Gross negligence

Gross margins attract a lot of attention.  The big numbers near the top of the income statement, gross profits and gross margins provide insight into the business and are easy to understand and compare.

Except they frequently don’t provide all that much insight, they are not well understood and can be difficult, if not impossible, to compare.

Reading between the columns

Hidden between the columns of the income statement lies the truly useful metric that provides the insight that people seek, and to an extent think they are getting, from gross margin.

Contribution is the impact of that extra £ of sales on profits.  Contribution margin is a clear number we can think about as having a direct impact on the results.  This is particularly important in slowdowns and at inflexion points.

Another way of phrasing it is operational leverage, defined as change in operating profit / change in revenues.  It is a matter of personal preference how you phrase it and see it, but it is important not be lured into the gross margin trap.

Gross margin is the revenue less the cost of goods sold.  Revenue less cost of goods sold does not equal revenue less variable costs, nor does it equal revenue less the direct physical cost of manufacture.  Cost of goods sold is principally the cost of the inventory sold.  The calculation of inventory can include the recovery of overheads and even a multitude of non-cash items.

Moving down the income statement into operating costs, there are plenty of costs associated with ensuring customers get the products and services they demand.  For example, good after-sales support is a reason many customers buy products.  More products sold can thus mean more effort on customer support, but it does not make any difference to cost of goods sold – unless we start billing for it.

Contribution margin is a better margin, not a perfect margin

The impact is different from one industry to another, and from one company to another.  Frustratingly, we can’t examine exactly what contribution margins are with precision from outside the company, but we can look at how an increase in revenue affects gross profit, and then EBITDA and EBIT margins.

Such calculations are not going to provide exact answers, and short-term distortions to adjusted EBITDA et cetera could well cause the figures to be unreliable.  As always, before relying on a figure it is important to do a background check for funnies, and there is no reason for contribution margin to be any different.  Looking at recent and current figures also introduces the distortion of the pandemic, with many companies seeing unnaturally low revenues and/or operating costs.

A note of caution is that while much noise is made nowadays about companies (tech companies in particular) building up costs ahead of revenue growth, costs can also lag revenue growth.  We say this not simply because it affects the numbers in our analysis but because it is a useful perspective with which to examine the consistency of some companies’ margins. A changing company or industry could mean changing contribution margins, but the direction of these changes should be consistent the intended nature of the changes.

But these issues apply to all metrics. Contribution margin is a better margin, not a perfect margin.

Results speak for themselves?

Taking UK-listed companies, the results are interesting and suggest that some companies, sectors and industries might not be quite what some of their proponents have made them out to be.  A handful are shown below.

Contribution margins can also explain why some companies’ managements are more risk averse than some investors might like.  Where spectacular gross margins hide lacklustre operational leverage, a drive for growth may not provide quite the return that less analytical investors might hope for.

A review of contribution margins can also help identify anomalous estimates, where looking forward the contribution margins implied by the forward years’ profit estimates are inconsistent with those it has seen historically – and as the year progresses, the once-optimistic CFO starts to edge guidance on costs up bit by bit. However, looking a few years out the opposite can often be seen, with analysts’ earnings growth trailing what is implied by revenue growth and historical contribution margins.

Contribution margin needs context to be of value (like all metrics!)

Contribution margin analysis is a valuable tool for growth and value investors alike, but it takes time and effort as a high contribution margin figure is of little value in itself.

Contribution margin and operational leverage should not, however, be taken as a measure of volatility of earnings or as an indication of how a business could scale. It requires changes at the top line to have some effect. For example, the operational leverage of Darktrace (cyber security software) and Diageo may be similar, but the likelihood of significant organic changes in revenue is considerably greater for Darktrace.

Furthermore, it is important to understand the source of the high or low contribution margin and how long that dynamic might persist for. For example, they could have the same current contribution margin but there is a considerable difference between Company A, which has high operational gearing because every new sale is filling up fully written-down capacity from previous overambitious investment and M&A and Company B, which has a well-planned, efficient and scaling manufacturing business model.

Ian Robertson

irobertson@progressive-research.com