Welcome back! Today we continue our Craft of Rule Maker series, in which we're taking a stroll through the financial side of how to analyze Rule Makers. If you're just now joining us, here are links to Part 1, Part 2, and Part 3. Today's lesson -- part 4 of 9 -- is about gross margins. By the end of the Craft series, you should have a good handle on practically everything you need to know about Rule Maker financial analysis.
After the Craft series is over, the stage will be set for our annual extravaganza, the Rule Maker 2001 online seminar: The Art of Rule Maker ($49). We'll deliver eight in-depth lessons to your email box over the course of March (two per week, allowing plenty of time to absorb the material), and we'll introduce and explain our four qualitative Rule Maker criteria: sustainable competitive advantage, great management, expanding possibilities, and paying a reasonable price.
All of the Rule Maker managers will be out on the private seminar discussion boards helping you learn (as we learn from you, too). And finally, we'll conclude the experience with an in-depth report on our favorite 25 Rule Maker investment ideas, written specifically from the perspective of the qualitative factors that we'll be studying during the seminar. We hope you'll join us!
Now on with today's lesson....
When it comes to profits, most people think of net income because, in a perfect world, (one without accountants and lawyers, that is) net income represents what is left over at the end of the day. Or at least, that's what most people think. But as Rich explained on Wednesday, here at the Fool we are dedicated to dispelling that myth and directing you -- the common investing Fool -- toward free cash flow as a better measure of profitability because it is less conducive to manipulation.
Another figure that is practically impenetrable to the ways of Wise bean-counters is gross profit. Gross profit is the dollar amount left over after subtracting the cost of making a product or delivering a service from the sales price. It is the first step toward profitability, despite what the founders of Buy.com (Nasdaq: BUYX) say.
Gross profit is measured two ways and is also commonly referred to as gross margin. In dollar terms, gross margin is sales less the cost of goods sold (COGS). That is:
Gross Margin ($) = Sales - COGS
Gross margin is also represented in percentage terms and calculated as follows:
Gross Margin (%) = (Sales - COGS) / Sales
The components: COGS is also known as "cost of sales," "cost of service," and "cost of product." Sales or revenue is sometimes shown as "net sales" as is the case with Cisco (Nasdaq: CSCO). Cisco's sales are shown net (after subtracting) of returns and allowances. Don't be confused by the semantics. No matter what terms are used, the objective is to measure what is left over after a company makes a product or delivers a service.
Gross margin ignores costs like marketing, research and development (R&D), and general administrative costs. These costs are not directly associated with the production of the product or service. We are after the core of the company. How much is left over from widget sales after the parts are paid for.
Let's take a look at some real numbers.
For consistency throughout our Craft of Rule Maker series, Cisco is used as the primary example. Looking at its fiscal 2001 second quarter income statement, net sales were $6,748 million and cost of sales was $2,581 million. Therefore, Cisco's gross margin in dollar terms was $4,167 million and its gross margin in percentage terms was 61.8%. Wow. That means that it sells its goods and services for nearly three times its material costs. Impressive, eh? And that's all the work you have to do to get to gross margin.
So why do we care about gross margins, when net income per share, or if you've been paying attention, free cash flow per share is really what Foolish investors care about? Several reasons, but before we run through them, burn this into your brain: Rule Makers are companies with gross margins north of 50%.
There are several reasons behind this stringent requirement. First, companies that can command such lofty gross margins are usually dishing out products and services with a high value proposition. If consumers and other companies are willing to pay so much for the product or service above what it costs, it must be valuable.
Second, high gross margins provide a cushion -- a margin of safety -- with regard to profits and cash flow. Companies with high gross margins have a competitive advantage because they have room to maneuver in tough markets. For example, gross margins can be sacrificed to gain market share or squeeze the competition's margins to the point where they are unable to compete on price. Intel (Nasdaq: INTC) boasts gross margins around 60%, while its nemesis, AMD (NYSE: AMD) struggles to maintain gross margins in the 30%-45% range. When it comes time to cut microprocessor prices, who do you think gets hurt the most?
Third, and perhaps most important, is the relationship between gross margins and net margins. The costs associated with gross margins -- cost of goods sold -- tend to be variable in nature meaning that they move in proportion to the revenue. For every dollar in increased revenue there is a dollar increase in cost of goods sold. But the costs subtracted from gross margins to get to net margins -- costs such as sales and general administrative expenses (SG&A) -- tend to be fixed meaning they do not move in proportion to revenues. This relationship allows for margin expansion, as Matt Richey explained in a December Rule Maker article using Microsoft (Nasdaq: MSFT) as an example. Let's revisit that example:
"When you combine fixed (or slow-growing) costs and growing revenues, the result is margin expansion on the bottom-line. Microsoft's history as a public company serves as an excellent example of this phenomenon:"
Fiscal Year: 1985 1990 1995 1999* 2000* Gross Marg.(%) 78.6 77.0 77.8 85.7 86.9 Net Marg.(%) 17.1 23.5 23.9 39.4 41.0 * Net margins from 1999 and 2000 include gains from investment income. Back this out and Microsoft's net margins for 1999 and 2000 are 30.3% and 27.2%, respectively.
Also, the greater the spread between gross margins and net margins, the greater the control a company has over profits. Cisco has proven this relationship to be vital to its market share dominance. The December issue of CFO Magazine supplied this example:
"In 1999, Cisco spent 36.7 cents on SG&A expenses for every dollar of operating revenue it generated, exceeding the median for its industry group by 340 basis points [3.4%]. Yet the $18.9 billion [revenue] company was a veritable miser when it came to COGS, with that figure equaling just 30.9 percent of operating revenue in 1999, way below the industry median of 51.8 percent. Combine Cisco's SG&A and cost-of-sales numbers over the four years from 1996 through 1999, and the company ends up with an industry-leading CMI of 66.5 percent versus an industry median of 82.9 percent."
CMI is the "cost management index" and is calculated by adding COGS and SG&A expenses and dividing by revenue. It is a measure of operating efficiency. The lower the number, the better.
What this example proves is that Cisco's high gross margins, resulting from its relatively low COGS, allow it to spend more on SG&A than its competition and still come out on top. Management has used this advantage to offer a level of customer service befitting a king, differentiating Cisco from it competitors. This differentiation -- Cisco's high customer satisfaction -- protects its market share and builds a competitive advantage.
It is worthy to note that gross margins vary widely across different companies and different industries. As we have pointed out before, industries such as software, pharmaceuticals, network communications, telecommunications and beverages are inherently more profitable than others because the products and services these industries provide have a high value proposition. It is no wonder that most of our holdings are in these industries.
On Monday, we'll continue our series with a look at net margins. Four lessons down, five to go. Have a great weekend!
Part 5: The High Profit Margin Advantage �
Todd Lebor is a co-manager for the Rule Maker portfolio and lives in Alexandria, VA. At the time of publication, he owned shares of CSCO, INTC, and MSFT. Todd's other holdings can be found online along with the Fool's complete disclosure policy. The Motley Fool is investors writing for investors.
