Not to sound curmudgeonly, but the one thing we think that’s been lost in stock market analysis over the last 20 or so years is respect for marginal profitability. If a company makes $100 million on $1.0 billion in sales (a 10 pct net margin), what will it make on its next $100 million in revenues?
- If the company in question is under competitive threat, it might only make $5 million. That would be a contribution margin of 5 pct, less than its base 10 pct rate.
- If the company is holding its own, contribution margins might be 12 percent because some of its costs are fixed. This would mean profits rise by $12 million.
- If the company is doing well, the profit on a marginal dollar of sales could be 30-40 percent. Perhaps it has a new, higher margin product or enjoys strong pricing power.
Such analysis used to be commonplace, at least when looking at cyclical industries because in any given quarter or year demand can be quite variable. Contribution margins make for earnings surprises in the up part of a cycle and disappointments when the macro economy is going south.
Today, however, we want to apply it to US Big Tech using analysts’ Q2 2021 estimates for revenue and net income growth versus last year’s second quarter actual results. Three points to this analysis:
#1: To set the stage, here is each company’s Q2 2020 actual net margins and what’s expected in Q2 2021:
- Q2 2020: 18.9 pct
- Q2 2021 (E): 23.1 pct
- Q2 2020: 29.4 pct
- Q2 2021 (E): 32.7 pct
- Q2 2020: 5.8 pct
- Q2 2021 (E): 5.4 pct
- Q2 2020: 18.3 pct
- Q2 2021 (E): 25.0 pct
- Q2 2020: 27.8 pct
- Q2 2021 (E): 31.3 pct
Takeaway: every company here except Amazon has net margins that are well above the S&P 500, which is expected to show 11.8 pct net profitability in Q2. If you average AAPL, MSFT, GOOG and FB you get a 28.0 pct net margin; that’s more than double the index. And remember that we’re talking about $200 bn in quarterly revenues between these 4 companies – these are large, global businesses. As for Amazon’s profitability, one must keep in mind that it is a high margin (30 pct operating) cloud computing business tied to a category-killing but break-even online retailer.
#2: As good as those margins are, contribution margins are even better. We calculate this as the growth in expected net income in Q2 2021 versus Q2 2020 divided by the growth in revenues over the same period.
- Apple: 42.4 pct contribution margin
- Microsoft: 52.4 pct
- Amazon: 3.8 pct
- Google: 39.6 pct
- Facebook: 38.5 pct
Takeaway: ex-AMZN this averages to a 43.2 percent contribution margin in 2021 on top of 2020’s already-high 23.6 pct net margin. As with the prior point, we’re talking about a sizeable chunk of revenues here: $46 bn more than Q2 2020. Amazon is once again the exception, but the market understands its strategy and is OK with it. AMZN, after all, made a new high just last week.
#3: As easy as it is to be blasé about US Big Tech, it is important to occasionally take a step back (as we are doing here today) and remember exactly why they are fully one-fifth of the S&P 500’s market cap. Starting from a collective annual revenue base of $700 bn, Apple, Microsoft, Google and Facebook are generating 2x the profit margins of the S&P 500 and almost 2x incremental margins on marginal revenues.
Takeaway/summing up: we occasionally hear from clients who ask about the comparison between Big Tech in 2021 and Big Oil in 1980. It is an entirely fair point. Energy stocks dominated the S&P back then just as Tech does now.
The difference between the two comes down to the drivers of incremental profit growth. Oil companies had a decade-long commodity price tailwind in the 1970s. That worked for a while, but eventually new sources of supply came online as one would expect. Big Tech’s profit growth comes from intellectual, not physical, capital that builds products people and companies essentially must buy to stay connected and relevant to society. This is what makes these companies not only different from 1980’s Big Oil but from most of the rest of the S&P 500.