Slightly less cynical reply... it will lead to someone’s promotion by writing something like “doubled gross margin percentage by streamlining product lines to focus on core competencies” in an annual review. Sad to say that this happens all the time.
My theory is that it was partially our MBAs and partially the stock analysts MBAs. In our industry, normal margins were 60 points, so when our company was generating 36 points, it looked wrong to the analysts, so it needed to be fixed....
Nothing in my MBA curriculum has taught me that low margins are bad, just that low margins with high capital intensity is bad. At the same time, absolute numbers are critical and should be analyzed independently from margin.
They also forget that in an environment where capital is fairly cheap (which hasn’t been the case in human history until extremely recently) the margins shouldn’t be compared against other industry players, etc, but rather against the overall cost of capital on the market.
Comparing margins across industry is useful because if your margins are lower than your competitors then it could indicate inefficiencies or mistakes you might be making. But one needs to understand why those margins are lower. Apple, for example, can enjoy much higher margins than Dell, because although they are in the same industry, the brand and value proposition Apple brings is very different from Dell’s. Dell could try and chase the margins Apple has, but it would have to then become a very different company from what it currently is.
You’re talking like a rational actor. However there is a lot of irrational behavior caused by principal agent problems in investing. If a trade goes belly up the boss or client is going to ask why you bought a company doing 36 points of gross margin in an industry where the average is 60. In many cases, to preserve competitive advantage, the company doesn’t want to disclose the mix of revenue and profit margins of its business units, so investors don’t even have any way to evaluate why the company is doing only 36 points. So in many cases it can be “rational” to shut down a business unit making $25 million of gross profit.
I think I don't understand what capital intensity means here. If the margin is low, doesn't it mean that it's capital intensive? In the example, $75M is required to get $25M. Isn't that intensive?
Capital intensity has to do with net operating assets (PP&E, working capital). It’s capital intensive if you have to build a $1B plant in order to make a 1% margin.
Slightly less cynical reply... it will lead to someone’s promotion by writing something like “doubled gross margin percentage by streamlining product lines to focus on core competencies” in an annual review. Sad to say that this happens all the time.