Indian companies that have low operating margins but high asset turnovers
11-Nov-2019 •Rajan Gulati
Companies generally gain a competitive advantage in two ways: (1) by building strong brand loyalty and attaining a high pricing power to get superior margins or (2) by selling products at a low margin but increasing production to a level that the cost per unit reduces drastically and economies of scale can be achieved. Obviously, the production has to keep pace with the sale of products.
Mathematically, competitive advantage can be deciphered by breaking down the return on capital employed into (1) operating margin, which is earnings before interest and tax divided by total sales, and (2) asset turnover, which is total sales divided by capital employed.
In our analysis, we looked at the companies that operate at a relatively low operating margin (less than 10 per cent) but have an increasing asset turnover (more than three times), which they have achieved through operational efficiency (see the table). Also, they have delivered a return on capital employed of more than 15 per cent in each of the last five years.
Walmart and Ferrari
Let's understand this analysis with the examples of two companies: Walmart and Ferrari. Walmart's business model works on lower margins but high volume. Its sales are pegged at over $500 billion at a very thin operating margin of around 3 per cent but an asset turnover of more than 3.5 times. This means that Walmart compensates for its thin margin by bringing in operational efficiency and building a huge scale.
On the other hand, the business model of Ferrari focuses solely on the very high-end sports car, which enables the company to command a very high operating margin of more than 20 per cent.