Curated Insights 2019.03.01

The value chain constraint

To put conservation of attractive profits in generic terms, profit in a value chain flows to whatever company is able to successfully integrate different component pieces of that value chain; the other parts of the value chain then modularize and are driven into commodity competition.

In other words, what matters is not “technological innovation”; what matters is value chains and the point of integration on which a company’s sustainable differentiation is built; stray too far and even the most fearsome companies become also-rans.

The reality is that technology has an amplification effect on business models: it has raised the Internet giants to unprecedented heights, and their positions in their relevant markets — or, more accurately, value chains — are nearly impregnable. At the same time, I suspect their ability to extend out horizontally into entirely different ways of doing business — new value chains — even if those businesses rely on similar technology, are more limited than they appear.

What does work are (1) forward and backwards integrations into the value chain and (2) acquisitions. This makes sense: further integrations simply absorb more of the value chain, while acquisitions acquire not simply technology but businesses that are built from the ground-up for different value chains. And, by extension, if society at large wants to limit just how large these companies can be, limiting these two strategies is the obvious place to start.

The risk of low growth stocks

If a 5% growing business requires a 4% cash flow yield (a free cash flow multiple of 25x, the inverse of 4%) for investors to earn 9%, you can easily do the math to figure out what sort of cash flow yield a 3% growth business or a 1% growth business requires. While a 4% yield plus 5% growth gets you to 9% total return, if a business is only growing at 3%, it needs a 6% cash flow yield. If it is only going to grow at just 1% per year, it needs an 8% cash flow yield.

Now that’s scary. And seriously risky. Because an 8% cash flow yield means a stock is worth exactly half of what it would be worth if it was trading at a 4% cash flow yield. We’re talking about a $100 stock that needs to fall to $50 if the company is only going to grow at 1% rather than 5%. Even a small change, like a 5% business slowing to 4% (in perpetuity) requires the cash flow yield to jump from 4% to 5%. This means a change from 25x cash flow to 20x or a 20% decline in the price. Ouch.

That perpetual 5% growth rate? Remember it is descriptive of the market as a whole. But under the surface, individual companies are experiencing large swings in their growth rate. The market as a whole keeps returning to about 5% growth because that’s approximately the growth rate of the overall economy. But many companies find that while they might be able to reverse temporary periods of decline, once their ongoing growth rate slows down they hit what might be thought of as “stall speed”. In aerodynamics, the stall speed is the minimum speed at which an aircraft must travel to remain in flight. If it slows to a speed below this rate, it will stall and eventually crash.

Zillow is now the Netflix of homes

You already know how Netflix shows you stuff. When you browse, you see Netflix originals plus you see all the content other studios serve through Netflix. Going forward you’ll now see this on Zillow. Why? Because last April they started buying homes directly from sellers, and want to ramp up to buying 5,000 homes a month over the next 3-5 years. How? Fill out a form on their site, get an offer. If you accept, you close in days. If you decline, they pair you with a local non-Zillow agent who can list your home for you the traditional way.

Listing with an agent might be slightly cheaper than the 7% of sales price you might pay to sell to Zillow (or other instant offer firms like Opendoor), but it doesn’t have the same certainty or speed. Since 61% of you sellers are also buying a new home, you’ll need a new mortgage. Zillow bought a mortgage company last year so they can also do your loan—whether you buy your new home directly from them or through another real estate company.

So you might hit Zillow to look for a new home or ask them to buy your existing home. Either way, this is as close as the housing industry has gotten to a one-stop shop. Over time, they might prioritize Zillow listings over non-Zillow listings like Netflix prioritizes Originals, but our TV habits have gotten us used to that already.

Aligning business models to markets

USHG is a constellation of very different restaurants and chains. At one end it has michelin star fine dining restaurants like The Modern and Gramercy Tavern. While at the other end it has the large chain Shake Shack. And many restaurants in between those two ends of the spectrum of pricing and scale.

If you do well you could go on to run a restaurant in USHG’s portfolio. Or if you wanted to open your own restaurant, you could open one with Danny Meyer as part of USHG–or start your own restaurant and have USHG as an early investor. In fact, another possibility is what the three michelin star restaurant 11 Madison Park did. It was a USHG restaurant that they sold to its general manager and head chef, who’d both worked at USHG for years.

By having a portfolio of restaurants at different scales and price points, employees are able grow their careers while staying in the family. And USHG is able to have high retention and invest more in its employees.

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