A marginal truth

The context was relevant, too. Mr Coupe made his comparison between the healthy margins made by the likes of Unilever (ULVR) and Associated British Foods (ABF) and the subsistence margins eked out by Sainsbury by way of justifying the proposed deal to an influential committee of MPs. The key sentence in his letter to the committee read: “We understand concerns that have been raised about how suppliers will be impacted, but to give some context for this – for every £1 that a customer spent in Sainsbury’s last year we made 2p profit. If you compare that with large suppliers, they generally make more than 10p profit for every pound that we spend with them.”

To the average back-bench MP, who may know as much about what drives company profitability as I know about parliamentary procedure, Mr Coupe’s comments might sound persuasive. Yet they should be anything but. As a businessman who has been around consumer staples industries all his working life, including a spell with Unilever, Mr Coupe knows full well that comparing profit margins between the retailers and the suppliers of these staples is like comparing Red Leicester with Camembert: both are the result of similar processes – churning revenues and costs to make profits, churning cows’ milk to make cheese – but the end product is quite distinct. Indeed, regarding profit margins, it’s tricky to compare data between industries because they are all driven by different factors.

It is important to grasp that some industries, by their very nature, are low-margin operations and some high-margin. Companies in low-margin industries can still be beautifully profitable, while those in high-margin areas usually need that generous dollop of profit from sales in order to become truly profitable.

To see why, take the table of financial data for UK supermarket operators and their suppliers. The data are for profit margins (operating profits over turnover), capital turnover (turnover divided by capital employed), return on capital (operating profits over capital employed) and current ratio (current assets divided by current liabilities). For supermarket companies, they are the average ratios generated in the past five years by Sainsbury, Tesco (TSCO) and Wm Morrison (MRW); the supplier companies are Unilever, Reckitt Benckiser (RB.), Associated British Foods, Kerry Group (KYGA) and Dairy Crest (DCG). Click on the link below for a spreadsheet of the full data set.

Ostensibly, Mr Coupe has a point. On average in the past five years the big-three listed supermarkets generated pathetic profit margins of 2.6 per cent (although there was a distinct improvement in the past two years). Simultaneously – and boosted by Reckitt Benckiser’s incredibly fat margins – the suppliers averaged 14 per cent (with a little trending down in the past two).

Yet that hardly tells the whole story. For every unit of revenue that supermarkets produce, they use less capital than their suppliers. Proof of that is shown in the data for capital turnover. The supermarkets turned over their capital a sleek 2.6 times a year compared with the stodgy performance of 1.4 times from the more capital-intensive groceries suppliers.

Much of the reason for this difference lies in the ability of supermarkets to shift their inventories very rapidly, often selling them before they have paid for them. The result is that supermarkets tie up no expensive capital in funding their stocks and debtors – hence a current ratio of just 0.6 in the table – and, in effect, they get interest-free capital from their suppliers.

The effect is to boost return on capital. That must be so since, by one definition, return on capital is simply profit margin for an accounting period multiplied by the number of times a company turns over its capital. So, by their more efficient use of capital, supermarket operators make good some of the lost profit margin. Put another way, their capital efficiency allows them to price in – or to get away with – lean profit margins.

And if return on capital is a better indicator of profitability than profit margins, then supermarket companies claw back some of the profit gap between themselves and their suppliers. Profit margins of just a quarter of those made by suppliers become return on capital of just over a half. Yet, of course, that still reveals a horrible gap. It may even mean supermarket groups are not properly profitable since their return on capital may be less than its cost.

Even that may not warrant a merger between Sainsbury and Asda since the current situation may not endure. After all, go back 20 years or more and – while I don’t have the data – I would bet that the current profitability between supermarkets and their suppliers was reversed. In the 1980s and 1990s, Sainsbury and Tesco were the rich kids with margins of still only 5 per cent, while Unilever, AB Foods and their ilk were the leaden-footed strugglers.

So there is no immutable law that says the current superiority of suppliers must persist. But there is an immutable lesson for investors – a company’s profit margins only have meaning in the context of its need for capital and that margins and capital intensity mostly travel in opposite directions.