business models/competition/economics

Industry Economics, Business Model Design, and Destiny

Posted on by antonzitz
Industry Economics, Business Model Design, and Destiny
Industry Economics, Business Model Design, and Destiny

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.

Retail

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.

Conclusion

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.

business strategy/competition/economics

7 Powers, a practical Strategy read

Posted on by antonzitz
7 Powers, a practical Strategy read
7 Powers, a practical Strategy read

I recently re-read an excellent business strategy book, 7 Powers: The Foundations of Business Strategy, by Hamilton Helmer. I read it about two years ago, but it really didn’t stick with me back then. Part of this may be that I didn’t have a great system for absorbing what I read, but I *think* I have a better one now. Please note I intend to write about my evolution of reading, learning, and note taking in a future post.

I was a bit conflicted in writing this up in that there has been a lot of good coverage of this book. That said, I intend to keep it short and sweet. I will link to that coverage at the bottom, including a podcast interview with the author.

I will explain i) Why I liked the book, ii) Describe the 7 Powers, and iii) List Takeaways from the book.

Why I liked the Book

I really liked the book because up front provides a clear and consistent framework for terms that have always seemed “foggy” to me. These terms are Strategy, strategy, and Power. A lot of Strategy textbooks will define terms and give anecdotes, but when I finish the book I’ve never connected it to concepts I discover later. Going forward, I feel like I have a path now. Helmer states the framework is meant to be simple, but not simplistic and I think this is useful. Lets jump right into the terms:

Strategy: the study of the fundamental drivers of business value.

This was useful me in that it differentiates between the study of a discipline and what a company should be “doing”. We can say Strategy is studying what drives business value and this seems important. Next, lets define the concept of strategy.

strategy: a route to continuing Power in significant markets.

Note this is different from the above. Strategy is a study of strategy. Is that confusing? Perhaps, but it is meant to separate the study of a general discipline from what a company’s mission should be. And what should companies be doing? They should be looking for sources of Power they can wield to create and maintain a competitive advantage.

Power: a set of conditions that create and allow for persistent, differential returns.

For a business to have a true strategy it must have Power. This usually involves recognizing a source of Power and then seeking to exploit it. Helmer emphasizes Power must have a benefit and barrier component. The benefit serves to increase cash flow through some combination of higher prices, lower costs, or lower investment needs. We come to a key point: many companies can create benefits and increase value (to customers), but they need a way to capture some of the value they create. So, that means the barrier is the key; a company needs a way to not only capture value, but keep competitors at bay. Taking the benefit and barrier a step forward, the benefit determines the magnitude of free cash flow and the barrier determines the duration of the free cash flow. The combination of these two discounted to the present determines value.

Finally, I like how Helmer divides the book between the “statics” and “dynamics” of Strategy. Statics describe the “being there” of strategy after you’ve attained Power. It describes the end state of where you want to be and we will cover the types of Power in the next section. He then spends the last two chapters of the book explaining the dynamics of strategy, or the “getting there”. He does this because sometimes describing the statics may give you a mistaken conclusion about what you need to do. For example, based on statics, you may decide you “need to get big”. Scale may be important, but you want Power and merely getting big doesn’t guarantee it.

Description of the 7 Powers

Next, we will touch on the 7 Power Helmer identifies as statics of “being there”. The goal is to be both brief and informative. Again, if you want to dig in, reference some of the links at the bottom as they do an excellent job providing more depth.

Scale Economies is a decline in unit cost with increased volume. The benefit to the leader is a cost advantage that results in increased cash flow. The barrier to the competition is that it will be painful for the challenger to gain share while the leader has this cost advantage. A good example of this is Netflix’s Power with its cost per subscriber given its large subscriber base. Scale Economies is an exclusive source of Power in that only one can have it. A key consideration for this Power is how much of the industry cost structure is fixed. In other words, having a large variable cost structure won’t help you here. Asset-light logistics companies have very variable cost structures which they tout, but that implies this Power is hard to come by.

Network Economies is when the value of a product increases as the installed base increases. The benefit here comes from a price premium the leader can charge, increasing its cash flow. The leader charges for it directly or indirectly in its advertising rates (i.e. Facebook or Google). The barrier to the challenger comes in the form of losses to try and catch up. Like Scale Economies, Network Economies is an exclusive source of Power so there may be no challenger as its “winner take all”. Network effects can also exist, but without Power. Finally, attracting complements (i.e. application developers) can be an indirect network effect that’s important depending on the industry.

Counter-Positioning is when an entrant adopts a new business model that is superior and the incumbent is unwilling to respond because of collateral damage to its existing business model. The benefit to the challenger is that the new business model is superior and results in higher cash flow. The barrier actually comes from incumbent’s fear to abandon or shift its existing business model. This fear comes from some combination of sunk costs, opportunity costs, and high margins embedded in the existing business model. Again, Netflix is the example here as we discussed in this post in its fight with Blockbuster. Unlike the first two powers, Counter-Positioning is not exclusive source of Power as others can adopt the new business model. For Netflix, they had Counter-Positioning relative to Blockbuster, but they needed to Scale Economies to have a viable long-term strategy.

Switching Costs occur when a customer determines a greater loss than value gained by switching to a competitor. The benefit allows the company with Power to charge a higher price. The barrier is that the challenger must compensate customers for switching costs to induce them to switch and its usually uneconomic to do so. A firm can grow its switching costs by launching new products and making acquisitions. Like Counter-Positioning, Switching Costs is not an exclusive source of Power and can lead to other Powers such as Network Economies and Branding.

Branding is an asset that conveys information to consumers and invokes positive feelings, increasing their willingness to pay (WTP). The benefit is a price premium for the brand that stems from a combination of positive feelings, associations, or uncertainty reduction. The barrier to the entrant is the time, costs, sunk costs, and uncertainty it takes to build up a brand. This Power type is non-exclusive and is typically stronger in consumer markets than in business to business markets.

A Cornered Resource is access to an asset on attractive terms that enhances value. The benefit comes from having a superior deliverable that results in price or cost benefits. It comes in the form of a person, patent, or access to some resource. The barrier depends on the nature of the resource, but it could be personal choice (if a person), property rights (if access to a resource), or patent law (if a patent) depending on the nature of the asset. For example, Helmer considers the Pixar Animation “Brain Trust” of Steve Jobs, Ed Catmull, and John Lasseter a Cornered Resource. This access needs to come at a non-arbitraged price meaning the holder of Power does not pay “market value” for this asset.

Process Power is a compounding of company activities to improve product benefits or lower its costs. The benefit to the company is driven by improvements in quality and cost that persist even if employees leave. The barrier is the time it takes to build these improvements. Also, these activities may not be copied because the process is complex and opaque. A key point to make is operational excellence is not Process Power. Operational excellence is table stakes and not a strategy. Helmer gives the example of the Toyota Production System as an example of Process Power.

Takeaways

Any discussion of strategy must address a path to Power. If management tells you about a “strategic acquisition”, you should pause. Ask yourself: does this lead to Power? If so, how? I believe the definitions given above along with the Powers provide a good filter for industry analysis. Any time the word strategy is mentioned, I hope this book primes me to pause.

A Power’s exclusivity dictates the pace. With Scale Economies and Network Economies, the goal should be to build scale or the installed base quickly. Branding, Switching Costs, and Process Power all take time to build up so its about careful decision making.

Invention is powerful in that it not only opens the door for Power, but can also expand the market size to create more value. Value is when a customer gets more for less. Invention leads to the potential for Power, but you need a barrier to obtain Power. Industries in flux is a good place to search for Power.

Power comes from invention, adaptation, action, and risk taking. A strategy cannot be planned but only crafted over time. It usually end up being come combination of leadership, timing, execution, and luck.

Supplemental Reading:

business strategy/competition/investing

Business Ironies

Posted on by antonzitz
Business Ironies
Business Ironies

If you were to make a list of desirable traits for a business to have, I think the following would be at the top of the list:

  • A large total addressable market (or “TAM”) with a high growth rate
  • High gross or net margins

I believe the value of a business is the present value of all its future cash flows discounted back to today. In determining that value, two factors regarding that cash flow are very important: both the magnitude and duration of those cash flows. The two factors I mention can give some certainty to the former, but not necessarily the latter. In fact, they may even be factors that make the duration of those cash flows harder to achieve. In this piece, I’d like to take a closer look at both of these traits and make us think a little more deeply about what they mean for businesses and competition.

Large TAM / High Growth

I have opened countless investor presentations that state they are in a large and growing market. This is thought to be a good thing and it may be, but in order for that to be true the business needs some sort of moat to be able to fend off competition to actually create value, or in this case durable free cash flow. There is a concept in economics called minimum efficient scale (or “MES”) and its the smallest level of output at which scale economies have been exhausted. This basically means what is the smallest market share a company needs to be able to have as efficient of cost structure as that of the market leader. The reason this is relevant is essentially the market size divided by the MES will determine how many competitors you may have. If a business is in a large market but has a small MES, there will likely be many competitors and fights for market share. This will be a tough market to generate sustainable free cash flow without some sort of barrier to protect the company or differentiation in its product or service.

Now, lets consider the market growth angle. Paradoxically, a higher growth market signals a larger opportunity to competitors and it could encourage entry. Additionally, consider above when I stated the number of competitors is the market size divided by MES. Well, if the market is growing that creates more “room” for competition it could dilute the MES advantage the incumbent has. So, in certain case, a small TAM coupled with a slower growth can actually insulate a company from competition. In most cases, what actually ends up happening is as a market grows, there are niches created in that market a company can focus on to survive and generate profits.

A good example of the small TAM coupled with slower growth is Shimano, the bicycle gear maker. It has over 70% market share in bicycle gears and breaks with large profits to boot. Why do they have such large profits? Most likely because they have a large MES relative to this market size. A competitor could enter this market, but it is not economically rationally for them to do so so they don’t and Shimano enjoys an enviable position in this market.

A large and growing TAM may only be good if a company has a moat to protect itself or has discovered some niche in which it has strong relative scale to the market size.

High Margins

A business with high margins certainly has more options than a business with lower margins. A company with high margins can do a lot more in terms of reinvesting in its business or can possibly return cash to shareholders via dividends or buybacks. High margins may even indicate the presence of a moat. However, high margins can also come under attack without a moat. There are many businesses with low margins that actually generate a lot of free cash flow such as Amazon, Walmart, or even Costco. The fact these companies have low margins serve as a competitive barrier to new entrants as its difficult for them to make the economics work without scale. In short, high margins may be a nice feature, but if they are not defensible they could make you a target.

Paradoxically, high margins can also be a deterrent that sinks the incumbent in certain situations. In his book, 7 Powers, Hamilton Helmer identifies a concept called “Counter-Positioning”. It is when an entrant adopts a superior business model and the incumbent is unwilling to respond because of collateral damage to its existing business model. In this example, an entrant comes in with the new business model and the incumbent will wait to respond and often by the time they do respond it is either a half-hearted effort or too late. For example, Netlfix’s DVD subscription business model had the Power of Counter-Positioning over Blockbuster’s brick and mortar model. Blockbuster’s choices were either to 1) respond to Netflix directly and waive its late fees, or 2) continue to lose customers to Netflix. I am sure the high margin revenue provided by late fees was part of the reason Blockbuster did not respond aggressively.

Helmer notes that in Counter-Positioning the incumbent may not respond because of its high margins. A lot of companies do not want to kill the golden goose. The problem is if the entrants business model gains traction, you will not only lose your market share, but also you will lose those margins eventually. Essentially, high margins create an opportunity cost and deterrent to act when you need to.

Conclusion

I would like to conclude by saying that a business in a small market with slow growth and low margins is not better than the opposite type of business. What I am trying to explore is that large high growth markets and high margins are subject to competition without a moat, so having a defensible business is what creates value, not just those characteristics themselves.

In addition, when thinking about value, you must not only consider magnitude of free cash flows driven by the factors we discuss above, but also duration of those free cash flows which is driven by a moat. Most things in life are trade-offs, so even if the magnitude of free cash flow is lower because of a smaller market size, growth, and lower margins, the duration of cash flow may more than make up for that allowing for more value creation in the aggregate.

This piece by Andreessen Horowitz really made me think more deeply about this and I suggest you give it a read.

Please let me know what you thought of this piece. Thank you.

investing/markets

SPACs, Market Savior?

Posted on by antonzitz
SPACs, Market Savior?
SPACs, Market Savior?

We knew the COVID pandemic would have an impact on the markets, but one I did not anticipate was its effect on the SPAC (or “Special Purpose Acquisition Companies”) market. The boom part has been well covered, but what I wanted to describe is some of the interesting “uses” of SPAC’s and the real substitute its providing to the traditional IPO market.

What is a SPAC?

Also known as a “blank check company”, a SPAC is a company that actually is a pool of public money that is looking for a company to buy. It is similar to the private equity model in that it is money looking for an acquisition, but the money is actually public and the target “reverse merges” into the money. Essentially, it is a backdoor way of going public that can be done much quicker and with more certainty than in the traditional IPO process. All SPACs go public at $10.00 per share and have two years to find an acquisition or it returns the money to its shareholders. If you are interested in learning more, this article provides a good summary. One thing to point out there is certainly an incentive issue here in deploying capital especially when the SPAC gets close to the end of its two years.

Established SPAC’s

The first time I encountered a SPAC was when I was an investment banker working on a sales transaction for a restaurant chain. It was one path we pursued in addition to potentially both selling to private equity and even going public. At that time, SPAC’s seemed like a non-standard route to getting a deal done and ultimately we didn’t pursue it. I’d say since then I’ve been casually interested but I think the market has a bit of a stigma attached to it. However, in 2019 SPAC issuances were $13.6 billion, and 2020 year to date raises are at $12.3 billion and we are a little more than halfway through the year. Many somewhat successful companies have gone public via a SPAC recently such as Nikola Motor and DraftKings. Now, Goldman Sachs is getting in on the action, raising a $700 million SPAC and famed investor Bill Ackman has raised the largest SPAC ever ($4 billion!) to buy a “mature unicorn”. Previously, this market has experienced its ups and downs but it seems like its attracting sophisticated players.

Advantages of SPAC’s Today

There are a few interesting reasons why SPACs are hot now and why companies may want to pursue this path over a traditional IPO.

  • More certainty of getting a deal done as the IPO market can be volatile.
  • More certainty around proceeds.
  • A less complicated negotiation.
  • Potentially a cheaper cost of capital as compared to a traditional IPO.

Byrne Hobart of The Diff has a really nice breakdown of SPACs here. I recommend subscribing to his newsletter – its fantastic.

Uses for SPACs?

In getting a little more familiar with this, I have noticed three specific uses for SPAC’s that are worth highlighting.

“The Tech Public Reset”

Shift, a player in the used car market, that lets people buy, sell, and finance cars on its platform went public via a SPAC. It has a similar business model to Carvana and Vroom, who are both public companies themselves. Shift was hurt by the COVID-19 pandemic and had to make some painful moves to make it through the pandemic. The SPAC route gave it the cash runway it likely needed to continue to scale its business and make it work. Moreover, another private fundraise was probably not feasible given the pandemic and given the cuts they had to make. It was time to raise cash as quick a possible and the best way to do that was via a SPAC.

“The Stalking Horse”

I think almost everyone knows that Uber bought Postmates, but I don’t think everyone knows the other bidder was a SPAC, so in a way this IPO option via SPAC represents an interesting option to the Company accepting an acquisition offer it does not like. Ultimately, the merger with Uber will be easier for Postmates to realize its potential, but it doesn’t hurt to have other options.

“The Compelling Spinoff”

Tilman Fertitta, the owner of Golden Nugget Casinos, Landry’s, and the Houston Rockets spun off his online gaming business and is using some of the proceeds to pay off some loans taken out as a result of the COVID-19 pandemic. He will have voting control in this SPAC, but I find it interesting he would spin off a business with arguably a higher valuation and upside in the future. Perhaps he looks at Draftkings success and is seeking to capture some of that upside. In the SPAC model, you can likely execute a spinoff more quickly and at a lower cost than in a normal IPO process. I’d also point out that in a post COVID world, I’d argue online gaming is an economic substitute for going to the casino and not a complement, so perhaps he is spinning off the business which has some potential to cannibalize his core business at what he feels is an attractive valuation?

Conclusion

The SPAC market definitely is serving some purposes in this market and is growing significantly. It will be interesting to see how this market develops. As I see other interesting cases, I will flag them. I would also love some feedback on this post if you wouldn’t mind commenting.