Wednesday, February 8, 2023

Some of the most important insights about corporate performance can be found at the margins. So we at Calcbench wondered — what do the margins say about companies’ fight against inflationary forces?

Specifically, we wondered about gross margins and operating margins. Both disclosures are non-GAAP metrics, but they are easy to calculate and consistent across many companies. They also provide a window into how well a company can pass along rising costs to its customers.

How so? First let’s look at gross margins. That is simply gross profit divided into revenue, and gross profit is revenue minus cost of goods sold. So as your cost of goods rises, your gross margins will fall. The way to counteract that would be to pass along those rising costs to customers by raising prices. Those higher prices would lead to higher revenue, and your gross margins would return to normal.

Operating margins work in the same way. They are calculated as operating profit divided into revenue, and operating profit is revenue minus cost of goods sold and sales, general, and administrative costs. So as your costs for labor and services rise, your operating margins get squeezed. Again, you counteract that by raising prices, which leads to higher revenue, which preserves operating margins.

That’s how things work at the theoretical level. Here in the real world, companies spent all of 2022 grappling with higher costs for materials and labor. Did that squeeze their margins? Using our Bulk Data Query page and our Multi-Company page, we decided to investigate.

First we looked at Google ($GOOG). Figure 1, below, shows the change in gross and operating margins from 2020 through 2022.

We can see a few things here. First, Google has impressively high gross margins — but then again, why wouldn’t it? Google is a tech company. It doesn’t spend lots of money buying materials to be reprocessed as physical goods to sell.

Second, you can see how operating margins bulged upward from second-quarter 2020 (16.7 percent) into third-quarter 2021 (32.3 percent). We didn’t look into the footnotes to understand exactly why that happened, but it’s not surprising; everyone was stuck at home either working remotely or surfing the internet. Result: lots of Google searching, which means a rapid increase in revenue for Google. When growth in revenue exceeds growth in operating costs, operating margins go up.

Third, however, notice how operating margins started to decline in late 2021, with gross margins drifting downward in the same timeframe. That operating margin decline continued all through 2022, dropping from the 32.3 percent we saw in mid-2021 to 23.9 percent at the end of 2022.

Why? One reasonable theory is that Google splurged on hiring in 2021, so its SG&A costs went up. For example, Google headcount went from 150,000 in September 2021 to 190,000 at the end of 2022, a jump of 26.7 percent. Now look at the increase in costs shown in Figure 2, below.

R&D costs rose by 17.9 percent from Q4-2021 to Q4-2022. Sales and marketing costs fell by 5.5 percent, but general and administrative costs popped by 23 percent. That led to a drop in operating income of $3.72 billion at the end of 2022 compared to the year-earlier quarter. Operating margin fell from 29 percent one year ago to 23.9 percent now — and in relative terms, that’s a lot.

Look at everything that way, and suddenly you can see why Google decided to cut headcount. It’s a brutal but efficient way to cut operating costs and keep those margins up — which, in turn, preserves net income and ultimately helps share price. (In the short term, at least.)

That’s enough for today. But the next obvious question is what we can learn from changes in gross and operating margins (or the lack thereof) at other companies, other sectors, and even the S&P 500 overall.

That will be in our next post.

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