Profit magnitude AND duration

It’s not enough to focus on a company’s profitability–especially if it’s huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.  

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.  

Or, consider Apple. It’s hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple’s valuation.

Or, what about Sprint (the telecom company)? It’s clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint’s valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse?  The value of the business hinges on the outcome.

I don’t mean to imply that answers to these questions are easy–they aren’t. In fact, I’ll be the first admit I don’t have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.  

I should know, I’ve fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank–a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That’s why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).  

As I said last week: it’s not about market share, it’s about profitability. Now, I’d like to add that it’s not just about profitability, but also durability. Your investing future depends on both.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Profit magnitude AND duration

Profits, not market share

As a shareholder of Dell, I must admit to being frustrated by all the focus both Wall Street and the media apply to market share. Listening to them, you’d think all that matters is market share. They’re wrong.

What matters in business is profits.  Not market share, but profits and their sustainability. Market share is a measure of sales relative to other companies. It’s a top-line focus. Profits are bottom-line. It’s the money a company makes, it’s a measure of value-added, and it’s the money a business has to compete in the future.

In Wall Street and the media’s defense, there are some businesses where market share is all important. In Internet search, for example, Google dominates with high market share and very high profits. There’s a network effect in search that hugely rewards number one. Number two and below not only don’t make much money, they lose big-time (just ask Yahoo! and Microsoft (another holding of mine)).

Let me give you a quick theoretical example of how to gain very high market share but lose in the end.  Buy $30,000 Honda’s sell them for $15,000. I guarantee you’ll have #1 market share. But, you’ll be out of business so quickly it won’t matter. Now, buy those Honda’s and sell them for $29,000. Once again, you’ll have very high market share and you’ll last longer, but you’ll still be out of business in the long run, guaranteed.

Now, back to the computer market.  

A couple of years ago, Acer overtook Dell by grabbing the #2 market share spot. Was that #2 in profits? Not at all. In fact, Acer gained #2 market share selling netbooks. Remember those. Perhaps not, because they’ve been almost completely supplanted by tablets–mostly Apple’s iPads. Acer gained market share selling a cheap, low profit margin product. Dell didn’t follow. Since then, Acer has fallen back below #2 and Dell continues making profits and competing successfully. Dell focused on profitability, not market share, and it worked.

Fast forward to today, and Lenovo just overtook Dell for #2 in market share. Instead of selling netbooks, Lenovo is dominating sales in China and doing very well in emerging markets. Their profit margins?  1.85% at last report on an accounting basis. Dell’s profit margins? 5.8% on an accounting basis (7.6% on a cash basis).

Now, think about that. Profits are what is used to buy inventory, innovate new and better products, build supply chains, hire productive employees, etc. Just for the sake of the argument, let’s assume Lenovo is selling a product that’s just as good as Dell’s (which is unlikely with so much lower profit margins). Lenovo is essentially selling $30,000 Honda’s for $30,555 and Dell is selling them for $31,740.  Lenovo is making $555 on each sale and Dell makes $1,740–more than three times as much!

That’s the money each company has to pump back into the business. Lenovo would have to have over three times the market share to have the same amount of profits to plow back into the business in order to be competitive. Does Lenovo have three times Dell’s market share? Not even close. In other words, Lenovo cannot compete by focusing on market share, it must either focus on profitability or risk losing that market share over the long run.

I’m simplifying the argument a bit to make things clear, but my point is still valid. For a company to survive and thrive over time, it’s about profitability, not market share. An over-focus on market share is the wrong way to think.  It’s a focus on effects, not causes.

In the long run, Dell doesn’t need high market share to succeed. It needs profitability. That, it has.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Profits, not market share