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The Power of Latent Earnings

March 27, 2024

In today’s markets, most investors recognize that smaller start-up companies need to reinvest heavily in their businesses to accelerate growth and capture market share and scale, accepting lower profitability today for greater potential profits tomorrow. Management can either prioritize growth or profitability, and a greater focus on one naturally comes at the expense of the other. As a result, current profit levels for fast-growing companies might not necessarily be representative of their true earnings power or “latent earnings power.” When it comes to large businesses, we believe this concept may be underappreciated because they are generally assumed to be operating closer to a mature, steady state.   

Recent stellar earnings reports from several mega-cap technology companies exemplify the idea of latent earnings, even in some of the largest corporations in the world. Meta (Facebook’s parent company) famously declared 2023  the “year of efficiency” and extracted billions of dollars of savings from their income statement. Many years ago, Google started breaking out “other bets” in its segmented results, showing just how much capital the company was investing in all manner of moonshots and the incredible profitability of the core business. Undoubtedly, Apple, Microsoft, and Amazon all have similar profitability reserves into which they can dip.

Amazon may be the most famous example of latent earnings power. Historically, the company reinvested all operating profits into growth, suppressing Amazon’s GAAP earnings for the first few decades of its existence. This had a polarizing effect on investors; some doubted the company would ever be profitable, while others correctly recognized that the underlying business structure was far more profitable than headline earnings results suggested. In other words, it was a conscious management decision to forego current profitability in exchange for market dominance and future outsized profitability.

More recently, Amazon appears to be slightly shifting its mentality from sowing to reaping. Along with other large tech companies, Amazon reined in its spending across a wide range of business units in 2023, hoping to improve profits and redirect resources to more promising growth initiatives such as generative artificial intelligence. Over the last year, Amazon cut nearly 30,000 jobs (the most among any of the large technology-focused companies), which affected a wide range of business units including Alexa, One Medical, Prime Video, MGM Studios, and Twitch.

Though Big Tech's ability to quickly shift from growth to profitability focus may be obvious, there are less readily apparent examples. Take global IT consultants Cognizant and Accenture. While they have similar earnings before interest and taxes (EBIT) margins, Accenture spends ~10% of EBIT on research and development (R&D) compared to Cognizant’s ~1%. Given that it's already operating closer to maximum efficiency, this makes Cognizant a more fragile business, whereas Accenture has room to cut costs and maintain margins in an economic downturn by temporarily trimming its significant R&D budget. Not only is Cognizant less able to withstand economic shocks, but its competitive position is also likely being slowly eroded by its lack of investment in the core business.

Considering latent earnings power is a quick and useful exercise that helps shed light on a business's true strength. Investors often look to profit margins as the main indicator of a business's strength (the higher the better), but headline figures can obscure wide variations in underlying structural profitability and the degree to which businesses are investing (or not) in furthering their competitive advantages.

This blog and its contents, including references to specific securities,  are for informational purposes only. Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this blog were prepared based upon the information available at the time and are subject to change. All information is subject to possible correction. In no event shall Mawer Investment Management Ltd. be liable for any damages arising out of, or in any way connected with, the use or inability to use this blog appropriately.

References to specific securities are presented for informational purposes only, and should not be considered recommendations to buy or sell any security, neither is it implied that they have been or will be profitable.