Here is something that caught our eye this week:
Some thoughts on a key operating metric
At Chenmark, we live and die by our Free Cash Flow numbers. Free Cash Flow is a no BS way of knowing how we’re doing; it tells us how much cash we have in the bank after operating our business and meeting all of our financial obligations.
On a day to day basis however, we actually speak much more frequently about gross profitability and work with all our companies to make sure we understand it at a customer and service line level. For us, Gross Profit is the most important internal operating metric because it speaks to the core profitability of any given product offering. Put simply, revenue less cost of goods gives us insight into how “tight” our operations are – i.e., how efficient we are at using our labor and supplies to generate revenue. Any operator in the Chenmark network will know the drivers of her gross profitability numbers and make decisions to optimize her numbers accordingly.
Since Gross Profit is such a frequent topic of conversation, we were interested to hear thoughts on the subject from venture capitalist Fred Wilson, who noted that “gross margins, in particular, can be tricky to compare. In some cases, a software business is in the middle of the revenue flow, takes the revenue, and then passes on a lot of it, and is left with what looks like a low margin, but is in fact high margin.”
Wilson looks at Gross Margins of Adyen, a Dutch payment processing company, and Macy’s, the US retailer. In the example, Adyen reported $2.6 billion of revenue and $496 million of Gross Profit (a 18.7% gross margin). Macy’s had $25.3 billion of revenue and $10.1 billion of gross profit (40.1% gross margin). On the surface, a higher gross profit margin is better than a lower margin (i.e., Macy’s is better than Adyen). However, Wilson doesn’t quite agree:
“So while it is the case that Macy’s has more than double the gross margin of Adyen, I believe Adyen has a much more attractive business from a margin perspective than Macy’s. That is because Macy’s expends enormous amounts of working capital and operating expense and effort in its $15bn cost of revenue where Adyen expends very little working capital and operating expense and effort in its $2.1bn cost of revenue.
The trick, I think, is to wrap your head around the cost of revenue or cost of goods sold line item in the income statement and think about what is going on there. If it is very little to no effort, and largely just an accounting entry, then you may have a “low margin business” that is actually a high margin business. On the other hand, if it is a lot of work and capital investment to produce those margins, well then what you have is often a low margin business.”
Chenmark evaluates businesses across industries and we are familiar with the limitations of comparing gross profitability across a range of business models. We usually try to solve this problem by working to develop an understanding of industry specific benchmarks. More broadly, however, Wilson is driving to compare businesses not on Gross Profit alone, but on the Gross Profit production per unit of overhead and invested capital. He wants to know how efficiently a company’s Gross Profit converts to bottom-line profit, and eventually, cash, which is another way of expressing the concept behind Free Cash Flow. We continue to see value in measuring at different points along the way, but in our experience the trajectory of the checking account balance rarely lies.
Have a great week,
Your Chenmark Team