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Back Story

Fat margins motivate over spending. The bigger the margin the greater the temptation to waste cash on selling, general and administrative expenses. That's margin myopia.

This is a blind-spot in the management of large smart-technology enterprises. Many CEOs seem willing to trade higher top-line growth for slower increases in cash flow. Because that's what investors look for in the short term. But when keepsake investors make competitive comparisons the numbers speak for themselves. Sometimes they even shout!

For example in his March 4, 2013, article Eying Apple James Surowiecki said in The New Yorker:

[Apple's] cash hoard is bigger than the market cap of almost every company in the S&P 500. … Unlike its competitors it also does an exceptionally good job of turning sales into profits.

Gerstner's Rule

Louis Gerstner described a simple yet revealing measure of margin myopia in his 2003 book Who Says Elephants Can't Dance? He was the first one to define this measure, so I call it "Gerstner's Rule." The meaning is simple: less is more.

One can apply Gerstner's rule to any public company and see in a flash if management is overspending on three critical line items: Research and Development + Marketing and Sales + General Administrative Expenses. Combined, these are labeled selling, general and administrative (SG&A) expenses if they are not reported as individual line items in the income statement. All the data used in this analysis are from company SEC filings.

Gerstner said that CEOs should minimize their SG&A cost per dollar of revenue. Do they follow this rule when faced with fat margins? In a word, no. The results of this first analysis of the top 6 smart-technology firms appear in the following table.

Table 1

Smart-Tech Companies, SG&A Per $ and Gross Margin

Smart-Technology Companies 2012

SG&A Per $ Revenue

Gross Margin Percent

Apple (AAPL)

$0.09

43.9%

Google (NASDAQ:GOOG)

$0.33

58.9%

Microsoft (NASDAQ:MSFT)

$0.38

76.2%

Yahoo (NASDAQ:YHOO)

$0.55

69.8%

Facebook (FB)

$0.63

73.2%

Linkedin (LNKD)

$0.73

87.1%

Apple, with the thinnest margin in the group (43.9%), spent 9 cents to generate a dollar of revenue in 2012. Linkedin had the fattest margin in the group (87.1%) and spent 72 cents to generate a dollar of revenue. Or, LNKD management spent 8 times as much to generate a dollar in revenue compared with AAPL management. How can this be explained? Margin myopia. The gross margin available to Linkedin management was double that of Apple.

The correlation between SG&A per dollar revenue and gross margin percent in Table 1 is 0.9. So it seems fat margins do motivate big spending, right? Sort-of right. Unfortunately, correlations don't prove anything. What's required is a theoretical relationship between spending and margins. I introduced just such a measure in my book Competing for Customers and Capital I called it the "Enterprise Marketing Efficiency Ratio." Forgive the following self-reference but I hope it helps make the point stick in your mind.

Cook's Ratio

Most of a company's SG&A "assets" are intangible. But that does not mean their effects are invisible. In the long run the actual costs of an intangible, like the salesforce, will equal its theoretical costs to the company, at the margin. Here's the equation:

x = s/y.

Where (s) is actual SG&A expenses and (y) is the theoretical SG&A expenses required to maintain current revenues. Values of this x factor for the same six smart-tech companies are reported in the following table.

Table 2

Smart-Tech Companies, Efficiency and Gross Margins

Smart-Technology Companies 2012

Marketing Efficiency Ratio (x)

Gross Margin Percent

Apple (AAPL)

$0.2

43.9%

Google (GOOG)

$1.7

58.9%

Microsoft (MSFT)

$2.3

76.2%

Yahoo (YHOO)

$2.5

69.8%

Facebook (FB)

$2.9

73.2%

Linkedin (LNKD)

$3.3

87.1%

There are three important differences between Gerstner's Rule and Cook's Ratio:

1) The ratio is calculated in a strategic group of all six companies;

2) It is a non-linear, theoretical, unobservable number; and

3) The expected value of x is 1.0 with a minimum value of zero.

What does the x factor mean intuitively? This is where the numbers shout:

Apple management spent only $0.2 per unit for its bundle of intangible resources while Linkedin spent $3.3 per unit. Or, AAPL was 16 times more efficient than LNKD. This explains how AAPL unlike its competitors did an exceptionally good job of turning sales into profits.

Why were Linkedin and Facebook management so inefficient? Because they are focused on top-line growth and they can afford to over-reach with the corresponding loss in efficiency. That's margin myopia.

The Therapy

What's management to do to cure their narrow vision? First, make competitive comparisons using Gerstner's Rule or Cook's Ratio. Then, spend less or spend smarter to bring the company into line with the best in class.

Source: Margin Myopia

Additional disclosure: I hold 100 shares of Yahoo for the long term.