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Principles of finance ah la shmoop review of margins as

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they apply to inventory management All right people as a

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financial manager a big part of your report card will

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come from how you're doing relative to competitors into key

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categories and these air the primary drivers of share price

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overtime Yeah margins and revenue growth revenue growth not just

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revenue if you're in the sunglasses business while they're just

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a handful of large scale competitors one growing revenues at

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thirty percent with twenty five percent operating margins is going

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to trade at a big multiple premium toe one growing

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revenues that only ten percent with fifteen percent margins Right

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Multiple of what Yeah Good question Glad you asked burnings

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or cash flow or a composite of the two All

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right we'll come back to that What if you're in

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the lemonade delivery business So take a look at this

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before we get started You remember eliminate stands are us

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income statement here Twenty nineteen margins All right So that's

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the income statement lemonade stands are us Note the margins

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there for the moment Focus here is on these margins

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Inventory is an expense I either cost structure of the

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ingredients that go into a product or service like plastics

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and glass and you know to hinges pushing forward our

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lemonade stand metaphor Here we've decided to include on ly

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the cups and the liquid as costs that go against

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gross margin so that we have very high gross margin

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product in our lemonade at eighty five percent Well how

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do people get served ignoring labor How do they pay

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ignoring visa and mastercard Do robots or ghost magically do

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this No maybe labor should go up There is part

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of the gross margin expense Maybe not We'll think about

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it anyway In the case of lemonade business if the

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costs of the cups doubled and the cost of sugar

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and lemons went up fifty percent that is instead of

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ten cents a cup it cost twenty and instead of

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a nickel it was seven and a half cents for

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the sugar and lemons but we'd still have a really

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high margin business Gross unit margins would be a dollar

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minus twenty cents for the cups minus seven half cents

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for the sugar and lemons and that give us a

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gross unit profit of seventy two and a half cents

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A cup was ninety seventy two still really good Well

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the key idea here is that inventory management and price

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optimization for those kinds of inputs doesn't matter all that

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much In this case if a can of coke sells

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for a buck and sugar prices double well that can

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produces seventy cents of profits instead of eighty or something

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like that in very high margin business is you don't

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go bankrupt if input costs go up your just less

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wildly profitable And in reality you pass along those price

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hikes to consumers usually pretty easily Yeah all right but

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what about the low margin airline industry where fuel is

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a huge part of expenses and its pricing is extremely

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volatile What happens then Well in times of falling fuel

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prices assuming they aren't reflective of a failing economy or

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that star trek thing or the i dream of jeannie

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thing where she just blinks and then appears like four

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thousand miles away and that air travel and economic times

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were highly correlated So you know the airlines are more

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profitable than otherwise In this example things can whips off

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fast in the airline industry and in the economy one

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bomb goes off in the middle east and fuel prices

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double overnight and airlines hemorrhage losing money so inventory management

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is hugely important there The inventory of fuel So is

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capital management in the notion of how much margin life

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insurance companies are willing to pay for a given amount

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of protection All right wait What is marjan life insurance

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What is that Well it's hedges that is most airlines

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purchase forward contracts giving them the right to buy fuel

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like airline fuel for a set price per gallon for

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a set period of time Like they know roughly how

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much fuel they're going to consume in april of next

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year in august of next year and maybe eighteen months

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forward from that because their business pretty steady So they

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buy future contracts toe lock in their prime ice is

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so like you know knows surprised if that bomb does

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go off in the middle east Alright so example here

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we go that is if you'll today is sixty bucks

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a barrel of oil Jets fly jet a fuel usually

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But pricing is highly correlated to the pricing of a

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barrel of oil so we'll just use that now for

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our proxy because it's more liquid So if oil is

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sixty bucks a barrel today and the airline industry is

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okay feeling the pain of a fuel hike all the

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way to eighty bucks a barrel But beyond that eighty

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dollars they want a hedge half their exposure up to

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one hundred dollars a barrel meaning we'll split the difference

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of ten bucks up to one hundred dollars when it

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then wants to hedge all of it like if prices

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go above one hundred bucks a barrel they'll just pay

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a lot of money for life insurance above there And

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the forward contracts will then reflect that and protect their

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margin and manage their quote Inventory costs unquote All right

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so why is all this important Conceptually because fuels aki

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volatile inventory input element of the airline industry it's low

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margin and so their life is threatened if fuel prices

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go really really high really really suddenly the hedges purchased

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by the airlines are essentially profit margin life insurance When

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fuel prices do go up a ton you know they

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always do All right Well when that happens the airline

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industry doesn't go bankrupt They can pass along a lot

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Of the fuel price hikes to customers in the form

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of higher ticket prices because well all of their comm

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editors smartly hedge their fuel costs and can still offer

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the sfo jfk leg for four hundred sixteen bucks You

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can imagine if you're the one airline who didn't hedge

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and everyone else can drop the prices of four sixteen

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and break even in your break even prices five eighty

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well then we suggest glass door or indeed either those

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are pretty good places to find a job here's a

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simple example lacking detailed accuracy so that it's relatively clear

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so we're not going to get lost in the weeds

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here Shmoop west airlines uses ten million barrels of fuel

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a year It believes that oil prices will rise because

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the economies of the world have improved and that air

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travel will remain robust so they don't think they'll fly

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Heavier planes burn more fuel on more packed flights or

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more routes All else is held the same shmoop west

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wants to hedge five million barrels for next year so

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it looks at the derivatives trading desk and has offered

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for eight dollars a barrel for shmoop west to buy

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A call option or really a future on an eighty

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dollars a barrel of oil contract for one year that

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is for eight bucks shmoop west vice the right two

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then pay eighty dollars a barrel for fuel all in

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cost Then would be eighty eight bucks a barrel if

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you know a fuel prices really spiked into the hundreds

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So shmoop west pays the kindly loving derivatives trader at

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goldman sachs five million times eight bucks or forty million

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dollars for this margin life insurance And remember that you

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know today oil in this example sixty bucks a barrel

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of oil would have to go up a lot in

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price to execute this call option but eighty eight bucks

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all in cost per barrel Shmoop west is still a

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profitable airline And remember that in this transaction shmoop west

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has hedged on ly half of its oil needs for

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next year at five million barrels right they used him

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If oil goes crazy say goes to one hundred fifty

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dollars a barrel Well calf of shmoop west fuel needs

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are naked Yeah fully exposed Nothing hides there That is

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shmoop west still has to buy then five million more

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Barrels at market prices of fuel that year A tte

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that time they can do the same exercise paying for

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call options which give them the right to buy that

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fuel of say a hundred bucks a barrel and that

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higher strike price would likely be a lot cheaper than

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eighty dollars Strike price memory paid eight bucks for that

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eighty dollars because in order for that call option contract

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to execute oil prices would have to go up from

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sixty bucks a barrel today Toe well over one hundred

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during the life of that call option contract Could it

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happen Yes likely to happen unless so At sixty bucks

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a barrel shmoop west has an eighteen percent operating margin

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really high for an airline historically at eighty eight bucks

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a barrel the wily financial manager who took this course

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knows that you have to include the cost of the

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hedge as it is inextricably bound now to the cost

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of the fuel inventory So now shmoop west has eight

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ten percent operating margin or something like that because they

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paid so much for hedge is still not a bad

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margin for an airline The key thing you need to

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protect against is negative margin I eat that you ignored

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the fact that the very volatile price fuel expense was

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a key part of your cost structure And if that

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bomb really did go off somewhere in the middle east

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well then at one hundred fifty bucks a barrel could

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shmoop west still keep flying profitably Well it's your job

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to be sure that they can So what happens if

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the price of oil never goes above eighty bucks a

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barrel in the next year Well the gallant goldman sachs

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then just made forty million dollars for a whole lot

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of not working much The contracts expire when they expire

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and the trader at goldman has almost one hundred percent

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profit on the hedge that she sold the nervous nellies

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here It's from up west airlines Nice work if you

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can get it in a whole lot less stressful than

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flying a fleet of jetliners that are you know low 00:09:13.069 --> [endTime] on

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