We have all heard something like this before: the restaurant business is a tough business. Restaurants are tough because there is a lot competition, changing tastes, and a fixed cost structure, with food, labor, and rent eating up a lot of the margin.
This post really isn’t about restaurants, but to highlight there are many industries with a reputation for average or even poor economics, yet there are businesses in those industries that thrive. It is valuable to understand why. This was in part motivated by a passage Eugene Wei shared in a recent post on TikTok:
They say you learn the most from failure, and in the same way I learn the most about my mental models from the exceptions.
Studying exceptions helps us realize that industry economics are not destiny. You can do well in an industry with average economics if you approach things differently that everyone else. One way to do this is to choose a business model that will position you differently than the competition. This will also lead to you performing different activities to create value.
I will highlight two examples, one in retail with a well known business and another in the lending space that is a start-up.
Like restaurants, retail is a tough business and for many of the same reasons. Lots of competition, changing tastes, and a high fixed cost structure. Yet, there are exceptions and the one we will discuss here is Costco. I read this piece on Costco from 2005 in which investment manager Nick Sleep lays out his “Scale Economies Shared” thesis and why the business is a perpetual growth machine. He was obviously right given its market capitalization is up 7x from $21 billion from where it was in 2005! Costco has created a tremendous amount of value and captured some along the way.
Costco is able to do this because it does things differently. It can do things differently because its business model allows them to do so. This business model both drives value creation for the customer and allows them to capture some of that value. Retail industry economics are not destiny because of how it is positioned.
Most retailers try to profit on the spread between the price they buy from suppliers and the price they sell to customers. Costco does something different. They intentionally keep gross margins low and do not mark up anything more than 10-15% above what they pay. This both aligns interests with customers when negotiating with suppliers and creates a ton of value for the customer as Costco passes the savings to them. The piece I link to raises an important distinction: supermarkets make money buying from suppliers whereas Costco makes money selling to its customer. Its a subtle distinction, but an important one.
We’ve addressed how Costco creates value, but how do they capture it? It doesn’t make money on marking up goods, but on memberships fees. Costco has applied a subscription model to retail that Amazon copied with Amazon Prime. The annual membership fee is $60 and they have 98,500 members as of the last 10-K which equates to around $6 billion in revenue. It is also important to note this revenue requires very little marginal cost and is almost all profit.
The membership fee model and its low markup in which it passes its purchasing savings to customers enables strong retention. After all, Costco may sell goods, but its real business is to add new members and retain them. Costco earns good returns with this model as its goal is to continually grow sales volume and its membership base. It earns a decent return on invested capital (ROIC) not because of its margins but because of its turnover (Sales / Assets). This enables a very strong business model that is hard to compete with. Not to mention, its scale is now large and its margins are low making it very defensible.
Costco succeeds in retail because they play a different game enabled by a different business model. Its strategy to grow sales volume and its business model are very complementary to one another, each pushing the other forward.
Lending / Payments
In a recent piece, Marc Rubinstein gives a great overview of both the lending and payments businesses and how they are different. I suggest you read it in full.
He explains that in lending you are not only in the lending business but also the funding business. The interesting thing is these two businesses are not really complementary to one another. So, its tough to scale and expensive to get and retain customers making the economics average or even poor.
He then explains how the payments business is more complementary which allows for better economics. The payments business has a consumer and merchant side that mutually reinforce one another. Also, the payments business has more frequency than that of lending, allowing for lower customer acquisition costs and higher retention. The two sided network of consumers and merchants combined with this frequency allow for both high growth and more predictable economics.
The contrast between lending and payments is interesting as companies pursue novel business models taking elements of the payments business but applying them to the lending business. The two firms Marc mentions are Afterpay in Australia and Affirm in the US. I had not heard of Affirm until bought a Traeger Grill this summer. I probably should have – they are planning to IPO at at a $10 billion valuation. That is a large valuation so they must be doing something interesting and it seems they are.
Affirm is a point of sale lender with a different business model than that of a typical lender. They appear at the point of sale, so its cheaper for them to acquire the customer. The customer is ready to buy. Another interesting thing is they are not paid by the customer, but rather the merchant. The merchant pays around 4-6% of the transaction versus the 1-3% they pay to credit card companies. The fee is higher, but if Affirm can increase sales conversion it may be worth the higher cost. These business model elements of being at point of sale and paid by the merchant take elements of the payments business and apply it to lending making the economics potentially better.
From the customer vantage point, Affirm takes all the best elements of a credit card and debit card. It offers an installment plan where you can pay down the cost in four installments over two months. We use credit cards to delay settlement but hate that pesky interest. Affirm doesn’t charge interest as long as you pay. We use debit cards to avoid interest, but you need to pay right away. Affirm lets you have your cake and eat it too. It combines the best elements of both.
Affirm’s business model offers a lot value to both the customer and the merchant. As more merchants sign on more customers will know about it. As more customers know about it, they may ask more merchants to add Affirm as an option. If Affirm increases conversions for merchants they will likely be happy to use to them. Each side could push the other forward, like in payments. In addition, Affirm will likely get better at making payment plan offers as they collect more data as they grow. This seems powerful, but I am not sure how power yet.
Affirm offers an interesting substitute to paying with a credit card or debit card. When this S-1 comes out, I will be sure to read it to better understand the economics. They may not be the next Costco, but they have created an interesting business model that is worth our study.
A business can alter its economic destiny by changing its business model. Industry economics are a powerful force, but business model choices can allow a business to both create and capture value differently to become exceptions to the rule.
Studying those exceptions help us figure out why that business may be doing better and will hopefully make us smarter.