Gross Margin for Fun and Profit – Involves Beer and Music Streaming!

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.

big-ballast

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:

cradt

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:

nnnnpv

Three venture capitalists talk about what you want to have in a startup business below:

Mark Suster:

“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).”

Fred Wilson:

“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.”

Chamath Palihapitiya:

“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:

  1. Labels get 60% of total revenue
  2. Publishers get 10.5%
  3. 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?

  1. Personnel costs and general and administrative costs (G&A)
  2. R&D
  3. Customer acquisition costs (CAC)

To illustrate, Mattermark has assembled these unofficial figures regarding Spotify from available reports:

2015 results:

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:

 

Adobe                                                   86%  http://financials.morningstar.com/ratios/r.html?t=ADBE

Pfizer                                                     80%  http://financials.morningstar.com/ratios/r.html?t=PFE

Oracle                                                    80%  http://financials.morningstar.com/ratios/r.html?t=ORCL

eBay                                                       79%  http://financials.morningstar.com/ratios/r.html?t=EBAY

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

Comcast                                                 70%   http://financials.morningstar.com/ratios/r.html?t=CMCSA

Southwest Airlines                               70%   http://financials.morningstar.com/ratios/r.html?t=LUV

Johnson & Johnson                               69%   http://financials.morningstar.com/ratios/r.html?t=JNJ

Alibaba                                                   66%  http://financials.morningstar.com/ratios/r.html?t=BABA

Cisco Systems                                       63%  http://financials.morningstar.com/ratios/r.html?t=CSCO

Intel                                                         63% http://financials.morningstar.com/ratios/r.html?t=INTC

Microsoft                                               61%  http://financials.morningstar.com/ratios/r.html?t=MSFT

Google                                                     62%  http://financials.morningstar.com/ratios/r.html?t=GOOG

Coca-Cola                                             61%  http://financials.morningstar.com/ratios/r.html?t=KO

Verizon                                                 60%  http://financials.morningstar.com/ratios/r.html?t=VZ

Anheuser Busch                                 60%  http://financials.morningstar.com/ratios/r.html?t=BUD

Starbucks                                              60%  http://financials.morningstar.com/ratios/r.html?t=SBUX

Pepsi                                                      56%  http://financials.morningstar.com/ratios/r.html?t=PEP

AT&T                                                     54%  http://financials.morningstar.com/ratios/r.html?t=T

Boston Beer                                         52% http://financials.morningstar.com/ratios/r.html?t=SAM

Disney                                                   46% http://financials.morningstar.com/ratios/r.html?t=DIS

The Hershey                                        46% http://financials.morningstar.com/ratios/r.html?t=HSY

Nike                                                      45% http://financials.morningstar.com/ratios/r.html?t=NKE

AAPL                                                     39% http://financials.morningstar.com/ratios/r.html?t=AAPL

McDonalds                                           39% http://financials.morningstar.com/ratios/r.html?t=MCD

Mondalez                                              39% http://financials.morningstar.com/ratios/r.html?t=MDLZ

GNC                                                        37% http://financials.morningstar.com/ratios/r.html?t=GNC

Kohls                                                     36% http://financials.morningstar.com/ratios/r.html?t=KSS

Whole Foods                                        35% http://financials.morningstar.com/ratios/r.html?t=WFM

Amazon:                                               33%  http://financials.morningstar.com/ratios/r.html?t=AMZN

Netflix                                                  32% http://financials.morningstar.com/ratios/r.html?t=NFLX

Kraft Heinz                                          31%  http://financials.morningstar.com/ratios/r.html?t=KHC

GameStop                                            31%  http://financials.morningstar.com/ratios/r.html?t=GME

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

Target                                                    30% http://financials.morningstar.com/ratios/r.html?t=TGT

HPE                                                        30% http://financials.morningstar.com/ratios/r.html?t=HPE

Exxon                                                     30%  http://financials.morningstar.com/ratios/r.html?t=XOM

Wal-Mart                                              25%  http://financials.morningstar.com/ratios/r.html?t=WMT

Walgreens                                             26%  http://financials.morningstar.com/ratios/r.html?t=WBA

Best Buy                                                 23% http://financials.morningstar.com/ratios/r.html?t=BBY

Sears                                                       23% http://financials.morningstar.com/ratios/r.html?t=SHLD

Tesla                                                       23%  http://financials.morningstar.com/ratios/r.html?t=TSLA

Kroger                                                    22%  http://financials.morningstar.com/ratios/r.html?t=KR

Daimler                                                 21% http://financials.morningstar.com/ratios/r.html?t=DDAIF

Toyota Motor                                       20%  http://financials.morningstar.com/ratios/r.html?t=TM

Panera Bread                                       20%  http://financials.morningstar.com/ratios/r.html?t=PNRA

HPQ                                                        18% http://financials.morningstar.com/ratios/r.html?t=HPQ

KB Homes                                             16%  http://financials.morningstar.com/ratios/r.html?t=KBH

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

 

Notes:

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

Bill Gurley: http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/

Fred Wilson:  http://avc.com/2015/10/negative-gross-margins/

Mark Suster: https://bothsidesofthetable.com/what-is-the-right-burn-rate-at-a-startup-company-ae80d5d76c07#.679fl2f2x

Chamath Palihapitiya: http://www.vanityfair.com/news/2016/03/chamath-palihapitiya-interview-says-start-ups-are-mostly-crap

TechCrunch: https://techcrunch.com/2017/02/02/sources-spotify-may-delay-ipo-to-2018-as-it-rethinks-licensing-deals/

Mattermark: https://mattermark.com/spotifys-ipo-paradox-2/

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