn't do it?

Lower cost.

Imagine two guys delivering newspapers. The guy delivering papers to half the homes in the street can charge less per paper delivered than the guy delivering papers to 10% of the homes. The second guy has to walk/cycle/drive the length of five streets to do the same work as the first guy.

McLane is the same but on a very large scale. They deliver thousands of SKUs to thousands of small shops and generate enormous efficiencies by planning their routes efficiently.

So McLane may have slim margins, but you are never going to enter that business. They can do what they do at a lower cost than you could ever hope to.

In other words, it does not matter if you charge $200 for a days work delivering cat litter or $200 for a days work delivering cigarettes. The former has much higher gross margins. If, after reading this, you still believe delivering cat litter is inherently more profitable than delivering cigarettes, then I fear I will never be able to explain to you the concept of a moat.

P.S.

If you like high-margin stable businesses, maybe you like GNI. That company has net margin of more than 75%. By the way, the added value of GNI is slightly less than 0. The world becomes more efficient the day GNI ceases to exist.

I could find you another dozen examples of companies that don't add any value but have margins far in excess of companies like Coca-cola, Google or for that matter Johnson & Johnson. More stable too. If you're really interested in understanding this, I suggest you go looking for some examples yourself. It should be pretty easy to find companies that have higher margins than google but on the face of it, add far less value.

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