Friday, July 31, 2015

Another financial metric: Useful sales growth

In my latest critique of Linkedin results, I introduce the concept of useful sales growth.  This can be understood as simply growth in gross profit less marketing and depreciation expenses.

Useful Sales Growth
If a company increased sales by $100M in a quarter, but its costs of revenue went up by $50M, and its marketing expense up another $50M, then that company had no useful sales growth at all.  It did not make any extra money availble to pay for other expenses.  It probably "bought" all of its sales growth by extra spending on marketing.

The metric is critically important in detecting poorly performing companies.  If I have a $1T bribery slush fund (marketing budget), then I can easily increase sales by $1T.  Spending $1 in advertising to get $1 in revenue is inneffective, except for padding revenue numbers that may deceive investors into seeing growth.

The reason for including depreciation expenses in the formula
For a mining operation, where equipment is built and purchased at the begining of a mine opening and is likely to last for the life of the mine, depreciation would not be considered, as that buildout is a one time sunk cost.

Similarly, old economy factories, have considerable depreciation attached to large buildings and repairable long lived machines.  Much of the depreciation in those operations is one time sunk costs.

For tech/web companies, however, their depreciation expense is entirely tied up in recurring computer equipment expansion and replacement.  For growing companies, the amount usually increases every quarter.

That depreciation expense for tech companies, is in fact a cost of revenue.  Increases in those costs are costs that increases in gross profit must cover in order to make that gross profit growth useful and attractive.

As an alternative, it would be possible to take property and equipment purchases as the more relevant deduction, but that number is not guaranteed to be exclusively computers or quick depreciable items, and it can be more variable as purchases are deferred for a quarter. So the long term smoothing benefits of  depreciation writedowns are more useful for this reason too.

(increase in sales less increase in cost of revenue, sales&marketing, depreciation) / last period's revenue.

Useful Gross Margin, or Beneficial Margin
A similar metric using the same 3 components relative to revenue.  What is left over after paying for the 3 components.  It can also be captured as Gross Profit (including depreciation) less Marketing expenses.

The term Beneficial Margin is used.

LNKD (Q2-2015) increased revenue by $178M over the same quarter last year.  The increases in cost of revenue ($30M), Sales and Marketing ($77M) and depreciation ($21M) total $128M.  Useful sales growth was thus $50M.   9.36% useful sales growth rate over Q2-2014 revenue of $534M.

Linkedin's Beneficial Margin dropped from 43.3% the previous quarter to 39.4%.  A 9% drop in "beneficial profitability of sales"  FY-2014
208M revenue increase.  CoR change of -9M. S&M change of -4M, depreciation change of 20.5M.  Useful sales growth of $200.5M.  8.6% useful sales growth rate over FY 2013 revenue of $2.319B.

The remarkable point about these 2 companies useful growth rates is that if they are about the same, the companies should be valued the same.  AOL is also profitable.  While its top line growth is about 9%, it has much lower incremental direct costs and marketing expenses than linkedin, which makes most of linkedin's 30% top line growth, fake and useless. Q1-2015
From its last report included in my linked analysis, $8.7M increase in revenue.  +$0.9M CoR, +$6.7M marketing.  $1.1M useful sales growth, 3.1% useful sales growth rate.  Beneficial Margin went from 53.2% in q1-14 to 44.8% in q1-15.  A 16% drop in "beneficial profitability of sales"

An example of fairly inneffective marketing overspend.

Facebook Q2-2015
1132M increase in revenue.  $195M increase in cost of revenue.  $268M increase in marketing.  (depreciating unclear).  $669M useful sales growth.  23% useful sales growth rate.

Roughly same top line sales growth as LNKD but created a surplus effective in covering other expense growth instead of creating a large loss.

FB's Beneficial Margin is 68%

Twitter Q2-2015
190M incremental revenue.  Incremental CoR of $67M. Incremental Marketing of $61M. $62M useful sales growth.  About 20% useful sales growth rate.  While growth is declining and marketing expenses might not, it is so far being relatively responsible in its chase of growth.

For FY-2014, $739M delta-rev, $180M delta-CoR, $298M delta-marketing = USG of $261M or 39%.  So Twitter's useful sales growth while still reasonable is deteriorating considerably.

Yelp Q2-2015
$45M delta-rev.  $7.2M delta CoR.  $20M delta Marketing.  $3M delta-depreciation. USG of $14.8M or 16.8%

As bad a quarter as Yelp had, its not nearly as bad as linkedin's.  Expense growth was below revenue growth, and margins are relatively reasonable (though hard to hope for better than break even expectation).

Google Q2-2015
1782M delta-rev.  $469M delta-CoR.  $138 delta-marketing.  USG of $1173M or 7.35%.

While useful sales growth% is lower than linkedin's.  Its over $1B, and achieved with improving margins.  The %increases in CoR and marketing were less than revenue growth, and contributed to enhancing already solid core profit.

Low USG companies masquerading as high growth companies

  • Growth rates of companies slow as they saturate their target market.
  • The saturation portion of growth is the temporary short term (a few years) process.
  • Other sources of growth include specific market growth (internet penetration), population growth, inflation, and market share fight.  The first 3 can be called ambient growth.  Specific market portion can become a declining force eventually.  
  • Saturation growth declines rapidly and never comes back.
While its ok for an early stage (startup) company to lose money or break even as it captures early (saturation) growth, detecting the end of that saturation phase is relatively easy:

Useful Sales Growth showing growth equivalent to ambient growth (for internet companies, the growth rate of mature companies that don't have much hype or excitement to them (ie. while losses accelerate is a completely foolproof indicator that the company does not have any useful growth whatsoever.

Hoping that such companies reinvent their value proposition is the only remaining hope, but joining in such hope as a shareholder should be only at rock bottom prices.


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