Thread by @hkeskiva

Great value is sometimes hiding in plain sight, such as the value of INCREMENTAL RETURNS.

In this thread (🧵), we'll take a brief look at different cases built on this simple and under-addressed, yet quite powerful concept.

Best served with a hot cup of coffee...

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Incremental returns reveal the underlying profitability of future growth, while removing "legacy burden" of the business from the picture.

To get started, imagine a company with the following financials:

YEAR 1
Revenues 100
Earnings 10

YEAR 2
Revenues 120
Earnings 20

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First observations:

- Margins on year 1 were 10%
- Revenues grew by 20%
- Margins on year 2 were 17%

These numbers are obviously fine, albeit not stellar. However, there is more than meets the eye, which can be revealed with the concept of incremental returns.

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Separating the legacy fundamentals from growth, we see it all differently.

The existing business had earnings of 10 with revenues of 100, hence a margin of 10%.

However, growth (the additional revenue) of 20 brought in added earnings of 10, hence a margin of 50%. Better.

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As a concrete example, take Semler Scientific $SMLR, a medical device company.

In 2014-2016, it grew its revenue by +3.8 MUSD and operating income by +2.2 MUSD for an incremental profit margin of 57%.

Yet, the company still had operating LOSSES of -2.2 MUSD in 2016.

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The consistently high incremental margins were telling something not visible in the last twelve months (LTM) figures.

As growth continued and high-profitability business scaled, Semler's operating margin slowly approached the levels indicated by its incremental margins.

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Interestingly, $SMLR incremental margins have floated above 20% starting March 2017 when it still had the following fundamentals:

- market cap 15 MUSD
- revenues 8 MUSD
- annual revenue growth > 15%
- operating losses -2 MUSD

Market clearly wasn't crediting the potential.

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Assuming 30% operating margins for $SMLR (still less than what the incremental margins implied):

- market cap 15 MUSD
- revenues 8 MUSD
- operating income 2.4 MUSD (30% margins)
- EV/EBIT 6

$SMLR has since reached 30-50% margins (while market valuation has grown 30-fold).

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Take another example, internet service provider Verisign $VRSN. In 2010-2020, it added +600 MUSD revenues and staggering +590 MUSD profits for nearly 100% incremental margins.

Basically all revenue growth turned into operating income as costs didn't grow with revenues.

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Also with $VRSN, the incremental margin profile was giving an early indication of where the profit margins might be heading to.

Great tool to spot promising business dynamics!

In 3Q2010:
- op. margin 35%
- incr. margin 64%

In 3Q2020
- op. margin 65%
- incr. margin 63%

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Incremental returns can be applied in many ways.

For example, one new Chipotle $CMG restaurant in 2015:

- investment 0.8 MUSD
- sales 2.4 MUSD
- income 0.6 MUSD

In other words, the first-year incremental return on invested capital was incredible 75% (= 0.6 / 0.8)

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Hence, Chipotle was able to grow in 2012-2015:

- tangible assets (PP&E) +342 MUSD
- operating profit (EBIT) +397 MUSD
- incremental return on investment 116%

With such economics, possibilities to continue to invest heavily will make investors very very happy.

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That's the thread (🧵) on INCREMENTAL RETURNS!

For great tweets in the business domain, please follow @10kdiver, @SahilBloom, @BrianFeroldi (also $SMLR follower), @FocusedCompound, @vetleforsland and @borrowed_ideas.

Humbled for your attention! 🙏 Have a good weekend!

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