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Subject: Margins and Profitability rss

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Chad Ellis
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Our recent thread about the gross margins allowed to insurance companies under Obamacare made me think that a primer on margins and profitability might be useful, especially since a lot of "true but meaningless" statements were cropping up, e.g. "X is one of the least profitable businesses" based on net margins.

First, some quick-and-dirty definitions:

Gross margin is gross profit (which is sales less the cost of goods sold) divided by sales. COGS includes things like direct labor that goes into making a product plus everything bought for that product.

Operating margin is like gross margin but the numerator also subtracts the costs that aren't directly related to product generation. Admin, sales, things like that.

Net margin is the final profit attributable to shareholders divided by revenue. Taxes, interest expense and various other expenses that weren't included earlier are included here.

Now, what is a "good" margin and how does margin relate to profitability?

At the end of the day, there is virtually only one profitability ratio that matters, and it isn't a margin ratio; it's risk-adjusted return on investment. Investors put up capital and what they care about is how much money they get back. Risk affects how much of that capital can be structured as debt and how high a return is necessary to justify debt and equity investments, but once that's accounted for all that really matters is the return.

Here's a simple illustration of why margin in and of itself is meaningless. Company one and company two have comparable risk profiles.

Company one requires an investment of $100 million to get started and then has the following:

Sales: $100 million
Net Income: $10 million

Company two requires an investment of $10 million to get started and then has the following:

Sales: $1 billion
Net Income: $5 million

Company one has a 10% margin; company 2 has a 0.5% margin. But from an investor's perspective, company two is massively more profitable -- each year it returns 50% of the money that was spent creating it while company two returns only 10%.

Obviously gross, operating and net margins can be useful measures in understanding a business and in making comparisons between similar operations. But just looking at a margin and saying it's "high" or "low" is likely to be wrong.

First of all, how a company's financial statements are structured can have huge implications for margins. I used to cover a company called Johnson Matthey, which had broad involvement in the world of platinum. One of its activities was acting as a broker to platinum mines, but it also manufactured things like catalytic converters for cars.

Johnson Matthey had tiny margins. Why? Its brokerage business financial statements treated its business as though it bought all the platinum it brokered and then sold it. So if it had a commission of X% and sold $100 worth of platinum it recorded revenue of $100 and COGS of $(100-X) rather than revenue of X, as a regular broker might. This enabled it to keep its financial statements somewhat opaque but clearly didn't make the business actually less profitable.

Are game stores less more profitable than grocers? You might think so if you looked at gross margins. Your FLGS probably has a gross margin of close to 50%, while a grocer's margins are in the single digits. The difference is more than made up for in stock turnover. From memory, a grocer typically sells its goods within a week (on average), while games can stay on the shelves for months. Not only does this mean that lots more sales can take place per dollar spent on operating costs (e.g. rent, staff) but it also means that the investment required for a grocer is much lower because it actually has negative working capital. A store pays for its inventory; a grocer (who sells something for cash a week after it arrives and pays 30 days after it arrives) has his inventory more than fully financed by his vendor.

That brings us to whether it's reasonable for the government to cap gross margins for medical insurers at 20%. First off, there's the obvious argument that the government should never try to set margins; that's the sort of thing that markets are much better at than governments so whether you're a utilitarian or a libertarian when it comes to government power this should be an area for skepticism. Then there's the question of whether 20% is adequate.

I'm not expert enough to discuss the 20% number, although it doesn't seem unreasonable to me based on the financial statements I've read. I'd like to talk about the rationale for setting a margin limit at all.

The insurance industry has considerable economies of scale; as a result of that, and in a national market with exchanges and substantial government involvement it is likely (IMO) that virtually all medical insurance will be provided by a relatively small number of companies. In that environment (i.e. one with substantial barriers to entry) there is a natural risk of collusion, either explicit or implicit, to fix prices. Coke and Pepsi avoid price wars, cereal manufacturers were extremely profitable for years because they kept prices high through an unofficial agreement. Margins could gradually drift upwards with campaign contributions and the lack of ability most people have to understand financial statements making it unlikely that there would be a way to block the collusion.

As an aside, the regulation I'd really like to see considered would require insurance companies (of all kinds) to pay claims on a time-adjusted basis. Currently if you have a $1 million claim and the insurance company's cost of capital is 10% (just to use easy numbers) it is profitable to them to delay paying you for a year by spending anything up to $100K on legal fees to challenge your claim in court. That is, even if you win and even if you're awarded legal fees they were better off fighting you as long as the total legal bill isn't more than their cost of capital times the judgment. This is a huge incentive to delay payments.
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The Steak Fairy
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This should have been a blog post.
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Chad Ellis
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If I had a blog about general MBA stuff it would have been.
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Mac Mcleod
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I read up on this last time and insurance company accounting is different as they are service companies.

Interesting point on delaying payment.
I really want some way to incent insurance companies to be less evil.
 
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Bojan Ramadanovic
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So Chad - is it the case that risk adjusted ROI is actually relatively flat across most established businesses in western world ?

Short of public euphorias such as FB and such it seems to me that investing in a blue-chip health insurer is about as "profitable" a venture as investing in any other blue-chip out there.

I am not efficient market guy - but it does seem to me that company profits are one area where market is actually somewhat efficient...

(If so of course, then any government regulation of profitability would be pointless).
 
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bramadan wrote:
So Chad - is it the case that risk adjusted ROI is actually relatively flat across most established businesses in western world ?

Short of public euphorias such as FB and such it seems to me that investing in a blue-chip health insurer is about as "profitable" a venture as investing in any other blue-chip out there.

I am not efficient market guy - but it does seem to me that company profits are one area where market is actually somewhat efficient...

(If so of course, then any government regulation of profitability would be pointless).


Profit margins in some business are tighter in some industries. In the food distribution industry we run 4-7%. Technology runs higher.

http://finance.yahoo.com/q/ks?s=IBM+Key+Statistics
Profitability
Profit Margin (ttm): 15.01%
Operating Margin (ttm): 20.60%

vs
http://finance.yahoo.com/q/ks?s=WFM+Key+Statistics
Profitability
Profit Margin (ttm): 3.70%
Operating Margin (ttm): 5.99%


Likewise dividend payments from 0% to 15% based on profitability.

Part of it is the risk and volatility.
 
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Chad Ellis
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Drew1365 wrote:
Well, the average profit margin for health insurance companies hovers around 4%. So one could conclude not just that the government has no business capping the margin, but that it's a meaningless gesture in the first place.


That's net margins, which are naturally much lower than gross margins.

Quote:


This article is repeating one of the true-but-meaningless stats the OP is trying to address; that health insurance (or any industry) can be considered "least-profitable" on the basis of Net Margins (or any other measure of margins).
 
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Chad Ellis
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Drew1365 wrote:
Which groceries? If we're talking about fresh meat and produce, then the margins need to be high because of the potential for spoilage. It can be lower for product that does not need to sell as quickly, but because everything you find in a store has a "sell by" date, the clock is ticking on every item you stock. Some items are sold at a loss to bring in business (that coupon flyer in your local paper) but I suspect the profit margin in the grocery business is, on average, about 40%.


You're right (or at least the truth is between us); according to Whole Foods the industry average is 25% gross margins. Not 40%, but also not single digits. I'm not sure what I was remembering -- perhaps a particular section of the store. Also, gross margins (unless I'm mistaken) generally include losses from expiration, etc.

Quote:
Quote:
The difference is more than made up for in stock turnover. From memory, a grocer typically sells its goods within a week (on average), while games can stay on the shelves for months.


Er . . . not always, and it depends. See above. But again, because every item has a "sell by" date, every item also has a greater potential loss tied to it than other retail businesses.


I'm off here as well; again according to Whole Foods, the industry average for stock turns is 16X, which is more like once every three weeks than every week. It's still faster than most retail businesses, which allows for lower gross margins than average retailers.
 
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Drew1365 wrote:
Chad_Ellis wrote:
This article is repeating one of the true-but-meaningless stats the OP is trying to address; that health insurance (or any industry) can be considered "least-profitable" on the basis of Net Margins (or any other measure of margins).


Why is it meaningless?


It's not how you measure the health of an industry. It's entirely possible to be very profitable in terms of return on investment and yet have low margins or to be awful in ROI and have high margins.

Quote:
Don't you think the enormous cost of Medicare fraud is meaningful?


Yes, but it's not the topic I'm addressing in this thread.
 
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Chad Ellis
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Agreed, but their annual report includes stats for the industry average, which is what I was citing. That's always a bit risky, but should be accurate enough for a general discussion.
 
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Insightful analysis. If we had signatures, you could post a link to that in your sig so that economic discussions need not break down over ignorance of basic financial literacy.
 
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For any sort of technology services work (software) - we aim for 30% gross margin on the work itself. We genaerally get it - hitting around 32-33%. I cant say on net margin since i do not have access to corporate costs which would go againt the gross margin.
 
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Drew1365 wrote:
Chad_Ellis wrote:
Drew1365 wrote:
Which groceries? If we're talking about fresh meat and produce, then the margins need to be high because of the potential for spoilage. It can be lower for product that does not need to sell as quickly, but because everything you find in a store has a "sell by" date, the clock is ticking on every item you stock. Some items are sold at a loss to bring in business (that coupon flyer in your local paper) but I suspect the profit margin in the grocery business is, on average, about 40%.


You're right (or at least the truth is between us); according to Whole Foods the industry average is 25% gross margins. Not 40%, but also not single digits. I'm not sure what I was remembering -- perhaps a particular section of the store. Also, gross margins (unless I'm mistaken) generally include losses from expiration, etc.


Whole Foods is probably not the best measure of the grocery business. That'd be like going to Restoration Hardware for a measure of the home-improvement store business.


They are currently recommended as a superior investment. They have extremely high sales per square foot and vertical integration in their areas.
 
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Chad_Ellis wrote:
...As an aside, the regulation I'd really like to see considered would require insurance companies (of all kinds) to pay claims on a time-adjusted basis. Currently if you have a $1 million claim and the insurance company's cost of capital is 10% (just to use easy numbers) it is profitable to them to delay paying you for a year by spending anything up to $100K on legal fees to challenge your claim in court. That is, even if you win and even if you're awarded legal fees they were better off fighting you as long as the total legal bill isn't more than their cost of capital times the judgment. This is a huge incentive to delay payments.
This also touches on another way that a business, such as a managed care organization, can rake in piles of cash: By keeping your money on the books for as long as they can, while cutting the check at the very last second, in order to preserve any interest payments they can squeeze out of the accounts. You would be surprised at how long it took insurance companies to figure out how much money could be made simply by better managing the vast amounts of cash they have in their systems.

 
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maxo-texas wrote:
Drew1365 wrote:
Chad_Ellis wrote:
Drew1365 wrote:
Which groceries? If we're talking about fresh meat and produce, then the margins need to be high because of the potential for spoilage. It can be lower for product that does not need to sell as quickly, but because everything you find in a store has a "sell by" date, the clock is ticking on every item you stock. Some items are sold at a loss to bring in business (that coupon flyer in your local paper) but I suspect the profit margin in the grocery business is, on average, about 40%.


You're right (or at least the truth is between us); according to Whole Foods the industry average is 25% gross margins. Not 40%, but also not single digits. I'm not sure what I was remembering -- perhaps a particular section of the store. Also, gross margins (unless I'm mistaken) generally include losses from expiration, etc.


Whole Foods is probably not the best measure of the grocery business. That'd be like going to Restoration Hardware for a measure of the home-improvement store business.


They are currently recommended as a superior investment. They have extremely high sales per square foot and vertical integration in their areas.


They are also more furniture store than home improvement store, but that's neither here nor there.
 
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Chad_Ellis wrote:
Agreed, but their annual report includes stats for the industry average, which is what I was citing. That's always a bit risky, but should be accurate enough for a general discussion.


But that doesn't work to undermine your point!

Thanks for this, I was wondering if someone would post this kind of clarification, all while being too busy and lazy to do it myself.
 
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fightcitymayor wrote:
This also touches on another way that a business, such as a managed care organization, can rake in piles of cash: By keeping your money on the books for as long as they can, while cutting the check at the very last second, in order to preserve any interest payments they can squeeze out of the accounts. You would be surprised at how long it took insurance companies to figure out how much money could be made simply by better managing the vast amounts of cash they have in their systems.


Delayed payment and exploitation of float are not topics for an MBA blog.
 
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out4blood wrote:
Insightful analysis. If we had signatures, you could post a link to that in your sig so that economic discussions need not break down over ignorance of basic financial literacy.


Economics and Finance are closely related, quite obviously, but having a narrowly focused discussion of either's abstruse workings is entirely possible without referencing the other's. I know, for example, far more about Finance than I do about Economics. That is because Finance makes money for me, while Economics is some tedious horseshit invented by Adam Smith and mutated by some unnamed Austrians. Just kidding! Economics makes plenty of money for me, too.
 
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MisterCranky wrote:
out4blood wrote:
Insightful analysis. If we had signatures, you could post a link to that in your sig so that economic discussions need not break down over ignorance of basic financial literacy.

Economics and Finance are closely related, quite obviously, but having a narrowly focused discussion of either's abstruse workings is entirely possible without referencing the other's. I know, for example, far more about Finance than I do about Economics. That is because Finance makes money for me, while Economics is some tedious horseshit invented by Adam Smith and mutated by some unnamed Austrians. Just kidding! Economics makes plenty of money for me, too.

Hey, let's pretend I actually meant "economic" as an adjective, instead of "economics" as a noun.
 
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I'd rather pretend you said "financial discussions."
 
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How about "asinine discussions?" Does that work better?
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BGG needs both an Accounting and an Economics FAQ.

People in general (including plenty of BBGers) tend to assume they know a lot more about both disciplines than they actually do.

http://en.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effect

 
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djgutierrez77 wrote:
maxo-texas wrote:
Drew1365 wrote:
Chad_Ellis wrote:
Drew1365 wrote:
Which groceries? If we're talking about fresh meat and produce, then the margins need to be high because of the potential for spoilage. It can be lower for product that does not need to sell as quickly, but because everything you find in a store has a "sell by" date, the clock is ticking on every item you stock. Some items are sold at a loss to bring in business (that coupon flyer in your local paper) but I suspect the profit margin in the grocery business is, on average, about 40%.


You're right (or at least the truth is between us); according to Whole Foods the industry average is 25% gross margins. Not 40%, but also not single digits. I'm not sure what I was remembering -- perhaps a particular section of the store. Also, gross margins (unless I'm mistaken) generally include losses from expiration, etc.


Whole Foods is probably not the best measure of the grocery business. That'd be like going to Restoration Hardware for a measure of the home-improvement store business.


They are currently recommended as a superior investment. They have extremely high sales per square foot and vertical integration in their areas.


They are also more furniture store than home improvement store, but that's neither here nor there.


???? They sell food. I don't even get your comment as a non-sequitor.
Are you talking about Whole Foods Market the grocery store chain?
 
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maxo-texas wrote:
djgutierrez77 wrote:
maxo-texas wrote:
Drew1365 wrote:
Chad_Ellis wrote:
Drew1365 wrote:
Which groceries? If we're talking about fresh meat and produce, then the margins need to be high because of the potential for spoilage. It can be lower for product that does not need to sell as quickly, but because everything you find in a store has a "sell by" date, the clock is ticking on every item you stock. Some items are sold at a loss to bring in business (that coupon flyer in your local paper) but I suspect the profit margin in the grocery business is, on average, about 40%.


You're right (or at least the truth is between us); according to Whole Foods the industry average is 25% gross margins. Not 40%, but also not single digits. I'm not sure what I was remembering -- perhaps a particular section of the store. Also, gross margins (unless I'm mistaken) generally include losses from expiration, etc.


Whole Foods is probably not the best measure of the grocery business. That'd be like going to Restoration Hardware for a measure of the home-improvement store business.


They are currently recommended as a superior investment. They have extremely high sales per square foot and vertical integration in their areas.


They are also more furniture store than home improvement store, but that's neither here nor there.


???? They sell food. I don't even get your comment as a non-sequitor.
Are you talking about Whole Foods Market the grocery store chain?


Sorry, replied to the wrong comment. I meant that Drew's comparison to Restoration Hardware didn't make sense, because they don't sell hardware in the home improvement sense.
 
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Chad_Ellis wrote:
.Are game stores less profitable than grocers? You might think so if you looked at gross margins. Your FLGS probably has a gross margin of close to 50%, while a grocer's margins are in the single digits.


I read this to be reversed of what you meant.

I think you meant "are game store MORE profitable than grocers?"
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