What are 5 High Margin Businesses?

What Are 5 High Operating Margin Industries?

When you start a business, buy a business, or invest in a company, are you stacking the deck in your favor???

Most individuals are not stacking the deck in their favor. Why? They choose businesses with poor operating margins. So how do you stack the deck in your favor? Choose companies with high operating margins. This article will look at 5 industries with intrinsically high operating margins: database, merchant, brokerage, Real Estate, and social media businesses. There are other industries with high margins that I will cover in future articles.

Database Businesses

Database businesses rent out their space and software on their servers. They are highly efficient at creating profits. Companies like Oracle and Microsoft have extremely healthy Operating Margins (Operating Margin = Operating Revenue / Total Revenue). Currently, Microsoft has a 41% Operating Margin, and Oracle has a 38% Operating Margin. How can these companies command such high margins? The physical form of their business determines how efficient their capital is. Both of these companies rely on warehouses full of servers that sit in temperature-controlled buildings running proprietary software. Once the servers are up and running, they are highly reliable. They require software updates, small warehouse staff, programmers, a sales force, and customer / technical service.

Since these companies predominately serve other large business customers, they receive large recurring revenue streams each month. These companies will consistently pay their monthly bill. Why? It requires enormous switching costs and downtime for a company to move their data from one ecosystem like Oracle to another ecosystem like Microsoft. They will stick with one service provider. If Oracle provides a reliable and secure product, then the probability of a company switching from Oracle to a competitor is low.

Also, these database companies have low operating costs, and their costs reduce each year as technology improves. They also can raise prices each year due to their brand strength and switching costs. The maintenance costs are relatively minimal, as is seen in these companies' gross margins. Typically these companies have 20% gross margins. It only costs 20% on each dollar to provide its products and services. An oil company will spend 80% of each dollar earned to produce oil which is 4x the cost of what it cost per dollar for Oracle to create its products. Also, it doesn't cost Oracle that much money to spin up a new server to add more space and computing power for a new client. If an oil company is looking to expand its output, it will require substantial capital expenditures. If you are looking to grow your wealth quicker, then investing in a business that is 4x more effective at producing money is a better investment.

Database companies are incredibly efficient at running their software and producing profits. They pay healthy dividends from cash flow which enrich their investors. An oil company paying a large yield through dividends will take on debt to do it. A company such as Oracle pays 20% of its cash flows towards dividends. An oil company would have to pay 80% of its cash flows to compete with Oracle. Invest in a better business.

Merchant Businesses

Merchant businesses like MasterCard and Visa have massive Operating Margins of over 60%. They provide merchant accounts and payment systems for companies. They are similar to a toll booth on steroids as they take transaction fees off billions of transactions. It's a very profitable business model. Think about it. They set up a secure electronic payment system with most companies worldwide; then, the merchant pays a transaction fee when each customer makes a transaction. It's an electronic toll booth. Every time you or someone else uses a credit card to purchase something, Visa or MasterCard makes money. We rely on our credit cards to buy gas, food, and anything we buy every week, making this a very sticky business.??

Powerful businesses entwine their products and services in the daily lives and operations of their customers. Banks couldn't operate without Oracle. Most stores couldn't operate without Visa or Mastercard. Great companies like Oracle, Visa, and MasterCard work themselves into the ecosystems of people. A product or a service that people and businesses use daily and are an integral part of what they do will be a valuable business.??

You Can Find More Articles Like This at the Red to Black Podcast Website

Social Media

Social Media companies can have high margins like Facebook, which commands a 42% margin. At their core, social media businesses offer phenomenal economies of scale. They require servers, software, and user-generated content. User-Generated Content (UGC) is entirely new with the advent of social media. You can run your own media channel through Facebook, Youtube, Instagram, and Linkedin. Social Media has disrupted the entire marketing industry. Marketers, in the past, would spend add dollars then wait to see the results. With analytics and targeted market data, you can choose and observe exactly how your dollars are converting. These targeted analytics are a game-changer.

Also, enabling people to share their lives on Facebook has turned the entire world into content creators. Anyone at any time can build a brand from their living room. That is a monumental achievement that, as stated above, has rocked the marketing world. Since anyone can become a content creator, it has created vast libraries of information. In the past gathering, this information was highly challenging because you had to know someone who knew a topic you had desired to learn. You then had to find and communicate with that person to gather the knowledge. This discovery process was inefficient as compared to the information at your fingertips in this digital age. You can jump on youtube and create or consume any content. As social media companies successfully deploy effective advertising business models in this industry, they can be highly lucrative.

Marketplace Businesses

eBay and Nasdaq have solid margins that are not as large as a database, merchant, or social media business. They typically have 25%+ operating margins. That's still solid, and both of these companies pay dividends which means they make enough money to redistribute to their shareholders.??

Marketplace businesses connect buyers and sellers. These are very efficient businesses that enable buyers and sellers to exchange goods and services online. eBay merely maintains servers, updates software, and makes improvements. They created an efficient marketplace for buyers and sellers worldwide to connect.?

Before eBay, the market for used gear was word of mouth, classifieds like Craiglist, and garage sales. It was location-dependent. It wasn't very efficient because if there was no buyer for your rocking chair in your local town, you didn't sell it. When eBay opened your market for your rocking chair expanded to the world. Now instead of no buyers locally, you have 100s of potential buyers worldwide. eBay opened the opportunities for buyers and sellers of used products to a worldwide market.

Since eBay built a marketplace on technology, it didn't and still does not require substantial capital expenditures to bring on a new 100,000 users. When these users come on board, they only need new database fields running the same software everyone else uses. This technology allows the user to transact and use the software at a low price. These low costs are a win for eBay and sellers and buyers who can transact with low expenses.

Real Estate

Real Estate stands out amongst most businesses due to its tax write-offs, leverage, and simplicity. Multi-Family Real Estate is one of the most profitable, reliable, and simple business models in the Real Estate world. Multi-family Real Estate becomes more fiscally productive as the number of units in the property grows. A 300 unit building has more revenue potential and upside than a fourplex. Every time you add a new fee, you multiple by 300 versus 4. If you lose two tenants in 300 units (fully occupied building), you still have 99% of the premises occupied. If you lose two tenants in a fourplex, you have 50% of the units occupied. The risk profiles between a fourplex and a 300 unit building are vastly different.

Real Estate is location-dependent. A 300 unit building will be worthless if you are in a town with no employment options or a fluctuating economy. In locations with plenty of customers, it is a simple block and tackle operation. You buy an asset, revamp the units, rent out the refurbished units at a higher rent and manage the renters and the Real Estate. It requires work, is straightforward and tedious, yet can be highly lucrative. Due to leverage typically in 80%, you can make 5X more on your money than regular assets. Returns on Real Estate can be north of 40% Net Income, not Operating Margin, depending on the purchase price. The returns can be extremely high if you know how to buy, add value and run the asset.

The drawback of Real Estate is that it cannot grow as fast as a database company like Oracle or a marketplace business like eBay. When you have 300 units, you can only raise the rents so much every year. Tech companies can continually sell and expand their offerings. They don't have a finite offering of 300 units like a multi-family property. However, the Multi-Family asset class is a block and tackle business because everyone requires a place to live. Leasing is straightforward as you can walk a unit and see what you will get for your money. It's one of the most straightforward high purchase price items on the market. Also, you own the controlling interest in the property; therefore, you control the cash flows. When you invest in publicly traded companies, they control the cash flows and pay you a dividend. Part of investing is judging how much management you are willing to take on when investing in an asset. Buying a public stock requires no management, and buying Real Estate requires 100% management.

Final Thoughts

There are low operating margin businesses within each of these industries because of management, market competition, growth objectives, etc. Sound analysis is the cornerstone of evaluating any of these businesses. You can buy an excellent company at an inflated price and have a poor investment. Or you can buy a mediocre business at a low price and have a poor investment. Find the companies with high operating margins, determine a price at which you are willing to buy the asset, then wait. Investing is simple. Evaluate investments and patiently wait for the investment to reach your price.??

You Can Find More Articles Like This at the Red to Black Podcast Website