Geoff Gannon June 25, 2012

Why Capital Turns Matter – And What Warren Buffett Means When He Talks About Them

Geoff here.

Someone asked me what Warren Buffett meant when he talked about a company turning over its capital “x” number of times a year.

When Buffett says capital turns he means Sales/Net Tangible Assets.

Most websites, etc. tend to just use assets. And they may even be including cash assets as part of that ratio. Based on the way Buffett has talked about return on investment at Berkshire subsidiaries in the past – it’s clear he uses the net amount of tangible capital invested in the business. In other words, he nets tangible assets against accounts payable and accrued expenses. He gives a company credit for these zero interest liabilities – rather than assuming shareholders are really paying for all of a company’s assets themselves.

A lot of the businesses Buffett has bought for Berkshire actually don’t have very high margins. What they have is higher sales per dollar of assets. Distributors for instance. Once a company in a business like that can achieve higher sales per dollar of assets it is hard for others to compete – because even if they have the same margins, they have lower returns on capital.


The Advantages in Always Moving Product

Buffett has talked about survival of the fattest before. A high volume, low margin business can sometimes turn into a survival of the fattest situation. That’s because everybody has to start with just a trickle of product moving through their pipes. This is not a recipe for catching up to the leaders who are already moving flood like quantities through their infrastructure.

We’ve talked about movie studios – mostly DreamWorks (DWA) – on this blog before. That’s a bit of a survival of the fattest situation. The best way to distribute a movie is to distribute 12 of them a year – not 2 of them. But the best way to make movies is to make 2 of them a year – not 12 of them. A producer’s dream situation is to make 2 blockbusters a year. A distributor’s dream situation is to always be distributing something. Over the last three quarters of a century there hasn’t been much change in who distributes movies. In fact, from a competitive economics sense – when we say “studio” we mean “distributor”. That’s where the oligopoly exists. You’ll notice that where someone new did became a major studio – Disney – they did it by succeeding on different terms as a producer first and then succeeding as a distributor. Basically, they cheated.

It’s an interesting question whether the integration of production and distribution influences the movies that are made. My belief is yes – it does. And that the historical evolution of the movie industry lead to a situation where more smaller, lower quality movies were made than would otherwise be the case. I actually think there were always huge incentivizes to make blockbusters. They’re just weren’t huge incentives for distributors to focus exclusively on blockbusters – because maximum efficiency in distribution can’t be achieved if you put out 2 movies a year.


The Advantages in Doing a Lot of Volume in One Place

Grocery stores often compete on turns instead of margins. With the exception of a few grocers, like Whole Foods (WFM) and Arden (ARDNA), most grocers will not depend on a strategy that actually requires them to have better margins than the competition to win in their market. Instead, they try to drive more traffic per store rather than specifically drive margin improvement.

In fact, when gross margins improve because costs fall, they will often pass these cost reductions right on to the shopper if they have good reason to hope they can take more trips from each shopper and more shoppers from the other grocers in town.

This is not immediately obvious to folks who look at grocery store stocks for two reasons:


  1. Inflation causes grocery stores to report increasing costs of goods sold even when they may be holding costs of goods sold completely steady or actually allowing it to expand at lower than the rate of inflation.
  2. Margins vary tremendously on different items in a grocery store. Increasing traffic per store is often coupled with increasing sales of prepared foods, bakery, etc. If you are getting the big weekly shopping trips from families, etc. you’re also probably getting more and more of this high margin business which makes your reported margins look like they are widening even when you aren’t making any more money per purchase on cereal, soup, etc.


In this way, they can get to a position where it is very hard for any grocer – even a grocer with an equally low cost structure – to compete with them in the same local market.


You Can Only Target a Capital Turns Advantage in Some Industries

The reason is capital turns. The amount of sales a single grocery store can do is tremendously variable. As a teenager, I worked in a store that did around $50 million a year. The reason for this is complicated but includes:

  • Location
  • Size
  • Price
  • Selection
  • Parking

Some of these factors are so important – like location – that in the town I grew up in we had 3 grocery stores of which none (despite many changes in corporate ownership) ever moved its location nor did a new location open for almost a quarter century despite the town’s population more than doubling. When a new store opened it was only because land that had been previously off-limits to development was turned into a new strip mall. Even more telling, 2 of the 3 grocery stores were located directly across the street from each other. They still are. They’ve been close to 30 years in those locations. Again, the parent companies of 2 of these 3 stores have been through several mergers, spin-offs, bankruptcies, and reorganizations of all sorts.

What’s the point of this story?

Sure, there are some differences in how much capital it takes to open a grocery store. But you can’t do it with no capital. And the store doing $50 million in sales is probably not using 2.5 times more capital than the store doing $20 million in sales.



Gross Profitability Matters

This is not true in some other industries. In some businesses, if you are doing $50 million in sales and a competitor is doing $20 million in sales it is almost certainly the case that you are tying up about 2.5 times more capital to achieve this. I’ll talk up one such industry in a minute.

But let’s look at the issue of gross profitability on the micro level and how important capital turns are to paying for all the stuff a corporation needs to – and wants to – pay for.

Imagine the two of us run competing grocery stores. We each have gross margins of 24%. Your annual sales are equal to your assets. But my annual sales are 4 times my assets. If I have $100 of assets – I will be generating $96 of gross profits to pay all my operating costs, to advertise, to build new stores, etc. You will have only $24 in gross profits to pay all your operating costs, advertise, build new stores, etc. In the grocery business – even if you are pretty efficient putting aside COGS – you’ll actually have a really hard time doing any better than break-even with a 24% gross margin if you don’t turn your capital faster. If you can double the turns, it’s not inconceivable that you can achieve a 10% return on your capital while a competitor who has a pretty similar price and cost structure to you in the store is actually earning very close to 0%.

This is a big deal. For example, a grocery store with half the gross margins of a jewelry stores can actually make twice the return on capital. That’s because a jeweler can have capital turns as bad as 1 times sales. Whereas a good grocery store can do $400 million of sales on just $100 million of invested capital.

I actually think capital turns were a very important part of the tab card industry. The kind of gross margins they had were good. But there are manufacturers in some industries who comfortably have 50% gross margins over time.

There are even companies with 50% gross margins that actually aren’t very good businesses at all. They never have been. And unless they can change their inventory situation – they probably never will be.

Personally, I think there’s much more protection investing in a business that’s part of an industry which has shown it tends to have both:

  • Adequate gross margins
  • Adequate capital turns


A Strong Flank Lets You Kill Competitors Who Are Focusing on the Center

In industries that haven’t demonstrated this double adequacy, you should be even more careful about betting on a follower rather than a leader.

Part of the reason is competitive. If an industry depends heavily on either margins or turns it opens itself up to a devastating attack from the player who can maximize the key variable you can control – which could be:

  • Price
  • Cost
  • Working capital management
  • Etc.

I can think of a lot of industries where this happened. For example, Dell (DELL) was able to go very far in working capital management precisely because PC manufacturers can’t live on margins alone. They need turns. In other businesses where turns are relatively fixed – capital turns in transportation businesses tend to be very hard to use to get an edge on anyone – you have to find some other advantage.

This is why I think Carnival (CCL) has a really big advantage in the cruise business. I think the cruise business is a cost leadership business. An efficiency business.


Companies Can’t Compete on Metrics They Don’t Control

That’s because I believe the nature of the assets means you are going to tend to all have pretty similar ratios of passenger nights to offer relative to PP&E you own. And then I think you are all going to price to fill your ships.

So capital turns are mostly fixed by the asset you are using. And price is mostly fixed by the capacity of the industry in any given year relative to demand.

So I think every cruise company will tend to be an asset owner and a price taker. But I think some companies can be a cost leader.

So the key competitive metric for me in the cruise business is cruise costs excluding fuel per potential passenger night. All 3 major cruise companies give out this info.

If the capital turn circumstances of the business were different – if I thought you could get more passengers each night, more nights a year, etc. from the same ships – I’d feel differently. I do feel differently in the grocery store business. The grocery store business is not just about costs.

In fact, if you can charge high prices and have normal costs while achieving high capital turns in the grocery business you can compete with someone who has normal prices and low costs and good turns.

What you both need is margins and traffic. Not just margins. You don’t have to be low price. But you do want to achieve the double whammy of margins and turns. If you can be high price and attract high traffic – more power to you. If you can be low price, low cost and attract high traffic – go for it. But you need to find a position where you can get the complete combo of margins and turns working for you.

It would actually be a mistake to try to figure out the absolute cheapest way to get food on store shelves, because unless you can keep people coming back week after week low costs aren’t enough. For instance, you can’t alienate customers with a non-sensical (from the shopper’s point of view) stocking scheme just because it keeps costs down.

Low costs only work in groceries if you can keep the store full of shoppers.

Locally, this presents some problems in groceries – unlike cruises – because it can encourage a competitor to keep driving prices lower and lower as they gain more and more traffic to the point where you can’t compete.

In cruises, someone will only do this if they have the available capacity. So, if someone can kill you in cruises they have to kill you slowly. They have to kill you year by year rather than month by month. In the short-term it’s hard to increase the number of passengers on your cruise line. It’s not so hard to increase the number of shoppers in your grocery store. In fact, some companies can keep doing this year after year after year in some towns if they keep margins pretty steady even while their costs are falling. And they’ll do exactly that because more traffic per store is something they want. It allows them to both make money and widen their moat in the local market at the same time.


To Adapt You Need a Relevant, Controllable Metric You Can Win On

My point is just that companies often compete on a specific trait. It has to be a trait that is relevant for business success. It has to be a trait that is variable – you can target it for change.

Obviously, you can make mistakes by trying to adapt to your circumstances in a way that ends up backfiring. This is what happened to George Risk’s competitors. They thought targeting costs made sense. They tried out a “low cost” variation. It turns out the low cost trait is inversely correlated to the dependable, customized delivery trait. And it turns out dependable, custom service was actually preferred to low costs.


Sometimes a Move That Reduces ROI Increases Competitiveness

Capital turns are important. But they aren’t always the answer. Dell had success competing through better working capital management. It was an inherent part of their system. It was great for ROI and great for competitiveness.

Meanwhile, ADDvantage (AEY) actually has a high working capital burden as an inherent part of their system. They think carrying more slow moving inventory can be a competitive advantage because of the needs it lets them satisfy for customers (and the prices they get to charge for such satisfaction). Historically, they were right about this. And their record compared to competitors who though keeping working capital low has been quite good over the last decade.

To me, it’s very interesting that tab cards had both high margins and fast capital turns. It was a dream business. And it looked like a business where Buffett could make money on an investment in a company where he didn’t know if they would end up being a leader in the national industry or not.

He felt he knew they’d make enough money faster enough for his investment to pay off.