Phil Fisher
Does the company have a worthwhile profit margin?
To hammer the importance of this point home, you need not look further than traditional auto manufacturers.
Does the company have a worthwhile profit margin?
Auto manufacturers have historically low profit margins. MSN Money reports a 5-year industry average of just 3.4% for auto manufacturers versus 11.5% for the S&P 500. That is, for every dollar of sales at the auto manufacturer, just $0.03 ends up in net income. The rest is spent on costs of goods sold, operational expenses, etc.
Take, for example, General Motors. In its fiscal year ended December 31, 2007, General Motors reported $178.2 billion of automotive sales. To make the vehicles sold, GM reported “Automotive Cost of Sales” of $166.3 billion. Simple math would tell you that GM generated about $11.9 billion in revenue, after taking into account the cost of the materials to make the vehicles.
Here’s the problem: In the three years leading up to the end of last year, GM had to spend an average of $13.7 billion on “Selling, General and Administrative” expenses – the costs to keep the lights on, to keep the salespeople motivated, to advertise, etc. $11.9 billion in, $13.7 billion out. Starting to see the problem?
When Margins are Slim
If your company doesn’t have a “worthwhile” profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it. When things begin to turn around, your company’s ability to generate cash will be delayed relative to its high profit margin competitors.
As your company begins to use cash rather than generate it, your ownership is in jeopardy. I’m not just talking about negative free cash flow; your company will have to sell assets, fire people, take on debt, and/or sell more stock. The result: Less sales as capacity to fill orders is diminished, lower profit margins and excess cash as interest expenses increase, and dilution of your ownership resulting in less value going forward.
Check out GM’s balance sheet on Morningstar, and specifically look at the changes to shareholder equity. Here’s a company that has spent the last ten years trying to keeps its head above water, struggling to find a balance between too big to be profitable and too small to maintain unit volume. When margins are too thin, the slightest breeze can knock your business around.
The Owner’s Margin
Profit margins are important when looking at the industry and at historical figures for a company; the Owner’s Margin looks forward.
Calculated as owner earnings (or free cash flow) divided by total revenues, the Owner’s Margin can help you judge whether or not your business will be able to sustain prolonged periods of slowed sales or unusually high expenses.
In the case of General Motors, sales slipped and any excess cash they might have been able to eek out when times were good is now a pipe dream. Let’s turn our attention to Pfizer.
Generating about $10.6 billion in owner earnings last year on sales of $48.4 billion, Pfizer’s Owner’s Margin is 22%. That is, for every dollar of sales that Pfizer recorded, it generated about $0.22 in excess cash. Think of it this way: If sales at Pfizer sank 20%, or $9.7 billion, to $38.7 billion, Pfizer would still be able to crank out more than $900 million in owner earnings without firing a single person, selling a single asset, or assuming a dime of additional debt (if it’s business as usual).
A 20% hit to sales, and the company is still generating excess cash without making a single adjustment to its business? Now that’s a worthwhile margin.
Of course, some adjustments would likely be made. At that level, Pfizer would definitely have to kill its $8 billion annual dividend payments (unless management wanted to foolishly assume $8 billion a year in debt to keep the dividend). Furthermore, Pfizer would likely cut staff and take other measures to return to a more worthwhile margin. Still, the company has the operational capacity to sustain a very serious hit to sales without sustaining a commensurate hit to operations or its balance sheet.
When Times Get Tough
Going back to troubled companies. If you are attributing GM’s tough times to tighter consumer spending and higher gas prices, let’s move out of the beaten down auto sector and move to another business – Blockbuster.
For its fiscal year ended December 31, 2006, Blockbuster reported total revenues of $5.5 billion. It generated just $183 million of owner earnings – an Owner’s Margin of 3.3%. For the record, 2006 was a “business as usual” year for BBI.
Here’s where it gets hairy: To generate cash and actually have any sort of value for investors, Blockbuster needs to keep sales extremely high, to keep expenses extremely low, and to operate at perfect efficiency. Any slight change can have a dramatic effect on the business.
Well, it got hairy for Blockbuster. Revenues and most expenses in 2007 were largely unchanged. However, Blockbuster’s costs of sales increased by about 8%, from $2.5 billion to $2.7 billion. Owner’s Margin of 3.3%; cost of sales increase of 8%. Doesn’t look good for this fragile business.
Sure enough, Blockbuster’s operations swung from generating owner earnings of about $183 million to requiring an additional $114 million after all expenses were paid. Its Owner’s Margin dropped to a negative 2%. For every dollar of sales Blockbuster generated, it had to cough up $1.02 to keep the doors open.
In the highly competitive world of movie rentals (think Netflix, Wal-Mart, Apple TV, Comcast On Demand, etc.), a 3% Owner’s Margin is definitely not worthwhile. And Blockbuster shareholders have suffered because of it.
What Is “Worthwhile”?
The term “worthwhile” is relative, and depends on your estimation of how bad things can get at your company. If you are expecting a 50% hit to Pfizer’s total sales or a doubling of expenses at some point in the future, a 22% Owner’s Margin is definitely not worthwhile. If, however, in the ordinary course of business and economic cycles, you would not be surprised by 10% swings in sales, a 13% or 15% Owner’s Margin may very well be worthwhile.
As with everything in investing, look for a margin of safety. The higher the Owner’s Margin, the better.
Filed under: How to Value a Business
Dave,
The $900 million of excess cash would be if revenue got hit, but Pfizer didn’t change a thing in its business. That is, if revenue dropped 20% to $38.7 billion but expenses remained the same at $40.3 billion – thus putting the company at a GAAP earnings loss of $0.23 a share – the company would still be able to generate $900 million of excess cash.
If Pfizer did take such a hit to sales, it would likely make adjustments to its business – shed assets, fire staff, reduce expenses – in an attempt to return to that 22% Owner’s Margin (thus generating $8.5 billion). Until it made the proper adjustments, it wouldn’t be cash flow negative like an auto maker or Blockbuster after a 20% hit to sales.
Does that clarify my above statements?
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Very good post, however, whenever I read something like this, the first thing that pops into my head is “what is the exception to the rule?”. Peter Lynch:
“I’ll take a lousy industry over a great industry anytime. In a lousy industry…the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever increasing share of a stagnant market is a lot better off than one that has to struggle to protect an ever dwindling share of an exciting market. <b>In business, competition is never as healthy as total domination.</b>”
I have never considered investing in an airline and even though I probably never will own one, I’m looking at Southwest, in light of what’s happening right now. Although still too early, I’m looking at a couple of home builders like Toll Bros. I’m looking in autos (and seeing a scary abyss) and so on. Finding a low margin enterprise with a strong balance sheet in an industry where others are going bankrupt or abandoning the game, can work as well as the approach expressed in this post.
The point here is not that Fisher is wrong. The point is that I believe in building your portfolio the way that Billy Beane builds (and re-builds) the Oakland A’s year in and year out. What is the market undervaluing today? It’s different every year and sometimes from month to month. I love articles like this, they make me think and recall why I do things a certain way and make me try to justify why.
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Pfe’s free cash flow in morning star under estimated 1523 = 2,573.0 – 1,050.0 netborrowing in 2007. Owner’s earning is equity owner’s, so this borrowed money should be added. Cut dividend doesn’t have effect on equity owner’s earning. So to maintain 22% owner margin, cut dividend will not help. In addition, if you use morning star’s free cash flow definition, change dividend policy and change debt ratio will not affect morning star’s “free cash flow”
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Dave: After this series on Fisher, I am going to go through Seth Klarman’s book – Margin of Safety. Then, I’ll put up a (long overdue) post of owner earnings versus free cash flow. If you can’t wait until then (a few weeks), email me and I’ll send you a PDF of a comparison I put together for another visitor.
Rene: What is a great business? It’s one that can thrive in good times and survive in bad times. That’s why bottom feeding can be so lucrative. When Mr. Market is overly pessimistic on an industry, opportunities arise. As you pointed out, everyone should remember that portfolios are dynamic, living beasts. Though you may hold some positions for many years, you may also dance in and out of some positions as you find better opportunities.
G: Glad you’re enjoying it!
jay: Borrowed money does not affect owner earnings (the cash generated from operations), it affects net worth. A business is not always wrong in borrowing money and borrowing does not necessarily reduce value. For example, if the business can borrow at 8% and grow that borrowed money at 18%, the borrowing is well justified.
Though cutting the dividend won’t affect owner earnings, it will have to be a consideration if Pfizer takes a large hit to revenue. The only reason it can pay out $8 billion in dividends is because it is generating $10 billion in excess cash. If revenues drop and Pfizer can’t scramble to return to that 22% Owner’s Margin right away, owner earnings will suffer. At that point, Pfizer will have to make a decision: Borrow money to support the $8 billion dividend, or reduce the dividend.
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Can’t wait for your posts on Seth Klarman’s “Margin of Safety”. He’s one of the greatest investors of our time, and we’ll all benefit greatly from his words. Besides, not all of us can afford his book, so I’m sure that this rare occasion will bring extra attention to our beloved blog.
Thanks Joe!
Nick
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joe,
long time! you’ve stumped me on this one. you say,
“Pfizer would still be able to crank out more than $900 million in owner earnings”
but how are you coming up with the 900 million? if O.E. is 22%, then shouldn’t FCF be 8.5Mill? Where did I go wrong?
Dave miller asked a similar question, but I still don’t understand.
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Just thought I’d chime in with Buffett’s statement last month from the annual meeting on pharma:
“That industry is in a state of flux right now. It’s historically earned very good returns on invested capital, but it could well be that the world will unfold differently in the future than in the past. I’m not sure I can give you a good answer on that.”
Buffett also told CNBC this:
Joe Kernen asks about recent purchases of Glaxo and Sanofi? Why? Buffett says he made the decision to buy those stocks and that with drug companies he knows less specifically about those companies than, say, a candy company. Hard to make a bet on a specific drug company based on a drug that might be in the pipeline. “If you have a group” of drug companies, you’ll “probably do OK.” Would he buy a domestic drug company? Yes, but he does like earnings coming from abroad than earnings coming from the United States. Most big drug companies in the U.S. do get a lot of their profits from overseas.
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Hi Joe
If you see in morning start, from the last 5 years 2004 – 2008 with the exception of 2006
Total Equity of Pfizer is declining.
2004 –>68278
2005 –>65627
2006 –>71358
2007 –>65010
2008 –>57556
Do you see this as a problem ?
On basis of above figures how you get the Owner earnings as positive. $10.6 billion in owner earnings last year on sales of $48.4 billion. I also did not got the point that the company will still produce $900 mn in owners earnings after taking a hit of 20% in revenue everything remaining same. How can a GAAP -ve earning results in positive owners equity.
Great Blog, thanks for educating us
Regards
Ajay
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Owner Earnings tell you how much cash the operations generate. They don’t automatically make it to the Shareholder Equity on the balance sheet because a number of things affect Shareholder Equity – debt assumed, assets purchased or sold, etc – items that don’t appear in the Owner Earnings calculation but affect the Equity.
If Pfizer took a 20% hit to revenue, it would likely experience a significant drop in earnings and Owner Earnings. Once it “normalized” (i.e., fired excess staff, reduced expenses, etc.) to meet the new revenue level, earnings and Owner Earnings would likely revert back to a more “normal” level of revenue as well.
Any time a business takes a hit or posts superior numbers, you have to ask yourself, “Is this a temporary condition and what will the result be in a few years?”
Make sense?
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Looking at Morning star data I doubt that Pfizer makes up for a good investment
1) Topline has stayed flat ( in fact decreased marginally) for nearly four years.
2) Shareholder equity decreasing.
3) And the company is relying more on debt as a source of funding as can liabilities are on increasing compare to equity.
Even if the company is having a worthwhile Margin now, data shows that it may not be able to sustain it
and in pharma business where competition is increasing and law suits over patents are increasing and
drug making becoming complex and approvals not coming so fast is it still a good sector to be in ?
Joe / All , a lot of us do not understand the number you quite, I think it will save a number of posts and repeat efforts for some extra one time effort if you or someone who understands the number show us how the numbers are derived.
Thanks again and your thoughts please.
Regards
Ajay
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Regarding Ajay’s comment: I don’t read this post as Joe saying Pfizer is a good investment, just that it has a good margin of safety with respect to owner earnings.
Another awesome post Joe; it has been far too long since I’ve visited this blog; I’ve forgotten how refreshingly clear you make things.
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I’m not in Pfizer, and wouldn’t likely invest in it. The predictability factor in pharmaceuticals is small, if existent at all. I think that there are better opportunities out there. Of course, if the price was right…
Welcome back Chris B. It’s been far too long since I’ve been here too!
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Hi,
Found yr blog through Google, and I like your articles.
Just a few points about owner margins, or even GAAP profit margins:
1. Even with low owner margins (and low profit margins), a company may still have a competitive advantage – asset utilization. Take 2 companies, A with asset turnover of 5x, profit margin of 5%, and B: asset turnover of 1x, profit margin of 25%. Both companies are debt-free. For A, if all other competitors have asset turnovers that cannot match up or come close, A has a very big advantage in terms of asset utilization efficiency, and because low profit margins, less incentive for competitors/new entrants to come in, unless I can beat this company’s asset turnover. Now take B, which is generating only $1 for every dollar of assets, but with a profit margin and ROA of 25%. Much more incentive and determination for competition here, without going into qualitative measures (patents, brand name, etc).
Now assume both companies have $100 in sales. Let’s say sales fell $10 for both companies, Profit margins and assets remained the same. For A, because it has a higher asset turnover, it’s ROA won’t be impacted as much as to Company B. Now let’s say sales increased $10. Same thing here – ROA for A will be higher than ROA for B.
Example of companies that fit into A will be Walmart, and large efficient retailers. For B, more asset-intensive businesses like utilities, telecoms.
Not to say one is better than another, but just wanted point out that low net profit does not necessarily mean it’s a bad thing.
Pls keep writing!
redds79
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Joe,
A quality post that is very timely given the current market conditions. Not that it changes the impact of your post but I think you have your math off slightly for PFE.
With a FCF margin of 22% and a decrease in sales from 48 billion to 38.7 billion the expected FCF would be 8.5 billion. The company’s outlook would still be the same and would still have to reconsider its dividend policy and debt structure.
Dave
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