Since I released my initial thoughts article here on SIRC, I wanted to release a few individual articles discussing some of the topics I went through in more detail.
Today’s article is going to discuss my opinion on SIRC’s profit potential long-term. What I mean by profit potential is not necessarily whether it will be profitable, but what are my expectations of its profit margins.
Just so we’re all on the same page, SIRC’s primary business is that of a distributor and installer of solar panels and solar technology for customers in the residential and commercial sphere. They appear to be much more sales focused and I’ve heard it hinted that they tend to outsource installation and associated labor to third party partners, but it’s not important for this article.
They do not manufacture or own the technology, brands, etc. of the solar technology they are distributing and installing for customers. They enter into distribution/reseller agreements with the manufacturers/product owners, find customers who need the technology, develop a solution for the customer (where do we put the panels, how many do you need, which panels are best, etc.), and then install it themselves or contract someone else to install it for them.
Now, as a baseline, we are going to be focused on SIRC’s operating margin potential. Operating margin is defined as operating income divided by net sales. Operating income is defined as revenue less cost of goods sold as well as your selling, general, and administrative expenses. It does not include non-operating items such as interest income/expense, other financial items (gains/losses on derivative liabilities, gain/loss on debt, etc.), nor taxes.
It is considered one of the best indicators of the performance of a business, without considering the capital structure of the company, such as interest, debt, dividends, etc.
Now, in theory, with any given product there is an associated value chain. The value chain is basically just who all contributes to a product moving from development all of the way to the end customer purchasing it.
All along the value chain, the company(ies) involved will expect to earn some sort of return for their contribution to the value chain, subject to general business risk. This is all built into the final price of the product that the customer pays.
We already know SIRC is only an authorized reseller/distributor, as well as an installer. That is their contribution to the value chain. But what else is there? Let’s break this down.
Components of the Value Chain
Starting from back to front, we first have the companies that are actually spending billions of dollars in R&D developing the technology that goes into solar panels. These companies are what we call the intangible property (“IP”) owners.
They generally then coordinate the entire supply chain for their products they spent so much money developing. Where do they start? (I’m going to oversimplify a supply chain here, but the theory is the same, so bear with me!)
First, someone needs to source the raw materials, manufacture your products, and ship them to your desired location. You can do it yourself, or you can outsource it to third parties (for example, Nike outsourcing production to southeast Asia). This function contributes to the value chain and will want a profit… the question is does the IP owner want to take the risk and effort to try and do it themselves, or pay someone else. Either way, it doesn’t matter in this example.
Next, now that they have the products made, somebody needs to sell these things and interact with the customers. Again, using the same logic, they could hire hundreds of salespeople and customer support people, develop an entire organization, strategy, etc.
This is where SIRC steps into the value chain… more below.
To recap, let’s simplify the value chain as: R&D, Manufacturing, Supply Chain, and Sales
What can we infer from this?
Theoretical Allocation of Profit/Loss Amongst the Value Chain
Now, this can vary by industry so it is not uniform. But in a technology heavy industry like the one that SIRC is involved in, it generally works like this.
At the end of the day, your central IP owner is what we call the “entrepreneur” generally has the most to gain or lose by this whole operation. They’ve spent billions of dollars and years of effort to develop these products they’re now trying to monetize. And remember, there was no guarantee that these products would work, so the R&D could have been all for naught, which happens all of the time.
However, each of the other pieces do not require the same level of investment and risk in order to operate.
Example – The Manufacturer
Let’s take the example of the manufacturer. The manufacturer, assuming it isn’t the IP owner, is only responsible for taking the exact specifications and manufacturing guidelines the IP owner creates and executing on it. They have to hire factory workers, build out a manufacturing plant, and then bear the risks associated with that.
Generally, this manufacturer is somewhat replaceable and is not doing anything that another ambitious business owner could do. However, they could also pivot their plant to do something else if needed. So there is some risk, but not as much. Remember, if there was no risk, everyone would do it and everyone would earn scraps. But because there is some level of risk, we can expect a profit exceeding 0%.
Because of that, the manufacturer will work to make sure that they cover their costs of operation and earn some level of profit that makes the risk worth it. But because their risk is so much less than our entrepreneur, we don’t see them commanding high margins.
Theory in Short
Extrapolate that example of the manufacturer across the value chain now. What do we see?
What we tend to see is the entrepreneur company, in a technology heavy industry, earn a return that can either be quite high or quite low. For example, at the beginning they could be earning -20-30% margins. However, longer-term, you can see consistent 20-30% margins, much like a company like Microsoft, Apple, etc. This is all due to the heavy investment in IP (and associated risk) and the return they are now earning because of their success.
Everyone else on the supply chain, naturally, tends to be quite squeezed and will almost never earn profits in that level. This includes your manufacturers, supply chain/logistics partners, and your sales partners.
As a basic example, I suspect the operating margins of Apple’s supply chain (fictitiously assuming apple doesn’t manufacture or sell anything themselves and it’s all outsourced) would look something like this:
- Apple: 30%
- Supply chain/logistics: 5-10%
- Manufacturer: 5-10%
- Sales: 5-10%
SIRC’s Theoretical Profit Potential
Now that you have a flavor for the theory, let’s get more into SIRC. SIRC’s only contribution to the value chain is around its sales and installation services it provides to customers and the companies they purchase product from.
Using my example above (and I don’t need to rehash this too much), the theory tells us that SIRC should only expect to earn operation margins somewhere between 5-10% longer term. Let’s discuss briefly:
Before someone furiously types this in the comments, let me first point out that in its first profitable quarter, SIRC earned an operating margin of around 37%. This clearly does not mesh with the theory I posed above. Why is that?
To be honest, it’s because those profits are temporary, in my opinion. Why? First, SIRC themselves have said that the company earns gross margins of around 40-45% generally. Your gross margin is your gross profit divided by revenue. Gross profit is revenue minus cost of goods sold.
For SIRC, cost of goods sold should theoretically be the cost of the products they are reselling, as well as any labor associated with the installation. Everything else, mostly sales costs, will be included as an operating expense within operating profit.
Given that, there is almost no evidence to show that operating expenses is only 3-8% of sales, bringing us to an operating margin of around 37%. So, long term, expect operating margins to come down significantly from the 37% margin they earned in Q3.
Q3 appears to be, unfortunately for many, a fluke due to the business ramping up. They had a higher-than-expected gross margin and somewhat lower operating expenses.
Observations from the Market
What I also did was run some rough company pulls which perform similar functions in generally similar industries to SIRC. I ran two pulls (based on what my screener could provide) and calculated the median operating margin of profitable companies in the prior 12 months. They were:
- Trading Companies and Distributors – Median Operating Margin of 7.46%
- Construction and Engineering Services – Median Operating Margin of 5.13%
While companies can earn higher than those amounts, the best we can expect as prudent analysists is for a company to gravitate towards the median. So it appears that my theory is holding up somewhat in practice.
Wrap up and SIRC Opinion Time
We now have a good theoretical understanding of SIRC’s value chain and where we can expect profits to concentrate long-term. SIRC, unfortunately, will not be getting (in my opinion) 37% operating margins into perpetuity in my opinion.
I expect their operating margins to fluctuate somewhere between 5-15% each quarter depending on business performance. If they go higher, that’s awesome, but I just cannot see it happening with much consistency. Remember, this is just a theory, but it is very present in the everyday market.
So what does this mean for investors, this seems like I’m bearish right??
I am not bearish at all.
What I am telling you is that the company’s profit margins will likely begin to trim down. But remember, that’s just profit margin. What haven’t I talked about at all yet? Revenue.
Revenue is the extremely key figure we need to follow here. While margins may by thinning in the future, if revenue keeps increasing exponentially like it has been, the company is still going to be raking in high profits at a nominal level. For example, would you rather have 1m in revenue and 250k in profit (25% margin), or 200m in revenue and 10m in profit (5% margin). I think we all know the answer 😊.
So as an investor, you really need to think to yourself “is exponential revenue growth attainable?”. In my opinion it absolutely is.
SIRC is heavily investing in acquiring new sales companies and hiring more sales personnel. All of this, coupled with an extremely high growth industry, positions SIRC very well to capitalize on this industry and reward shareholders.
Remember though, none of this is guaranteed. Some new hot shot company could always come along and squeeze out SIRC, SIRC could also just generally not perform well. There is always risk.
But if you believe in management and their ability to execute, you should sleep well at night knowing that the odds are in your favor, win or lose.
In closing, with this whole margin concept, just remember that for your valuation models, you need to factor in a lower profitability margin in future years. Very simple!
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DISCLAIMER – AT THE TIME OF WRITING THIS ARTICLE I DO NOT HAVE A POSITION IN $SIRC. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. I AM NOT A FINANCIAL ADVISOR. AT THE TIME OF WRITING THIS ARTICLE, PERSONS AFFILIATED WITH THE COMPANY ANALYZED ABOVE MAY BE PROVIDING MONETARY COMPENSATION AS MONTHLY PATRONS THROUGH MY PATREON. THIS COMPENSATION IS NOT PROVIDED IN RETURN FOR ANY SERVICE, WRITING ABOUT A PARTICULAR TOPIC, AND/OR FAVORABLE OR UNFAVORABLE OPINIONS. MY PATREON SUPPORTERS HAVE NO INFLUENCE ON THE CONTENT OF MY ARTICLES.