Margins give the little guy chance

First published in the Financial Times on the 5th March 2013.

Profit margins can be higher in many cases for medium-sized enterprise than large ones

Margins are an issue of profound importance for any business. But how much scientific thinking is there on the subject? Are certain activities naturally high margin and are they always a good thing?

High margins mean a company is more likely to be nicely profitable, and deliver a decent return to shareholders. It means a business probably generates cash, which can be used for investment and hopefully create more jobs and pay more tax. All that seems highly desirable, both for owners and society.

But high margins also attract competition. Pricing analysis is much more prevalent than in the past and the internet means costs are more transparent than they ever have been. If products can be sold cheaper by someone new, while still showing a profit, then they probably will be. As long as goods are not protected by patent or government mandate, replicas will appear very swiftly, at progressively lower prices. This is capitalism in action: relentless competition to the benefit of the consumer.

Moreover, high margins can make industries complacent, bloated and unprepared for leaner times. It corrupts the psychology of management and breeds arrogance. Traditional media players suffered from this disease. Successful broadcasters and publishers enjoyed 20 per cent plus operating margins for decades. Then the internet arrived, and Google and others ate their lunch. Now they face an existential threat; but they did not anticipate or invest during the years of plenty, and are struggling to cope with the more typical margins and returns available in 2013.

The pharmaceutical sector is suffering the same nemesis. It waxed fat with blockbuster drugs sold at eye-watering profits, protected by patents. But now pressure on healthcare spending, the rise of generic drugmakers, and the empty pipeline of new medicines mean the days of 30 per cent margins are history.

By rights, franchise businesses should be wonderful to own and ought to luxuriate in high margins. The owner simply rents out its brands and format and collects a royalty – with no capital employed. McDonald’s is a successful example of the model. But in my experience a franchiser cannot really control its destiny – franchisees do that. Conflicts frequently erupt – just ask Burger King, which has a history of disputes with its franchisees. And hefty franchise and advertising fees often mean a meagre living for franchisees, which ultimately undermines the business model.

Amazon is an extreme example of a business to which the capital markets have provided almost free financing. As a consequence it has been able to operate at very low margins – often 2 per cent or less – and deliver a superb service and cheaper products than the competition. Thus the bookshops and DVD retailers that used to dominate the supply of entertainment items are steadily going broke. And Amazon has an astonishing share of ecommerce in the US: at least a third. Because shareholders have forgone dividends and are not demanding growing earnings per share, Amazon has undercut all-comers and established a dangerously powerful machine. After all, who wants to spend billions to trade at margins of less than 2 per cent?

In theory margins across all sectors should revert over time to generate the mean cost of capital. But chronic overcapacity can mean negative returns for long periods. Automotive manufacturers have suffered from value-destroying margins (with a few exceptions such as BMW and VW) for many years. Similarly, airlines are an industry that has been plagued for decades with poor economics and feeble margins.

Curiously margins can be higher in many cases for medium-sized enterprises than giant ones. For example, leading food producers must trade with the oligopoly of supermarkets, who consequently dominate their order book – and squeeze their profits. But smaller rivals can happily stick to independent retailers, and so enjoy a fragmented customer base. This allows them to charge reasonable prices.

It is surprising how often inverse economies of scale can be applied in business. This should give entrepreneurs hope that they really can compete against monster corporations.