Back Story
Fat margins motivate over spending. The bigger the margin the greater the temptation to waste cash on Selling, General and Administrative expenses. That’s margin myopia.
This is a blind-spot in the management of large smart-technology enterprises. Many CEOs seem willing trade higher top-line growth for slower increases in cashflow. That's what investors look for in the short term. But when keepsake investors make competitive comparisons the numbers speak for themselves. Sometimes they even shout!
For example in his March 4, 2013 article Eying Apple James Surowiecki said in The New Yorker:
[Apple’s] cash hoard is bigger than the market cap of almost every company in the S. & P. 5000. … Unlike its competitors it also does an exceptionally good job of turning sales into profits.
Gerstner’s Rule
Louis Gerstner described a simple yet revealing measure of margin myopia in his 2009 book Who Says Elephants Can't Dance? He was the first one to define this measure, so I call it "Gerstner's Rule." The meaning is simple: less is more.
We can apply Gerstner’s rule to any public company and see in a flash if management is overspending on three critical line items: Research and Development + Marketing and Sales + General Administrative Expenses. Combined, these are labeled Selling, General and Administrative (SG&A) expenses if they are not reported as individual line items in the income statement. All the data used in this analysis are from company SEC filings.
Gerstner said that CEO’s should minimize their SG&A Cost per Dollar of Revenue. Do they follow this rule when faced with fat margins? In a word, no. The results of this first analysis on the top 6 smart-tech firms appear in the following table.
Table 1
Smart-Tech Companies, SG&A Per $ and Gross Margin
|
Smart-Technology Companies 2012 |
SG&A Per $ Revenue |
Gross Margin Percent |
|
Apple (AAPL) |
$0.09 |
43.9% |
|
Google (GOOG) |
$0.33 |
58.9% |
|
Microsoft (MSFT) |
$0.38 |
76.2% |
|
Yahoo (YHOO) |
$0.55 |
69.8% |
|
Facebook (FB) |
$0.63 |
73.2% |
|
Linkedin (LNKD) |
$0.73 |
87.1% |
Apple Computer, with the thinnest margin in the group (43.9%), spent 2 cents to generate a dollar of revenue in 2012. Linkedin had the fattest margin in the group (87.1%) and spent 72 cents to generate a dollar of revenue. Or, LNKD management spent 8 times as much to generate a dollar in revenue compared with AAPL management. How can this be explained? Margin Myopia. The gross margin available to Linkedin management was double that of Apple.
The correlation between SG&A per dollar revenue and gross margin percent in Table 1 is 0.9. So it seems fat margins motivate big spending: Right? Sort-of right. Unfortunately, correlations don’t prove anything. What’s required is a theoretical relationship between spending and margins. I introduced just such a measure in my book Competing for Customers and Capital. I called it the “Enterprise Marketing Efficiency Ratio." Forgive the following self-reference but I hope it helps make the point stick in your mind.
Cook’s Ratio
Most of a company’s SG&A "assets" are intangible. But that doesn’t mean their effects are invisible. In the long run the actual cost of an intangible, like the sales force, will equal its theoretical cost to the company, at the margin. Here's the equation:
x = s/y.
Where (s) is actual SG&A expenses and (y) is the theoretical SG&A expenses required to maintain current revenues. Values of this x factor for the same six smart-tech companies are reported in Table2.
Table 2
|
Smart-Technology Companies 2012 |
Marketing Efficiency Ratio (x) |
Gross Margin Percent |
|
Apple (AAPL) |
$0.2 |
43.9% |
|
Google (GOOG) |
$1.7 |
58.9% |
|
Microsoft (MSFT) |
$2.3 |
76.2% |
|
Yahoo (YHOO) |
$2.5 |
69.8% |
|
Facebook (FB) |
$2.9 |
73.2% |
|
Linkedin (LNKD) |
$3.3 |
87.1% |
What does the x factor mean intuitively? This is where the numbers shout!
Apple management spent only $0.2 per unit for its bundle of intangible resources while Linkedin spent $3.3 per unit. Or, AAPL was 16 times more efficient than LNKD. This explains how AAPL … unlike its competitors did an exceptionally good job of turning sales into profits!
Why were Linkedin and Facebook management so inefficient? Because they are focused on top-line growth and they can afford to over-reach. That's margin myopia.
The Therapy
What's managment to do to cure their narrow vision? First, make competitive comparisions using Gerstner's Rule or Cook's Ratio. Then, spend less or spend smarter to bring the company into line with the best in class.
Thanks for your time and attention. As always, your comments are welcome.
Victor Cook
