Margins, Efficiency, and the DuPont Formula, Part 1

I recently read an interview with Jeff Bezos (CEO of Amazon.com) where he talks about margins, and it got me thinking about how companies differ across industries and whether their margin is connected to their efficiency.

The quote is as follows:

"There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins."

Later he says:

"We think it’s a unique approach in the marketplace—premium products at nonpremium prices. We’re a company very accustomed to operating at low margins. We grew up that way. We’ve never had the luxury of high margins, there’s no reason to get used to it now."

I agree with Jeff -- high margins are a luxury.  In a free market economy, companies with high margins should be rare, because new competitors should appear with lower margins which will undercut the high margin players.

However, high margin companies exist.  I can think of at least  a few reasons why:

1.            Monopolies protected by government regulations.  Historically, the telephone companies are a good example of this in Canada, as are the cable TV companies.  They are regulated by the CRTC and therefore can charge atypically high margins for their services as long as the government approves them.  Competition is not allowed under a government imposed monopoly.  In recent years, some competition has being permitted in the phone industry, but the CRTC still regulates some pricing and still limits competition by way of preventing foreign-owned companies from entering the market.  Think of Bell or Rogers.

2.            Successful marketing of luxury brands.  Some companies  succeed at marketing their brand as being higher quality than their competitors, and therefore some customers are willing to pay higher prices.  Because most people are unwilling or unable to pay for these high priced products, they become luxury status symbols for the few who can afford them.  Think of Porsche or Mazerati.

3.            Complex professional services.  Certain areas of expertise that require years to obtain can command high prices for their services.  While there is competition in these professional services industries, all the competitors tend to keep their margins high and compete on niche expertise  or reputation.  Think IT consulting firms or law firms.

But do high margins translate into higher profits?  I did a quick and unscientific sampling of a few companies with widely varying margins, and the answer appears to be a resounding NO.

I reviewed 8 companies from different industries that I chose arbitrarily and graphed their operating margin and their net income per share from their latest published annual reports.  The results are shown below.

Clearly, high margins (those companies at the far right of the graph) do not always translate into high profits (top of the graph).  In fact, the highest profit per share is from one of the low margin companies in my survey.

The 8 companies I chose are listed below.

Company	Fiscal Year	Industry	Operating Margin	Net Income/Share
Rogers Communications Inc.	2010	Telecomm	38.0%	2.65
BCE (Parent of Bell)	2010	Telecomm	39.8%	2.85
Sears Canada	2010	Retail	38.4%	1.40
Indigo	2011	Retail	40.6%	0.46
Amazon.com	2010	Online Retail, Computing Services	22.3%	2.58
Walmart	2011	Retail	24.7%	3.72
Loblaw Companies Ltd.	2010	Grocery	4.1%	2.45
Empire (Parent of Sobeys)	2010	Grocery, other	5.0%	4.51

(Net income per share is in $CDN, except for Amazon and Wal-mart which are in $US.)

The two telecomm companies, Rogers and Bell (BCE), both have high margins and reasonably high profitability.  However, two large retailers, Sears and Indigo, also have high margins but much lower profitability.  In fact, Indigo has the highest margin of these 8 companies and the lowest net income per share.  The grocery retailers, Loblaws and Sobeys (Empire) have significantly lower margins, but still manage to generate strong profits.  Empire has the highest profitability among these 8 companies despite its low margin.

So clearly high margin does not guarantee high profit.  So why does margin appear to be unrelated to profit? 

Variation in cost efficiency is one possibility.  If the margin is high and profit is low, then there must be a lot of expenses that are eating up that revenue.  If margin is low and profits high, then there must be high sales volumes and low expenses, which is how Amazon.com has built up its business.

Comparing cost efficiency across companies is difficult however, and cost efficiency is not the only factor that affects net income per share.  For instance, the denominator (share equity) could be causing some of the differences.  Number of shares alone could affect that measure.  Return on Equity takes the total equity value of the company instead of a single share value, so that may be a fairer comparison.

But even Return on Equity is driven by many factors, so it's challenging to compare companies' performance.  That's where the DuPont Formula comes in handy.  It takes the Return on Equity and breaks it into its component parts.

(Continued in Part 2.)