A Brief Note on Profit Margins
Why the market pays a disproportionate premium for sustainable margin expansion, what the margin can tell you about the moat, and why I think the operating margin is supreme
This post is an expansion of a concept that was first mentioned to me by Leviathan Capital over on Twitter. That concept was roughly, “Where the margin is going matters more than where the margin is.” I feel like this concept doesn’t get quite enough attention, and I think profit margins in general are much more useful for analysis than they might appear at first glance.
Where the margin is going matters more than where the margin is — the market already knows where the margin is. But an increase in the margin will increase earnings not just in the immediate year, but in every coming year assuming other factors are held equal, which affects discounted cash flow valuations in a big way.
Let’s look at an extremely basic example, comparing two firms with constant sales and gross margins, and slightly different operating lines. Company ABC below makes a 20% operating margin on $100 in annual sales. Assuming earnings are taxed at 20%, they make $16 in income annually (we are also assuming all earnings are converted to cash flows and paid to investors which is not realistic at all, but for this example, it gets the point across).
We are using a 10% discount rate on Company ABC’s earnings, and we can see that $16 in annual earnings over 6 years gives a present value of $69.68. Now, let’s take a look at a similar company, Company XYZ, that implements cost controls to grow it’s operating margin by 1% annually.
When discounted at the same 10% rate, the present value of earnings from Company XYZ over 6 years is 11% higher than that of Company ABC, even though their operating margin only increases by a single point every year.
Say you’re looking at this series of earnings in Year 2. Should Company XYZ really be valued 11% higher than Company ABC because their operating margin is higher by 1%? If XYZ’s cost controls and margin expansion are sustainable through to Year 6, absolutely.
This is why the market is often willing to place an immediate premium on the prospect of margin expansion. When you discount future cash flows at incrementally higher margins, the present value of those cash flows can change meaningfully.
Similarly, margin erosion can be absolutely crushing in the same way. You may notice the share prices of public companies underdoing even minor margin erosion dramatically correct down, because the market is extrapolating those depressed margins forward for every coming year.
So; future profit margins matter more, but today’s profit margins can still be very useful for analysis. Where the margin is today can tell you things about operating efficiency and how strong the company’s moat is (pricing power and ease of providing the product or service). In my experience these are best looked at on a case by case basis, so lets walk through some examples:
Interactive Brokers, IBKR 0.00%↑;
A brokerage business with a 70%+ operating margins due to automation (ease of providing the service) and majority interest income at 90%+ margins, even though the firm almost completely lacks any pricing power. This case study is extremely interesting to me, and IBKR is one of my favorite businesses to study due to this reason; they have no pricing power but still retain royalty-like profit margins and have demonstrated margin expansion, thanks to the impact of extreme automation, which speaks to the company’s moat. Competing brokers have half the profit margins if they’re lucky.
The ultra-high margin interest income IBKR earns is the product of lending, which requires capital and an intelligent risk management framework, both of which IBKR have. If you can largely automate such a lending process like IBKR has, congratulations, you’ve developed a machine that literally prints money. IBKR is only enjoying these margins today because they’ve spent decades building the global infrastructure that supports this system, a system that would be tricky, time intensive, and operationally intensive to replicate, which all speak to the company’s moat.
Intercontinental Exchange, ICE 0.00%↑;
ICE is a diversified exchange business with a 45%+ operating margin due to a few factors. Firstly, exchanges across the board calculate revenues net of transaction related expenses, which leads to 100% GAAP gross margins. Secondly, the company has a large business selling software and data services connected to the exchange, which are higher margin than transactional income.
Fair Isaac Corporation, FICO 0.00%↑;
FICO, the credit score business with 90% operating margins on Scores. This is, frankly, an absurdly high margin. This is possible because Scores is really just an IP licensing business, as pointed out by Bristlemoon Capital in their FICO report. IP licensing might as well be a royalty, where COGS are almost nonexistent and the company earns nearly pure income from the licensing fees. This factor speaks to FICO’s moat, its near-monopoly and deeply entrenched position within the credit ecosystem. Any competitors that could come after FICO’s extremely high margins would have already, if it were feasible. FICO bulls would tell you that it’s not so feasible.
We’ve seen examples of high margins, now let’s look at some lower margins.
Waste Management, WM 0.00%↑;
Instead of the above examples where earnings are generated through automated lending, platform effects, and licensing income, WM makes money out there in the real, physical world, by collecting trash. WM gets paid to collect trash, then they extract and sell recyclables, and natural gas generated by decomposing trash.
WM makes about a 17% operating margin, which is much lower than any of the previous three examples due to the physical nature of it’s earnings. Physical assets like garbage trucks need employees to drive them, they need fuel, they need repairs, and they depreciate in value faster than intangible assets, like a piece of software or an IP asset.
Still, a 17% operating margin on such an asset intensive business that relies on depreciable physical assets like garbage trucks and landfills is an impressive feat, which speaks to the company’s high moat; they own more landfill space than any other garbage company, and there are environmental and regulatory barriers to constructing any new landfills. They also enjoy dominant market share in US waste management, which gives them pricing power on their trash collections.
The point I’m trying to make here is that today’s profit margins can tell you a lot about a company’s revenue/income sources and how strong the competitive moat is. For services and operations companies, higher margins generally equal higher moats, vice-versa for lower margins.
Let’s explore the inverse of this principle though, by looking at a low-margin retailer with a very high moat: Costco, COST 0.00%↑.
Costco makes an operating margin just under 4%, which is much lower than any example so far. Yet, Costco still has a very strong competitive moat and enjoys dominant market share in retail wholesale. In the case of retail companies, higher sales and earnings are driven by higher market share, which is driven by delivering lower prices to consumers than competitors. Somewhere between higher market share and lower prices, you can generate a positive margin trend as Costco has done in recent years.
Next, I want to make a case for the operating margin as the supreme law of the land when it comes to investing in services companies, which are primarily what I invest in.
Operating income represents all income from the core operations of the business. It does not include any corporate-side interest expense, it doesn’t include taxes, and the only non-cash items that are included are depreciation and amortization, and maybe stock-based compensation expense.
Compare this to the income margin; GAAP net income can include any number of non-cash and non-operating costs or gains that skew a company’s true earnings power.
For example, a few quarters ago Google beat consensus earnings (income) estimates with help from an unrealized gain on their SpaceX investment. That is a non-cash gain that will probably not be converted into cash anytime soon, so functionally, it might as well not be real cash flow for investors.
These GAAP fair value changes can swing the opposite way. This past quarter Crocs marked down the value of their HEYDUDE brand after it performed poorly (they acquired HEYDUDE in 2021). This led to massive GAAP losses on their income line, even though the company maintained positive operating income and generated significant cash that quarter.
At least on the income statement, the operating margin is what you want to watch in my opinion. I would even venture to say that operating income can be a better, smoother metric to track than free cash flow in certain cases.
Free cash flow is affected by numerous up and down swings that are far past the operating line, such as working capital changes, and capital expenditures. In my experience, this leads to free cash flow being a much more volatile metric in general than operating income. If a firm needs to replace certain assets every 5 years and invest in new ones, their free cash flow margin will decrease that 5th year, while the operating margin remains unchanged.
Now, technically, free cash flow is much more important than earnings power, because investors are paid with cash, not earnings. But still, if you want to track and measure core earnings power, I think the GAAP operating margin is ideal.
A lot of companies these days quote EBITDA margins, which are just operating margins with depreciation and amortization added back to operating income. In my opinion, this metric has lower signal than the operating margin, because depreciation and amortization are generally important expenses.
Some software companies will capitalize and depreciate sales commissions, for example. Sales commissions are a real expense and are required to grow revenue. It makes sense than they could be capitalized for multi-year contracts, but ignoring the resulting depreciation is a mistake in my opinion. The EBITDA margin might lie to you about how profitable the business truly is in cases like this.
Similarly, for physical operations companies, depreciation is probably more important still, as physical assets suffer constant wear and tear and degrade in quality round the clock. Eventually, the company will have to invest to replace or maintain these assets, which will consume cash and decrease cash flow to investors, so depreciation is a relevant expense that ought to be included in earnings metrics.
As I said above with the margin vs. moat section, everything here ought to be taken on a case by case basis. No two companies are alike, even companies in the same industry can have massive differences in operations, profitability, and growth. There are cases where depreciation and amortization should be stripped out, and the EBITDA margin is more important. Similarly, there are also cases where the operating margin may be misleading if a company has a high level of interest expense or other re-ocurring non-operating costs.
Free cash flow is the most important metric for investors, that's how investors get paid at the and of the day. But I’d argue that the humble operating margin can make a good proxy for free cash flow with lower volatility, which is why it is my personal favorite metric to watch.