One problem I have with theories is that there are always exceptions in reality (how's that for deep insight?). And I think with investing, the right approach is to uncover the exceptions to theories/rules under the assumption that a business that doesn’t conform to expectations has greater potential of being mispriced. Subprime auto lending sounds like something that screams, “run far far away in the other direction,” but there are compelling cases for some of the industry participants (see Rishi’s write up on NICK for an example, and the section on lending in his post on Leucadia, a company that has made a lot of money in the sector).
So I wrote a post about being a middleman and competition the other week and tried to draw on some of the businesses I have written about in the past. Tangible examples help any idea really come to life. Partially as a result of Buffett lauding the success at Gilette and partially because there are clear examples where it is very true, the idea of recurring revenue is something that I have found myself attracted to in the past. I don’t think that’s the actual trait that can make a business attractive.
Perhaps this is a pithy point and a needless nuance, but the most important result of recurring revenue is that it keeps the competition out. There is no inherent characteristic of recurring revenue that drives superior operating results. Furthermore anyone can identify a recurring revenue stream (maintenance/service contracts for example). I think this is the proper way to look at it because it is a more adaptable perspective. The answer to “why is it the way that it is?” is that implicit in a recurring revenue source is that the competition is kept out. One of the more base appeals of a company like GMCR is this idea that it’s a razor business model. That distracts people from other factors that David Einhorn pointed out. Maybe this the exception to the rule, but it's clearly something that can cause unnecessary losses stemming from unnecessary assumptions.
Even though it looks like a razor-blade business model, it can’t capture the economics typically associated with other businesses that claim the same quality – Rolls Royce, Immucor, Gilette, etc – judging by ROIC. But I don’t think that’s the point – a dollar doesn’t care what business model makes it and there is no single universally triumphant business model. The ideal business model is something that keeps the competition out to the extent that it provides pricing power. That is the one of the major underlying qualitative factors that will drive investment returns assuming a modest price is paid. If a business can keep competition out, they have the potential to capture superior economics from their business dealing. If they can’t, they won’t. But I think it can be a distraction to focus on the razor-blade aspect rather than whether or not it effectively keeps out the competition and supports actual impressive returns, as opposed to expected. Because nobody else can sell the blade, it acts as an impossible barrier to overcome for competitors.
To an extent GMCR is a straw man and so is Netflix, another example I’m tempted to dismiss. Subscribers can create a position that keeps the competition out and so some people have decided to do a comparative valuation of Netflix on a price/subscriber metric. This is the kind of issue I want to avoid in the future by noting this. I don’t care if people subscribe to X, I care if X has something that keeps people from subscribing to Y. A cell service provider, which may have spectrum, can keep certain amounts of competition out while maintaining some pricing power – think of the dumb charges for international roaming or not having unlimited texting. People who want a lot of data available for their phones – I like having GPS, popping open my reader if I’m caught waiting for someone and didn’t bring a book, etc. – don’t have too many options because spectrum and cell companies are figuring out how to price appropriately.
There are a couple things that interest me about this. If you think of a company like Apple, which is not a razor-blade business model, they possess several characteristics that keep the competition out. One factor is scale, which has several benefits. If you read this article, it discusses how they get discounts, still squeeze cash flow from suppliers, have a more price competitive product, and keep out the competition by making certain basic components unavailable to them. This compounds into their ability to force competitors to lose money if they want to make a tablet, mp3 player, or laptop that competes at the same price and quality point. It’s an economies of scale that not only gives them lower per unit costs, but forces competitors to have higher per unit costs. It’s a shame that they have these advantages in an inherently ephemeral industry – consumer electronics – but it’s still worth noting how they keep the competition out. The shallow takeaway is to just design better products, but there is a lot more underlying the calculus that can be applied to other companies.
Another example of keeping the competition out is that of Walmart and Tesco, two incredibly entrenched and consistent retailers. Walmart’s advantage was originally derived from near monopoly status in many rural areas that provided scale and consistent profits to reinvest into the business. From there they have branched out and been able to build on that scale. Tesco has an incredibly entrenched position at the opposite end of the spectrum: urban areas. Their footprint in a densely populated area like London is incredibly hard to replicate simply as a matter of cost.
Land is cheap in rural areas, so in that regard Walmart is not invincible. They have a huge advantage in that no sane person really wants to go head to head with them over some scraps of business in some small village in the Ozarks or Appalachia. The flip side of Tesco’s position is that even an insane person couldn’t afford to replicate Tesco’s land holdings and that is an enduring advantage in their cost structure. This negates the negative lollapalooza effects of density – attractive market economics drive entrants, much easier to make money when a total addressable market is 500,000 vs. 5,000, etc - while capturing all the positive effects – volume that can be achieved in a dense area without sacrificing profit to competition.
I think assessing a business on the grounds of whether or not they can keep the competition out – literally or figuratively – is a more effective way to assess the quality of a business. While a razor-blade business model can generate that positive click, whirr that will indicate an attractive business, the idea of keeping the competition out is a more fool proof way of assessing a competitive advantage in that respect. For thought.
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