Gross margin can lie and lead investors to over (or under) value a business.

Material margin is more accurate, and it gives management teams guidance on which levers will generate value.

When evaluating any M&A target, margin analysis is essential to project future cash flows and, hence, the valuation of the firm. Margin analysis is even more critical when diligencing a manufacturing target given material and labor costs tend to increase faster than many companies can raise their prices.

However, there is too much emphasis placed on gross margin analysis. Gross margins can lie. They rarely tell the truth about the profitability of a firm because absorption, variances, and other GAAP-approved vagaries can make a firm appear healthier than it is. In addition, gross margin analysis hides how profitable our large customers are – and how unprofitable our small customers are – as manufacturing overhead is usually allocated by revenue rather than actual cost and effort. Finally, relying on gross margin leads to short-sighted managerial decisions such as overproducing in order to absorb (rather than manage) overhead.

What can’t lie is a more simple and powerful metric: material margin. Easily calculated as net sales minus cost of materials, material margin is a much better indicator of a firm’s health because it can’t be manipulated by creative accounting. Material margin is also the numerator in the Strategex Key Ratio, one of the most predictive KPIs in business.

For investors, understanding material margins can have a profound impact on the way a firm is evaluated pre-close and operated post-close.

For example:

1. Material margin tells us if the firm is producing a commodity or a differentiated product. A commodity business typically has a material margin of 40% or less (materials as a percent of net sales is 60%) whereas a differentiated business typically has a material margin of 70% or more (materials as a percent of net sales is 30%).
2. Material margin tells us how much a customer is willing to pay the firm to transform materials to product.
3. In an inflationary environment, material margin is the only way to accurately determine if price actions are enough to offset the rising cost of materials. Further, it tells us if there is true revenue and volume growth or just inflationary pricing growth.
4. Material margin helps us focus on managing – not absorbing – overhead.
5. Finally, material margins make it very easy to identify the post-close value creation levers that will make the greatest and fastest impact.

For example, in the case of Firm A, all focus should be on growth, specifically growing wallet share with our existing Quartile 1 customers and target selling new accounts that look like our existing Quartile 1 customers. This is because the company is already extremely profitable and topline growth will flow to the bottom line. However, in the case of Firm B, all focus should be on margin improvement because what’s the point in focusing on growth if only 10% hits the bottom line?

Granted, not much can be done to improve Firm B’s material margin since materials tend to be the stickiest of costs; however, customer and product rationalization workstreams – especially focused on eliminating Quartile 4 transactions – can simplify the business and drastically improve profitability. At practically every manufacturing target we have evaluated, the bottom quartile of the customer base is losing money because the overhead and SG&A required to service these customers is always greater than the contribution margin dollars these customers generate.

A strategy that virtually never works is to take a low material margin business and try to grow out of the problem.

A strategy that virtually never works is to take a low material margin business (like Firm B) and try to grow out of the problem. This is because growth does not address the root cause of low margins, which is the fact that sixty cents of every dollar sold is used to pay for materials. In fact, growth in a low material margin business may destroy value if that growth occurs in Quartile 4, which only adds complexity and overhead which further compress already-thin margins.

When I was acquiring my businesses, I was looking for businesses with material margin greater than 40% and single-digit EBITDA percentages.

To summarize, I asked Carmelle Giblin, Vice President and 80/20 Expert at Strategex who has closed over 90 M&A deals to comment on why she never had goodwill impairment, and how she used material margin as a foundational M&A tool.

She stated, “When I was acquiring my businesses, I was looking for businesses with material margin greater than 40% and single-digit EBITDA percentages. I knew that if I had a high material margin business, I could make it much more profitable by simplifying, investing in growth, or a combination of the two. If I had a low material margin business, it was going to be nearly impossible to create value without major investments in R&D, innovation, and of course, first simplifying the business."

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Anthony Bahr is a Managing Director at Strategex. Besides material margin, Anthony is enthusiastic about data, analytics, research, and finance.