Why revenue doesn’t tell the whole story and why we need comparables in retailers’ financial reports

This post addresses these two questions

  • What do you think when you read on the news: Retailer A’s sales increased by 9% this year compared to last year?
  • What does “a 7% jump in comparables/comps for a retailer” mean?

In addition to revenue growth, look at gross margin as well

The first thing that jumps out of an income statement is revenue or net sales. That’s why it’s often referred to as “top line”. Does a change in revenue say a lot? Not so much. Let’s say if there is a year-over-year decrease in revenue, it’s safe to say that the company goes backwards directionally. If there is an increase year-over-year, the only conclusion that can be made at this stage is: well, at least this year isn’t a disaster, yet. Because there are a lot of factors that can contribute to the increase in revenue and can make such an increase pretty meaningless. It requires further investigation.

Let’s look at an example. You sold 10 tomatoes last year, each of which was bought at $7 and sold at 10$. The total revenue last year was $100 and the gross margin was ($10 – $7)*10 pieces = $30. Gross margin ratio is $30/$100 = 30%.

This year, you sold 15 tomatoes for $12 each, but the cost of sales for each tomato went up $10. The total revenue this year went up to $180, an increase of 80% compared to last year. However, gross margin stays at ($12-$10)*15 = $30 and the ratio, as a result, decreased to $30/$180 or 16.7%. You can see clearly that the unit economics worsened and your business is actually in a worse shape than it was last year. Of course, this doesn’t even take into account other expenses such as Sales and Marketing, Selling, General and Administrative Expenses (SG&A) or R&D. I don’t want to go off track too much and this example should show you that relying on revenue growth alone isn’t anywhere close to being enough.

If gross margin isn’t an issue and revenue increased, does it mean that it’s all good? Not really.

Why do we need comparables?

For instance, if a retailer that operates multiple stores has an 8% YoY increase in revenue, it means that it brings 8% more this year than it did last year. There are two important factors that can contribute favorably to that and potentially mask the true performance of the retailer

  • Time: sometimes the comparison is between 52-week and 53-week fiscal years. As a result, it’s not surprising that the 53-week fiscal year brings in more sales. You can see from Figure 1 below Target highlighted the fact that 2017 had 53 weeks and they removed the results of the 53rd week from comparison to make it fair
  • Number of stores: if this year’s performance is derived from more stores that last year’s, it’s then not a fair comparison.
Figure 1 – Source: Target

That’s why retailers use the comparables concept in their reporting. It reflects the increase or decrease in performance derived from the same stores over the same period of time. Such an approach will result in a true fair comparison and an honest reflection of a company’s health

Figure 2 – Source: Costco

Figure 2 is a table from Costco’s latest annual report. The changes in comparable sales are smaller than the changes in net sales, albeit that all are positive. It means that in addition to the growth organically from the same stores in 2018, Costco also benefited from opening new stores. Without the breakdown, investors would not be able to discern Costco’s true performance in 2019.

Another useful metric to look at is Revenue Per Square Foot. It divides the total revenue by total square feet and reflects how much money a retailer can generate per a square foot. A square foot’s size doesn’t change over time. Using this metric, investors can generally tell whether a retailer leveraged its retail space better, regardless of how many stores were closed or opened.

Figure 3 – Source: Target

In Figure 3, the first number column from left to right is for 2019, followed by 2018 and so on. As you can see, Target increasingly generated more revenue per square foot from $298 in 2017 to $326 in 2019. Generally, it should be a positive sign, but like the case of revenue above, it may still be a misleading metric.

Figure 4

Let’s run a scenario. This retailer ran two stores in 2018 and added one more store during the year of 2019. As you can see, the revenue per square foot in 2019 was higher than that in 2018, but it may not be cause for celebration. Sales in Store A and B declined and the increase in revenue and revenue per square foot came solely from Store C’s performance. It means that there was some trouble with Store A and B; which caused a decrease in revenue.

In conclusion, it’s hardly enough to use one single metric to judge a company’s health. It’s a combination of many. Hope you found this helpful. Have a nice 4th of July.

Revenue and margin makers

What I noticed in many businesses is that there are revenue makers and margin generators. Revenue makers refer to activities that draw in the top line numbers in the income statement, but small margin. In other words, these activities can bring in $10 of revenue, but about $1 or less of gross profit (revenue minus cost of revenue). On the other hand, margin generators refer to activities that don’t bring in as much revenue as revenue makers, but act as the source of most margin. Usually. these two complement each other. Let’s take a look at a few examples.

Apple sells their products and services that can only be enjoyed on Apple devices. Products bring in multiple times as much revenue as services, but products’ margin is much smaller than that of services. Take a look at their latest earnings as an example. Products’ margin is about 32% while services’ margin stands at 65%. Folks buy Apple devices mainly to use the services and apps that are on those devices. Apple continues to sell devices to maintain their own monopoly over their unique operating systems and ecosystem.

Source: Apple

Amazon’s eCommerce segment is a revenue maker. They warehouse the goods and ship them to customers. It generates a lot of revenue, but the cost is high as well. Built upon the infrastructure Amazon created for eCommerce, 3rd party fulfillment is a margin generator. In this segment, Amazon acts as a link between buyers and sellers to ensure transactions go smoothly without having to store and ship the goods itself. Margin is significantly higher than that of eCommerce. Amazon takes it to another level with Prime subscriptions and AWS. While trying to figure out how to keep their sites up and running 24/7 smoothly, Amazon came up with the idea of selling unused IT resources. Long behold, AWS is now a $40 billion runrate business and Amazon’s arguably biggest margin generator.

Costco is a household name in the US. Families go to their warehouse-styled stores to stock up essentials and groceries. Due to the volume they sell every year, Costco manages to keep the prices low, but thanks to the cut-throat nature of the industry they are in, the margin is low, about 2-3%. That’s their revenue maker. To compensate for the low margin, Costco relies on their membership fees. Whatever customers pay to be able to shop at Costco is almost pure profit to Costco. There is virtually no cost to process an application and issue a card.

McDonald’s essentially has two business segments: their own McDonald’s operated restaurants and franchising. The brand’s own operated restaurants serve as references to franchise owners for how good McDonald’s brand is as an investment. However, it offers the brand way lower margin than their franchised restaurants.

Airlines make money by flying customers, but there are a lot of costs involved such as planes, airport services, food and beverage, fuel, etc…Airlines can generate more margin with their branded credit cards. Many airline-branded credit cards come with an annual fee. Plus, card issuers may pay airlines a fixed fee for new issued cards and a smaller fee for renewals. Plus, there may be a small percentage for first non-airline purchases. Agreements vary between airlines and card issuers, but it brings a lot of margin to airlines.

Ride sharing apps are notoriously unprofitable. Uber and Lyft lost billions of dollars in their main operations. Recently, they tried to launch a subscription service and in Uber case, a credit card, hoping that these services could help generate the margin they need.

We all know the saying in business: cash is king. Cash can only increase, from an operating perspective, when margin increases. Revenue is crucial because, well, a business needs to convince folks to pay for products or services first. Nonetheless, a business is more robust and valued when margin increases.

Comparing Enterprise SaaS Companies’ Metrics

Interested in how enterprise SaaS companies whose some or all of their revenue come from subscriptions, I set out to collect data from the companies that I know offer subscriptions to enterprise customers. Please be aware that this is my personal research stemming from intellectual curiosity only. They are not meant to be anything more than that.

  • Data is collected from the latest year in the companies’ latest annual reports to ensure that seasonality factor is removed
  • The metrics include subscription gross margin (subscription gross profit/subscription revenue), overall gross margin, Sales & Marketing expense as % of revenue, R&D as % of revenue, SG&A as % of revenue and net dollar expansion rate (or retention rate)
  • If there is a difference between subscription gross margin and overall gross margin, it’s because those companies also generate revenue from other sources such as hardware or professional services
  • Much as I tried to keep the figures accurate, do use them at your discretion

Subscription Gross Margin

Median: 82%/ Mean: 80%

Gross Margin

Median: 72%/ Mean: 71%

Sales & Marketing Expense as % of Revenue

Median: 44%/ Mean: 42%

R&D as % of Revenue

Median: 22% / Mean: 22%

SG&A as % of Revenue

Median: 15% / Mean: 15%

Operating Income (Loss) as % of Revenue

Median: -14%/ Mean: -10%

Dollar Expansion Rate

Median: 115% / Mean: 115%