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Issue 179, 06 July 2005

Investor's College Gross profit margins explained Don’t know margins from margarine? Then make this article your bread and butter. We promised a closer look at the topic of gross profit margins in our review of small retailers last issue. It’s a fascinating and important topic to explore and one that’s particularly pertinent to those who own retail stocks. And who better to introduce the topic than the world’s greatest investor, Warren Buffett? If you head to and click on the ‘customer services’ tab at the top of the page, you’ll then see a ‘Warren E. Buffett’ link down the right hand side. Follow that link and you’ll find an interesting lesson on jewellery retailing. Here’s an excerpt that steps through the concepts of gross profit, operating costs and pre-tax profit (pardon Buffett’s American spelling, apparently he doesn’t know any better— Ed): ‘In order to establish a selling price for his merchandise, a jeweler must add to the price he pays for that merchandise both his operating costs and his desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more. The math is simple: Jewelers charge $1 for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents, they typically pay 40 cents for operating costs, which leaves 10 cents of pre-tax earnings for every $1 of sales. Taking into account the massive investment in inventory, the 10 cent profit is adequate but far from exciting.’ Mark-ups and margins In our experience, many retailers think and talk in terms of their ‘mark-up’ percentage, as opposed to their ‘gross margin’, but it’s just a different way of expressing the same thing. If a retailer purchases an item for $40 and sells it for $100, the mark-up would be 150% (the $100 selling price less the $40 cost of sales— giving a gross profit of $60— divided by the $40 cost price). The gross margin would be 60% (the $100 selling price less the $40 cost of sales— giving a gross profit of $60— divided by the $100 sale price). It’s crucial to be clear, though, which of the two you’re talking about— confusing them can be very dangerous. Now we’ve got some basic concepts down pat, let’s look at some real life numbers. The accompanying table shows three sets of figures. They are JB Hi-Fi’s first-half profit results for the 2005 and 2004 financial years, and Brazin’s first-half results for the 2005 financial year. Although not an ideal comparison, we’ve selected these two retailers because they both sell CDs and DVDs. JB Hi-Fi’s prospectus stated that 34% of its 2003 revenue came from the sale of CDs and DVDs, while Brazin’s CD and DVD retailing arm accounted for two-thirds of its sales in the most recent half year. Firstly, let’s consider the change in JB Hi-Fi’s numbers over the two periods. Notably, the company’s gross profit margin actually fell from 23.2% to 23.0%, while its earnings before interest and tax (EBIT) margin rose from 6.3% to 6.8%. This was achieved by reducing operating costs from 17.1% of sales to 16.3% of sales. In other words, customers got a better deal— the mark-up was smaller, so JB was selling goods even closer to wholesale price than it was in the prior year. Higher margin Brazin’s gross margin was much higher by comparison. This is partly a reflection of its higher margin operations in lingerie and surfwear, but also a necessity due to its higher cost structure. As you can see from the table, Brazin’s operating costs were a comparatively large 37.3% of sales for the period— more than twice JB’s. And although its 9.5% EBIT margin appears higher, this seems largely attributable to $8.3m in unspecified ‘other income’, a point management deigned to be unworthy of discussion in its results commentary and presentation. Excluding that amount, Brazin’s EBIT margin for the half would have been a much less impressive 5.9%.

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As a point of interest, the 37.3% of Brazin’s sales that were chewed up in operating costs were in the ballpark of the 40% Buffett cited as typical for jewellers. The difference between these two companies highlights the extreme low-cost nature of JB’s business model, which we discussed in our detailed introductory review in issue 176/May 05 (Long Term Buy— $3.43). Now we arrive at an interesting question: Which is preferable, a high gross profit margin or a low one? As with many things in the world of investing, the answer is: it depends. Next issue we’ll take the discussion further and explain why we believe a low gross margin is, generally, a positive factor for a business like JB Hi-Fi, while the very same thing could be a significant negative for a company like Billabong International.

C o p y r i g h t © 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.

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Now we’ve got some basic concepts down pat, let’s look at some real life numbers. The accompanying table shows three sets of figures. They a...