Private equity investment professional Gordon D'souza, provides a framework for investors on how to break down the business model when evaluating stocks.
Investors often come across companies which are “positioned” -- usually with a well-known, well-followed and often highly valued company, in the hope that it will command some valuation premium. In some cases, companies are positioned as “unique” stories to either explain a niche business or when intent falls short, to complicate a simple business.
Understanding a business in terms of its core business activity brings clarity and helps break away from this association bias.
Most businesses can be classified into one or more of the following business activities:
- Manufacturing / Production
- Financing / Leasing
- Store / Outlet based models
- Rental
- Construction / Project based business
- Distribution
- Trading / Arbitrage
- Platforms / Exchanges
- Capacity creation
- Intellectual property (IP) monetisation
- Manpower
One should also triangulate this with (a) where management spends the maximum time, (b) the assets which consume the bulk of the capital on the balance sheet, and (c) the assets which generate the most earnings.
A few case studies will help illustrate the point.
Case 1: Distribution
Most consumer businesses in India today are distribution businesses. The business activity of FMCG or consumer companies is to manufacture or manage the manufacturing of products and make them available via a distribution network to where the customer shops for them. Most FMCG products if stripped down to their bare essentials are usually commodities (agri based, chemicals, etc). Very few consumer products actually have some intellectual property in them. The key value driver in most of these cases is a distribution network. Once you begin to look at an FMCG company as a distribution network the way you will evaluate its growth prospects and risks will begin to change. (Note: Some truly innovative consumer companies can be a mix of IP + distribution.)
Case 2: Capacity creation + distribution
Companies which operate in aviation, telecom, shipping, power, cement are all in the business of creating capacity in wholesale and breaking bulk down. Some (like power, cement) have an additional manufacturing model before selling it down to retail. All these business require upfront capital to create capacity. The specifics of how they do it may vary (airlines and shipping business models have evolved to lease capacity). Given that the capacity they create is upfront and mostly long gestation the constraints to growth are usually in the form of external factors which facilitate the creation of this capacity and the potential to absorb the capacity. Value and growth is largely tied to capacity creation. Moreover, given that capacity is critical for growth, superior capital allocation (ie when capacity is created and at what cost) is usually what separates out the winners from the pack.
Case 3: Arbitrage + manpower + IP monetisation
Most consulting or manpower intensive businesses will fall in this category. The ones which will win are the ones which manage to invest sufficiently in people and skills such that they maintain the spread of the premium from the IP monetisation with the manpower cost. Most Indian IT companies fall in this category. They may be operating in the technology space but a large part of their growth, scale and profits are determined by the spread between the premium they are able to charge for their IP (if they are able to do it) and their manpower cost.
Case 4: Construction / project based
Most of the real estate operators, infrastructure companies will fall in this category. Some which own assets will have the added layer of capacity creation or rental business models. I have found such businesses very difficult to evaluate since the business is lumpy and unlike most other businesses the economics of every project is different. Moreover, it is not easy to separate out the economics of the past, present and future unless the company transparently provides for it.
Case 5: Platforms
Platforms are very interesting businesses where the capex goes into creating the infrastructure and creating the initial mass of users. Once a critical mass is built the model automatically brings in more users since the marginal costs for all users come down with scale. Value is created as users increase the transaction sizes on these platforms. Credit cards, Exchanges in traditional businesses are platforms. Other examples we see around us are plenty (cab aggregators like Ola, Uber, content aggregators like Netflix, marketplaces like Amazon, Flipkart). Given that platforms become viable at a critical mass most companies spend most of their lifetime capex upfront to create the mass of users. Deep discounting as seen by many marketplaces is a tactic to achieve this strategy.
Case 6: Lending + platforms
Almost all financial institutions come under this category. The ones which build sustainable businesses are the ones which build quasi-platforms with sticky business models like cards, payments, wealth services. Some of the more successful banks in India have a large portion of their profits coming from such quasi platform businesses. The sticky platform business allows banks significant leverage in managing their growth without diluting equity.
The objective of breaking down a business into simple easy to understand constituents is not to discount the work done by management in building a brand or a franchise. Good management can build sustainable brands in any of the above categories. More importantly, thinking of a business in its basics has the following advantages:
- It makes you aware of risks of potential risks that would have been missed.
- Eg: Risks to the FMCG distribution model are rarely discussed.
- It helps build conviction
- Eg: Understanding well-run banks as quasi platforms and not just as lending businesses will make you look beyond book quality. Some of these strengths are not captured in valuation multiples and can help you take advantage of mis-pricings with conviction.
- It helps structure your investment themes.
- Eg: To a low risk appetite investor playing the real estate growth through a distribution model of building materials at the right price may be better than betting on real estate operators even if they are available cheap.
- It helps call out incorrect positioning or identifying inconsistencies ahead of time.
- Eg: A prominent education company which had a product sold to schools had a balance sheet that suggested it was actually in the leasing / financing business, most fin-tech businesses today are actually lending businesses using tech as an underwriting tool.
Business growth is a function of how the business model scales and the capital it consumes as it scales. Getting to the basics can help you form a bottom-up objective assessment of what is valuable in a business and what you should be willing to pay for it. That way you are in better control of your decision making rather than playing into the popular narrative.
You can also follow Gordon D'souza on Twitter.
