I’m launching a new, recurring series called: Competitive Strategy – Spotlight on Decisions that Strengthened Companies, No Matter the Industry. Why am I doing this? Frankly, I am tired of hearing “this is a good business” or “this is a bad business” with some blanket statements behind why. How many times have you heard why a certain company is a “good business”?
Leading national market share
Of course, saying a business has a “moat” doesn’t hurt
A company that has some of these features isn’t necessarily great. If you want to learn why (or disagree and would like to hear differing thoughts) stay tuned. I am actually launching the first in the series today – and what better way than to start with a company like Amazon.
A company’s competitive strategy outlines what decisions it will follow every day.
Where it will compete, what segments of the market it will target, where it will choose to scale, how it will use its balance sheet, and what will customers value?
These decisions can result the metrics I mentioned above, but the metrics themselves do not make the business good, or differentiated.
I will go through the competitive strategy of a wide array of companies. Decisions companies have made / are making to show how those decisions upgraded them from good to great.
I hope to surprise some folks by discussing names that are in “bad” or cyclical industries. Sometimes you can have a bad industry, but a great company within that industry – and sometimes the stars align for a great investment opportunity.
After writing a few of these, knowledge will build and I probably will refer back to previous posts for examples on different company tactics (e.g. hard to not say Amazon Prime is similar to the Costco Membership strategy)
Here is a preliminary timeline of companies and industries I will examine (subject to change). If there are any companies you’d like for me to add, reach out to me in the comments or on twitter and I’ll add it to the queue. Some names may jump to the top if there is enough demand.
As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2“, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures. I came to the conclusion that Amazon was preparing for a split up of the company and I would need to think of AWS valuation.
The split would be simple: take the traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.
For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources.
AWS allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.
This led me to ask myself:
What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
Is AWS actually a good business?
Would splitting the company make sense?
Is the AWS valuation not factored in to the stock price today?
I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:
Allow focus in areas of strength.
Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
Optimize capital allocation
AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
Better align incentives
Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
Wouldn’t it be better if your performance and the company’s performance were linked?
Note, AWS valuation being underappreciated is not really a core tenant here.
Is AWS a good business?
“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”
-Jeff Bezos, 2014 Letter to Shareholders
Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.
The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models. As an aside, what a beautiful competitive decision that was.
As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.
AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.
Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.
The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.
However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.
How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Jeff Bezos, 2016 Letter to Shareholders
In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.
But Microsoft ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns.
In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…
Lastly, its no secret that building data centers to support growth is capital intensive, and that will impact the AWS valuation (see financial table above).
They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.
Unfortunately, I DO think returns are going to come down materially over time. And that will hurt the AWS valuation.
The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.
Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage.
Think about commodity businesses that reports utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.
As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.
Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.
I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?
How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.
So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.
AWS Valution: Final Thoughts
Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases.
I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.
For the reasons stated above, I think this results in returns coming down over time. I still model goodreturns to be clear, but that the return on assets comes down meaningfully.
This may be hard to read, but I end up with an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.
However, AWS would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.
Walmart announced a new partnership with e-commerce platform Shopify. Shopify is used today by over 1 million small-to-medium sized businesses, offering services “including payments, marketing, shipping and customer engagement tools to simplify the process of running an online store.” The partnership clearly makes sense for sellers if they can get cheap access to Walmart.com’s 120 million monthly visitors.
I covered Amazon’s third-party marketplace in a previous post, but if you’ve been on Walmart.com recently, you’ve probably seen third-party listings such as the one pictured below. In fact, a cheap-o like me has started to notice that Walmart’s prices in many cases are cheaper than Amazon (with no Prime membership either).
So if Walmart already allows third-party players to sell on its site, why is partnering with Shopify important?
This is Walmart’s first real foray into allowing small-and-medium sized businesses access to its platform. Currently when you shop on Walmart’s site, you’ll see merchants such as Autozone. This opens the playing field to many smaller businesses. As the program ramps, this could allow Walmart to quickly add literally hundreds of thousands of sellers.
It’s very competitive with Amazon. Shopify’s announcement noted that, “unlike other retailers” Walmart charges no setup or monthly fees, though it will charge a “referral fee”. It looks like Walmart will charge anywhere from 6-15% of the sale (except Jewelry is 20%). Amazon charges essentially the same rates, it appears. However, as discussed in my last post, Amazon charges $39.99 for “Fulfilled by Amazon” services as well as other fees.
FBA sellers don’t pay for shipping or packaging, but you do have to pay an “FBA fee” which covers these costs – detailed here
FBA also has monthly storage fees (which can be long-term or short-term)
It is launching at a near perfect time. One challenge with any marketplace is getting sellers and buyers to sign up. Walmart.com already has the buyers and COVID19 has caused all retailers to move most of their business online. That’s why US e-commerce sales were up ~74% in Q1 Y/Y. At the same time, Amazon is under anti-trust scrutiny. Perhaps this is an opportunity to launch competition in the space (while a competitor is both slightly distracted but at the same time, welcoming a competitor).
It is clear Walmart wants to bea platform, not just compete with them as a physical retailer with an online presence. Probably the most important item in the post and research I’ve done on Walmart’s recent actions is that it is clearly trying to pivot and use its already massive scale to its advantage. Clearly, if its going to compete in the future, it must take on Amazon.
Still though, if you are someone who wants to see a competitor to Amazon, this deal leaves something to be desired. With just 1,200 additional Shopfiy sellers (that also have to be pre-approved) it’s not really opening up the floodgates of competition.
I also wonder what products they will sell – is it items that just doesn’t make sense for Walmart to sell? Perhaps this is a way for Walmart to prune low margin sales in its portfolio and just collect a platform fee.
Either way, it’s a positive for Walmart and a clear shot across the bow at Amazon. Walmart wouldn’t be doing this if their 3P marketplace wasn’t a key part of its go forward strategy.
Walmart had just launched “Walmart Fulfillment Services” or “WFS” in February of 2020, so clearly teaming up with Shopify would help both of them to compete with Amazon’s FBA service.
It will be interesting to see if Walmart can market this well enough that consumers and sellers recognize the benefits. Consumers are paying Amazon $120/year for Prime whereas Walmart is free. Returns are free on most Amazon Prime and you can do it through any Whole Foods, but 90% of America lives within 15 minutes of a Walmart store, so returns will also be free and pretty easy for all of America (not just the 1%…). Is this a strategy that Walmart recognizes?
So far, Walmart doesn’t have a ton of sellers on its platform and it seems like its holding them to high standards (e.g. only allowing 1,200 at first in this launch, believe they only have ~300k in total vs. millions at Amazon). This may disappoint shareholders who would prefer Walmart “move fast and break things” but it also will reduce scrutiny and costs down the road like Amazon has received and it also means you’re not competing for space against a bunch of other sellers on Walmart.com.
Well, it happened. Hertz is cleared to issue equity in bankruptcy on Friday, June 12. This is a monumental day (which I live tweeted the hearing process on my twitter for those interested). Companies issue equity all the time – why does anyone care that Hertz is issuing equity in bankruptcy.
To put it simply: because the equity is likely still worthless.
$HTZ counsel adds that prices for used cars have improved meaningfully from time of prepetition and there has been positive movement in the business, but quick to say the increase in biz so far does not justify the "moves that have happened in the market"
Now, I can back up. Hertz was already highly leveraged coming into the COVID19 crisis, but the economy was good. Perhaps Hertz could manage its way through its debt problem.
When people stopped traveling due to COVID19, that crushed demand for transportation, especially rental cars which are typically picked up at airports. In addition, the pressure on the economy meant that the “residual value” it receives for cars coming off lease was also diminished (i.e. used car sale prices went down).
Here is how Hertz described it in their bankruptcy filing:
Typically, when a company goes bankrupt, its stock will still be listed for a little bit of time, but it will not be worth anything. It will trade, but its typically much smaller amounts. It is just waiting to be delisted.
There are a few exceptions to this such as W.R. Grace. Grace filed for bankruptcy because of growing asbestos liabilities, but did not have solvency issues. The equity continued to trade and had value. It had value because the value of the business after all liabilities were paid was still greater than zero. There aren’t many other cases I know of like this except maybe General Growth Properties, which Bill Ackman was involved in.
Another example is American Airlines when it last filed for bankruptcy. The equity was initially deemed to be zero, because unsecured creditors were not going to be made whole, but valuations moved up and that created equity value in bankruptcy.
So why is Hertz issuing equity in bankruptcy different?
First, it still seems pretty clear that the market is saying the bonds are not going to be made whole. Let’s look at the trading prices and also discuss the “waterfall.”
Here is a Hertz unsecured bond. You can see that pre-covid, investors essentially deemed it likely that Hertz would pay the money back and they would be made whole. These bonds traded from par to a low of 12 cents on the dollar, but some others traded as low as 9 (before bankruptcy, bonds that mature earlier than others are said to have temporal seniority – i.e. the company will try to take those bonds out first, so you at least have some chance or option value to make out better than later-maturing classes).
Trading at 9-12 cents on the dollar means the bonds are saying that’s likely what their recovery in bankruptcy would be. Pretty simple – bond investors wouldn’t just sell a bond at 10 cents on the dollar for no reason. The coupon on these bonds was 6.25% too so the market with such a low price was implying in March and April already that they wouldn’t pay another coupon.
Here’s an example “waterfall” chart. It’s simplistic, but the point is to say, if there is no value after the secureds are paid off, senior unsecured creditors get nothing.
Here’s another way credit debt investors draw it out. I’m showing 3 scenarios that hopefully are self-explanatory enough:
This math is why it is so crazy to people that Hertz is issuing equity in bankruptcy.
Even with all the positive news (for creditors) that Hertz is issuing up to $1 BILLION in bankruptcy, the bonds are still at less than 50 cents on the dollar. That implies the bonds are still in the hole by 50%. So Hertz may raise a $1 billion of equity that may immediately be worthless.
The thought that maybe issuing equity increases option value of the equity might be a little crazy too. At this point, it is still hard to argue that the unsecureds are going to be made whole here. Even if they rise to 65, 70 cents on the dollar that is still the case. The market started to improve for GGP from 2009 to 2010, but its bonds also snapped up to 100 cents on the dollar.
It also hard to say right now that the operating environment will improve in such a strong way that Hertz will increase in value. Valuations are conducted on a 5 year view anyway (i.e. no one is valuing Hertz solely on trough 2020 earnings – they essentially do a DCF) so it seems unlikely to me they aren’t already including some strong rebound next year.
$HTZ judge has a great comeback stating that there is never any promise that a capital raise will increase enterprise value
Now with the S&P back up to near highs, many are calling out Buffett and saying he’s lost his touch. “Maybe he’s too old now” and “maybe he doesn’t care anymore now that he’s approaching 90 and loaded” or “maybe the oracle has lost his touch”.
I don’t really think that’s the case and think the negative sentiment creates an opportunity in Berkshire Hathaway stock. People who argue that Buffett is too old and “lost it” could have easily argued the same thing when he was 65 going on 70, 75 going to 80… Buffett has that itch that can’t be scratched.
I do think some of his methods are too old fashioned. I can’t actually confirm this is true, but he has said he won’t participate in auctions. What board would actually be able to justify selling to him without a second bid? Especially when times are good and they are a good business.
I’m taking Berkshire Hathaway’s current market cap and subtracting the market values of his equity holdings (note, I pulled this from Bloomberg, so it may not be 100% accurate). I then subtracted the cash to arrive at the value the market is ascribing to the “core Berkshire Hathaway” business.
I say core, but in reality there are so many subsidiaries within Berkshire Hathaway. You have GEICO, Berkshire Hathaway Energy, BNSF, Precision Castparts, just to name a few well known ones. If interested, I highly recommend perusing the list of subsidiaries on Wikipedia. I bet there are quite a few you didn’t realize he owned.
At the end of the day, you’re being asked to pay <8x earnings for the collection of businesses that Warren has acquired AND you have free upside from the cash if it is ever deployed.
Frankly, the real upside in the stock may be 5-10 years away when Berkshire Hathaway is broken up and people realize the sum of the parts is worth more than the whole.
Either way, look at the impact of Berkshire going out and deploying cash. Earnings could likely go up 30% from where they currently are and even deploying the cash at a worse multiple than where Berkshire trades today (i.e. dilutive), you’re still paying <9x earnings.
Unfortunately, if you want to read a 10-K to get better at investing or understanding how companies work, you can’t just read a 10-K in a vacuum. You must put the knowledge and information you glean into context.
If you were moving to a new city and needed to purchase a home, would you look at one home and determine you had enough information? Probably not. You’d probably want information on that home as well as several others and weigh the pros and cons of each (how are the schools, how much room am I getting for the price & is it a good trade off, do I need to pay city taxes, etc.).
Same is true for investing in companies. I want to read about this company, understand how it works, determine if I think it is good or not, and then go read about its competition. Is the competition even better? Maybe the customer is actually the better business or its supplier.
As you can probably tell, this creates a web of information you need to understand, but can be worth it in the end.
Also in the context of not reading a 10-K, I almost never open up a 10-K without opening up the company’s latest investor presentation (typically on their investor relations site), and then also typically plan on reading the latest earnings calls as I get more interested.
Ok – let’s dive into what I do when I first open a 10-K.
“How does this business actually make money” – Read the Business Overview Section and Understand How that Flows Through to the Income Statement
Nowadays, there are links upfront in a 10-K that can help you jump to the sections you want. First thing I do is click on the Business Overview section.
From there, I jump ahead to where the company has the opportunity to describe what it does.
I can’t tell you how much I respect companies that really take the time to help investors understand what they do. Sometimes companies leave it ambiguous which is super frustrating. Especially when covering small caps and I also look at private companies, the amount of times I’ve heard investors think an a company does one thing, when in reality they do not actually understand how they make money, is alarming.
As a quick aside, I once had a company describe themselves like this: “[Company’s] performance resins and surface overlays are ubiquitous in products used in residential and commercial applications and are increasingly displacing traditional building material through value-adding attributes. [Company] is a highly profitable, vertically integrated provider of these products.
Very hard to even determine what they were doing. Turned out, they would saturate paper with a formaldehyde-based resin and sell it into various building products. That’s the importance of diligence.
I have to commend Fastenal on how well they describe their business in 7 sentences. It gives some history, what customers they target, how many branches they have, and what their general strategy is.
So right off the bat, I can generally tell how Fastenal makes money. They sell fasteners. Their business description actually continues on for several pages, which I’ll let you read as opposed to pasting here. It’s a good read.
But as soon as I read this description, I start to have questions pop into my head. I’m trying to understand the value chain. Do manufacture themselves or buy from suppliers? What industries do they target? How do they differentiate themselves? The reason why I ask these is because the answers will start to tell me things about the business.
If they manufacture themselves, it’s probably a unique offering that they can charge a higher margin for, but it will be more capital intensive (need machines, plants as well as branches). If they just buy from China and sell in the US, maybe others can do the same so I’d expect their margins to be lower, but not much capital is really needed.
Turns out, Fastenal mostly buys from third-party suppliers, but as you’ll see later, its margins are surprisingly high. Fastenal is a rare company where it actually provides some detail on this. As I said in my competitive strategy series, looking just at the numbers doesn’t tell the whole story. We need to understand why a company may have high margins or not and if that is OK.
To understand a business and get better at investing, you have to know how a business works. If the above snippet doesn’t make a ton of sense to you, then you need to map it out.
Here is a quick snapshot of what I typically do. I first just try to make a made-up model of the company. I just say, “Hey, I understand selling fasteners, widgets, what-have-you, means buying fasteners in inventory and selling them for a profit. Let’s assume I sell 100k fasteners for $5 – how does that look here for Fastenal?” Note, these numbers are made-up, but the margins are about what Fastenal has.
Hopefully from the notes above, you can see I’ve also made attempts on how the cost structure of the business works. Is this a highly variable cost business or not? I would say it is highly variable. If my sales go down, I’m not just going to keep buying fasteners and keep paying bonuses to sales staff (I’m going to incentivize them to get sales up).
Contrast that to an automotive company like Ford or GM. They typically have unionized workforce, so I’m not sure how many people they can actually cut in a downturn. They also have huge manufacturing plants that are hard to just turn off and turn back on without expenses associated with it. Contrast that to Fastenal, whose branches are very basic stores with shelves. That’s one reason why automotive companies and airlines go bankrupt so often. They are highly competitive, highly cyclical, highly fixed cost businesses – demand going down hurts the bottom line a lot more.
I digress. Back to Fastenal.
Let’s now see an impact of what happens with more fasteners being sold – what impact does that have on the bottom line (using EBITDA here for now)?
As you can see, a 4% increase in fastener sales actually leads to a ~7% increase in EBITDA. The main reason is that, while COGS went up by a similar amount to sales, SG&A stayed relatively flat. This is important to understand because you may say, “Ok Fastenal is a mature business. Maybe it should only grow with growth in industrial production, manufacturing, or GDP in the long term. Well if that is 2-3% growth, earnings probably will grow at a faster clip than that, which is important for valuation.
This is a simplistic example and view (for example, more detailed models will have store branches modeled out, how many fasteners each branch sells, what the sales impact and cost impact will be of adding a new branch) but hopefully shows in more detail of how I examine a business and how it makes money.
“Show me the money!” or, uh, Free Cash Flow – Examine the Cash Flow Statement; Understand Drivers
First, the income statement doesn’t capture everything. Net income does not equal free cash flow that we use to value a business. It may capture depreciation which can be used as a proxy for capex in a mature business, but for a fast growing business, capex will likely exceed depreciation. The income statement doesn’t capture the working capital investment needed to grow the business. It also doesn’t tell us where the free cash flow is going (M&A, dividends, share buybacks, debt paydown, just sitting on the balance sheet?).
I also focus on the cash flow statement next because frankly I am trying to find good businesses. If after examining the business overview and parts of the income statement, I see that the cash flow statement is a mess, I may or may not decide whether or not it’s worth my time. Sometimes I like to dig into a messy cash flow statement because people who do simple stock screens will miss opportunities. Other times I’ll decide it’s best to drive on.
To find the cash flow statement, I typically search the document for “Operating activities” which will allow me to jump to “Cash Flow from Operating Activities” part of the cash flow statement. If you don’t know, free cash flow = cash flow from ops minus capital expenditures. This is typically the cash leftover to the business that it can use for other discretionary items.
So I do some quick math and try to determine FCF for Fastenal.
They generated around $600MM of FCF last year, which was a nice jump from $500MM the year before despite what clearly was a big increase in capex. You probably want to figure out why to see if it is sustainably higher. Very quickly, I can see that net income increased (+$39MM), depreciation & amortization increased slightly (+$11MM) which is non-cash so added back, and I have to do some math, but I can see changes in working capital also benefited them in that it looks like they didn’t need to invest as much there, as you can see the increases in inventory and accounts receivable are down a lot Y/Y (total W/C benefit +$141MM Y/Y).
After figuring this out, you need to understand why these occurred. Does the company say anything in its earnings calls about this? Investor presentations? Why is capex up so much? New branches? Is that what drove net income higher? But if they opened new branches, why didn’t working capital increase? Is it a new type of branch that doesn’t require as much of an upfront investment?
After figuring out FCF and whether the past few years look sustainable, I take a look at where the cash is going. It looks like from above Fastenal paid down some debt (as payments are larger than issuance of debt) and paid a big dividend, which has been consistent in size.
However, one red flag I immediately see is that 2019’s dividend is nearly identical to 2018’s FCF… do they have enough FCF to cover the dividend? Yet ANOTHER reason why focusing on net income and payout ratios that are thrown around never makes much sense to me.
Anyway, looking at the cash flow statement provides a lot of clues as to how good the business is. Frankly, I only really need to Income Statement and Cash Flow statement to get an idea if the business generates a good return on capital.
Management’s Discussion & Analysis
This section of the 10-K is when management teams can really explain what drove business results over the past few years. Look at how much detail Fastenal provides in just one section. This doesn’t even really get into cost of goods or operating expenses.
This section really should help an investor with the detective work needed to understand the business. It certainly helps me model companies and think about drivers for the future.
Obviously, there are many more things to study when evaluating an investment, but wanted to share my starting point for how I read a 10-K.
Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.
McDonald’s is not in the restaurant business, per se, it is in the real estate business.
As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.
Why Does McDonald’s Own or Lease the Real Estate?
Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.
As you can imagine, this is a unique relationship between franchiser and franchisee.
Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.
Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).
This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.
McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.
As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.
But doesn’t this make McDonald’s more capital intensive?
Here is a chart of capex as a % of sales for each of the players:
But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.
What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.