Introduction

In this lecture, we look at long term trends in gross margin, and explain how investors should analyse this key metric on a 15-20 year timescale if possible. This allows you to look at the underlying long term trends, and be less distracted by short term noise.

Additional Comments on the Video

When we beta tested this course, one of the important criticisms we received was that it was unsatisfactory to show a chart with a clear long term trend without knowing and explaining the reason. This is certainly a fair and reasonable criticism - so we did some additional work. Remember that we have analysed Amazon in the past so we understood that trend. The Microsoft trend is clear from its change in business model.

But we have never analysed Alibaba or Apple, so we really don't know the reason, even after further investigation, but we can make some guesses and we can point interested students in a direction for further study, if they are indeed interested. Before we do so, there are two important points to be made here:

1. you need to know why gross margin trends have changed to feel comfortable in making the investment
2. you may need some help, whether from the company, or from the sell-side to achieve that understanding

I am in the tuition business, not the investment research business. I don't know the answers to the Apple and Alibaba trends but I am not stressed about this, because I am not trying to create an investment thesis, merely to illustrate a useful point for my students. If I were creating an investment thesis, understanding the gross margin movements would be an important element of my research.

If we look at the Alibaba trend, one hypothesis is that it represents a change in mix. I attach a spreadsheet which shows why I doubt that is the reason. It may reflect increasing investment in non core acitivity, within the core commerce segment - meal delivery or similar, or fights for market share. Have a look at the spreadsheet and see for yourself. And if you know the answer, please share it with us in the comments section which has been opened for this module.

Apple

The Apple explanation looks simpler - we have sourced this from an article on the net, and it seems plausible, as the thesis is that gross margins fell because of a combination of factors in the period after the iPad was introduced:

1.      iphone selling price declined.

2.      Iphone production costs went up

3.      iPad profitability declined

See https://seekingalpha.com/article/1843932-the-explanation-behind-apples-gross-margin-decline-and-why-the-future-looks-brighter (requires a subscription for full article). The third reason seems debatable, as one would have expected iPad margins to improve with volume etc.

The conclusion is that the specifics don't matter for the purposes of this course - what matters is that you understand why this is really important to understanding the business and investment.

Reading

The article or reading exercise looks at costs and margins in the retail supply chain. To help understand the drivers of inflation for retail goods, it sets out the main costs and margins involved in supplying retail goods to consumers. Around half of the final price of retail items can be attributed to the cost of the goods themselves, with the remaining half covering the gross margins of wholesale and retail firms in the distribution supply chain.

This article again shows how gross margins, although not necessarily directly comparable across companies in a sector, can be used to analyse the overall trends in sector profitability. They can also be used to infer profitability across different points in the supply chain.

The article can be skimmed and has only been included for general interest - it is not an integral part of the course.