An Exchange on ROIC...the Key Measure of Profitability

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go...

Hi Derek, 

It's a Charlie Munger quote, and it's among the most important constructs for any long-term investor to understand. It goes to the heart of the return on invested capital (ROIC) portion of the economic model of a business. (See 3(d) of, "Does the economic model work?" from theMad Men MBA 4-Part Framework for Really Understanding Companies.) 

Consider this...a company has $1M of invested capital (equipment, buildings, accounts receivable, etc.) supporting its business. It earns $60K on that each year, meaning it sports a six percent ROIC. Tell yourself that $1M is cash in a savings account and the $60K is your interest on your principle. The concepts are the same. You can grow your overall interest earned (earnings) by putting more cash into that account (increasing its capital), but the rate of return remains the same...a lousy six percent.

For the company, the earnings can go one of three ways in the future: 1. They decline; 2. They stagnate; or 3. They grow. What happens to those earnings is important, but it's most important in the context of what happens to that base of invested capital at the same time. Let's consider number three, where the earnings grow. (That tends to be the happiest scenario.)

Say the earnings grow ten percent a year, going from $60K to $66K to $73K to $80K, etc. Ten percent growth seems pretty good, but we have to ask how much capital had to be invested in the business to generate that earnings growth. We must always look at earnings in the context of invested capital.

If the invested capital stayed steady at $1M, you're looking at a rosy scenario in which a business doesn't have to add to its capital base to grow. That means it can probably pay out those earnings to shareholders without fear of losing its competitive position in the market and continue to compound its value. It started off earning 6% ROIC, but that number grows with each passing year (6.6%, 7.3%, 8%, etc.). 

You won't find a lot of business like this. The vast, vast majority must plow back capital in order to increase earnings.

How much is this business worth? That's up to the judgment of individual investors, each of whom must attempt to predict the future in terms of whether this growth rate continues. (Are the earnings protected by competitive advantage? That's number two on the Mad Men MBA framework.) My threshold for an investment is a 15 percent yield. That means with earnings of $60K, I want to pay no more than $420K ($60K x about 7). But if I'm confident those earnings will continue growing at 10 percent, I might be willing to look, say, three years into the future, take that $80K in earnings and pay 7x that number (about $560K). But only if I'm confident that ten percent earnings growth (plus little additional capital reinvestment needs) continues deep into the future. 

That exercise is nothing more than an abbreviated form of discounted cash flow. Of course it's unlikely you'll find too many businesses with $1M invested in capital, earning only six percent ROIC, trading for a fraction of its capital. Someone would likely buy the whole company, liquidate it, and take the cash for a fast, hefty, and low-risk return.

But what if earnings are growing at ten percent while invested capital is growing at 15 percent? Now the economic value of the business is being destroyed with each passing year. What would you pay for a business like this? Nothing! Unless you have the power to shut it down and cash it out. As a shareholder, you'll never get the benefit of those earnings because the business has to plow all of it back into property, equipment, accounts receivable, etc. 

Munger's quote is really highlighting the famous dictum from Ben Graham's, "in the short run the market is a voting machine, but in the long run it is a weighing machine." In the short run, investors will have different opinions of the prospect for this business. The different views can lead to wildly different prices each is willing to pay, and that can lead to a lot of volatility in the stock price. 

But over the long run, the economic viability of a business (its ability to compound earnings at a rate AT LEAST equal to its need to reinvest capital) will define its price. That's the weighing machine. If it returns six percent ROIC, even if you buy it at a cheap price, you won't get much better than six percent returns over extended periods of time. If it returns 20 percent (and you think it might be able to keep that up for a while), you can buy it at almost any price and you'll do fine. 20 percent is a powerful rate for compounding any number if you give it enough years to do its compounding work! 

To get a mathematical proof, create an spreadsheet. Start with $1M on the row A. This is invested capital. To its right, multiply it by whatever ROIC you expect the company to earn. Say 1.1 (10 percent) and push that out 19 more rows compounding at the same rate each year. 

On row B, start with $60K for earnings. To its right assign whatever multiple you want for its growth, and push that out 20 years. 

On row C, divide B by A and show it as a percentage. This is your ROIC.

Now, if you select variables in which the growth of the invested capital outpaces the growth of the earnings, you'll see the ROIC creep closer and closer to zero the more years you extend the simulation. The company is eating itself. It has no economic value.

If you select variables in which the growth of earnings outpaces invested capital, you'll see those ROIC and earnings grow the further you push out the model. The business is creating economic value, and it's worth a lot more. 

But it's far less about creating a mathematical proof, and much more about understanding the concept of return on invested capital. A proof might lead you down the path of seeking false precision; searching for that perfect screen that unearths all the best ROIC companies. I think of it more as a way of looking at the world of investment opportunities while thinking in terms of compounded earnings. The more a business can grow its earnings without reinvesting them (as capital) back into itself, the better its ROIC...the more it pays out to its investors (dividends or share repurchases) while continuing to compound.

Kind regards, 

Paul

The Mad Men MBA: A 4-Part Framework for Really Understanding Companies

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we're the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I've expanded with a barrage of verbosity. I've agreed to his proposal (and we'll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I've dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn't send him running for an escape, perhaps we'll feature one or two of the case studies in a Mad Men MBA series here on the Adjacent Progression. 

Ok, Doug, let's up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what's good or bad about a company, but unless you have some way to organize all the information you're taking in...it tends to float around in disconnected ways. That's how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on. 

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom. 

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men...

1. What is the nature of the company's earnings?

This question forces you to go to the heart of a company's prospects, asking hard questions about the demand for its products or services and the potential for growth. It also forces you to consider whether your starting point (the financial results of a given year) are an aberration from the norm or a signal that a new trend is taking effect. 

Some businesses have cyclical earnings demonstrated by high peaks and low troughs of demand. This makes their earnings really high some years and really low others. Auto companies (the Jaguar discussion from Mad Men) tend to have cyclical ties to the economy. When it's good, they kill it. When it's bad, they have a hard time scaling back operations to meet the decline in demand...they hemorrhage money.

Some business depend on blockbuster success. Think movies, music, video games, even toys. They will have huge earnings in a year when they have a blockbuster seller, but then drop off precipitously if they can't produce another blockbuster. For movies, you have a lot of production companies working on the next hit, but a disproportionate amount of the money goes to only a handful of successes. Economist (and fitness guru) Art DeVany did some research that demonstrated that it's virtually impossible to predict what movies will be huge successes and which will be bombs...even for the studios themselves. 

You have businesses whose earnings are declining over time because technology or habits have just passed them by. (Think GameStop...at some point even the most graphic intensive video games will be played via the internet - and probably on iPhones - rather than on consoles.)

You have businesses whose earnings just stay the same. They're neither growing or shrinking. They have their niche, they make a set profit from it, and they just keep plugging along.

And you have businesses whose earnings are growing over time. The growth companies. Either demand is increasing for their products/services, or they're expanding into adjacent markets, or they're raising prices to generate more profits, or they're reducing costs to generate more profits. 

(Also, see here for a discussion of Owner Earnings, an incredibly important concept to understand as part of the framework.)

2. What competitive advantages exist to protect those earnings against foes trying to steal the company's customers?

This is the most important piece of the framework. In a free market, there is vicious competition for profit. And when a business pops up, demonstrating an ability to make tidy profits, it's only a matter of time before bigger, faster, smarter competitors start gunning for them. They will build similar products, they will undercut pricing, they will exclude them from distribution networks...anything to steal their customers and take those profits for themselves.

So, what competitive advantage (or "advantages" plural...the more it has, the better) does the business have that makes it difficult for bigger, faster, smarter competitors to steal customers? The four main categories are these:

a. Low-Cost, Low-Price. Think Southwest Airlines (or Amazon, or Costco). Customers prefer paying less instead of more. (So if you're charging a higher price than your competitor, you better give them a really good reason to pay more.) Companies possessing this competitive advantage usually have some sort of scale benefit from being large. They've passed that tipping point where they can produce more of a product and thereby do it for less on a per unit basis. The best of these are fanatical about keeping costs down and equally fanatical about passing the cost savings on to customers in the form of lowest prices (think Sam Walton).

b. Network Effects/Customer Captivity. It's a matter of making your product or service "sticky" so customers either can't or don't want to leave you. Facebook is the textbook example of this right now, and the case is made when you compare it to what Google is trying to accomplish with Google+. It's arguably a better service, but not enough people use it to get other people using it. Google can't pull people from Facebook because that's where all their friends are. And all their friends are there because all their friends are there. They're stuck! That makes it really hard for Google to make inroads.

My favorite example, however, is online banking with their billpay features. I have stuck it out for way too long with a bank whose other services I can't stand because I didn't want to go through the hassle of switching my bills over. That's a sticky feature.

c. Brand. This is the hardest to define, but you tend to know it when you see it. The hallmark of a great brand is that have such an emotional connection to it that they'll pay a premium to buy the product over a competitor's offering that costs much less. Coke and Apple come to mind for consumer brands. IBM has a powerful brand in corporate IT. A great test of a brand is how well its products do when it gets serious competition from a lower priced competitor. There's a great case study of Richard Branson trying to make Virgin Cola a legitimate contender against Coke and Pepsi. As we know, he failed. It's hard to take on established brands. 

d. Legal Protections. It's always a nice advantage when the government tells your competitors they aren't allowed to go after your customers (legalized monopolies like local cable providers), or you have airtight patent protection for your product (pharma), or you have exclusive rights to an asset like FCC-managed bandwidth (local tv franchises). 

The big debate about competitive advantage is how and whether innovation fits on here. It is, unquestionably, a competitive advantage. Apple is the best example. (See my previous write-ups here, here, and here.) They have a long string of innovation successes that have differentiated their products from the competition, allowed them to charge a premium, and made them amazingly profitable. But how durable is that advantage? Innovation is very, very hard to sustain over long periods of time. Competition will study your success, and they will eventually figure out how to do it. If your earnings depend on constant innovation (as tends to be the case in consumer electronics) - and you don't have other forms of competitive advantage protecting you - I don't call that a durable advantage. You'll stumble at some point. 

3. Does the economic model of the business work?

This is where you get more into the finance and accounting stuff. Basically, you want to know if the basic economics of the business make sense. The questions seem almost too elementary, but you have to ask them. If you're considering an investment in the business, you have to go through them like a check-list. They're critical. 

a. Gross Margin Model. Does the company cover the costs of making the goods by the price it charges for them? i.e., Does its business allow it to create a gross profit? Again, elementary, right? Sure, but there are so many things you can learn by watching a company's gross margin. 

For some early-stage and growing companies, sometimes they won't produce a gross margin despite having demand for their products. Their costs for acquiring and transporting materials might be too high, but it will go down as they hit scale and can procure raw materials in high volumes. 

A declining gross margin can show that a business is being attacked by the competition and must therefore reduce prices so it doesn't lose customers. It makes you ask the important questions about competitive advantage.

An increasing gross margin might suggest that the company has some form of pricing power where it can raise prices without losing market share. Maybe its brand is just that good. 

Gross margin is the highest line-item of profit on the income statement, and it's the one that can be least manipulated by accounting tricks. It's the pure one that can tell you a lot about what's happening with a business, so it's worth paying attention to.

b. Operating Margin Model. From the gross profit (above), a company will subtract its operating expenses (overhead, marketing, selling, etc.) to come up with an operating profit. What I'm looking for here is that the business can cover its operating expenses with the amount of gross profit it generates. For a mature business, this is the true sign of control over expenses. Discipline. It also gives you the first hint of what the company might have left over to reinvest in itself or to payout stakeholders (the government, owners of its debt, and then owners of its equity).

c. Net Margin Model. This is the bottom line number. Though it should tell us what the business should have left over the payout to shareholders, accounting standards actually force us to spend time with the statement of cash flows and balance sheet to really figure out that number. Consider it a discussion for another long, boring email. Suffice it to say, the net margin model is really forcing us to look at required debt payments to see if it leaves anything over to pay equity owners. 

d. Return on Invested Capital Model. I've left the most important - and least understood - one for last. It, too, would require its own lengthy discussion. While everyone spends their time frittering away on a-c above, they forget (or just don't know) that the true sign of economic viability is a company's ability to produce earnings in excess of the amount of capital that is invested in the business...and the amount of money that must be reinvested in the business over time so it can maintain its competitive position. 

Back to Mad Men and the Jaguar example...The nature of earnings for automobile companies tends to be cyclical, high in good economies and low in bad. When the economy is especially bad, car companies have a very hard time scaling back their operations (reducing costs) so they don't bleed out all the profits they accumulated in the good times. Scaling back, unfortunately, tends to mean laying off a lot of employees. That's why you have governments stepping in for bail-outs. They're far less interested in whether GM, Chrysler (or Jaguar in the 70s) survive as viable businesses and much more interested that 1. important union constituents aren't out of jobs and 2. that the unemployment of massive workforces won't lead to a ripple effect in the economy, making a vicious downward spiral. Those are important points to understand in terms of the nature of Jaguar's earnings.

For its return on invested capital model, the auto companies engage in high-stakes combat with each other that involves putting obscene amounts of capital to work in building and maintaining production lines in their factories. The constant competition led them to create new models for nearly all their cars every year, and to introduce brand new models every few years. Each time they do that, they must invest capital to change or completely overhaul their production lines. And these are HUGE investments that don't always create the most reliable returns. (Some car lines succeed, others are black holes.)

That additional invested capital they plow back into the business would otherwise go to shareholders in the form of dividends or share buybacks or acquisitions that generate more earnings in the future. Instead, they must put all that money back in the business in a way that doesn't necessarily even create more earnings in the future. It's the worst kind of heavy capital reinvestment...the kind you must make just keep running in place, to stop competitors from taking market share from you.

Even while those car companies might produce a tidy profit in any given year, the brutal truth is that shareholders will probably see very little of it. The car companies must hold onto it (retained earnings) and reinvest it back into the business even though it won't necessarily make for bigger earnings in the future.

That's the nature of a capital intensive business. Over periods of several years, its return on invested capital model will demonstrate that it's not a very good place to invest money. Because you just don't get much of it back... 

If a company can invest capital in itself and produce higher earnings as a result (and I mean higher than you think a reasonable investor could get by putting the cash into a safe investment somewhere else), than you're onto something good. That means it passes this measure of profitability. It can grow and create value in doing so. It will be worth more further down the line than it is now.

If it invests money in itself while the earnings stay the same or shrink, it fails this test. It's probably not worth investing in. Hell, it's likely to be out of business before too long.

4. (For investment purposes)...Does the price make sense?

The three questions above help you establish whether or not the company is a high quality business. This last one tells you whether or not the business is worthy of your investment. Even the highest quality businesses (those with growing earnings, durable competitive advantages, and economic models that make sense) can be priced so high that they don't make sense as an investment. That happens all the time.

The price question forces you to combine elements of what you discovered answering all the questions above. In the end, the value of a company is roughly what cash you can expect to get out of it over the long-term. Once you estimate the value (and since it involves predicting the future using very complex variables, it's NEVER a precise number), you see if the market is offering the company to you at a price that's comfortably below that value.

a. Flat Earnings. If the framework questions demonstrate that the nature of the company's earnings are flat (neither growing nor shrinking), plus protected by some combination of competitive advantages, plus they don't have to reinvest tons of their earnings into keeping the company going (i.e., their economic models make sense)...then you've learned a lot and can probably make a good guess about its value and therefore what you should be willing to pay for it. 

In the above scenario (flat but protected earnings), I would generally pay something around 7x earnings. These tend to be cash cow companies, and since the markets recognize them as steady and true producers of cash, they don't tend to have much fluctuation in the stock price. But because they're so predictable, they tend to fetch premiums above that 7x mark. You have to be patient and prepared to catch them trading for what you want.

b. Shrinking Earnings. If the framework demonstrates shrinking earnings, be very careful. All you know for sure is that the value of the company is in decline, but rarely will you know how quickly the decline happens. Think GameStop again. I'm an investor even though the business will necessarily shrink over time. How can that possibly make sense? Because the price of owning it is low when compared to what the company is paying me while it shrinks. It's market share is currently a bit over $2 billion. As of yesterday, it offers a 5.5% dividend and has committed essentially all the earnings/cash it generates over the next two years to paying dividends and buying back stock. It estimates that amount to be $2 billion, meaning if the stock price stays where it is...GameStop management says it will essentially buy back the whole company using its cash flow.

Except in situations like these, I shy away from shrinking earnings. Unless you REALLY know the company and its market, it's like trying to catch a falling knife...chances are good you'll cut yourself up when you grab it.

c. Cyclicals and Blockbusters. I tend to shy away from these unless I really understand the business, the industry, and the cycles in which they operate. The trick here is to have the discipline to only buy at a low point in the cycle or in a non-blockbuster year (but you anticipate - with good reason - that the company will produce more block busters in the future). Never, ever, ever buy at the high point of earnings. You'll overpay and get burned when the earnings drop.

d. Growing Earnings. A business with growing earnings, protected by durable competitive advantages, and with profitable economic models (especially when it comes to returns on invested capital) is the holy grail. These are the compounding machines that take capital in, apply the eighth wonder of the world, and make that capital really grow. Most investors, naturally, want their money with these companies, and so they tend to be overpriced. Sometimes to ridiculous levels.

Take Amazon.com for a moment. Today the market values it at 240 per share. That's about 300 times its reported earnings over the previous 12 months. Ludicrous, right? Probably. I mean, you know I'm fascinated by this business. Its earnings will undoubtedly grow over time. (They're currently depressed because of all of Amazon's investments in growth.) It has low-cost, low-price, network, and brand competitive advantages protecting its earnings. It's hard to see someone being able to take those away. And its economic model is profitable, especially for returns on invested capital (despite the depressed earnings, it invests very little capital to create higher earnings). 

But to pay 300 times earnings is a tough pill to swallow. It requires that you assume the current earnings will grow at a rate (and for an extended period of time) that very few large companies have ever accomplished. Not an impossible feat, mind you. But tough. 

So here's my investing prime directive, a sub-heading of the "price question" in this framework... 

Never, EVER buy anything when the market is optimistic about its future prospects. Only buy in pessimism, and preferably in dark pessimism. 

(See the Buffett quote at the end of this article.) 

I still want high quality companies, but I want to buy them when the price is depressed. This creates a margin of safety for your investment. For Amazon, people are very heady on that business right now. They understand its dominant position in web retailing, and they see how it's expanding its competitive advantages. But Amazon's earnings are bumpy. Not in a bad way, but in a way that's just natural for a fast-growth business. The market HATES bumpy earnings, and if it sees a couple of quarters of falling earnings it may decide that a downward trend is in play and quickly change from optimism from dark pessimism about its fortunes. When that happens, the stock tanks. 

I'm on the sidelines of Amazon, knowing that it will likely show a loss in next quarter's earnings report, just waiting for the optimism to turn dark. When/if that happens, that current 300x earnings valuation will likely drop in breath-taking fashion. Which will create an buying opportunity for anyone that has studied the business and understands it according to the framework above...anyone who recognizes that its earnings will grow substantially over time, be protected from competitors, and show a nice return on invested capital. 

But it takes a strong stomach to buy even the highest quality companies when the market says they're junk.

The best way to use the framework questions is to lay it on top of any company that you want to understand better, practice using it, and make sure to consider the questions in an intertwining (as opposed to "siloed") way. In other words, the answers to one question will help you better understand the answers to another question. 

So, what's the next Mad Men case study?

What Would You Buy If Price Didn't Matter? (Take Two)

Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.

A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you!  Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.

I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?

And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?

Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.

Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. 

So, for anyone new or interested, I wanted to re-issue my thought challenge. 

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?


The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...


1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)



What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

Re: Google vs. Your Boys (but really about amazon)

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.] 

Uh-oh, a threat to Amazon's AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I'm not. It's more because the challenges keeps me honest. 

It reminds me of the verse from Rudyard Kipling's "If": 

...If you can trust yourself when all men doubt you,

But make allowance for their doubting, too...

It's the only way to keep a kernel of intellectual integrity in his game of investing...look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It's possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Thanks for passing this on, T. I'm fascinated by this impending convergence of the major tech giants. They're all sitting on these enormous and valuable assets, mainly large customer bases and some combination of tech gear, tech infrastructure, and customer captivity. As a sort of manifest destiny, they are all compelled to extend and expand the use of their infrastructure...those assets. It's inevitable, as if the combination of management ego and economic drive for higher profits, creates a siren's song for the businesses to expand. I've started calling it the growth imperative, a set of behaviors I've noted in other industries, too.

So it becomes interesting with Amazon, Apple, Facebook, and Google. [See The Great Tech War of 2012 by Farhad Manjoo in Fast Company back in October 2012.] Their markets, as they expand, are overlapping more and more. They must compete, not only to grow, but also to make sure one of the competitors doesn't gain some advantage that allows them to attack their core markets....sort of like offense is the best defense.

A theory I've considering works something like this: cloud computing is a huge market that Amazon entered early and has pretty much controlled. Amazon is taking great pains to commoditize the industry - making the services non-branded - so it will be defined by who can offer computing at the cheapest price to customers. Amazon has demonstrated its willingness to make AWS (its cloud computing) cheaper and cheaper, having lowered prices 20 times since launching. Jeff Bezos has thrown down a gauntlet and dared others - IBM, Microsoft, a slew of tiny players, and now Google - to follow. Amazon has said it will make it all about price.

That creates a fascinating dynamic, and this is where the theory part kicks in. What company can afford to offer cloud computing the cheapest? Both Amazon and Google have deep cash reserves, so they can duke it out on low price there while subsidizing any losses with their own cash. That could be a painful war, and we must ask who would win.

My bet would be with Amazon, and for a simple reason...Amazon has demonstrated both an indifference to how the stock market perceives it as it pursues long-term dominance of an industry, and it has demonstrated a capacity to suffer while its stock price is getting killed because it is losing money in pursuit of dominance. Jeff Bezos frequently says he's comfortable being misunderstood for long periods of time.

So let's consider this like a game theory scenario...you have two giants pressing on the gas, hurling their dragsters at each other in a business that one of them (amazon) is willing to define by price. They will both take losses. The more they fight, the deeper those losses will be, and the more likely their stocks will tank as long as the war persists.

Jeff Bezos is fond of saying something to the effect of ..we want to sell the same thing as everyone else, but because we run more efficiently than they do, we can sell it cheaper. So if they want to have a price war, they'll go broke 5 percent before we do.

He's signaled to the world his intentions and his willingness to be a fanatic in pursuit of them. Now, how crazy is google willing to be as it enters the cloud computing market? How deep is its capacity to suffer? And remember, there's a lot of catching up to do since Amazon has been in the market since 2006.

In this game theory game of chicken, my vote is with crazy Jeff Bezos. That dude's a fanatic!

Scale Advantage and The Great Coke Scandal

Profits are good. And our profitability bias - that preference to own, to cover, to work for, to partner with companies that turn a profit - is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition. 

It's not as if they don't recognize that everyone prefers they were profitable. It's that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage - strong brand, legal protection, captive demand, and scale - the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position. 

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke's most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars. 

Pepsi wasn't so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it's nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola's competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst. 

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary's shop. 

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990's with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn't even get most grocery stores in his native UK to give his drinks a shot. When you can't gain entry through basic distribution channels, you must know your future is grim. Price doesn't even matter.    

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke's scale. As a last resort of scale, Coke could always fall back to its balance sheet - it has plenty of cash - and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola's most valuable secrets. In reality, Coke's competitive advantages are hidden in plain sight.  A big piece resides with its brand...but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.

Competitive Advantages - The Umbrella Categories

Sometimes it makes sense to deny the profitability bias, the investor's case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market. 

For the sake of simplicity, let's say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale. 

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term "gestalt." The whole is much greater than the sum of its parts. 

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs' crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user's experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple's connection with customers. 

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot. 

But let's remind ourselves, those profits were the result of investments that lowered Pfizer's overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents. 

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month's time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill. 

For captive demand, "sticky" has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor's offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank's website? And for what? A free toaster with your new checking account? No thanks. 

Finally, we have economies of scale, or just "scale" for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it's foolhardy to even attempt to compete with you and the fanatical ones - those that make an irrational decision to compete anyway - would run out of money before you.  

We'll dig more later on the benefits of scale...

Profits As Marshmallows

Let's continue the thought from our last post regarding the profitability bias... 

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer's 2009 article Don't from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two. 

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you've spent much time around young children, you'll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel's experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence. 

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths - getting that immediate surge of sugar energy - even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let's talk about what those competitive advantages are...

The Profitability Bias

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there's money left over, it's a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you're using a framework to understand and assess businesses, it's fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time. 

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don't translate into profits tomorrow. 

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business. 

Enter the competitive advantage. That post is next...

What Would You Buy If Price Didn't Matter?

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?


The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...


1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)



What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

Is Price Everything? (A Thought Challenge For Value Investors)

A thought exercise. You're attempting to evaluate a business for investment.  Here are some of the rough data points you've managed to gather through a quick investigation.

1. Market Size. 

This is a situation in which the service offered by the business has helped create a market. It did not exist before. So its size is unknowable. 

You have no way to quantify this, but it's beyond evident that it's large. Very large. Many billions. And it's growing.

The service provides a clear value for clients, a point so obvious that it's not even worth debating.

Today, the company holds a dominant share of the market.

2. Competitive Advantage.

The business you're evaluating appears to have several levels of competitive advantage protecting its services in the market. 

It's developing a scale cost advantage, though that's not yet established. But it does have the market share lead over competition, and once scale is established it seems highly unlikely it would cede ground to a foe. 

It has early brand appeal with customers preferring its services, even in cases when it competes against free alternatives. 

And it's establishing a network effect whereby the range of services it offers tie in tightly with customer mission-critical needs. In other words, the more they use it, the more difficult it is to leave it.

The company has a culture of innovation, and it's constantly rolling out new offerings as part of its services. And it likes to surprise customers from time to time by offering the same services, with additional features, but at a lower price point.

3. Economic Model.

While there is scale cost advantage, the scale is not yet sufficient for the venture to be profitable. So it's losing money both from an income statement perspective and in terms of cash returned on invested capital. This could continue for a few more years.

It's a model in which heavy fixed costs must be recouped by a tremendous volume of sales with low gross margins. 

But you can reasonably conclude that the business will reach scale and therefore benefit from a profitable economic model (indeed, one with extremely high ROIC), but not before it suffers heavily for these investments.

4. Price.

This business currently has no earnings, and its losses will mount for at least a couple more years. Its assets depreciate rather quickly, so there's no meaningful liquidation value. 

That said, investors are assigning it value. The market seems to hold high hopes for its future.  Optimism abounds. 

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So do we put this immediately in the "too hard" bin? Turning up our nose because we wear the VALUE INVESTOR badge, and we only buy cheap stuff come hell or high water?

What of the large and growing market? What of the economic model showing high ROIC...or the ability to compound earnings at a high rate of return as it expands its share of that market? What of those competitive advantages that seem very likely to ensure that the business maintains its market leader position and protects the stream of profits generated from holding the lead?

Each of those variables makes it likely (and you can go out on a ledge and assign a high degree of probability to it) that this business will be large, profitable, and immovably entrenched five years from now. 

In the meantime, it will lose money. You will suffer these losses. It's likely to make for a bumpy ride. Volatility will ensue. 

But in five year's time, it will be a franchise. 

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Under that banner of VALUE INVESTING, we often miss the forest for the trees. We fixate on price, convinced that TRUE value investing demands we only place our hard earned dollars behind businesses sporting some low-price valuation measure.

The purpose of all investing is compounding your returns, and when you can do it with low risks...gravy. But is PRICE necessarily the center of the universe? Or is it one variable to consider among others that should hold weight in your decision process?

Truly great businesses are few and far between. They don't often come cheap. That's not to rationalize an expensive purchase. But expensive is only expensive if the value doesn't compound. If the market isn't as big as you imagine, or the economic model as lucrative, or the competitive advantages as deep. But if they are as reliable as your analysis suggests, the power of compounding can make something that appears expensive today seem like peanuts in retrospect.

*****

For the record, I've not invested in the unnamed business considered here. But there's only one reason why...

Optimism. The business is currently awash in optimism for its future. Many people have analyzed it and reached similar conclusions to me. 

But I suspect their optimism knows boundaries. The business is certainly engaged in a high wire act in suffering losses to grow its market share and reach scale cost advantage. The price will fluctuate. Earnings will not improve quarter over quarter. And those lacking intestinal fortitude will not enjoy the view of a long drop from the wire. 

I'll revert back to this Warren Buffett quote last posted under No Extra Credit for Being a Contrarian:

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait. 

Whom Does Management Serve?

This week I've been a bit obsessed with the idea that the manager's job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet: 

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors' interests on their minds, remaining on constant look out for ways to increase shareholder value. 

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business' success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees. 

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don't align?

As a frequent visitor of Charleston, South Carolina, I've been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel. 

The Citadel, a military prep college in Charleston, is hard on its first year students (called "Knobs"), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he's supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school's creed. 

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It's simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it's unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters. 

What's a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor...that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line. 

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers. 

Pricing Power Part III: Amazon.com As Vehicle For Low Price/Scale Cost Advantage

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them. We discussed the general benefits (here). Now we will look at how it applies to Amazon.com specifically.  

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In November 2011, Wired Magazine featured a Jeff Levy interview of Amazon CEO Jeff Bezos. Here is an excerpt:

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?

Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.

*****

Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

In talking about competitive advantage, Thiel had this to say:

For a company to own its market it must have some combination of brand, scale cost advantages, network effects, or proprietary technology...Scale advantage comes into play where there are high fixed costs and low marginal costs. Amazon has a serious scale advantage in the online world. Walmart enjoys them in the retail world. They get more efficient as they get bigger. 

Plenty of businesses have achieved scale sufficient to make them lower-cost producers than competitors that don't have the demand to manufacture as much of a similar product. These businesses can do a variety of things to press their scale cost advantage, one of which is to lower prices to a point where the competitors cannot follow suit and still maintain an adequate return on investment. But the scale advantaged business can also charge a premium, sinking its cost advantage into (for example) marketing campaigns that build a brand around the product.

To offer low prices, the company has to make a conscious decision that it will not exploit its advantage by charging a premium and using the scale cost advantage to make its margins even fatter. It must commit itself to a bigger vision of what can be accomplished by lowering price even when your advantage doesn't demand it.

*****

As we explored in our previous post (here), several retailers have built advantages around themselves by being low-cost low-price. But to date, their ambitions have been fairly limited to the retail industry. In many ways this makes sense...we encourage management to stick to its knitting, focus on its core, avoid (as Peter Lynch labeled it) "diworsification." A&P, Walmart, Costco and Home Depot have all demonstrated the scale cost advantage in retail.

Amazon is doing the same thing in web retail, and it has the additional advantage of an even lower overhead structure than the traditional retailers by virtue of being web-based instead of store-based. For example, Walmart has about 10,150 stores world wide that produced $444 billion in revenue last fiscal year. That's an average of $44 million per store. Costco has 600 warehouses that generated $89 billion in revenue. That's $148 million per warehouse. Amazon runs 70 fulfillment centers and generated $48 billion in revenue for an average of $685 million.

That's a tremendous amount of volume run through each warehouse. It clearly creates an advantage in fixed costs. It's a key component of how Amazon works "very, very hard to be able to afford to offer customers low margins."

It's predicated on the simplest of assumptions: when given the choice between a high price and a low price, consumers would prefer to pay the low price.

But it paints an incomplete picture to see Amazon only as a retailer; to think about low-price pricing power in terms of offering products at a cheaper price than other retailers. Amazon has a broader base of business operations and much wider ambition for where it can apply its low-cost low-price model.

*****

So what is Amazon? Let's try this interpretation on for size...

AMAZON IS A VEHICLE FOR APPLYING SCALE COST ADVANTAGE TO ANY INDUSTRY WHERE HEAVY VOLUME OF LOW MARGIN SALES CAN OVERCOME HIGH FIXED COSTS TO GENERATE SATISFACTORY RETURNS.

Retail is but one application of this Amazon business model, albeit a very important one. Retail has allowed Amazon to create an infrastructure that has progressed, adjacency by adjacency, into new product categories, new geographies, and new services. Leveraging, along the way, its technology, procurement, and fulfillment capabilities to facilitate the growth.

(Retail has also provided it a large cushion of cash, that large and growing pot of cash Amazon gets for getting its receivables much more quickly than it must write checks for its payables or other commitments.  That's about $10 billion - which will continue to grow as long as Amazon keeps selling products quickly - that Amazon can use for whatever purposes it wishes. And that capital carries with it no cost (as would debt), no dilution (as would issuing new equity), and no demands from Wall Street (as often happens when you ask outside sources of capital for money to finance your initiatives).)

Where else can the model apply beyond retail?

Consider the following exchange between Levy and Jeff Bezos in the Wired.com interview quoted above:

Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?

Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.

Has Bezos put the technology world on notice? What happens when Amazon exports this scale cost advantage from web retail into technology's fat profit domains, lowering prices for customers by sticking to its low-cost low-price approach to business?

*****

Below, a letter from the Amazon.com homepage at the launch of several new Kindles. See Bezos strike the steady drum beat of that message he shared in the Wired.com interview...