Valuation – Margins
What Drives a Company’s Value?
Company valuation is dependent on two major drivers – growth and margins (we will ignore the cost of capital for now, assuming a continuing steady interest rate environment). As companies mature, achieving high sales growth becomes increasingly difficult and the market tends to turn its attention to profitability. We are particularly concerned with gross and operating margins. However, sudden improvement or consistent outperformance against the sector requires additional analysis. Let’s have a look at two recent examples.
Case 1 – Consistent Margin Outperformance
Patisserie Valerie – much has been written about the fraudulent nature of the spectacular failure of this chain of cafés (specializing in cakes). This is not a business model that is too difficult to understand. We had a look at comparative operating margins of a few competitors and were surprised about the outstanding performance of Patisserie Valerie:
| Gross Margin | Operating Margin | |||||
|---|---|---|---|---|---|---|
| 2015 | 2016 | 2017 | 2015 | 2016 | 2017 | |
| Caffee Concerto | 44.1% | 45.4% | 47.3% | 0.7% | 0.9% | 0.9% |
| Starbucks UK | 26.4% | 21.3% | 19.1% | 6.9% | 1.7% | 0.2% |
| Costa | 71.4% | 74.6% | 73.9% | 15.5% | 13.9% | 12.8% |
| Cafe Nero | 24.4% | 23.7% | 22.8% | 7.3% | 7.0% | 5.7% |
| Patisserie Valerie | 77.3% | 78.1% | 78.2% | 15.9% | 16.5% | 17.6% |
Data source: Companies House
The only company that comes close to Patisserie Valerie’s margins is Costa Coffee, recently acquired by Coca Cola for £3.9 bn. Costa’s sales are more than eight times of Patisserie Valerie’s sales. The analysis highlights one factor which seems to have been missed by most investors in Patisserie Valerie – in a highly competitive market this was the only company that was able to increase operating margins over the 3 years analyzed. Considering that coffee carries a higher margin than cakes, and that rents and business rates have been increasing, this is an astonishing development.
We now know that fraudulent activity in Patisserie Valerie’s accounting department inflated the company’s performance. But could investors not have questioned the seemingly stellar performance earlier? Please note that all companies have different year ends but this should not impact the underlying analysis.
Case 2 – Questioning Margin Improvement
Tesla is being closely watched at the moment, not just by car enthusiasts and investors but also by the Securities and Exchange Commission following continuing tweeting by its founder, Elon Musk. The company has just published (1 March 19) that “We are incredibly excited to announce that the standard Model 3, with 220 miles of range, a top speed of 130mph and 0-60mph acceleration of 5.6 seconds is now available at $35,000!”
The press release for the full year results has some interesting numbers:
A great improvement in Q4 2018 YoY. Particularly as the company states: “Despite margins in the automotive industry typically being lower in Q4, that was not true for us as our operating margin remained strong at 5.7% in Q4”. For our analysis we will focus here on gross margin as we can see an equally large improvement and thought we do a deeper dive on quarterly numbers.
The below analysis looks at consolidated sales of Tesla but as most of the sales relate to cars, we are comfortable with this.
| Quarter | Quarter | Quarter | Quarter | |
| DEC ’17 | DEC ’18 | SEP ’17 | SEP ’18 | |
| Sales | 3,288.2 | 7,225.9 | 2,984.7 | 6,824.4 |
| Growth rate | 119.7% | 128.6% | ||
| COGS incl D&A | 2,849.5 | 5,783.0 | 2,524.7 | 5,296.1 |
| as % of sales | 86.7% | 80.0% | 84.6% | 77.6% |
| Gross profit | 438.8 | 1,442.9 | 459.9 | 1,528.3 |
| Gross margin | 13.3% | 20.0% | 15.4% | 22.4% |
| COGS excl D&A | 2,379.9 | 5,286.2 | 2,124.1 | 4,996.1 |
| as % of sales | 72.4% | 73.2% | 73.2% | 78.1% |
| D&A | 469.6 | 496.7 | 400.6 | 300.0 |
| as % of sales | 14.3% | 6.9% | 13.4% | 4.4% |
| as % of total COGS | 16.5% | 8.6% | 15.9% | 5.7% |
Data source: Factset
What is striking is the dramatic improvement in D&A as a percentage of sales. Actual COGS excluding D&A are relatively constant (except for the quarter ending Sept 2018) – we would expect this as they are mainly variable costs. So, what is happening? The note to accounting policies states the following:
“Depreciation for tooling is computed using the units-of-production method whereby capitalized costs are amortized over the total estimated productive life of the respective assets. As of December 31, 2018, the estimated productive life for Model S and Model X tooling was 325,000 vehicles based on our current estimates of production.” – 10K 2018
“As of December 31, 2017, the estimated productive life for Model S and X tooling was 250,000 vehicles based on our current estimates of production.” – 10K 2017
The units-of-production method means that depreciation is charged to expenses in direct proportion to the use of the asset, hence should be relatively constant as a percentage of sales.
Clearly the company has changed its accounting policy in terms of estimated vehicles. Interesting concept particularly as the company states under its risk factors:
“If we update or discontinue the use of our manufacturing equipment more quickly than expected, we may have to shorten the useful lives of any equipment to be retired as a result of any such update, and the resulting acceleration in our depreciation could negatively affect our financial results.” – 10K 2018
Let’s have a look at margins if we hold depreciation constant at prior quarter levels.
| Quarter | Quarter | Quarter | Quarter | |
| DEC ’17 | DEC ’18 | SEP ’17 | SEP ’18 | |
| D&A as % of total COGS at prior year quarter | 16.5% | 16.5% | 15.9% | 15.9% |
| 2017 actual/ 2018 implied D&A | 469.6 | 953.1 | 400.6 | 840.4 |
| 2017 actual/ 2018 implied COGS incl D&A | 2,849.5 | 6,239.3 | 2,524.7 | 5,836.5 |
| 2017 actual/ 2018 implied gross profit | 438.8 | 986.6 | 459.9 | 987.9 |
| 2017 actual/ 2018 implied gross margin | 13.3% | 13.7% | 15.4% | 14.5% |
| Reported gross margin | 13.3% | 20.0% | 15.4% | 22.4% |
Interesting? Adding this to the announcement on 1 March 2019 that Tesla is closing stores and only selling online (I still would prefer to test drive a new car, wouldn’t you?) and already messaging that Q1 2019 will not be profitable, one has to hope that the change in accounting policy is truly based on a more efficient manufacturing process.
We would like to highlight that these 2 cases are very different, and we are not implying any fraudulent activity at Tesla.