A Wealth Creation Journal

Category: Business (Page 1 of 2)

Nintendo Investment Update – The End of the Beginning

Nintendo reported, in my view, excellent results for the Fiscal Year (FY) 2021 and it is a real pleasure to be a business owner (and customer) in this fantastic business.

My core investment thesis for Nintendo remains the same: Nintendo Switch is a sustainable gaming platform because it is anchored by Nintendo’s world-class games and supported by a mix of long life-cycle games and new games by both Nintendo and third-party game developers. Nintendo Switch is in a positive feedback loop now where its large install base is attracting more third-party game developers which in turn attract more Switch buyers. If my assumption that the Switch gaming platform would defy the previous console lifecycle of peaking in year 5 and ending in year 7, then I assess Nintendo’s intrinsic value with the following factors: 1) Switch install base, 2) software revenue per install base, and 3) gamer engagement with Switch platform. Continue reading

Investment Memo – Stitch Fix – AI-first fashion retailer

Stitch Fix is a fashion retailer in the sense that they take inventory, do merchandising, buy at wholesale price and sell at retail price. But that is about where the similarity with a traditional retailer ends.

Stitch Fix’s business model involves users submitting detailed body measurement data and style preferences which is then used to feed into the Stitch Fix machine learning model. Stitch Fix will combine algorithm recommendation and the wisdom of a human stylist to pick out 5 pieces of clothing and sent them to users in a box which is called a Fix. Users don’t know what clothes they are going to get until they receive it. So there is a surprise and delight element. Users will pick what they like and return what they don’t like. Continue reading

Investment Memo – CD Projekt

I bought some CD Projekt shares in my previous portfolio update here. I am very excited to finally become a partner in this wonderful business after following it for 3 years.

I will first discuss CD Projekt’s business at a high level and then go into the recent debacle with Cyberpunk 2077.

As I wrote in my previous blog post – Thoughts on video games:

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

CD Projekt has one strong game franchise – Witcher and in the process of building out a second franchise – Cyberpunk. Despite the launch drama, I think CD Projekt has a reasonable track record as a game developer. So CD Projekt does not fulfil those two criteria – owning strong game franchises and proven game development capabilities – very convincingly.

But I think there is sufficient evidence that CD Projekt can continue to develop its capabilities and strategically build out future game franchise. So there is not really a lot of margin of safety here and hence this is a 2% position.

I always prefer game companies that own and operate persistent game worlds which provide game-as-a-service revenue model rather than game-as-a-product revenue model. Unfortunately, CD Projekt adopts the game-as-a-product revenue model which means its cashflow is very tied to game releases and very dependent on the success of each game release. This has historically lead to a hit-driven business model which many investors hate because it is impossible to predict the sustainability of the company’s earnings.

This has been my biggest reservation about CD Projekt. But a few things changed my mind – 1) the launch Witcher mobile game; 2) the launch of Witcher Gwent card game, 3) the planned launch of Cyberpunk multiplayer online game and the 4) the release of Witcher series on Netflix

In some sense, CD Projekt has a very similar business model to Disney. Disney use movies to anchor its IP franchise which can then be further monetised through theme parks, merchandises and video games. For CD Projekt, it anchors its game franchise with flagship AAA games such as Witcher 3 and Cyberpunk 2077 and then develops spin-off games based on these core game franchises. It also produces TV series to further expand the influence of its game franchise.

CD Projekt’s real upside comes from 2 sources – 1) it builds out new game franchises and 2) transition one or more of its game franchise into persistent game worlds which can build strong customer loyalty and generate stable cash flow. With Witcher mobile game and the planned release of Cyberpunk multiplayer game, we are already seeing some signs that it is happening.

On valuation – it is very hard to value CD Projekt. As part of the company’s incentive program, it announced a goal of generating an average net profit of PLN 1.5-2bn for the period between 2020 – 2025. Assuming that they hit this goal, then I paid 15x multiple based on earning base of PLN 1.5-2bn net profit. Not too ridiculous but also not very cheap.


CD Projekt share price plunged after the disastrous launch of one of the most anticipated game in 2020 – Cyberpunk 2077. Here is a good Bloomberg article that documented the events that lead up to the game’s launch. In short, Cyberpunk 2077 built up an incredible hype but ultimately disappointed gamers as the game was full of bugs and glitches. It was so bad that Sony had to take the game off the shelves because it was almost unplayable on consoles.

Marcin, the co-founder of CD Projekt, posted a video to apologise for disappointing gamers and explain what happened.

He cited the technical challenges of making the game work with the next-gen and current-gen console & COVID-19 restrictions leading collaboration challenges as reasons for the failed launch.

From the outside, it is absolutely clear that the management team had huge pressure to get the game released before Christmas 2020 and that pressure led to the bad decision of launching before the game is ready. I am sympathetic to the challenge of COVID-19 situation which would have really complicated the entire development process.

The legendary game developer, Shigeru Miyamoto, once quipped that “a delayed game is eventually good, but a rushed game is forever bad”. This comment was made when games are primarily sold on physical copies and played with consoles that had no Internet connection. So there was no way to update the game after launch.

Fortunately, CD Projekt (CP) lives in the Internet era where it is possible to continuously update and improve the game once launched. In fact, Witcher 3’s launch was very problematic too. See this Eurogamer article written in 2015 to recount the disaster! And it feels eerily similar to Cyberpunk 2077 – last-minute crunch, graphic downgrade issues and the 2000 game bugs. Post-launch, CD Projekt continued to support Witcher 3, patched the bugs, launched DLC and won universal praise for the game. I believed something similar is going to happen here and that Cyberpunk has the potential to become another great franchise.

Ever since CP transitioned from a regional game distributor to a game developer in the mid-2000s, CP has been pushing its technical and game-making competence with every game. With Witcher 3, CP had to make a game engine that worked in an open-world while developing the game at the same time. CP has insane ambitions to grow as a world-class game developer.

I think with Cyberpunk, CP was trying to push the limits of what they can accomplish again. For example, they had to upgrade the game engine for FPS and driving. The Cyberpunk world was bigger and more complex. Except for this time, they had the complication of COVID, higher expectations, bigger gamer base and co-existence of two generations of consoles.

CD Projekt clearly screwed up this time. But from an investment perspective, I focus on three things – 1) what does this incident show about the company’s game development capabilities, 2) what does it reflect about the company culture and 3) the long-term potential of Cyberpunk 2077 franchise.

For me, it seems like CD Projekt’s ambitions might be ahead of its game development capabilities this time. But it is also clear that CD Projekt is improving as a game developer and based on the company’s historical track record of learning from mistakes, this could be another learning opportunity for CD Projekt albeit an expensive one. I am more concerned about how this incident could crash their ambition and kill the operational momentum that they have been on.

Few game companies have developed such a strong brand within the gamer community. CD Projekt always believed in treating gamer well which is exemplified by their ethos of providing good value for money – free DLCs and DRM-free games. I personally don’t believe there is anything sinister going on here except for the fact that there is immense pressure to release before Christmas 2020. During game development, there are constant trade-offs to be made and we could argue whether CD Projekt has made all the right trade-offs. But I don’t think there are any bad intentions here. I guess we will see how CD Projekt make up to the gamers in the months ahead.

After reading through many reviews and playing it myself, I think it is a good game and has the potential to become another long-running franchise for CD Projekt in the same way as the Witcher franchise.

Ultimately, I think there is a pretty good chance that CD Projekt can bounce back from this fiasco and become a better game company in the process.

Nintendo entering the Cloud Gaming era

I played Control on Nintendo Switch today and it felt surprisingly good. Control was first released on PS4 and was previously thought impossible to port to the lower-powered Switch. But game streaming technology makes it possible.

The unique thing about a cloud game is that it requires an Internet connection to play and the gamer doesn’t own the game outright. Similar to the way that Spotify subscription users don’t own the music on Spotify.

Currently, Nintendo is working with a third-party company – Ubitus, a Taiwan cloud technology company to provide the cloud gaming solution. This is very different to Playstation and Xbox which both have gone down the path of developing their 1P cloud solution.

This could be a good thing for Nintendo as it allows Switch players to access AAA games which were previously unavailable on Switch. I wonder if the next Switch upgrade will come with 5G and introduce the possibilities of cloud gaming anywhere!

On the other hand, it also revealed the weakness in Nintendo’s cloud gaming strategy. They need to develop a proper company-wide strategy to adapt to the gaming era. I suspect at some point, they need to decide if they want to develop a cloud solution for Switch platform. The risk with a third party solution is that gamers would lose access to Control if Ubitus for whatever reason decide not to stream it any more.

With Xbox fully embracing the clouding game and cross-device future, the competitive pressure is heating up. It is possible that 5G smartphones + streaming could commoditise Switch’s superior gaming experience.

My next research project is to closely follow the technological evolution of cloud gaming.

Thoughts on the video game business

I am a gamer myself and I am very excited about the future of video game as a great entertainment medium and a “subset of reality”. But I am even more excited about the lucrative prospects of video game businesses as an investor!  I have learnt so much from the great thinkers in this industry – Chris Crawford, Nicole Lazzaro, Satoshi Iwata, Gavin Baker, Shigeru Miyamoto, Matthew Ball and many more. And I have taken their work and organized it in a way that is useful to me as an investor.

Note: While I will use game and video game interchangeably here, I recognise that many great games, such as Magic: the Gathering and Warhammer, share many common features with the video game as described below. For this discussion, I mostly focus on video games

1. Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. For example, puzzles in Legend of Zelda, defeat enemies with finite resources in a real-time strategy game, opponents to be killed in a first-person shooting (FPS) game. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a very cheap and effective medium to create all kind of problems for humans to solve. It would be stupendously expensive to recreate a typical role-playing game that involves 100 characters to act out 100 hours of game-play content in real life! So game worlds simulate problems for gamers to solve and gamers derive happiness from solving the problems. 

2. In this context, the video game industry has tremendous future ahead of it! Beyond its current incarnation as an entertainment media, video games can be used to solve real-world problems such as education and politics. Imagine the value that could be created if job interviews involve the candidate playing a game which simulates the work environment with high fidelity or two countries before engaging in a trade war is required to play a game that simulates the economic consequences of their trade policies in a game! Humans can sometimes only learn from things that they have experienced and games are an efficient way for human to learn from experience albeit in a virtual environment. This is very far into the future but I believe this is the direction that we are heading towards.

3. The most important difference, from a business model perspective, between video games and traditional media is that video games’ interactive nature creates a feedback loop of inputs and rewards. Gamers give up time and effort to create inputs into a game and the game rewards the gamer with some kind of positive emotions. If the gamers feel that they receive more reward from the game than the effort they put in, the gamer is said to be in a positive feedback loop where his/her emotional attachment to the game grows with time. Some game companies exploit this feedback loop (through mechanisms such as loot boxes) in a way similar to gambling. Other game companies create truly beautiful games where the gamers are treated to a rewarding emotional journey similar to watching a well-made movie.

4. There are three main roles in the video game value chain – 1) Game developers (Nintendo / Blizzard) who made the game, 2) Game publishers help to market and distribute the game. Game publishers can either buy the game content from game developers outright and take on the marketing cost to sell the game or more commonly finance part of the game development cost and strike a profit share agreement with the game developers. It is common to see big game developers such as Activision develop and publish their own games, 3) Game distribution platforms. Apple / Google for mobile games. Steam / Epic for PC games. Sony / Xbox / Nintendo for console games. Most game companies are involved in multiple roles across the value chain. E.g. Tencent takes on all three roles – game developer, game publisher and a distribution platform 

5. Game developers and distribution platforms capture the majority of the profit pool in the value chain while the game publishers are increasingly squeezed in the middle. Game publishers’ service, relatively speaking, add less value and least differentiated and hence they take the smallest slice of the cake on thin margins. Tencent is a unique case where it began as a game distribution platform and game publisher and grew to become a very successful game developer. As a content creator, the game developers differentiate themselves through game content. Fans are extremely loyal to great games but the challenge for the game developer is to consistently produce great games.  Game distribution platforms such as Apple App Store through their control of users are extremely profitable. For a typical mobile game on iPhone, the Apple app store clips 40-50% of the total revenue and the game publisher takes 10-20% and the game developer accounts for the rest

6. Why do people pay for virtual items in games? Gamers pay because they receive an emotional reward in exchange for time and money spent on the game. Ultimately, the maximum amount of money people is willing to pay depends on the quantum of emotional reward they receive. There are a couple of ways for people to get an emotional reward – not a comprehensive list. 1) enjoy a good the storytelling (similar to emotional reward from movies) 2) sense of competence as one becomes good at the game 3) social interactions – critical for many online games. E.g. gamer pay for cosmetic appearances for their in-game avatar. When my 15-year-old cousin was asked why she pays for virtual clothes in-game, she said “you don’t walk around naked nor wear the same cloth every day so why shouldn’t I behave any different in-game”.

7. Traditionally (let’s say before the 2000s), in the Game as a Product (GAAP) revenue model, gamers pay a fixed sum in exchange for unlimited gameplay time to get an unknown amount of emotional reward. The traditional distribution model of games is in essence very similar to books. A gamer walks into a physical game store to check out the latest games available and make a purchase decision based on very limited information. Pretty much judging a game by its cover. It is impossible to charge each gamer a different price based on how much each gamer liked the game. For the most part, the gamer cannot try the game before deciding on the purchase. Furthermore, the gamer’s relationship with the game developer is indirect because the game developer does not know who plays the game nor how the game is played. Feedback collection mechanism is chunky and ineffective. The entire experience is sub-par for gamer and game developer.

8. Internet and smartphones herald a new revenue model – Game-as-a-Service (GAAS). GAAS employs a continuous revenue model with free-to-play being the most dominant GAAS model for mobile games. GAAS spreads the revenue across the entire lifecycle of a gamer while GAAP is 100% upfront payment. There are many different manifestations of GAAS such as a game subscription, in-game transactions, in-game economy tax. I am excluding the discussion of cloud gaming here because cloud gaming is more about computation and I want to focus on game monetisation method here. Conceptually, GAAS is a superior revenue model to Game-as-a-Product because 1) game developers can build direct relationships with its gamers and own that relationship; 2) price discrimination of gamers; 3) maximise gamers’ lifetime value. Said in another way, for great games that use the GAAS model as opposed to GAAP model, the gamer’s loyalty is higher, generate higher revenue and play longer while also getting more emotional rewards from the game.

9. We are still exploring what is considered fair and ethical in the GAAS model. Some game developers design GAAS games with feedback loops similar to those that cause gambling addiction or create an unfair advantage to paying gamers.  Other GAAS games, such as League of Legends, sell virtual costumes for purely cosmetic purposes and does not impact the competitive gameplay at all. I believe that GAAS is especially powerful for great games with a fair monetisation mechanism.  Because great games are by definition offering tons of emotional reward, and it is likely to be under-monetised in the GAAP model because great games’ sale price is not too different from the average game price. On a price per unit of emotional reward basis, the great games are arguable under-monetised as a GAAP game. Using a GAAS model, gamers who otherwise cannot afford the game could play the game for free and the most passionate fans can be monetised based on the different amounts of emotional reward they each individually receive.

10. A great example is a Chinese online MMORPG game created by Netease called Fantasy Westward Journey. This game has two monetisation methods – 1) gamers pay an hourly rate of USD 1 to play the game and, 2) Netease charges a 1% commission rate for transactions between gamers. Most passionate fans are willing to spend thousands of US dollar to buy powerful characters from players who committed incredible time and effort to train up the character. Netease charges a 1% commission rate for this kind of transactions. The commission dollars help to keep the hourly rate low which then keeps the players with a lot of time and less money in the game to train up their characters which they can sell to players with more money but less time. Such an in-game economy structure improves the game experience, increase gamer loyalty and maximise gamers’ lifetime value in a continuous game world using a GAAS revenue model

11. Gamers can become incredibly loyal to one game over a long period of time once they become invested in the game. I started playing DOTA when it was just a customized game within Warcraft in 2007. DOTA has inspired League of Legends and the entire MOBA genre. DOTA has a reasonably high barrier to entry because the gamers need to develop a base level of game knowledge and skill to start enjoying the game meaningfully. Given that I have already become a reasonably good DOTA player, I don’t want to commit to another game where I need to build up a base level of competence to play that game. Instead, I prefer to enjoy the joys of playing a game that I am already pretty good at. And DOTA, which is now hosted on Steam, continues to release new game content to enrich the game experience which means it is never boring for me. The point here is gamers become loyal to a game when they become highly invested in the game world and the challenge is for game developers to provide new content to continue to enrich the game experience. Again this is only possible in a continuous game world

12. Finally, let’s think about how to value a game developer. There are two components to the value of a game developers 1) the present value of all free cash flow generated by the existing game franchise and 2) the present value of all free cash flow generated by future game franchises. The total profit generated by the existing game franchise requires one to estimate A) longevity of the game, B) revenue per gamer and C) the ongoing operating cost of the game. A game company’s development capabilities determine the probability of producing successful games in the future. It is much harder to assess the value created by futures games but it can have very real value

13. To assess the existing game franchise, one must understand the drivers for gamer loyalty to a specific game (longevity) and the quantum of emotional reward (revenue per gamer) received by the gamers. One can investigate the strength of the game community to get some sense of the social bond between gamers. The social bond formed through the game can be one of the most powerful retention mechanism. Another neat trick to assess gamer loyalty to the game is to investigate the behaviour of returning players. For example, Warhammer 40K has many gamers who played as a teenager but stopped playing as they got older. However, given a chance, many old Warhammer 40k players readily come back into the game. The “relapse rate” for Warhammer is very high. The revenue per gamer should be proportional to the emotional reward per gamer. However, if the game is fun for a sub-group of gamers at the expense of another group of gamers then the game might not be sustainable. Hence the pay-to-win model is inherently quite risky. Sometimes it is clear that the game is under-monetised. For example, Nintendo’s Animal Crossing is a great example. Many gamers are paying hundreds of dollars to acquire certain items from other gamers which Nintendo is not capturing. Finally, for any game franchise to attain super long longevity, the game developers must continuously innovate and create new game experiences in the game world.

14. There are a few exceptional game franchises that have proven their capacity to sustain themselves for a very long time into the future. Pokemon, League of Legends, Magic the Gathering, Legend of Zelda and the sports franchises are such examples. Pokemon is able to build an incredible IP and continue to generate high-quality game content. While Pokemon has sustained its longevity under the GAAP model, its transition to a GAAS model through Pokemon Go is going to make Pokemon a much more valuable franchise!

15. To assess the game development capabilities of a company, one must understand the game company’s culture, its development process and historical success rate. It is hard to define the commercial success of a game on an absolute basis. Typically, the game industry, just like any other creative industry, is defined by huge but few successes. So it is better to define success through return on investment. For the sake of this discussion, I define a 10x return on investment as a successful game. A great game company tend to have a very strong and unique culture. Some game company care more about making really great games than others who are more concerned about short term commercial success. Some great game companies have well-defined game philosophy, for example, Nintendo is a big believer in hardware and software integration as a source of differentiated game experience. One needs to assess if the game development team’s organizational structure makes sense for the games that they are trying to build. From an investor perspective, the most important method is to study the game development track record. CD Projekt Red is developing a very impressive track record and its future game franchise value makes up the majority of its market value. Nintendo maintains a very impressive game development track record over a long period of time though it is not proven in the mobile game space. Blizzard has a great track record but they are struggling in the mobile era. Netease and Tencent both have impeccable game development track records!

16. Scale matters a lot for game developers. Luck plays an important role in the outcome of any one particular game. Assume a good game developer can expect a 5% success rate and each successful game yield 10x return, then the game developer’s expected return is 50%. However, the game developers need many tries before the expected value can be achieved. Hence the two gamers with the same expected return, the larger of the two is much more likely to realise the expected return. But as game companies grow larger, they tend to become more bureaucratic and hinders the creative process and reduce the expected return. So scale matters only to the degree that the expected return doesn’t decline with scale.

17. GAAP vs GAAS involves very different game development process. Chinese game companies are generally leading in this regard. GAAS requires a game development team that continuously create and improve game experience after the game is launched. However, GAAP game development process pretty much ends after the game is launched. This difference to game development approach is, I think, one of the main reason why traditional console game companies, such as Nintendo and Activision, are not able to be very successful in the mobile game era.  Mobile games almost exclusively adopt GAAS model while console games are still very reliant on GAAP revenue model.

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. Please let me know if you know of any! The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

Ryman Healthcare – Update #5

Finally! I executed my first share purchase since the beginning of this crisis. I bought some Ryman shares @ NZD 10.45. It is a relatively small position now (~2%) and I aim to buy more if situation becomes favourable again.

Ryman Healthcare is a company that I have been following for more than one year now. I really started to do work on the company in Nov 2019. It is the largest retirement village operator in New Zealand. Globally, retirement villages are typically average businesses but there is one little quirk about retirement villages in New Zealand that completely transforms the economics of the business. For most real estate asset developers, there are really two ways to generate profits – either sell the assets for a profit upon completion or rent the property to collect the fixed income.  For example, most residential property developers would sell the asset upon completion while shopping mall developers often choose to rent the retail property as the long term rental growth would generate a higher return over time. The IRR is better if the property is sold upon completion while the rental model has lower IRR initially and can be more profitable over the long-term if rental growth is respectable.

But is there a business model in which the property is sold immediately upon completion while also retaining the right to collect rental payment over time?  You know, have the cake and eat it too.

Turns out that is exactly Ryman’s business model.

It builds retirement villages and “sells” elderly folks the right to live in their villages. The resident pays a deposit that is roughly equal to the value of the retirement unit. Ryman would charge up to a maximum of 20% of the deposit value as a management fee and the residents are granted the right to live in the retirement unit for as long as they wish to. At the point of exit, the resident is paid back 80% of the original deposit. In reality, most residents only stay in the retirement villages for 6-7 years on average because the average entrance age is more like 75+. This business model allows Ryman to recycle capital on day one through the deposit (great for IRR) while retaining the ability to collect fixed payment through the form of the management fee.

So why do the elderly folks chose to move into a retirement village? Many elderly folks find it very hard to maintain their large house as they get older. Property management service provided by the village operators relieves them of these chores. Another important motivation is a change in life circumstances such as the passing of one partner. Many prefer to live in a close-knit community than living alone. There is the hospitality aspect of living in retirement villages. There are weekly drinks, movies, field trips, exercise classes, and parties. It is kind of like living in a hotel with strong healthcare capability. Finally, a move into a retirement village helps to release equity in their home which can be used to finance their lifestyle.

New Zealand has a rapidly ageing population which will see the 75+ population grow by  ~3.5% for the next 10 years. The supply of retirement village is growing 5% and hence the penetration of retirement village is growing. The retirement village sector is ramping up supply to meet the growing demand; I would keep a vigilant outlook on the pipeline of new supply. However, Ryman should continue to do well relative to its peers because its villages offer better value for money.  Ryman charges 4% management fee p.a. capped at 20% while most competitors charge 5-6% management fee p.a. capped at 25-30%. Furthermore, people will always want the best care and safest pair of hands to take care of them in the twilight of their lives. They also need to trust operators that don’t take advantage of them when their mental and physical states are not in the best shape.

Hence Ryman’s competitive advantage comes from its reputation as a high-quality care provider and a trust-worthy retirement village operator. It offers a continuum of care model for its residents where independent units (normal houses with minimal care provided) and care centres (including hospital care) are on the same site. Elderly folks are not the most flexible bunch. Ryman pays its care staff above market rate to provide premium care and a strong culture of care.

The market also clearly acknowledges Ryman’s superior quality as its valuation is twice of its peers such as Summerset, Oceania and Arvida. Despite the valuation premium, I prefer Ryman over its peers as a strong culture of care is the best protection for long term franchise value. For example, I have found Summerset to have a mercenary attitude as compared to Ryman. This is not to say I will not invest in Summerset. Just that I think the valuation premium is at this moment reasonably justified. While I believe that Ryman is the best operator in the sector, the entire sector is likely to do well given the favourable economics of the business model.

If I am asked to buy the entire business (which I do sometimes fantasize about), I would value Ryman in a similar manner to an asset management company in that it clips ~3% of the total capital base. The capital base is generated by resident deposits. If I assume that Ryman builds out its existing landbank in the next 5 years without adding to the land bank, it would be able to generate, in my estimation, ~NZD 200m of incremental earnings. Note I exclude new sales gain from this analysis. Putting on a 25x earnings multiple, it would imply a share price of ~NZD 12. I think 25x is reasonable because the capital base enjoys 2-3% of house price growth even if there is no unit growth. This is comparable to the 4-5% rental yield in New Zealand. Of course, in reality, Ryman will maintain its land bank for growth beyond 2025. Hence our entry price is a very attractive one.

Now let me address the elephant in the room – can Ryman survive current pandemic?

  1. Ryman’s care revenue is well protected even in a national lock-down as the residents still live in the care centre. New residents are allowed to be admitted because these are typically need-based demand. Of course, there will be stringent isolation protocols in place
  2. Ryman’s care revenue more or less covers the fixed cost of the entire company. So they have liquidity to cover fixed cost even in a prolonged lock down situation
  3. New sales activity will cease but the company has a lot of leeways to stop existing construction projects to conserve cash. As of Sep 2019, the capital commitment is NZD 150m.
  4. Resale activity will cease too and this would impact Ryman’s ability to repay resident deposits on exit. Typically, Ryman promises to repay the deposit within six months after which Ryman will pay ~1-2% interest on the deposit. Legally, Ryman has three years to repay the resident. Even if we assume that COVID-19 lasts for 3 years (super unlikely in my view), Ryman can sell the apartment to pay back the resident
  5. It has roughly NZD 300m of liquidity headroom in an NZD 1.9bn credit facility. The credit facility is secured with underlying assets.
  6. According to the company, there are two main covenants – interest rate cover and gearing ratio

Given the above facts, it seems that Ryman has a very high probability of surviving this crisis.

The demand for Ryman product is mostly like to be delayed and not lost. Hopefully, we should see a reasonable demand recovery.

There is a risk with house price deflation in the event that we go into a recessionary environment coming out of this pandemic. Even though Ryman’s units usually sold at a discount to comparable houses in the same market, it would still impact Ryman because elderly folks need to sell their house to afford a Ryman unit.

Games Workshop – 1H 2020 Results Update – The Best Is Yet To Be

07:57

1H 2020 (6 months ending 1st Dec 2019) results were excellent! What a privilege to be a partner in this spectacular business! Especially the kind of hardworking partner where all I have to do is just sit and watch.

The most exciting part of the earnings release was the doubling of the licensing income from GBP 5.5m to GBP 10.7m due to the launch of a new video game. A big part of my investment thesis on GW relies on the increased monetisation of its Warhammer IP beyond just miniatures. While this is a step in the right direction, I fully expect the licensing income to be lumpy and would take years to materialise fully.

In the meantime, the core miniature business is firing on all cylinders….

The revenue grew 18.5% to GBP 148.4m which is above my long term expectation of 10-15%. New games and miniatures release schedule will impact the growth in a specific period. My long term expectation remains unchanged in this regard.

A more detailed study of the revenue growth reveals some encouraging signs. GW breaks down revenue into three channels – Trade, Retail and Online.

Trade channel is 52.6% of the total revenue and growing the fastest at 27.2%. Trade is mostly made up of local mom and pop hobby stores which stocks a variety of trading card and board games such as Magic the Gathering & Catan. These hobby stores are usually the centre of local hobby community which is very similar to GW’s own retail stores. There are 4900 distributors at the end of 1H 2020. The distributor count grew 11.4% and the annual revenue per distributor grew 14.2% to GBP 31.9k. The annual revenue per store for GW’s own retail store is GBP 173k. So there is a 5x gap. Over time, distributors should increase retail sales productivity to close this gap.

Retail channel is 31% of the total revenue and growing at a slower rate of 7.5%. Retail consists of Warhammers stores owned by Games Workshop. The store counted increased by 2.5% while the revenue per store increased by 5% on a YoY basis. Finally, the online channel grew 15.6% and makes up for 16.5% of the total revenue base.

Opening retail stores will help to build brand awareness and seed the initial Warhammer community in a new locality. However, the independent hobby stores is likely to remain the most important driver for revenue growth for the next few years. Because it is uneconomical for GW to open stores everywhere. Online will remain a complementary channel to help fans acquire miniatures that are not stocked in the local hobby store.

Due to the completion of the new factory and optimisation of operational controls, the gross margin has expanded by 2.5% to 69.5%. Different revenue mix of newer vs older miniatures in any one period lead to fluctuating gross margin. Gross margin of an older miniature is higher as the fixed cost of building a plastic mould is amortised over a larger volume. I would expect the gross margin to fluctuate between 67-70%. The core operating profit was GBP 48.5m which was up 37.8% due to the beautiful effect of operating leverage. Core operating profit margin stood at 32.7%.

Investment consideration – at ~GBP 67 per share, GW is valued at roughly 25-28x 2020E earnings. While it is not cheap on a headline basis, I am holding onto my positions due to 1) healthy top-line growth + operating leverage and 2) a very positive prospect on IP monetisation.

Games Workshop – An Investment Fantasy

Games Workshop (GW) is the largest investment (20%) within my portfolio as it is the cheapest and simplest idea that I can find. When GW ownership was first acquired in April 2018, I only committed 5% of total investment funds because I did not fully appreciate GW’s outstanding business quality. Despite the share price increasing from GBP 22.75 to GBP 61 since then, I further increased the investment in GW as my understanding and conviction in the business developed positively. I may be a slow learner, but it is better to be late than never.

GW is the UK-based creator of Warhammer Hobby which makes fantasy miniatures set in endless, imaginary worlds called Warhammer Universe. The Warhammer Hobby involves painting and collecting Warhammer miniatures with rich backstories developed over 500+ Warhammer novels in the last two decades. Fans can form armies with the miniatures to participate in the tabletop wargaming with the rules developed by GW. All miniatures are designed and manufactured in the company’s headquarter in Nottingham. The story writers collaborate with miniature designers and game makers to weave new characters, games and stories seamlessly together. GW generates revenue through the sales of miniature and the royalty income from licensing its intellectual properties (IP) for PC and mobile games.

I think of Warhammer fan base in three categories – Collectors, Gamers and IP fans. The Collectors preoccupy themselves with collecting and painting miniatures because of their design and beauty. The Gamers are passionate about the wargames and strategically acquire miniatures based on their roles and powers in the game. IP fans, fascinated by the Warhammer Universe, mostly enjoy the Warhammer novels. In reality, the fans have one main preference but also participate in other aspects of the hobby in varying degrees. Interestingly, the Collectors make up for 30-40% of GW’s revenue.

While not everyone is a natural fan of the Warhammer, those who carry the Hobby Gene have an innate tendency to become a fan. This love affair between fans and GW was under trial during the period from 2010 to 2015. Under the leadership of previous Games Workshop management, the company had minimal communication with the fan community, shun social medial (because they did not want to deal with criticism from the fans), closed down popular product lines and increased prices excessively to offset a shrinking fan base. During this 5-year period from 2010 to 2015, the revenue shrunk from GBP 126.5m to GBP 119.1m while the net profit declined from GBP 15.1m to GBP 12.3m.

Just when it seems like GW is set on an inevitable slow decline, Kevin Roundtree took over as the new CEO of Games Workshop in 2016. The first thing he did was to reconnect with the Warhammer fan base through the Internet. Then, he reintroduced the popular Warhammer games that fans loved. Most importantly, he makes it easier for fans to get into the hobby by offering lower price point starter sets and simplified the game rules. The fans are elated and came back into the hobby in droves. One fan even commented that “it is like Games Workshop was taken over by someone who actually knows about sales and marketing in the twenty-first century.” Its revenue doubled to GBP 256.6m while its net profit jumped five-fold from GBP 12.3m in 2015 to GBP 65.8m in 2019. This is a testament of the fans’ loyalty towards Warhammer. Few companies can not only keep their customers after years of mistreatment but also win them back with one big gesture.

So why are fans so loyal to Warhammer? Warhammer has a differentiated customer experience that few can match – beautifully designed miniatures with great details, a strong physical network of players, and cleverly crafted fantasy worlds that fans can immerse themselves into. Even as fans complained about GW during 2010 – 2015, they acknowledged GW’s miniature as best in the industry. GW has the unique competence to mass-produce high-quality miniatures in a cost-effective manner because it has years of accumulated manufacturing know-how and the scale to internalise its entire manufacturing process. As the largest fantasy miniature producer, they can cover the fixed cost of investing in customised tools and mouldings. The design team can work closely together with the manufacturing team to push the limits on manufacturing the next best miniatures.

Gamers are going to play the games that have a decent chance of finding another Gamer to play against in the local community; thus it is critical to have a minimum player population size locally. Hence, GW uses its fleet of 500+ physical retail stores to provide physical space for local fans to meet and recruit new blood into local Warhammer communities. Local Warhammer clubs are formed as the fan base grew. It took GW over 30 years to build this physical network of Gamers globally which new competitors will find it hard to replicate.

Put in another way, GW’s moat lies in its physical social network of Gamers. Warhammer – the game – is the equivalent of Facebook – the digital platform – that binds these players together. Each new player joining Warhammer strengthens the social network because it increases the existing players’ probability of finding a good game quickly. Physical social networks are of course inferior to virtual social networks because 1) Gamers cannot have a game whenever and wherever they want, 2) Gamers’ social relationships are not digitalised and hence not accessible to GW, and 3) Gamers’ interactions cannot be stored in a useful format. Nonetheless, the physical social network is still a powerful moat for the business.

Finally, GW’s IP elevates Warhammer above other board games and tabletop games. Most board / tabletop games are hit-driven businesses where new gameplays are easily copied by competitors. Unlike most board / tabletop games, Warhammer fans immerse themselves in the narratives as they collect and play the miniatures. It is a common scene to see Warhammers fans tries re-enact plots from the narratives through the games. Ask any Warhammer fan what they like most about their favourite miniatures, and the reasons usually are the characters’ personalities and their struggles and victories in the narratives. The progress in the narratives will introduce new characters which then is made into new miniatures. The stories give meanings to the lifeless miniatures and emotional bonds are formed when fans project themselves into the characters. This emotional bond with Warhammer drives repeat purchase. Or in the modern business parlance, Warhammer fans have high lifetime value. This strategy is common among other successful media franchises such as Pokémon and Star Wars.

I believe GW’s moat is likely to grow stronger with its unique corporate culture and first-rate management team. GW’s culture is formed by employees who are themselves biggest fans of Warhammer and they come to work here because they love what they do. GW also has a very strong creative culture where people have the creative freedom to try new things. After spending two decades at GW, Kevin, the CEO, is the right steward of company culture. I have come to know him better over the last year. He cares deeply about Games Workshop and he understands the full potential of Warhammer IP. Kevin set up a new media business unit to bring the Warhammer IP into mainstream media. If this is done successfully, the acquisition cost of new fans is going to decrease significantly. One of the biggest investment risks is Kevin’s departure due to some unforeseen reasons.

I value GW in two parts – core earnings from the sale of miniatures and royalty income from IP licensing. Through acquiring new fans and growing spend by existing fans, GW can grow its core earnings by 10-15% annually. I do not need to know precisely the size of the total market to believe that GW has a very long growth runway ahead. Another popular card game called Magic the Gathering has ~ USD 500m in revenue double that of Games Workshop’s revenue. GW has a sizable fan base in China but negligible revenue. I think China can be at least as big as the US which is GBP 100+m (50% of total revenue). On the royalty income side, GW is significantly underearning relative to the strength of its Warhammer IP. It is currently generating GBP 11.4m which is only 5% of its miniature sales. The top media franchises, such as Pokemon and Dragon Ball, make the majority of their income from licensing rather than merchandise sales. Despite paying a hefty multiple of 24x 2020 earnings, I believe we are getting a fantastic bargain because this is a very high-quality franchise with strong growth prospects, under-appreciated IP monetisation potential and strong corporate culture that reinforces its moat with time.

Information Flow – A Force of Nature

I have been going through old interviews by Meituan founder, Wang Xing. He is obsessed with the mechanism of information transmission in our society and technological advances that improves information transmission brings about drastic changes to how people interact and conduct their daily lives. And when people change their ways of conducting daily lives, it usually means formation of new businesses that take advantage of these changes. Incumbent businesses that rely on the older way of information transmission will be left in shatters.

Wang Xing likes to define information technology (IT) as technology that enables the flow of information. So in this sense, just like Internet and smartphones, older technologies such as printing press & books are also IT. In fact, three out of the four ancient Chinese inventions (papermaking, printing, gunpowder and compass) are about IT. Papermaking is about storage of information. Printing is about mass replication of information. Finally compass is about production of geospatial information.

Internet brought about a revolution in terms of information transmission. Not only does it lower the cost of information transmission, it also unlocks new ways to transmit information. For example, social networks built on top of Internet allows information to pass through the network of humans. We share news, products, services, personal experiences with our friends on social network. Direct to consumer businesses have taken advantage of this change. This is challenging the long-held belief that FMCG companies have impregnable moats.

Technology does not just reduce cost of information transmission. They also allow new types of information to be transmitted. For example smartphone allows the individual location information to be transmitted instantly and hence new businesses such as ride-hailing and food delivery platforms to emerge. Smartphones also allow companies like Meituan which is a marketplace for local services such as hairdressers, beauty salons and restaurants to market to potential audiences more efficiently than before. Meituan will show consumers nearby local services based on location information which are most relevant to the user.

The impact of information flow is even more nuanced than just allowing new business models to emerge. I believe that because the digital revolution has brought about reduced communication and management costs which has reduced the transaction costs within a firm. This partly explains why we are seeing companies becoming larger than ever. I don’t think this trend will reverse.

As investors, the appreciation of the magnitude of changes and the path of change can be very lucrative. For example Uber drivers have driven demand for vehicle hires and this demand for rental vehicle has driven fleet sales in Brazil. Since fleet sale is done at wholesale price, this meant that auto OEMs has to accept lower unit price and margin compression.

The increased digitalisation will transform the food industry in the next 10 years. The first step has been the arrival of the food delivery platform which brings food from the restaurants to the consumers. This can happen because the consumer side has been “digitalised” with smartphone. The next step is to digitalise the restaurant. Currently the bottleneck in terms of food delivery efficiency lies with waiting time at the restaurants. Digitalisation of the kitchen will allow the food delivery platform to predict cooking time much more accurately. Then it is about the logistics. Instead of delivering with clumsy human beings, the next step is to deliver with autonomous robots. Eventually, I believe that food production will be centralised and cost of food comes down dramatically. People will continue to go to restaurants for social experiences. But new flats might not have kitchens anymore.

After studying Wang Xing carefully, I am 100% with him that digitalisation will continue to change the society. And the next stage of change is mostly focused on the enterprise side. While Warren Buffett has derided “change” as detrimental to the investors, I think “change” can be quite lucrative if it is misunderstood by most.

Thoughts on great shopping malls

Given the threat of e-commerce making inroads on convenience/time-spend of shopping (innovations such as augmented reality improve online shopping experience further), what makes a shopping mall’s future relatively bright?

On some counts, offline has advantages, on the other hand there’s weak points that need to be minimized. I make a distinction on this basis and call them “pulls to offline” and “lack of push to online”.

Pulls to offline

  • Having a “great experience”
    • Beautiful and clean mall
    • Meeting friends
    • “M’as tu vu” (requires mall to be frequented by many shoppers, ideally local)
    • Day trip allure of a mall: a whole family can enjoy a day off in one place
  • For buying apparel: human advice
    • In-store advice and advice from friends. As online is making in-roads on human advice, I believe friends’ advice is more of a selling point

Lack of push to online

As buying online is efficient w.r.t time spent, this is a weak point for some offline shop. Mitigators:

  1. Easy-to-reach
    • great location close to population with disposable income: an outlet might be a pain to reach in the middle of nowhere versus a shopping centre next to a train/tube station, or simply on the way for tourists walking by
    • population density in the neighbourhood (think city centres)
  2. Access to multiple shops at once
    • Large shopping malls offer time-efficient access to many shops
    • High occupancy rate is a win for consumers as well in this respect
  3. Access to non-shopping stores that consumers need to visit anyway
    • Mall with gyms/restaurants/grocery/barbers
      • the sunk cost of getting to these places near other stores might even make shopping before/after more time-efficient than online shopping. These places might be the next shopping mall “anchors

The points in green are arguments for large shopping malls with many tenants from diverse categories such as gyms that cannot be done online.

If some shopping malls are indeed able to offer a “great experience”, this might even pull more footfall to these outfits over time as leisure time rises around the world.

The best shopping malls are aggregators of great brands for the best consumers. As such, there are some winner-take-all dynamics at play in this weak two-sided network (weak because the network is very local, but luxury brands and shoppers compound the network effect through increased possibility of building long-term relationship).

On property management

Best property managements are therefore long-term thinkers: willing to invest in renovations / repurposing to keep footfall and tenant quality high. For example, buying back shares at 8% current yield might optically look better than making a 7% ROI renovation, while the renovation can avoid atrophy in the type of customers, tenant base indirectly for years ahead.

It seems that the number of retail shops will certainly grow slower versus the growth in retail sales as the weaker brick-and-mortar links get shut out. The highest quality shopping malls meanwhile will still see a change in tenant base as tenants with products that are great to sell online disappear (uniform products with long-tail offerings such as books, films). Experience in managing tenant base is another important treat.

Brand advertising

Some companies such as Apple (Stratechery, Scott Galloway podcast), BMW use beautiful retail stores to raise brand awareness and customer experience. Some other functions that these stores serve besides selling products:

  • advertise brand (a superior physical impression is superior to an ad on a screen; what is in particular interesting is that the human brain better memorizes physical as opposed to digital impressions example 1, example 2). The superior physical interior, product design, aroma can convince the consumer that Louis Vuitton is for example superior to Zara in a way that digital ads cannot.
  • high-end product feature awareness, customer education
  • Genius bars in themselves are a point of differentiation as competitors do not offer this service

In short, these stores are but one piece in a consumer’s product experience. In Apple’s case, an iPhone is not only hardware, but also software (iOS) and experiences such as customer support and trying out new launches of features in Apple stores, underlying again how experience is becoming more important for shopping centres.

Conclusion

The economics of growing sales for brands is permanently changed because of a growing online sales share. Whereas in the past brands grew by growing quantity of offline presence because of the fixed link with sales, today, brands will want to occupy the best offline spots and rather not want to be associated with inferior malls. A “flight to quality” malls seems plausible.

To remain competitive, shopping malls have to pull consumers through strengths and avoid a push to online by remaining competitive on the strong counts of online (convenience, price). Multiple factors require malls to be

  1. In the vicinity of high-density affluent population or transport anchors (metro, train, highway) (time-saver, social aspect)
  2. Beautiful and well-kept (experience)
  3. Diverse tenant base with anchors such as gyms, restaurants that will largely remain offline experiences (time saver)
  4. Big (experience for a whole family)

The advantage that offline offers in terms of branding seems most relevant for luxury brands and hence luxury malls.

As malls ideally aggregate the best brands with local consumers, it is in a sense similar to the newspaper business: you want to own the number one mall in each city.

A major risk concerning e-commerce is that luxury brands themselves might become less important in an increasingly online sales world. We see this with Amazon trying to sell white-labels as consumers increasingly weigh functionality and price over brand as information asymmetry is smaller online (driven by e.g. customer reviews).

TC

Book Summary: The Energy World is Flat by Parilla

I read this book because its author proved to be correct on oil.  This is a non-exhaustive book summary I made last year. In the meantime, other events prove another call in the book: the book predicts convergence of global energy prices: oil has come down and the cheapest natural gas in the world (American) is rising.

The Energy World is Flat offers a refreshing view on the oil market. I found it through one of the better Real Vision interviews with Diego Parilla two years ago. The title is a variation to Tom Friedman’s best-selling book on globalization The World is Flat. Lastly, Diego Parilla and I are alumni from the same oil & gas business school.

I only read the book now as I realized that the author’s first call on the flattening of oil call has already proven profitable. These are the main calls the book makes:

  1. the term curve of oil will flatten
  2. geographic spreads will flatten
  3. spreads between energy equivalent prices of fossil fuels will flatten
  4. oil price volatility will lessen

If we compare the oil term curve between the publishing date (1/1/15) and now, we find that it has flattened considerably.

Chapter 1: the Flattening and Globalization of the Energy World

In the oil shock of the ’70s, oil was displaced for power generation and industrial uses in favour of coal, natural gas, nuclear and others because the primary consideration is price in these industries.

Today, oil still reigns over other fossil fuels for transport purposes despite its higher price (e.g. oil was 10X more expensive per energy equivalent than natural gas in the US in 2012). The main is reason is that oil is exceptionally compact both in terms of volume and weight per energy equivalent. Over the short-term, transport is very price inelastic.

Geopolitical events that created volatility sowed the seeds for more buffers ‘flatteners’: storage, demand destruction, new technologies and discoveries. A result can be found in 2014 when the exceptional combination of the below supply disruptions failed to make the oil price spike (the move was limited to 10$/barrel from bottom to peak).

  1. the arab spring (e.g. disruptions in Libya)
  2. oil sanctions in Iran,
  3. conflicts and disruptions in Sudan, Syria and Iraq

Chapter 2: Lessons from the Dotcom bubble

The tech revolution (and bust) created huge capital inflows that led to miserable investor returns over the cycle. The big winners were consumers that benefited from stranded assets such as fiber-optic broadband.

The revolution of fracking and horizontal drilling is similar. Although there is still a lot of skepticism towards shale for environmental reasons, Parilla draws a parallel with ultra-deep-water drilling that faced critics in the early ’90s but developed into a very safe technology. Peak oil sentiment similarities to the tech revolution includes huge capital investment into:

  1. LNG terminals (requires huge upfront capex)
  2. pipelines (see European and Asian projects)
  3. E&P
  4. demand efficiency

One trap for energy investors is to follow consensus according to Parilla. The sector is driven by extremely optimistic assumptions of demand growth. Every year, demand growth estimates are revised down an average of 15-20% from the January estimates (IEA, OPEC). Since 1998, only one year, 2012, has seen meaningful upward revisions. Main reasons are

  1. optimistic GDP growth estimates
  2. using the rear-view mirror correlation between GDP and energy demand that has been breaking down since 1998

Another parallel with the dotcom boom is the diversified ‘venture capital’ approach. In the energy world a lot of capex is being made in new technologies, with a lot of losers. The mentality for

  • big integrated O&G company boards is to ‘be’ invested in new areas as it looks better on paper
  • investors to be invested in all new areas as “you only need one winner”

Examples in the transportation world are:

  1. compressed natural gas (CNG)
  2. LNG for trucks, trains and ships
  3. electric and hybrid vehicles (EV’s and HV’s)

Note: according to Parilla, governments have delayed EV’s by subsidizing combustion-engine car sales (and bailing out the companies) post-recession by a 6-to-1 investment factor to EV subsidies.

Last parallel: the bubble accelerates the impact of the revolution. The runaway oil price in 2007 set in motion a huge supply response by oil producing and oil consuming countries alike.

Diego warns that a sum-of-the-parts valuation for companies that invest in many fashionable new technologies can be very dangerous with bad capital allocators, as the good parts might subsidize loss-making ones, and that focused companies should be welcomed.

Chapter 3: The 10 Flatteners of the Energy World

Interesting excerpt:

During the super-cyclical run up in corn prices in the 2000s, most commodities were making historical highs, from crude oil, to coal and natural gas, to copper and corn. Correlations had notably increased, which was often used as an argument to justify that speculators were driving prices. And of course, high fuel and food prices were generating inflation and increasing the risk of financial stability. One again, politicians and regulators were quick to blame the speculators. “Food inflation, how dare they?” Corn was considered too expensive and would impact the poor the most and increase inequality. How cynical.

The main reason why corn prices were going up was the surge in demand for corn-based ethanol in response to both high energy prices and the regulated mandates. Corn, which had traditionally been “food and feed”, had become “food,feed, and fuel”. [..] In 2012, following an acute drought in North America, the prices of corn reached historical highs, 400% of 2005 prices. “The speculators are taking advantage of the situation.” Yet, that year over 40% of the physical harvest went to ethanol to “feed” the car. The quantities were mandated by the government as “fuel” forced the demand destruction of “food and feed” via high prices. It was the cattle and hogs who had to change their diet, not the car. By mandate.

Do spot prices converge to futures prices, or is it the other way around? A causality study by Merill Lynch, and Parilla, say futures converge toward the physical fundamentals of the spot market. Speculators will discount future fundamentals in the price. If they improperly discount future risk factors into prices, they will lose money as the future prices converge toward the in-the-future-prevailing spot fundamentals.

TC

Should you invest in franchises or managements? It depends.

Note we wrote this post last year.

Many investors categorize themselves and either say

  • they make judgment call on management or
  • rather focus on the franchise or business (it’s rather cool for some in the value investing church to say not getting to know management is a good thing)

Should we focus on the horse or the jockey?

Investor Robert Vinall is known to focus a lot on management. He believes it’s a hard but important question. Important, because it is difficult to quantify, and therefore there’s less competition from conventional investors and quant funds.

Guy Spier, on the other hand, likes to think of himself as a merely good investor, with lots of limitations, such as judging management. He therefore avoids talking to management. Getting to know managements opens us up to get manipulated by their – often perfect – act.

On bad business turnarounds Warren Buffett has said this:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

While we definitely think there’s great arguments for both point of views, we think the relative importance of analyzing franchises versus managements changes a lot with one critical variable: growth.

Focus on the racehorse and on the show jumping jockey

As the entrepreneurial HBS author of the book Buying a small business often repeats

With revenue growth comes new customers, and with new customers come new (types of) problems

In other words, growth brings change. While changing companies are not necessarily growing (e.g. turnarounds in the above Buffett quote), growing companies are always changing.

Another recent observation I had redrafting this post one year later is that venture capitalists tend to focus much more on the founder or team.

From the above, we make a case for focusing on the franchise in mature companies in markets with stable competitive dynamics.

In fast-growing companies, management becomes much more important as they need to make a lot of judgment calls in execution and capital allocation of growth investments.

In show jumping, the horse needs the jockey.

Lastly, the only competitive differentiator in commodity companies is management (companies with fast-changing circumstances).

We believe there is an opportunity in looking at jockeys in commodity industries as 

  1. investors hate commodity/capital intensive industries
  2. investors are focusing on “great franchises” right now (peak quality?) while growing more sceptical of looking at management 
  3. we believe management can be the (non-durable) competitive advantage for these businesses

While media attention tends to go to the folklore of billionaire jockeys of once-fast-growing start-ups, some examples of great commodity Jockeys: 

  1. Philip Meeson in Dart Group plc
  2. Belgian owner-operator Luc Tack in Picanol and Tessenderlo
  3. Buffett overseeing (mostly incentives) in (re-)insurance operations

We’d love to hear your under-the-radar commodity jockeys and thoughts!

MC & TC

The HLP Lessons

In the past couple of months, I spent a lot of time and effort researching Hang Lung Properties (HLP). It is a Hong-Kong listed commercial property developer and owner. HLP has a portfolio of prime retail properties in HK and mainland China. My initial interest in the company originated from my belief that despite the threat from eCommerce, well-positioned shopping malls in demographically strong areas should continue to do well.

There is a lot to like about the company at first glance. It was trading at close to 4% dividend yield, a strong development pipeline and have at least 2-3% rent growth from its existing shopping mall portfolio. The shopping malls are relatively high-end and located in some of the biggest cities in China. Most importantly, it seems to have a well-aligned management (HLP is family controlled) and a “legendary” capital allocator at its helm. I recommend you read the Hang Lung’s Chairman Letters where the CEO’s impeccable ability to time the real estate cycle and reluctance to overpay are both well documented.

It was almost too good to be true. You have 1) very competent capital allocator, 2) a high-quality retail properties portfolio, 3) a highly visible development pipeline, and 4) a cheap valuation for this business quality. I allowed myself to become very excited about the company as I devoured the Chairman Letter religiously. I am actively looking for evidence to further support my investment thesis. Sure there are a few problems but as a long-term investor, I can look past these “short-term” issues.

However, as I learnt more about these “short-term” issues, inconvenient evidence began to accumulate. The consumption power of Chinese Tier-2 cities does not grow nearly as fast those implied in Hung Lung’s Chairman Letters. The oversupply of retail space in Tier-2 cities would take so many years to digest that the return on incremental retail properties in these Tier-2 cities is just too low for the level of risk involved. However, the company seems focused on its Tier 2 city strategy in China. Not to mention the first mover advantage of the luxury mall in Tier-2 cities is so entrenched that it is a winner-take-most economics. Most luxury brands will not open two stores in a Tier 2 city in China and luxury brands need to co-tenant together. This means that once the first high-quality mall captures most of the large luxury brands in its mall. It is extremely difficult for the second and third mall to compete. You can build mid-end malls but then you would have so many similar malls that the low rent almost guarantees an unsatisfactory return. Chinese Tier-2 cities retail space is over-supplied from high-end to low-end malls.

At this point, I am just confused. Why would such a smart and rationale capital allocator commit to such an obviously sub-par strategy? As I spoke to people who are close to the Chairman, it became clear that this is an individual who has a huge ego. It would be extremely difficult for him to openly admit the mistake and change course. It is unclear to me if he is just too proud to admit the mistake or that admitting the mistake to something that is so central to his personal identity (he sees himself as the smart guy that never overpays) is just too difficult for him.

In any case, I learn quite a few lessons which I can take along with as I continue my adventure in the investing jungle.

  1. Don’t give too much credit to CEO / Chairman just because they can write fantastic annual letters
  2. When the business’s core operation is transformed in volume or in nature (in Hang Lung’s case from property management to property development), one cannot assume that the company will naturally be able to adapt
  3. Even when the manager is heavily invested in the company, the ego can still get in the way such that mistakes are not corrected
  4. Human irrationality is more powerful than you might think
  5. Past track record does not guarantee future success

Of course, I could just be wrong in thinking that building malls in Chinese Tier 2 cities is a sub-par investment strategy. I hope I am wrong.

MC

Summary of French Bollore documentary

For those that understand French, I very much recommend this excellent documentary on Vincent Bolloré. I found it to be quite unbiased, surprisingly.

Disclosure: long a bit of BOL (main thesis being that a full simplification is a catalyst for the unlocking of the NAV which is at ~2X the share price by virtue of the economic share count which stands at around 50% of the total share count, after accounting for the circular ownership loops. The timing is very unclear, but in the meantime NAV is compounded at a decent rate. The author did a very similar exercise as the highly recommended Muddy Waters analysis that came out just months after)

For everyone else, I have summarized the documentary:

  • in France, Vincent Bolloré has the nickname “two-faced smiling killer”
  • Bolloré has a smartphone app counting down the moment he steps down. I think this shows he is obsessed by providing the “right” company to his family successor (whatever that is, importantly it could include a simpler structure)
  • when Bolloré started at the family company after his Rothschild banking experience, he managed to negotiate a 25% wage cut in his family’s rolling paper factory legacy business when the factories faced cyclical headwinds. This is almost unheard of in France and it shows his influencing skills.
  • the name Bolloré in Africa is very famous. Bolloré uses his abundance of smarts, political connections (including personal friends Sarkozy, Hollande* and Macron), capital and synergies from the media business to gain profitable contracts in many African countries

I didn’t build my empire from one franc by being a passive investor, it’s not in my genes, I am an activist. – Vincent Bolloré at the Havas board meeting.

*Although Sarkozy is one of Vincent’s personal friends, the documentary shows an example where a Hollande visit to Africa allegedly helped Bolloré win a bid for a Cameroon port concession.

Grocery Retailing – History & Future

I would like to use this post to document my thoughts on grocery retailing based on books I have read, conversations with investors in grocery retailing industry and studying historical developments. In writing this blog, I was most inspired by the following books:

  1. Sam Walton: Made in America
  2. The Everything Store (See this great book’s review by my dear Belgian partner)
  3. Alibaba: The House that Jack Ma built
  4. The Story of Mass Marketing in America
  5. The Grocers: The Rise of Supermarket Chains

I believe that the “wheel of retailing” is bringing us into a new generation of grocery retailing. I hope that by reviewing the long run history of the grocery industry, I can draw useful (and right) lessons to better understand the grocery retailing industry today.

The term “wheel of retailing” was first coined by Malcom P. McNair in 1958 to describe:

The cycle frequently begins with the bold new concept, the innovation. Somebody gets a bright new idea…… Such an innovator has an idea for a new kind of distributive enterprise. At the outset he is in bad odor, ridiculed, scorned, condemned as “illegitimate”. Bankers and investors are leery of him. But he attracts the public on the basis of price appeal made possible by the low operating costs inherent in his innovation. As he goes along he trades up, improve the quality of his merchandise, improves the appearance and standing of his stores, attains greater respectability. Then if he is successful comes the period of growth, the period when he is taking business away from the established distribution channels that have clung to the old methods…. The department stores took it away from the smaller merchants in the cities in the late 19th century and early 20th century; the original grocery chains took it away from the old wholesaler-small retailer combination, the supermarket then began taking it away from original grocery chains to the extent that the latter had to climb on the supermarket bandwagon. And today the discount houses and the supermarkets are taking it away from the department stores and variety chains.

Then the institutions enters the stage of maturity. It has larger physical plant, more elaborate store fixtures and its operating costs tend to rise…. The maturity phase soon tends to be followed by top-heaviness, too great conservatism, a decline in the rate of return on investment and, eventual vulnerability. Vulnerability to what? Vulnerability to the next fellow who has a bright idea and who starts his business on a low-cost basis, slipping in under the umbrella that the old-line institutions have hoisted.

While McNair’s original wheel of retailing idea relied more on incumbents trading up and allowing the operation to become less efficient and hence less able to provide value to its customers. My personal view is that the wheel of retailing is primarily driven by the emergence of a new format and/or innovation in retailing that is structurally more efficient than the previous one. History has shown that, for a variety of reasons, new entrants seems better suited to take advantage of new innovation and that incumbents, due to fear of self-cannibalization and institutional imperatives, are less likely to adopt the new innovation. (The Innovator’s Dilemma provides a good explanation of this phenomenon)

A word of caution – One of the most dangerous thing in investing is to draw the wrong lessons from history and application of wrong lessons into the future is hazardous to investor return! Hence I am always open to feedback, critique and new ideas. So please leave any comments/thoughts you might have.

The basics of grocery retailing

  1. Grocery retailing is, at its essence, a distribution business
    • Retailers buys goods from producers such as farmers, branded food manufacturers and then sell to consumers. The difference between the purchase price from producers and sales price to consumers is the gross profit earned by the grocery retailers like Walmart. Consistent with most distribution business, grocery retailers have a low gross margin typically around 20% depending on inventory accounting method and local competitive environment
  2. Grocery retailing is a negative working capital business because it takes goods from producers on credit whilst selling to consumers for immediate cash
    • Negative working capital business is highly desirable because as the business grows, the growth in sales itself generates cash flow from working capital which can be used to finance further growth
  3. Efficient operation & logistics is key to long term profitability and competitive positioning
    • Most supermarket chains / grocery retailers operates around 1 – 5% EBIT margin. Given the razor thin margin and inherently high operating leverage, efficiency is the necessary but insufficient condition to success in grocery retailing
    • E.g. Wal-mart, a best-in-class operator historically has been able to operate around 4-6% EBIT margin
  4. Grocery retailing is largely a commodity that largely (not fully) compete on price and winner provides lowest all-in-cost of grocery shopping
    • It is a commodity because if two adjacent supermarkets sell the same Coke, the only differentiation is price – price competition
    • All-in-cost of grocery shopping includes the sales price of groceries, time and associated travel cost
    • The best grocery retailer is one who can provide the lowest all-in-cost of grocery shopping i.e. a combination of low price and highest convenience of purchase
      • E.g. a grocer with normal price level + high convenience of purchase can trump a grocer with slight lower price level but very low convenience of purchase
    • This point is very relevant because changes in the components of the all-in-cost of grocery shopping have been driving industry-wide transformation
      • James Sinegal, founder of Costco, describes his business in the following manner:
      • My approach has always been that value trumps everything. The reason people are prepared to come to our strange places to shop is that we have value. We deliver on that value constantly. There are no annuities in this business – James Sinegal, Costco

      • The interesting thing to note here is the notion of “strange places” which means that customers are willing to travel to remote location to buy the same things that they might be able to buy in their neighborhood. They are only doing that because the price reduction in Costco exceeds the travel cost and extra time incurred – lowered all-in-cost!
      • Costco model would not be possible before the era of mass car ownership and well-developed public roadwork because the reduction in sales price is not enough to offset the exorbitant travel cost. (More on this later)
  5. Grocery retail is mostly considered a chore and not enjoyed by most people
    • Most people do not enjoy grocery shopping, especially young parents, and hence would prefer to spend as little time on it as possible
    • Costco is one exception to this “rule” where they managed to create a treasure hunt like shopping experience
  6. The complex logistics surrounding grocery retail does not naturally lend itself very well to the online channel
    • Perishable fresh food dictates time sensitive which means highly efficient transport and multi-temperature range storage facility. Perishable food also means that stocking a large amount of inventory without immediate large-scale sales channel can be very costly
    • But important to note that if grocer with right technology can kick off the new “wheel of  retailing” with online grocery, it is a potent secular force to be reckon with by all industry participants (more on this later)

Historical observations of grocery retail industry

I will focus on US grocery market because it is very representative of the general industry trend globally. As an investor, it is important to study the long run history to appreciate the full context of the industry development.

In my view, the US grocery retailing market is broadly divided into four phases of development. I will specifically look at the history of two companies – America’s Pantries (A&P) and Walmart – to better understand the industry’ transformation over time.

Phase 1 – Independent Retailers before 1900s

Phase 2 – The Chain Store Revolution between 1920s – 1930s

Phase 3 – The Supermarket Domination between 1930s – 2000s

Phase 4 – Rise of e-commerce from 2000s – present

Phase 1 – Independent Retailers before 1900s

In Phase 1, the independent retailers are typically small shops that serve the local community. These stores sold goods such as tea, flour, sugar, liquor, axes and spices. Gerald Carson, in The Old Country Store, described these 19th century stores in beautiful details.

“A great deal of time was wasted in looking for articles that were not in place or had no place…flies swarmed around the molasses barrel and there was never a mosquito bar to keep them off. There was tea in chests, packed in lead foil and straw matting with strange markings; rice and coffee spilling out on the floor where a bag showed a rent; rum and brandy; harness and whale oil. The air was thick with an all-embracing odor, an aroma composed of dry herbs and wet dogs, or strong tobacco, green hides and raw humanity”

Grocery retailers in Phase 1 heavily reliant on a complex network of wholesalers to supply the goods to them. Retailers sold mostly goods that they can get access to rather than the goods that their customers want. There is no direct link between food producers and retailers. Many store owners also go on shopping trips to New York to stock up on the latest wares. Otherwise they relied on travelling salesman, middlemen and jobbers. It is a rather inefficient system.

Phase 1 retailers typically have very low turnover and are correspondingly compensated by high margins. This feature is defined by the social demographics of the era. A largely rural population and high cost of travel ensured that many families are self-sufficient and visit the grocery stores very infrequently.

Surprisingly, grocery stores in Phase 1 exhibit high level of service. Purchase made using credit is an ubiquitous feature. Many urban stores also install telephone and offer delivery service (and we think that grocery delivery is a modern concept). By the end of 19th century, many retailers began to offer trading stamps (discount coupons) to encourage customers to pay by cash. Customers who collect the trading stamps can later exchange the stamps for a sizable reward. Groceries did not have clear price tags, and customers did not directly pick out the goods themselves. Customers were serviced by the storekeeper who stood behind the sales desk.

In summary, Phase 1 grocery retailing have the following characteristics:

  • High margin, low turnover and low sale volume – higher sales price
  • No direct relationship with suppliers and instead depended heavily on a complex network of wholesalers, middleman and jobbers
  • High level of service such as credit, telephone orders, trading stamps, and making deliveries
  • High degree of specialization by product line – meat shop, coffee shop and vegetable shop
  • Goods and groceries are undifferentiated commodities and hence compete purely on price (no national brands)

Phase 2 – The Chain Store Revolution between 1920s – 1930s

Through chain ownership and management of retail outlets and the backward integration, a “revolution in distribution” was in full swing by the 1920s. The centrally organised and managed chain store system is far more efficient when compared to the independent grocery stores. In the next decade, chain stores relentlessly replaced the independent stores.

American & Pantries (A&P)’s beginning as a mass retail winner

American & Pantries (A&P) was at the forefront of the chain store revolution and it later went on to become the unquestionable retailing giant of its time. A&P’s early success came in 1860s when it sold tea through direct-mail distribution method. Local communities would pool their demand for tea together and send the tea orders to A&P. I suspect this was only possible because the transport cost was lowered by the already advanced railway system. A&P’s tea offered up to a third discount from the price of the independent grocers.

A&P’s choice to launch its direct-mail business with tea is worth further examination. By the standard practice of that time, tea was priced relatively high to subsidize competitively priced commodities such as sugar, salt and flour. US in the 19th century was a rural nation that grow much of its own food if store price escalated but tea was a specialty product for which this was not an option.

Average grocers depended on tea to generate big chunk of its profit but consumers wanted to buy more tea at a lower price. A&P concluded it could make profit through increased volume on tea.

Over time A&P extended into other product categories such as baking powder, spices and extracts. By 1900, A&P operated couple of traditional physical stores and had sales of USD 5.6m with a profit of USD 125k. These physical stores were operated like any other independent stores where it extensively used trading stamps, provided credit and offered telephone orders and delivery service. However by this time, A&P already began to source goods directly from producers and bypassing the wholesalers.

The Economy Store

A&P started the Chain Store Revolution in 1913 when it introduced the Economy Store. The new store format is as follows:

“In our so-called “Economy Stores”, we do not make any deliveries, we have no telephone communication, we close the store when managers go to lunch, we sell strictly for cash, we give no premiums, trading stamps or other inducements. In our regular stores we do give trading stamps, we do make deliveries, we have telephones, in some instances give credit……”

 While the Economy Store format was not unique to A&P, they wholeheartedly believed in its inherent efficiency and pushed this format harder than any other retailer.  I suspect A&P’s conviction in the Economy Store was a reflection of John A. Hartford’s vision to sell quality food at low prices. John Hartford was the second generation owner-operator of A&P. He declared that:

“I have always been a volume man and unless we can operate in the future along economy lines, I do not believe I can put my heart in the business”

The new format lowered the operating cost and part of the operational savings were passed along to customers. (Indeed sharing cost saving with customers has always been part of the wining formula in retail) A&P expanded rapidly to take full advantage of the new format. These Economy Stores have very similar store design. Richard Tedlow detailed A&P’s expansion in The Story of Mass Marketing in America:

“Having established its new formula, A&P embarked on a policy of saturating its major markets by opening stores at a rate that was unprecedented in the history of American retailing. From 1914 to 1916, George and John Hartford opened 7,500 stores, and closed over half of them to weed out the weakest.”

A&P, the pioneer of Chain Store Revolution, emerged as the clear winner with a sales of ~USD 1bn in 1929 which was greater than Sears, Ward and Penney combined. Its profit went up ~7x from USD 4.8m to USD 35m between 1920 to 1930. The table below documents A&P’s extraordinary rise as Phase 2 retail winner.

A&P Financials

A&P launched the chain store revolution that brought the industry from a high margin / low turnover model to one of low margin and high turnover. Other national chains such as Krogers, American Stores Co., Safeway and First National Stores all adopted the chain store model at varying pace. As a group market share of large chains went from 4.2% in 1919 to 27.6% in 1930 according to A. C. Hoffman.

Why was chain store so successful?

A. Chain stores offered lower price v.s. independent grocers

There was abundant evidence to show that chain stores offered lower price than independent stores.  Based on the range of studies done below, chain stores’ price are cheaper by ~3% – 11%. As mentioned above, grocery is largely a commodity and coupled with low switching cost (assuming switching to a nearby competitor’s store involve minimal cost) means that customers flock to the store with lowest cost.

Price Comparison - Part 1

Price Comparison - Part 2

Source: The Story of Mass Marketing in America

It is important to note that chain stores were MORE PROFITABLE WHILE OFFERING LOWER PRICE.

The national grocers were highly profitable in the 1920s. The rate of return for A&P was in excess of 20% in the 1920s. The other four national grocers recorded 17% return on investment in 1928 while A&P achieved 26% in that same year. By comparison, average rate of return on investment for all US corporation that year was 14.8%. It is fair to say that independent stores were probably under performing the average US corporation.

This leads to the next logical question – what is the source of chain store’s ability to offer lower price while earning high profit?

B. Chain store’s source of competitive advantage

In my humble view, I believed that chain store’s ability to participate in ruthless price competition was due to structural operational efficiency. The operational efficiency gains were passed on as price cuts which allowed companies like A&P to offer structurally lower price and enjoy higher profit margin at the same time.

In Phase 2, grocery retailers’ operational efficiency came from:

1. Centralized and direct supply chain

  • Cost savings by cutting out the value leakage to traditional network of wholesalers
  • One could argue that a centralized direct supply chain is inherently more efficient by reducing the number of distribution points between the producer and customer. The diagram below illustrates this mechanics for the flow of fruits and vegetables in New York Metropolitan Area Markets in 1936.
    • As illustrated by the diagram, the goods that did not went through the wholesale market had reduced mileage, lower charges for loading, storage, order processing; and most importantly avoided the profit earned by the wholesalers
  • Integrated retail and wholesale system also meant that there was better co-ordination in terms of inventory management
    • For example, suppose a customer entered a small independent grocery store in 1930 and asked for goat cheese. The grocer probably did not keep goat cheese in stock and would have had to order it from wholesaler. If the wholesaler also did not carry the item, he would have to order it from a producer. Now the wholesaler would face the dilemma of either ordering a carload of goat cheese and risk not being able to sell more than one order or not satisfying his customer and lose future business. The wholesaler simply is not close enough to the consumers to size demand except directly through his customers, the independent retailers. In an integrated supply chain, like the one from A&P, the wholesaling department in A&P receiving weekly orders from its vast network of chain shops would be able to better size the demand and hence better inventory management
  • By comparing the chain store turnover with the retail + wholesale turnover leads to interesting analysis:
    • Chain store system has an annual turnover of 10x
      • Implying that it took 36.5 days to move groceries from producer to final consumer for chain stores
    • Independent retail stores have a turnover of 11.75x and the wholesaler has a turnover of 5.35x. The retail+wholesaler model has a collective turnover of 3.68x
      • Implying that it took 99.28 days to move groceries from producer to final consumer for retail+wholesale channel

Wholesale Network Diagram

Flow of Fruits and Vegetables in New York Metropolitan Area Markets, 1936

2. Dramatically reduced services offered at store level

  • Offering credit was a very costly activity for grocers as credit assessment done on an individual consumer level was not the grocers’ core competence. Grocers are in the distribution business; and not in consumer credit business
  • Various academics estimated that offering credit and making deliveries accounted for ~3%-4% of the sales of the independent grocers offering them in 1924 (Source: Malcolm P. McNair, Expenses and Profit in the Chain Grocery Business in 1929)
  • Naturally this is very high for a business that is earning low single digit net profit margin

3. Organisation efficiency through job specialization

  • Independent store keepers would have to everything by himself from buying goods, stock keeping, sales and accounting
  • Organised chain store was more efficient in terms of backward integration with dedicated real estate management team, finance support, logistics and supply chain infrastructure

It is important to point out one popular misconception about chain store’s ability to compete at lower price. came primarily from lower purchase price due to national grocery chain’s ability to negotiate lower price from suppliers. Federal Trade Commission data showed that approximately 15% of the chain’s price advantage resulted from lower purchase cost but the remainder (which is the bulk of the price advantage) must be attributed to lower gross margins and operating expenses. After the chains attained scale, it did help them to lower purchase price but it is not core to the chains’ ability to price compete.

Transition from Phase 1 to Phase 2 grocery retailing

Grocery retail moved from a high margin and low turnover business to one of low margin and high turnover. It was during this transition that early structure of modern distribution infrastructure took place and that grocery retailing became a negative working capital business as chains only accept immediate cash payment instead of credit. This grand scale industrialization of the distribution business lay the foundation for the industry’s next transformation.

In Phase 2 retailing, grocery stores stopped making food deliveries and offering credit to customers. Another way to look at it is that grocers in 19th century were not efficient in making deliveries and the resultant excessive operating cost was reflected in the higher grocery price. Hence it was better off for the customer to pick up grocery in-store themselves and enjoy the lower grocery price. The reduction in grocery price was more than enough to offset the customers’ travel cost such that all-in-cost of grocery shopping is lowered.

Grocers are not good at making credit decisions and consumers who want to purchase groceries on credit should get a consumer loan from financial institutions that specialize in making credit decision.

Phase 3 – The Supermarket Domination between 1930s – 2000s

In 1930, Michael J. Cullen wrote a letter to the president of Krogers to propose a new store format that is later known as supermarket. Needless to say, his proposal was ignored and of course Mr Cullen would decide to strike off on his own.

The keystone of Cullen’s strategy is low price:

When I come out with a two-page ad and advertise 300 items at cost and 200 items at practically cost, which would probably be all the advertising that I would ever have to do, the public, regardless of their present feeling towards chain stores, because in reality I would not be a chain store, would break my front doors down to get in. It would be a riot. I would have to call out the police and let the public in so many at a time – Michael Cullen letter to Kroger president in 1930

Cullen’s proposed store would have:

  1. Larger than traditional chain stores (5200 – 6400 sqft v.s. 1200 – 1500 sqft)
  2. Cash only (Some chain stores still accepted credit)
  3. Self -service (chain store would still have a clerk that sells to customers whereas in supermarket customers would pick out his/her own goods)
  4. Huge parking space which reflected the rise of the automobile era
  5. Out-of-town locations – cheap rent
  6. Almost 100% nationally branded merchandise

Below is a comparative review of the two store formats:

Chain Store v.s. Supermarket

Note that while Cullen’s supermarket format sacrificed 10% gross margin but the format was robust enough to be more profitable on the bottom line – a whopping 2.5%!

Supermarket beat chain stores at its own game because supermarket’s model was able to provide even lower price and higher turnover. I believe supermarket’s superiority in operational efficiency came from:

  1. Out-of-town locations – cheaper rent. The rise of automobile in the States dramatically lowered the travelling cost for the public. “Strange locations” became accessible for the public.
  2. Larger store format means larger sales volume – the fixed cost associated with operating a store does not scale up proportionately with store size. Hence by utilizing a larger store format, one can spread the fixed cost over a larger volume – economies of scale
  3. Self-service – self-service allowed the store to handle large increase in customer volume without corresponding need to increase workforce which means savings on labor cost

Supermarkets also largely stocked nationally branded merchandise. The chain stores, like A&P, had a large private label merchandise at the time. The food manufacturers wanted to capture more value through brand. Supermarkets as the emerging competitors were largely willing to let the manufacturers to do the selling / marketing for them. And the food manufacturers were more than happy to comply. Interesting that the industry came back full circle with private labels coming back with full force through Aldi and Lidl today.

While rise of national brands were important to the supermarket era, the dominant force was the popularity of automobile. It fundamentally changed the travel cost and hence the composition of all-in-cost of shopping.

A&P in the supermarket era

Like most successful company facing a sudden industry disruption, A&P – the industry leader – initially adopted a head-in-the-sand attitude and called the supermarket revolution – “an imagination of disaster”.

However, it did not take long for John Hartford, the company patriarch, to realize that indeed the new format is the store of the future because it is able to deliver better value for its customers and yet remain more profitable. John Hartford always believed that 2 pounds of butter at 1 cent was a better business than 1 pound at 2 cents. He held on to the idea of providing the best value to his customers – lowest price in the market.

After years of experimenting, A&P began a remarkable transformation that saw a massive closure of small chain stores in city center and opening of large supermarket in out-of-town locations. Between 1935 and 1941, the number of stores more than halved from 15k stores to 6k stores while sales per store more than tripled from USD 22k to USD 60k. John Hartford understood the supremacy of low price in the grocery retail space. He acted with more urgency compared to other national chains of the time. But the transformation was not easy – he remarked that “it is easy to build up a complicated and expensive structure, but very difficult to adjust and reduce it to the demands of time and conditions.”

However, the industry giant slipped slowly into oblivion after the 1950s when the founders of the business, John and George Hartford passed away. Successive professional management under invested and mismanaged the business. As the industry moved to even larger stores, more nationally branded merchandising program and expanded into non-food categories, A&P stuck to its private label program due its existing heavy manufacturing infrastructure.  Finally a West German company bought A&P in 1979.

The wheel of retailing in the supermarket era

A succession of rise and fall of retailers, such as Kmart, was predictably based on the premises that the operator with the lowest price wins. Variants of the supermarket format was experimented to varying degree of success. For example in one model, supermarket was used as a traffic builder and the real profit was made through concessions such as radio supplies, auto parts and general hardware.

In my personal view, the general structure of supermarket format remained unchanged. I would carefully conclude that between 1940s and 1960s, no retailers developed sustainable competitive advantage and hence it was more a question of management quality and execution. However this changed with the arrival of the next retail giant – Walmart.

Walmart – the ruthlessly efficient retail operator

Sam Walton, an incredibly driven retailer, started Walmart in Bentonville in 1950. Walmart’s early expansion strategy focused on small towns with less than 10,000 people which no large national discounters were going after. For example, Kmart would not expand to towns with less than 50,000 and Gibsons would not go much smaller than 10-12k people. In Sam’s autobiography, he explained that this strategy of focusing on small town was not after careful assessment of the market dynamics. Rather it was because Sam’s wife, Helen, did not want to live in towns with more than 10,000 people. Or more practically, Walmart could not afford to compete with giants like Kmart in larger cities.

Walmart’s saturation strategy of expanding concentrically from a geographic perspective was critical to lowering the distribution cost. High local store density lead to distribution efficiency Walmart expanded by filling out the areas that is within one day’s driving range from its distribution centers i.e. it would establish local monopoly before expanding out to new geographies. The operational efficiency from distribution was subsequently shared with customers which lead to ,wait for it, lower prices. And this structural advantage allowed Walmart to become more profitable despite selling goods at a lower price versus competitors.

Walmart kicked off its own wheel of retailing and Walmart in the 1980s was a period of relentless growth and value creation. The negative working capital and winner-take-all nature of the business accelerated the rise of Walmart. Similar to other retail giants before Walmart, it grew with the market but also ruthlessly stole market share from its competitors.

Again the formula here is the same as before:

  • Walmart obtained a structural operational efficiency which allowed Walmart to price lower than its competitors
  • Cost savings is shared with customers in the form of lower price
  • Growth itself accelerated more growth due to negative working capital and negotiation power bestowed by scale
  • Walmart’s source of operational efficiency, superior distribution efficiency due to local sales density, does not diminish with scale (but its source of efficiency also does not increase with scale) – as it expanded concentrically
  • This continued to ensure reasonably high return on incremental investment on opening new stores

Here is an interesting infographic showing how Walmart expanded geographically.

Summary of Phase 3 retailing:

  • The transition from phase 2 to 3 was driven very fundamental changes to the society in the US notably mass ownership of automobile and penetration of mass media such as TV and radio
  • The new supermarket format allowed for even lower prices than chain stores due to its structural superiority such as lower labor cost per unit of sales and higher turnover due to larger store format
  • Walmart was the clear market leader in this era as it has a structurally lower distribution cost versus its peers which allowed it to consistently price lower while generate higher operational margins

Phase 4 – Rise of e-commerce from 2000s – present

As we finally enter the 21st century, a completely new format of retailing – e-commerce is kicking off the wheel of retailing again. With the advent of Internet, a website can host unlimited SKUs to consumers. E-commerce operators can save on operating physical stores and consumers can save time by not having to travel. However e-commerce operators need to run a highly efficient and sophisticated delivery infrastructure.

Amazon has proven that for many retail categories, such as books, electronics and household goods, online retailing is a winning proposition as it effectively able to lower retail prices and provide convenience to the customer at the same time. However, the grocery retailing, especially involving fresh food, has been more resilient to online retailing because the logistics is much harder to achieve for the following reasons:

  1. Fresh food has limited shelf life and place demanding requirements on storage conditions – ambient / cold / frozen environments
  2. Picking of groceries is much harder versus traditional merchandise like books because:
    • The order of putting goods into the bad matters (eggs cannot be below watermelon)
    • Picking of groceries is much more labor intensive as fresh food require much more sensitive handling
    • Groceries are less commodity-like for example no two apples / tomatoes are exactly the same
  3. Grocery suppliers tend to be local in nature and hence difficult for online retailers to establish scale shortly

The economics associated with all-in-cost of shopping becomes as follow:

Can the e-commerce operators deliver lower all-in-cost of shopping by saving on the operational expenses associated with traditional physical stores (such as rent and labor costs) while not spending as much on delivery of goods to consumers?

One has to gain an understanding if the online grocery retailing method is structurally more efficient than the traditional brick & mortar ones. To understand that I looked back at the historical development of the distribution system:

Distribution Network

I would think that there is one clear trend from the diagram above – as the distribution infrastructure becomes more efficient, there is less inter-mediation between producers and consumers. For example, the transition from Phase 1 to Phase 2 saw the elimination of wholesalers and middleman and rise of centralized distribution network. In the supermarket era, the back-end integration of supply chain with food manufacturers leads to further removal of friction in the distribution process by bettering improving the flow of information from consumers to the suppliers.

Online grocery retailing promises to continue to simplify the distribution processes by reducing the contact points between consumers and suppliers. As shown in the diagram above in an online retailing model, goods move from warehouse / fulfillment centers to households directly as opposed to the stores and then to the consumers.

However, it is not at all 100% clear that online retailing is more efficient. Below I lay out the cost components associated with online retailing:

Grocery retailing cost components

As per the diagram above, online grocery retailing can save on rent and labors costs but have to figure out how fulfill and deliver orders to customers efficiently. One key point to note is that if the online grocer is able to deliver a basket of goods at the same price as its traditional competitor after accounting for the delivery cost, then online grocer has the lower all-in-cost of shopping because of the convenience of not having to visit a physical store.

If we assume that online retailers can take advantage of technology to solve the picking & delivery (robotics / better picking algorithm / automated delivery van), then it is almost a certainty that online grocers can offer the most competitive grocery pricing through its efficiency in distribution. The next question becomes can online grocers over time develop better technologies to increase automation of picking and delivering such that unit cost associated with per item of sales is reduced. If we look at some of the recent technologies below, the evidence points to a resounding yes. The question then becomes when would online grocery retailing become dominant rather than if.

See examples of cutting-edge technology below:

Given that online retailing model has very high initial capital and fixed cost structure, the unit cost would decrease quickly with scale. Hence I find the arguments that current model of online grocery retailing is not sustainable because of the higher unit cost to be unsatisfying. However there are start-up online grocery business in India and China that rely solely on cheap labor to conduct delivery. I find that model to be inherently unsustainable and not scalable.

Online grocery business that is based on technological advances i.e. an inherently more efficient distribution model, to be very sustainable even if the unit cost is still relatively high as it would decrease with scale.

One should also note that brick & mortar grocers attempting to rely on its network of stores for online delivery while might be rewarding in the short run but reduces motivation to invest to build a technology-based online retailing system.

I am not predicting the doom of all brick & mortar grocers. I am predicting the rise of online grocery retailing. That is different because Walmart can still develop its own online grocery system. And it is likely that we would see an omni channel way of grocery retailing. But the share of online grocery retailing is bound to rise. Retailers ignore this trend at its own perils.

The wheel of retailing is spinning to the favor of online retailing which is proving to be a structurally more efficient method of distribution. History has taught us that new organisations are better adapted to implement the new retailing innovations. It is possible for the old guards to change; the odds are just not in their favor.

 

Final thoughts – what it all means for investor today

As each new generation of retailers found a new way to provide customers with the best value, i.e. lowest all-in cost, the winner of the new generation of retailer will experience a long period of growth at the expense of the less efficient retailers. There are structural factors that lead to the “flywheel effect” experienced by the most efficient retailer:

  1. Price competition + low switching cost + commodity nature of grocery retailing = Customers will flock to the retailer that offers the lowest price
  2. Negative working capital = growth itself can bring about cash flow that can be re-invested for even more growth – Self-financing of growth
  3. Scale does not itself constitute competitive advantage but it will reinforce the current competitive advantage enjoyed by the winning retailer (Wal-mart & Costco in 1990s & Amazon today)
    • For example, Wal-mart adopted a saturation strategy and expanded by filling out the areas that is within one day’s driving range from its distribution centers i.e. it would establish local monopoly before expanding out to new geographies
    • The cost-savings from the operational efficiency of this strategy was used to reinforce Walmart’s low price strategy
    • This then in turn helps to attract even more customers and as Walmart gains scale, it is able to exert more discount from suppliers and spread the high fixed of its distribution network over a larger revenue base
    • In this way, scale reinforces Walmart’s competitive advantage as it establishes local monopolies through the saturation strategy. But scale itself is not the source of Walmart’s core competitive advantage
  4. Grocery retailing is one of the largest market in any country that allows for long growth runway

The concept of “wheel of retailing”

The wheel of retailing works because grocery retail is mostly price competition and there is little switching cost. The retail market is huge and allows for a long growth runway as the new retail format grows by replacing the older format. From an investor’s perspective, riding on the “wheel of retailing” can be extremely profitable and to some extent very predictable after initial signs of the wheel began to appear.

Stage 1 – Kick starting the wheel

  • A new retail format which can be a new store format /or a more efficient distribution system that have inherent operational efficiency that allows for cost savings to be achieved
  • Cost savings is shared with customer through lower purchase price

Stage 2 – Accelerating wheel

  • Standard corollary benefits of scale start to kick in due to
    • Negative working capital – growth itself produces more free cash flow which can fund further growth
    • Negotiation power with suppliers increase with scale
  • Operational efficiency’s relationship with scale
    • Depending on the source of the low price, the new retail format’s efficiency may or may not increase with scale
    • For example, A&P’s chain store format did not eek out much more efficiency with scale because incremental profit margin from incremental growth is flat or diminishing. As further growth primarily came from opening new stores which more or less have the same operating margin
    • However incremental profit margin being flat does not mean growth is not profitable. It just means rate of return on capital is flat but it can be flat at a very high rate
  • Continuous sharing of cost savings

Stage 3 – Sputtering of the wheel

  • Organisation inefficiencies associated with large companies began to outweigh further efficiency gain from growth
    • Management complacency
    • Lack of vision
    • Unwillingness to self-cannibalize
  • More critically is the inability to adapt to the new retail format

Finally, with great circumspection, I will offer a few signs to look for in the next long retail winner (Amazon is an obvious one).

  1. A source of structural operational efficiency
  2. Ability to grow organically through existing operational cash flow
  3. Huge reinvestment in the business to fuel further profitable growth
  4. Willingness to share operational efficiency through lowering price for consumers
  5. A track record that its current retail model is well-received by the consumers
  6. Continued improvement in operational efficiency with scale (lowering unit cost with scale)
  7. Preferably founder driven company
  8. Strong culture of delivering superior value to customers

MC

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