Thread by @investing_city

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An interesting metric to track is EBIT conversion.

EBIT conversion = EBIT margins / gross margins

Here's why it's interesting and how you can use it to assess business quality...

[THREAD] ⬇️

2/ It's a rough way to filter through business quality.

Why?

1) Low gross margins don't give much room for high EBIT margins (which are a key driver for ROIC)
2) Low opex hints at some sort of moat

3/ For example, if a company does $10 billion in revenue but has 10% gross margins, that's $1 billion in gross profit.

But say the company brings in $300 million in EBIT.

That's a 3% EBIT margin or 30% EBIT conversion (300 mil/1 bil)

4/ With 10% gross margins, there is likely not a chance to get 50% or higher EBIT conversion.

That would mean the company's opex budget runs at 4% of revenue.

60% EBIT conversion means the company would need $600 million in EBIT and therefore opex would be $400 mil

5/ Spending less than 5% of revenue on opex is pretty light. For reference, Costco spends about 10% of revenue on SG&A.

So that's one piece of EBIT conversion. A low gross margin is a tough starting point for a high conversion number.

6/ And if you look at the formula for ROIC (return on invested capital), it's basically EBIT (lots of people will use NOPAT) / invested capital.

High EBIT margins directly impact this equation. But the equation is just an output...

7/ If you think about a business, being able to profit a lot without putting much money into it, by definition, is amazing.

That's the essence of ROIC and EBIT margins are the numerator piece we can use to directionally understand this.

8/ Now, for part 2 -- low opex hints at a moat.

But I thought we just said that super low opex is probably not feasible??

Well, that's with low gross margins.

High gross margins give you capacity to invest in the business.

9/ So if you have high gross margins and low opex needs, then that's the killer combination that leads to huge EBIT margins.

For instance, if you are doing $10 billion with 80% gross margins, that's $8 billion in gross profit or 8x the last example.

10/ That gives you 8x the dollars to invest. But if the biz doesn't require you to invest those dollars, you're left with insane profit margins.

To do 60% EBIT conversion, you can spend $3.2 billion or 32% of revenue on opex (vs. 5% in the last example).

11/ Here's the calculations on that...

$8 billion in gross profit * 60% = $4.8 billion in EBIT

$8 billion - $4.8 billion = $3.2 billion in opex

$3.2 billion / $10 billion = 32%

12/ So if you can have high gross margins and don't have to spend a crazy amount of S&M or G&A, then it's likely your EBIT conversion will be really high.

Those are hints that you have some sort of advantage like lots of word-of-mouth, process power, or low competition.

13/ This isn't a perfect formula by any means but if you peel back the layers, the combo of high gross margins and low opex needs are two financial outputs of typical good businesses.

14/ To give you a sense of the business quality from EBIT conversion, below are some companies with the top scores in my database:

TSM - 80%
Tencent - 65%
Nvidia - 60%
Microsoft - 57%
Evolution Gaming - 56%
MarketAxess - 54%
Facebook - 51%
Futu - 51%

What are some other ones?

End/

EBIT conversion, again, is not a perfect metric but it's a shortcut I sometimes use to quickly filter and find quality businesses.

I also pair it with a growth metric to not handicap companies that are investing aggressively into their businesses.

Thanks for reading!