The primary challenge with this blog post on gross margins is to make it interesting enough for people to read. So let’s start out with beer. Who doesn’t like beer! One way to understand more about the cost of making beer is to look at the financials of Ballast Point Brewing on a percentage basis at the time it filed for an initial public offering. By the last quarter before its IPO the “gross profit” (in yellow) of Ballast Point was 53% (the cost of net revenue was 47%). I don’t like small print, but I do like these charts that set out the financials of a business on a percentage basis when trying to convey ideas since it is simple for people who may be allergic to accounting to understand.
The gross margin of a business is the percentage of each dollar of net revenue that is available after accounting for cost of net revenue. If a business has a cost of making products or services of $50M and total net revenue is $100M the gross margin is 50%. The dollar amount is commonly referred to as gross profit.
Businesses come in all varieties and the gross margins generated by various businesses are no exception. Software businesses and pharmaceutical firms have high gross margins. Costco and Exxon have low gross margins. Some firms make up for relatively low gross margins by selling a lot of products and some don’t. Some companies have high operating cost below the gross margin “line” on the income statement and some don’t. If a business does have low gross margins it does not have a lot of elbow room for operating expenses. Bill Gurley describes a key point out beautifully here:
“There is a huge difference between companies with high gross margins and those with lower gross margins. Using the DCF framework, you cannot generate much cash from a revenue stream that is saddled with large, variable costs. As a result, lower gross margin companies will trade a highly discounted price/revenue multiples. All things being equal, gross margin percentage should have a direct impact on price/revenue multiple, as there will obviously be more gross margin dollars to contribute to free cash flow. Journalists who quickly apply 10x multiples to all private companies should at the very least consider gross margin levels in their analysis.”
Like many things in life, high profit margins can be a double edged sword since it is much easier for a disruptive new business to attack an incumbent that has high margins. Jeff Bezos famously said: “Your margin is my opportunity.” In other words, Bezos sees a competitor’s love of margins and other financial “ratios” as an opportunity for Amazon since the competitor will cling to them while he focuses on absolute dollar free cash flow and slices through them like a hot knife through butter. If you do not have a moat, your margins are at risk.
Let’s return to beer to keep this blog post from getting boring! The craft brewer in the example below is not as profitable as Ballast Point probably due to lower scale and higher levels of competition. But the cost break down is interesting:
Many business face a large and innovative set of competitors and brewing beer is no exception. There are more than 5,000 breweries in the US alone right now.
The quality of life for a business can be much better for a business if gross margins are approach 80-90% as they can be in some software as a service (SaaS) businesses. An attractive SaaS business might have unit economics that look like this:
Three venture capitalists talk about what you want to have in a startup business below:
“In the startup world, low gross margin almost always equals death which is why many Internet retailers have failed or are failing (many operated at 35% gross margins). Many software companies have greater than 80% gross margins, which is why they are more valuable than say traditional retailers or consumer product companies. But software companies often take longer to scale top-line revenue than retailers so it takes a while to cover your nut. It’s why some journalists enthusiastically declare, ‘Company X is doing $20 million in revenue’ (when said company might be just selling somebody else’s physical product) and think that is necessarily good while in fact that might be much worse than a company doing $5 million in sales (but who might be selling software and have sales that are extremely profitable).”
“There are providers in the market who are not passing through the true cost, in effect subsidizing the cost of the service, to gain market share. This results in fast growth but negative gross margins. Again, the companies that are doing this are hoping that once they get to scale and users are “locked in”, they can raise prices. The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has “lock in.” And most don’t. Using volume to drive costs down can work, but if there are similar services out there, the provider who is being asked to take a cut by you might just move their supply over to another competitor offering a higher price.”
“Most companies in e-commerce right now are negative-gross-margin businesses. These companies are in the delivery businesses (Postmates, DoorDash, Instacart) and in the food business (SpoonRocket, Munchery). Basically, a lot of these new-generation, remote-control-type businesses—where the phone acts like a remote control to replace an offline experience—are generally, to date, highly, highly, highly unprofitable. There’s a lot of what I call “venture philanthropy” to prop these businesses up. Time will tell whether any of those can become a real business. We have to get back to this world of having pretty reasonable discipline on business models and understanding that many of these gross-margin businesses will never, never break even or become profitable.”
Here is an example from the recent news where a company is buying assets that generate high gross margin that is quite attractive: “We believe the AppDynamics [just acquired by Cisco] is likely to be accretive to gross margins (77% vs Cisco at 65%) and consistent with the company’s strategy to capture more high margin recurring software revenue.”
Here is another example illustrating the importance of gross margins. In the streaming portion of the music industry the numbers look approximately like this:
- Labels get 60% of total revenue
- Publishers get 10.5%
- 10.5% goes for billing, bandwidth and back end service and support.
Just considering these three items of expense, 80.5% of industry revenue is not available for streaming distributor profit. Some reports put the percentage of revenue going to these categories even higher. Where does the rest of the revenue go given that the streaming distributors are unprofitable?
- Personnel costs and general and administrative costs (G&A)
- Customer acquisition costs (CAC)
To illustrate, Mattermark has assembled these unofficial figures regarding Spotify from available reports:
Aggregate Revenue: $2.2 billion.
Revenue via Advertising: $219 million.
Revenue via Subscriptions: $1.95 million.
Royalty Payout Costs: $1.8 billion.
Revenue sans Royalty Costs: $400 million.
Net Loss: $194 million.
As I have discussed many times, Spotify must obtain less costly deal on “wholesale transfer pricing” from the rights holders so as to have a more attractive gross margins. A TechCrunch article linked below describes the current situation well:
“the crux of the matter is that Spotify has been locked into licensing deals that do not give it a strong enough margin. As of September 2016 — the last time Spotify publicly updated its figures — the company has cumulatively paid out $5 billion to music rights holders….But one source tells us that depending on the region and other factors — deals are negotiated case-by-case, covering an artist’s or group’s music but also the number of times a stream is played, and whether it’s a free user listening with ads, or a paying subscriber with no ads — that overall payout can go up as high as 84 percent.“The message to license holders from Spotify is: we can’t really make this work, guys,” our source said. “But, on the other hand, we’ve taken Spotify now to such a size that we need to make it work.”
The best defense of a firm like Spotify to the wholesale transfer pricing power of its suppliers would be to have enough distribution power so that it gets a favorable deal. The battle between Spotify and the rights holders is bound to be intense, so the best thing to do as an observer is buy some popcorn, find a comfortable chair and watch. I have a post coming soon on profit pools that will discuss Spotify’s wholesale transfer pricing situation more fully.
As a way to close this blog post, this list below illustrates how gross margins can differ by business and industry (I find this fascinating, but I am not normal). All the figures below are from Morningstar and vary with time:
Bristol-Myers 76% http://financials.morningstar.com/ratios/r.html?t=BMY
Eli Lilly 75% http://financials.morningstar.com/ratios/r.html?t=LLY
Salesforce 75% http://financials.morningstar.com/ratios/r.html?t=CRM
Southwest Airlines 70% http://financials.morningstar.com/ratios/r.html?t=LUV
Johnson & Johnson 69% http://financials.morningstar.com/ratios/r.html?t=JNJ
Cisco Systems 63% http://financials.morningstar.com/ratios/r.html?t=CSCO
Microsoft 61% http://financials.morningstar.com/ratios/r.html?t=MSFT
Coca-Cola 61% http://financials.morningstar.com/ratios/r.html?t=KO
Anheuser Busch 60% http://financials.morningstar.com/ratios/r.html?t=BUD
Starbucks 60% http://financials.morningstar.com/ratios/r.html?t=SBUX
Boston Beer 52% http://financials.morningstar.com/ratios/r.html?t=SAM
The Hershey 46% http://financials.morningstar.com/ratios/r.html?t=HSY
McDonalds 39% http://financials.morningstar.com/ratios/r.html?t=MCD
Whole Foods 35% http://financials.morningstar.com/ratios/r.html?t=WFM
Kraft Heinz 31% http://financials.morningstar.com/ratios/r.html?t=KHC
Shake Shack 32% http://financials.morningstar.com/ratios/r.html?t=SHAK
Dollar Tree Stores 30% http://financials.morningstar.com/ratios/r.html?t=DLTR
Walgreens 26% http://financials.morningstar.com/ratios/r.html?t=WBA
Toyota Motor 20% http://financials.morningstar.com/ratios/r.html?t=TM
Panera Bread 20% http://financials.morningstar.com/ratios/r.html?t=PNRA
Supervalu 15% http://financials.morningstar.com/ratios/r.html?t=SVU
Toll Brothers 20% http://financials.morningstar.com/ratios/r.html?t=TOL
Costco Wholesale 13% http://financials.morningstar.com/ratios/r.html?t=ALK
Ballast Point Brewing: https://www.sec.gov/Archives/edgar/data/1648798/000119312515346618/d87353ds1.htm
Huffington Post Craft Beer: http://www.huffingtonpost.com/2014/09/12/craft-beer-expensive-cost_n_5670015.html
Fred Wilson: http://avc.com/2015/10/negative-gross-margins/