The Percentage Margin Trap

One of the income statement metrics that stock analysts obsessively focus on is operating margin expressed as a percentage.  Stocks get punished when the operating margin drops or did not meet the goals. So businesses align their marketing and operations to focus on this improving operating margin. To an extent operating margin expressed as a percentage shows the profitability of the operations but the obsessive focus on percentage leads to two errors:

  1. Information loss – specifically the absolute profit earned. ( I am going to ignore here  a more rigorous number, operating cash flow and treat earnings as all cash.) Given two stocks of identical companies in the same market, one with an operating margin of 10% and the other 12%, both with a stated 5 year goal of 4% improvement, can we tell which stock is a better prospect? What about their absolute income level and growth prospects?
  2. Causation Confusion – percentage margin is incorrectly treated as the driver of overall profit. Higher the operating margin, higher the profit. Margins do not drive your profits it is the other way.

Operating margin percentage is a computed number not an intrinsic metric that needs to be actively managed and definitely not a driver for your marketing decisions like pricing the products. Let us take the case of Mattel just because it was in the news recently.

Recently Mattel anounced blow out earnings, with 86% increase in profits with only a single digit increase in sales.  This is extraordinary but there is a concern on what they are focusing on. The WSJ news story’s title reads “Earnings Up 86% As Margins, Barbie Sales Jump“. Margins did not drive the profits up. Profits went up because of price improvement on their Barbie line. In its earnings call Mattel CEO, Mr. Robert Eckert, made the following statement

“We will price our products consistent with our goals of long-term operating margin of 15% to 20%,”

Determining the price to sell based on the stated operating margin goals is cost based pricing.  Pricing the products to  meet a derived metric is like putting the cart before the horse. Price is not driven by a businesses need for meeting its operating margin targets  set by stock analysts but by the customer’s willingness to pay. Based that price the business must either try to make the products at costs that are profitable (price driven costing) or choose not to compete in the market. I want to believe that Mr. Eckert meant here choosing only those products that can help Mattel meet its margin goals and not set prices regardless of the customers.

What drives shareholder value is absolute profits. Not percentages. As Ford said about costs, operating margin is always a computed number.

What drives products prices is value to customers and their willingness to pay, not stock analysts.

What sets prices and drives profitability is effective price management not meeting operating margins.

Market Share Or Profit Share?

Would you prefer to get 50% of the market share (in whatever market you play in?) Almost all businesses would like half the market.  The focus on market share is built into every marketing campaign, sales and pricing decision made. Is market share the right metric to measure a business’ success? One other metric that was popularized by BCG was the Relative Market Share (RMS). It tries to add more relevance by measuring success of the business relative to others.

Relative Market Share (I) = Brand’s Market Share ($,#)/Largest Competitor’s Market Share ($,#) (source link)

For the market share leader, the largest competitor is the second largest competitor. For everyone else it is the market share leader. So for the business with 50% market share in a market where the next biggest competitor has 20% market share, the leader’s RMS is 2.5.

RMS does add more relevance over the simple market share metric. RMS, combined with market growth rate, is used to position the business in the BCG 2X2 (Star, Cash cow, ???, Dog). But does this still tell anything about the profits the business is making or what it takes to bring in the profit? Is the market share leader with 2.5 RMS in a growing market better off than its competitors?

Let us look at the cellphone market share and profit share metrics reported by The Wall Street Journal.  The chart “Ringing Up Profits” comes from the WSJ article. Looking at the simple market share numbers, Nokia is clearly the leader with 45% revenue share and Apple is no where to be seen on the revenue share.  The next biggest competitor to Nokia is Samsung that has a market share of 31%. So the RMS for Nokia is close to 1.5.

Next let us look at the profit share. Again Nokia is the leader with close to 59%. The next biggest competitor with most profit is not any Samsung, it is Apple with 20% share of the toal market profit.

If we used a metric “Relative Market Share Profit – RMSP” which is similar to RMS except computed using profit numbers, Nokia has a RMSP of close to 3.

Yet if you looked at Nokia’s latest earnings its not doing great. Barrons magazine wrote “sell” after the earnings report. Today Apple announced blow out numbers, 15% increase in net profit. Apple stock has been on a tear. So why Nokia with a high RMS number doing financially poorly and Apple with extremely low RMS is doing extremely well even in the down market?

The answer lies in what it takes to deliver the profit and RMS does not capture this data. Apple and RIM with a total of less than 3% market share have 35% of the total profit in the cellphone market. That clearly point to the high variation in the operating margin between  Apple+ RIM and the rest of the cellphone makers. The variation comes form the product mix – Apple and RIM sell just the high margin smartphones. The smartphone revenues  are still a very small fraction of the overall cellphone market but have a disproportionately higher share of the market profit.

The simplicity of using one metric like RMS to describe the market dynamics, while attractive, is far from useful in defining it meaningfully. Yet I am compelled to do just that with a different single metric,  “Relative Profit-Revenue Share Ratio “. This is defined as follows

Profit-Revenue Share ratio  =      Profit share %/Revenue Share%   ( let us call this  PR Ratio)

Relative  Profit-Revenue Share ratio =   PR Ratio/(PR Ratio of  largest competitor)

If we use the numbers from the WSJ article and computed the ratios, the results will look like this

rp-ratioNow we can see which market player is most effective in wringing out profits out of those revenues.