I had this debate recently with a leading entrepreneur of Delhi, over just what is the ideal Business Model in these turbulent times. What came up in the debate was a list of characteristics that investors might also look for, in the businesses they prefer. For entrepreneurs, this constitutes a “to-do” list that modifies their existing Business Models till they obey most of these rules. The list is not exhaustive; I would love to have somebody added to this list. This is not to be confused with “moats”, which are singular reasons why businesses protect their profitability and add sustainability.
Declaimer: This article written was originally in September 2009, and some of the data points may be outdated.
- Leverage of Equity: debt; higher is better. This condition is subject to the fact that Volatility in asset returns is minimal. High-debt companies can go into stress if the asset returns drop below the cost of debt. In a volatile world, both are EQUALLY likely, i.e. the cost of debt is AS LIKELY to rise dramatically, as asset returns may fall. This often results in a double whammy, e.g. the Ultra Mega Power Projects (UMPPs) born in 2006, which started with that rosy 70:30 debt: equity ratios (bundled with structured finance in an SPV, which pushed up the effective leverage to 9:1). These UMPPs saw their cost of imported Coking Coal go up by 300%, project delays, and environmental clearances pushing the Project Cost, and their revenues locked up with long-term PPAs that no longer made any sense. Even Variable Costs could not be recovered. This is before the baby was even born, i.e. some of the projects never even made it to the starting line.
Conversely, if you have a hedge operating in a commodity business, i.e. ‘Profit Insurance’, it helps you to take extra leverage. The Profit Insurance is provided by a Treasury that “trades against the business’, i.e. Bought Dollars and Sold Gold in a Gold Jewellery Retailing business, for example. The extra debt is allocated to this Treasury, and the Treasury outperforms the cost of debt. This pushes up asset returns IN A NON-VOLATILE MANNER, allowing you even further debt capacity.
Blindly pushing up debt in a commodity business can come to grief, like in the case of the steel companies.
- Industry Growth Rate; The higher the better. This is a motherhood. An industry that is taking up a rising share of Value Add in an economy, is a better place to be in, rather than a shrinking ‘sunset’ industry. That is as far as the topline goes……..BOTTOMLINE does not necessarily FOLLOW. A fast-growing industry THAT IS ALSO FRAGMENTING at an equally fast rate, is going to see a drop in profitability, even as Balance Sheets get stretched, to keep up with frenetic topline growth. Even market-leading companies can lose market share, or suffer stress in Balance Sheets, despite apparent good times.
JUST SUCH A THING seems to be happening in the Jewellery retail industry recently, which seems to have DOUBLED its share of GDP (from >1.5% to >2.3% over 2007-12). Most of the topline growth has come from the rising price of gold (a major macroeconomic trend), which has pushed up Raw Material (or Inventory Financing) requirements far more than profitability. NET RESULT: Balance Sheets have been stretched even as the industry has fragmented.
The differentiator in such an industry is the player who can generate FREE CASH FLOW, i.e. that portion of profits that can be ploughed back AFTER paying for incremental Working Capital and routine maintenance Capex. Most entrepreneurs don’t even think like this, let alone report their profitability like this.
The inflection point in such an industry comes after the Point of Consolidation, i.e. when the number of players starts to drop, even as the industry growth rate stays up. Then, as the industry growth slows, margins crinkle, and these marginal players fall by the wayside. That is when the differentiators kick in, “the tough get going when the going gets tough”. The Jewellery Retailing and Real Estate Industries might be in just such a place, at least for the next 5 years. I won’t go into the macroeconomic reasons just now.
- The potential of delta Market Share, or differential growth, within the industry; higher is better. Refer point above. This differential growth should be PROFITABLE, funded out of Free Cash Flow. Unprofitable growth is cancerous, leading to the ultimate death of a company. This is what is happening in the Retail industry just now; those who were the fastest growers of yesterday will be the worst sufferers of tomorrow (like Subhiksha, Fortune group, and Nilgiris). The blind race for building new stores, despite them not being profitable plus the fact that most of this came from leverage, i.e. the stores are on rent and have added to Fixed Costs; all of this will create a massive crunch in the industry. Surprisingly, it will be the low-leverage, low-spread (i.e. lower Fixed Costs, lower committed Investments) players who will survive tomorrow.
- Fragmentation of buyer: seller interfaces; higher is better. But in the choice of which end of the Value Chain one should operate at, it is very important to keep this rule in mind. If you look at the petrochemical chain, you will find that the most profitable businesses are those that buy from many sellers and sell to many buyers. The higher the fragmentation of the vendor/ customer interfaces, the more profitable the business. Most importantly, the rewards of differentiation against competition are more in quantum (and sustainability) if your business is structurally situated in a Value Chain, which is fragmented.
A perfect example of this is the Auto Component industry, which is squeezed between the domination of the steel industry and its customers, the auto assemblers. Despite the specialization and sophistication of their businesses, their margins remain meager, because there is no fragmentation of their vendors/ customers.
- Management depth and process orientation. Scalability (and repeatability) capability, standardization of customer/ stakeholder experience across all parts of the company. Subject to a few caveats, this is also a motherhood. The differentiator will be management quality. Without a deep “process culture”, you cannot convince anybody about scalability; if nothing, you have to speak the right language, even as you ‘walk the talk’
- Cost of (Failure of) incremental investment; lower is better. The acquisition of Corus nearly killed them. Tata Steel; despite 5 years of struggle, the new investments into Jamshedpur and now Odisha will still weigh down the company for another couple of years.
Compare it to the costs of setting up new stores (or closing them down) in Titan’s jewelry retailing chain, which allows them to grow incrementally (and even reduce size when warranted). The value attached to the 2 opposed Business Models is vastly different.
- Margin of Safety, Low Breakeven, and Fixed/ Variable Cost Ratios. There is no perfect combination, but the best business is one with very low Fixed Costs and very high margins per customer. So that with just a few customers, breakeven can be achieved. This happens in businesses with high intellectual property, big pricing power, and high people orientation. Businesses that need big factories (like the steel industry) end up with high Fixed Costs, which take a long time to pay down.
The dinosaurs died in the Ice Age because they had too big a body and too small a brain, while the amoeba survived without a brain because its body was small (and flexible) enough. This aphorism is true of business in adversity, again and again.
- Reducing the Role of Govt. Whether it is through taxation, permissions for growth, environmental clearances, land acquisition, etc., the less you have to interface with Govt the better it is for an entrepreneur. It helps if the product is intangible (usually a service), which makes it difficult for the ‘inspector raj’ to get its claws around your business. The visibility of success should also be low.