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.

LinkedIn’s life under Microsoft

In December of 2016, Microsoft paid $27 billion in total for LinkedIn and completed the acquisition. According to the latest annual report, the majority of the acquisition price came from goodwill which Microsoft clarified as primarily synergies gained from the integration of the acquired social network.

Source: Microsoft Annual Report 2019

Interestingly, among intangible assets, Microsoft assigned a little more than $2 billion for the trade names. I am not entirely sure whether it means Microsoft valued LinkedIn’s brand as that price. There seems to be a difference between the two concepts: trade names and trademarks, even though in some cases, the two can be interchangeable.

Source: Microsoft Annual Report 2019

Apparently, during the fiscal year when the acquisition took place, LinkedIn generated $2.2 billion in revenue, but registered a negative operating income

Source: Microsoft Annual Report 2019

Fast forward two years later, LinkedIn increased its revenue by almost 200%, from $2.2 billion to $6.7 billion approximately

Source: Microsoft Annual Report 2019

In terms of members, LinkedIn had 500 million members, 575, 645 and 660 in 2017, 2018, 2019 and Q1 2020 respectively. It’s interesting to notice how Microsoft commented on the primary source of revenue from LinkedIn. LinkedIn’s lines of business include Talent Solutions, Marketing Solutions, and Premium Subscriptions. As of the quarter ended December 31, 2017, most of LinkedIn’s revenue came from Talent Solutions

Source: Microsoft’s SEC Filings

Since the quarter ended March 31, 2018, Microsoft didn’t make such a comment any more. Instead, it has been replaced with “strong momentum across all businesses” or something along that line

Source: Microsoft’s SEC Filings
Source: Microsoft’s SEC Filings

It is not clear whether all lines of LinkedIn’s businesses contribute meaningful revenue now. Given the explosive growth in revenue, it won’t be surprising if that’s the case. After all, multiple firing cylinders are better than one.

Disclosure: I own Microsoft stocks in my personal portfolio

Mixed Feelings from Netflix’s Earnings Report

Netflix released its earnings yesterday. There are causes for optimism and concern from what I have seen.

Important metrics improved YoY significantly

This quarter, Netflix added 517,000 domestic paid subscribers and more than 6.2 million international paid members, bringing the total subscriber count domestically and internationally to more than 60.6 million and 97.7 million approximately.

Contribution margin for domestic and international streaming is 41% and 20% respectively, resulting in the margin for streaming to be around 30%. Contribution margin of Domestic DVD is around 61%. Contribution margin represents what is left of revenue after all the variable costs to pay for fixed costs and to generate profit.

On a year over year basis, revenue, operating income and paid memberships saw remarkable growth for a company this size

Cause for concerns

Even though domestic paid memberships increased, Netflix missed its own expectation by almost 300,000, making it the second consecutive quarter that it did so. The company blamed the miss on the higher pricing elasticity than expected

That’s really on the back of the price increase. There is a little more sensitivity. We’re starting to see the – a little touch of that. What we have to do is just really focus on the service quality, make us must-have. I mean we’re incredibly low priced compared to cable. We’re winning more and more viewings. And we think we have a lot of room there.

But this year, that’s what’s hit us. And we’ll just stay focused on just providing amazing value to our members in the U.S. And I think that gives us a real shot at continuing to grow net — long-term net adds on an annual basis. But we’re going to be a little cautious on that guidance and feel our way through here.

CEO – Reed Hasting in Earnings Call (Per Seeking Alpha)

I saw a sentiment floating around on Twitter a while back that argued that Apple TV+ and Disney+ aren’t really competitors to Netflix. I mean, to some extent, they may differ a bit from Netflix, but if we want to talk about competing for viewers’ attention, time and disposable income, how can they not be? Sure, boats move different from trains, but if patrons can choose either to go from point A to point B, how can they not compete with each other? Now Reed Hasting admitted the challenge from other streamers, especially Disney+

From when we began in streaming, Hulu and YouTube and Amazon Prime back in 2007, 2008, we’re all in the market. All 4 of us have been competing heavily, including with linear TV for the last 12 years. So fundamentally, there’s not a big change here. It is interesting that we see both Apple and Disney launching basically in the same week after 12 years of not being in the market. And I was being a little playful with a whole new world in the sense of the drama of it coming. But fundamentally, it’s more of the same, and Disney is going to be a great competitor. Apple is just beginning, but they’ll probably have some great shows, too.

But again, all of us are competing with linear TV. We’re all relatively small to linear TV. So just like in the letter we put about the multiple cable networks over the last 30 years not really competing with each other fundamentally but competing with broadcast, I think it’s the same kind of dynamic here.

Source: Seeking Alpha

Chief Product Officer Gregory Peters made an important point below

I would say our job and then what we think our pricing for a long-term perspective is continue to take the revenue that we have that our subscribers give us every month, judiciously and smartly invest it into increasing variety and diversity of content where we really want to be best-in-class across every single genre.

And if we do that and we’re successful in making those investments smartly, we’ll be able to continue to deliver more value to our members. And that really will enable us to, from time to time, ask for more revenues so that we can continue that virtuous cycle going

Source: Seeking Alpha

Quite an important “if” condition there. In short, Netflix borrows capital to invest in content to the tune of billions of dollars every year and hopes that their subscriber base growth and revenue will keep enabling them to do so. In essence, every streamer will do that. Every single one of them needs to churn out quality content to convince viewers to choose their service. Failure to produce quality content to justify expensive investments will be costly for these streamers.

For Netflix, the stakes seem to higher. Other competitors have additional revenue streams apart from their streaming service. Netflix essentially relies on their subscription revenue. As this quarter shows, the price elasticity already has some negative effect, and it’s BEFORE other heavy-marketed competitors such as Apple TV+ and Disney+ debut in 2-4 weeks. The new challengers price their services at much lower points than Netflix. The room to increase price to recoup their investments faster is getting smaller. I do think a price hike will negatively affect Netflix.

Some may say: oh Amazon kept investing heavily in their early days as well and Netflix can be the same. They are not, as I wrote here. Their free cash flow continues to be in the red while Amazon was in the black for years.

The expensive bidding war for content may play into Netflix’s favor. Their huge subscriber base enables them to spread the cost much better than competitors, especially new ones that have to acquire subscribers from scratch. Hence, it can be argued that Netflix will be one of the only few standing after the dust settles. It does make sense to think about the streaming war’s future that way. As does it make sense to think that there is a possibility that the game Netflix is playing may not work out for them, given the intense competition, the decreased price inelasticity, the huge debt they have incurred and the continuous negative free cash flow.

I think that we will have more clues around the next earning call or two as we’ll see how Netflix will fare after the arrival of Apple TV+ and Disney+. Even then, we won’t know definitively who will win in the end. Fascinating times ahead.

Amazon’s Quarterly Earnings

On that FY2019 Q2 earnings by Amazon…

Revenue

In the last 90 days, Amazon recorded $63 billion, meaning that it took the company less than 36 hours to make $1billion. An extraordinary rate. Compared to last year’s Q2, revenue rose by 20% with Services (31%) outperforming Products (12.5%). Nonetheless, gross margin slipped as this quarter’s figure is at 4.8% compared to 5.6% last year.

Source: Amazon

AWS

Among Domestic, International and AWS categories, the latter continues to lead the way in terms of YoY growth. AWS’s revenue in the last 90 days is $8.3 billion, a rough equivalent of about $32 billion annually. It’s pretty impressive for just a segment of a company. Not many standalone companies can generate that much revenue in a quarter. It’s even more telling when we put AWS next to GCP. Google announced last week that GCP’s annual run rate is $8 billion, meaning that AWS is approximately 4 times bigger than its rival from Google.

Despite making up only 13% of Amazon’s revenue, AWS is responsible for about 69% of the company’s operating income.

At 37%, AWS’ YOY growth is the lowest recorded in a long time, but the law of big numbers should be taken in account here as the division is not as small as it used to be. If broken down into more strategic categories, AWS isn’t the segment with the biggest YoY growth (Excluding FX) in the company. It’s Subscriptions. Subscription memberships, especially Prime, play a crucial role in Amazon’s ecosystem. The fact that it notched the biggest growth, ahead of AWS, is very positive for the company.

Advertising

As can be seen above, advertising slowed down significantly after a hot streak just 12-15 months ago. YoY growth decreased noticeably compared to the 3-digit growth just a while ago. Still, it contributed $3 billion to the company’s top line.

Free Cash Flow and Shipping Costs

Amazon’s free cash flow this quarter is truly insane with 65% YoY improvement in Operating Cash Flow and a 3-digit growth in Free Cash Flow.

Source: Amazon

Shipping costs continued to rise with 36% YoY difference compared to previous second quarter’s. It’s worth noting that none of the Online Stores, Physical Stores and 3rd Party Seller Services have the same growth (all grew at a slow pace than shipping costs)

Sometimes, it’s hard to believe that a company founded roughly 25 years ago can be this powerful and big. A segment responsible for only 13% of its revenue is the dream of so many and it continues to deliver at an impressive rate.