FOOL ON THE HILL
High Volume, High Profits

Believe it or not, even a humble neighborhood car wash can yield some valuable lessons about investing. When one slashes its prices to $1 and survives, some interesting things must be going on. It's all about profit margins and volume. High volume can more than make up for low margins. Heck, look at Wal-Mart.

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By Selena Maranjian (TMF Selena)
March 18, 2002

Ooh ooh
You might not ever get rich
But let me tell ya it's better than diggin' a ditch
There ain't no tellin' who you might meet
A movie star or maybe even an Indian chief
     
-- Rose Royce, from the song "Car Wash"

If you keep your eyes and mind open, you'll find that investing and business lessons are all around you. There's a car wash I've frequented over the past decade, for example, that has provided me good food for thought. Here are some things it's helped me think about:

Margins and volume
It used to be a rather typical drive-through car wash. About 5 to 10 years ago, it charged as much as competing car washes did -- somewhere in the neighborhood of $5 or $6, plus more for wax and shine and other goodies.

Then all of a sudden, several years ago, the car wash celebrated an anniversary. In honor of that, for a limited time, it offered $1 basic car washes. The result was no surprise: long lines of filthy vehicles. Like others, I enjoyed my $1 car wash. Then, a few weeks or months later (I'm not a slave to vehicular sparkliness), it was time for another wash. Lo and behold -- the $1 rate was still there! (And so were the long lines of cars.) In fact, the car wash kept the $1 rate for about an entire year. The next year, the rate was $2. It's now several years later and the base car wash rate is just $3, still considerably cheaper than alternatives in the region.

This demonstrates the power of volume. Too often we investors give too much importance to profit margins. (Remember that a profit margin -- or "net profit margin" -- is calculated by taking income (or profits) and dividing by overall revenues. The result shows how much of each dollar of sales remains as profit.) Look at the following companies -- which would you rather invest in? (Profit margins are taken from company "Snapshots" at the Fool's Quotes & Data area.)

            Profit margin

Company A:     18.1%
Company B:     13.2
Company P:     11.8
Company W:      3.3
Company H:      5.7
Company C:      1.7

Of course, this is too little to go on, but for many people, even though a company may have some additional promising points and perhaps even some red flags, strong profit margins are enough to entice them. At the very least, don't you find yourself drawn to the higher margins?

Here are the same companies, with their names revealed:

                         Profit margin

AT&T (NYSE: T):              18.1%
Bowl America (AMEX: BWL.A):  13.2
Pitney Bowes (NYSE: PBI):    11.8
Wal-Mart (NYSE: WMT):         3.3
Home Depot (NYSE: HD):        5.7
Costco (Nasdaq: COST):        1.7

The companies listed above with the lower profit margins are probably more promising, as long-term investments. That's because of volume. Wal-Mart, like most retailers, wrings only a few pennies of profit from each dollar of sales. But it just has so many dollars of sales that those pennies really add up, making the company very lucrative for shareholders. Wal-Mart actually happens to lead all other companies in the world, by the size of its annual revenues, having raked in $218 billion in sales in its most recent fiscal year, with net income of $6.7 billion.

Here's another handy measure to look at along with profit margin: inventory turnover. This reflects how many times per year a firm sells out its inventory. Let's look at Wal-Mart. Take its 2002 cost of goods sold (sometimes abbreviated as "COGS") of $171.6 billion and divide it by the average of 2002 and 2001 inventory levels ($22 billion). This gives us a turnover of 7.8. The higher the number the better, and this reflects that Wal-Mart has sold nearly 8 times its average inventory supply in a year. It's as if it cleared out all its inventory and restocked and sold it all again -- and again and again -- nearly 8 times. Impressive. (Compare that with poor beleaguered Kmart, with inventory turnover in the neighborhood of 3.6.)

My little neighborhood car wash is a bit smaller than Wal-Mart, but it's applying the similar principles. Who would have thought that a car wash could survive charging just $1 or $2 per wash? It can, if it's able to cover its costs and has sufficient volume.

Consumer psychology
Another thing I've noticed soon after the big "brushless" strips finish swinging back and forth over my car is the tip jar for the two fellows who wipe down cars emerging from the wash. I've noticed that I'm extra generous in offering a tip. My reasoning? Well, when a car wash would normally cost me $6 or more and I'm able to get one for so much less, then I figure I can give a decent tip and still come out ahead. The fact that I'm happy about getting a good deal puts me in a magnanimous mood. I bet I'm not the only one thinking that way.

If workers are getting higher-than-average tips, that permits the employer to get away with paying them a little less. Alternatively, it can choose to let the workers end up a little richer, which will tend to keep them around longer. Either way, it's good for business.

Business models
A final car wash-related thought I had relates to business models. I recently used a car wash in another part of the country and it operated with a rather different business model. For starters, I had to get out of the car, and send it on its sojourn alone. This wash cost me $10, plus a tip. When the car emerged, four or five workers swarmed around it, wiping it down inside and out.

My cheap car wash appears to employ very few people. Just one or two to take the money, push some buttons and spray soap onto the vehicles and two at the other end to wipe down the outside of the car. The expensive car wash employed those four or five wipers, plus a cashier insider, plus someone supervising the cars entering the wash. With all those people, no wonder it costs $10.

There's room for both kinds of washes in the world, and both can be profitable. But the $1 car wash taught me that profit margins can be a lot less meaningful than I'd previously thought. A business can do quite well by offering a good-quality service at a low price, with few frills. This is, in many ways, the model used by Southwest Airlines (NYSE: LUV), which has proved to be a terrific long-term investment.

Too bad that little car wash isn't publicly traded.

I'll close with a few more lyrics to the song "Car Wash":

Some of the work gets kinda hard
This ain't no place to be if you planned on bein' a star
Let me tell you it's always cool
And the boss don't mind sometimes if you act the fool
At the car wash...

Selena Maranjian's profit margin is low, but she doesn't carry a lot of debt. She owns shares in Costco. To see Selena's complete stock holdings, view her profile. The Motley Fool is Fools writing for Fools