Saturday, June 20, 2015

Review of The Art of Profitability by Adrian Slywotzky, Chapter One

How can a company earn a profit? By profit I mean what economists call an "abnormal" profit, the definition of which is somewhat circular but essentially means profit in excess of what is necessary to obtain its labor and capital inputs, enough profit that some competitor ought to try to compete it away.

Seriously, how? If your mind has been crippled by study of microeconomics, then you may not believe this is possible, because in the long-run firms will enter the market and the subsequent increase in supply will cause the price of the good or service to fall, such that the abnormal profit reverts back to normal.

This is a topic we have discussed before, for example when thinking about our Conrad Industries investment. Nate Tobik of Oddball Stocks has good thoughts on how small companies can be profitable:

"There are plenty of ordinary businesses that earn abnormal returns as well. Why aren't there competitors reducing the abnormal return down to an economic return? [T]he difference between a niche and an economic moat is the ability to scale. [Some companies] operate in a niche and earn excellent returns yet they don't have additional reinvestment opportunities and will most likely remain the same size forever."
The Art of Profitability is about ways that companies have found to achieve "abnormal" profitability. Specifically, he describes 23 "profit models", with a chapter for each model. I'm going to do this book review as a multi-part review, because models for achieving profitability is one of the most important subjects in business, and this book does it justice.

The first chapter and profit model is called Customer Solution Profit. The blogger Red Corner did a writeup of this chapter and he defines this model as:
(1) Intimate knowledge of the customer; and (2) customization of products and services into (3) integrated solutions that address (4) the customer’s mission-critical problems (5) in such a way that these solutions are woven into the daily fabric of the customer’s business operations.

Once all five components of the model have been locked in, it is very hard to compete against the incumbent, especially in a slow-growing, smallish market. It can command very high margins with impunity and earn returns far above its cost of capital. It is a moated enterprise, a franchise. It would take a revolutionary leap of some kind, or sustained bout of self-abuse, to threaten it. You can count on its earnings and you can calculate its earnings power value.
There are two further ways of defining Customer Solution Profit. First, learning all there is to know about customers - investing time and money - to create specific solutions for them that would be difficult to replace. Second, a pattern whereby you lose money for a short time, make money for a long time. Also, as Red Corner observes, the profit model classification in Art of Profitability competes with Michael Porter's less helpful notions of profitability and industry classification.

The book is Socratic, conversations between a mentor and a student. At the end of the chapter after describing the model, the mentor asks the student to come up with examples to bring to the next week's meeting about the next profit model. The examples the student comes up with for customer solution profit are industrial plastics, auto parts, and telecommunications equipment.

Using the Yahoo sector list as food for thought, it seems as though many of the customer solution profit models are in the services sector. The company that the mentor used to describe this model was FactSet, which is in the "Information & Delivery Services" category. The "Healthcare Information Services" is another rich category. Cerner Corporation "designs, develops, markets, installs, hosts, and supports healthcare information technology, healthcare devices, hardware, and content solutions for healthcare organizations".

Red Corner has been writing about these profit models and gives another example: Cegid Group, a European business software company.
"Cegid's competitive position relies on that combination of specialization, customization and installation known collectively as 'switching costs'. The uncertainty is in the original sale; after that, the customer is, more or less, locked in. Switching from one product or provider to another has costs – in re-training, disrupted systems, installation fees, and so on – that, unless Cegid makes a catastrophic mistake or is resolutely unresponsive, won’t be borne quickly or easily by its customer base."
Probably the most interesting companies using this model - and perhaps this is true of good profit models generally - are companies that have been wrongly ascribed a lesser profit model. 

For example, the bullish case for both Dell and IBM is that they are really services companies that are wrongly considered personal computer hardware businesses. (IBM sold its personal computer business to Lenovo in 2005, and is now officially in the Information Technology Services category.) See for example the fascinating discussion of IBM's relationship with BNSF, and why that may have led Buffett to buy IBM,
This BNSF exec also participated on an IBM client customer conference call to which supposedly about 1,000 IBM clients listened in. BNSF has been characterized as a ‘living laboratory’ for IBM. Perhaps not coincidentally, just over a decade ago BNSF outsourced a substantial portion of its IT operations to IBM. IBM offered jobs to over a hundred of BNSF’s IT staffers to stay on site at BNSF, as IBM employees. That initial 10-year contract was set to expire just around the time that Buffett started acquiring IBM stock. Maybe that was when IBM came more prominently onto Buffett’s radar.
Overall, many of customer solution profit companies apply information technology on behalf of companies that specialize in something else. Note that this does not mean "computers". Apple is not a customer solution profit company.

It is interesting to find companies with customer solution profit that aren't applying information technology. The guys at Horizon Kinetics describe [pdf] their Platform Specialty long in a way that makes it clear they have bought a customer solution profit model.
PAH produces specialty chemicals for a wide range of industries. It manufactures over 1,000 compounds, and its largest customer represents only 3% of sales. It exhibits very little cyclicality. Energy costs are only 2% of sales. It’s important to qualitatively differentiate the nature of the PAH chemicals business from that of the typical chemicals company. These particular chemicals are often proprietary both as to makeup (the company has over 750 patents) and process. Their employees spend considerable time with customers guiding them as to how to use these chemicals, often in multi‐step processes, such as might be used to enhance the performance of a circuit board. PAH refers to these as dynamic chemistries and seeks out markets requiring highly technical post‐sale customer service. What PAH sells tend to represent a very small portion of the cost of a customer’s product, yet are important to the product’s function or appearance. According to the company, customer retention is very high because the cost savings from switching to another provider are modest, while the switching costs are high due to process complexities and quality control requirements.
This is a great example why thinking about profit models is useful. Is this a crappy, capital intensive chemical company or is it a business with staying power? Figuring out why Conrad Industries made money is what gave us the confidence to hold that one for a four-bagger.

This is a 5/5; discussions of the other profit models forthcoming.


CP said...

I meant to do a joint series of reviews with valueprax blog, but it took me longer than expected to get this first review up. Here are the ones he has posted so far:

CP said...

Here's an investor presentation from Platform Specialty Products:

CP said...

Another good industry is "Business Software & Services":

For example, Iron Mountain offers "records management services, including flexible retrieval access, retention management, and records management program development and implementation based on best practices to help customers comply with specific regulatory requirements and policy-based programs".

CP said...

Other contenders:


CoreLogic, Inc. (CLGX)

CP said...

Important philosophical note. Identifying a business model that explains abnormal profit does not make a company a good long. It's actually neither necessary nor sufficient. A profitable net-net trade does not necessarily involve a company with a good, abnormal profit business. And an abnormal profit business model may belong to a company with overpriced stock, meaning it would not be a sufficient characteristic to be a good long.

Mr. Gotham said...

I don't think you give Porter enough credit. The discussion of Platform Specialty is almost a text book example of weak buyer power (or strong seller power if you want to invert it). From Competitive Strategy pp 24-25:

Buyers compete with the industry by forcing down prices, bargaining
for higher quality or more services, and playing competitors
against each other-all at the expense of industry profitability. The
power of each of the industry's important buyer groups depends on
a number of characteristics of its market situation and on the relative
importance of its purchases from the industry compared with
its overall business. A buyer group is powerful if the following circumstances
hold true:

It is concentrated or purchases large volumes relative to seller
sales. If a large portion of sales is purchased by a given buyer this
raises the importance of the buyer's business in results. Largevolume
buyers are particularly potent forces if heavy fixed costs
characterize the industry-as they do in corn refining and bulk
chemicals, for example-and raise the stakes to keep capacity filled.

The products it purchases from the industry represent a significant
fraction of the buyer's costs or purchases. Here buyers are'
prone to expend the resources necessary to shop for a favorable price
and purchase selectively. When the product sold by the industry in
question is a small fraction of buyers' costs, buyers are usually much
less price sensitive.

The products it purchases from the industry are standard or
undifferentiated. Buyers, sure that they can always find alternative
suppliers, may play one company against another, as they do in
aluminum extrusion.

It faces few switching costs. Switching costs, defined earlier,
lock the buyer to particular sellers. Conversely, the buyer's power is
enhanced if the seller faces switching costs.

It earns low profits. Low profits create great incentives to lower
purchasing costs. Suppliers to Chrysler, for example, are complaining
that they are being pressured for superior terms. Highly profitable
buyers, however, are generally less price sensitive (that is, of
course, if the item does not represent a large fraction of their costs)
and may take a longer run view toward preserving the health of their

Buyers pose a credible threat of backward integration. If buyers
either are partially integrated or pose a credible threat of backward
integration, they are in a position to demand bargaining concession~.~
The major automobile producers, General Motors and Ford,
are well known for using the threat of self-manufacture as a bargaining
lever. They engage in the practice of tapered integration, that is,
producing some of their needs for a given component in-house and
purchasing the rest from outside suppliers. Not only is their threat of
further integration particularly credible, but also partial manufacture
in-house gives them a detailed knowledge of costs which is a
great aid in negotiation. Buyer power can be partially neutralized
when firms in the industry offer a threat of forward integration into
the buyers' industry.

The industry's product is unimportant to the quality of the
buyers'products or services. When the quality of the buyers' products
is very much affected by the industry's product, buyers are generally
less price sensitive. Industries in which this situation exists include oil-field equipment, where a malfunction can lead to large
losses (witness the enormous cost of the recent failure of a blowout
preventor in a Mexican offshore oil well), and enclosures for electronic
medical and test instruments, where the quality of the enclosure
can greatly influence the user's impression about the quality
of the equipment inside.

Anonymous said...

The guy who mastered this is Mark Leonard:

The profit models book is brilliant.

Anonymous said...

Why does PAH have negative retained earnings of 224 million even though its been in business since 1922?

Mr. Gotham said...

I don't think you give Porter enough credit. The description of PAH's business is almost a text book case of weak buyer power (or strong seller power if you want to invert it). See pp 24-25 of Competitive Strategy,d.aWw

CP said...

"At essence, what Constellation buys are customer relationships—and in these vertical markets, relationships with customers tend to be sticky because they can’t get their software anywhere else."

Unknown said...

A few comments with respect to Platform Specialty:

The business they acquired from Chemtura has historically been quite volatile. EBIT fell ~75% from 2008 to 2010. Platform bought the business when its earnings were at an all-time high and paid 10x EBITDA for it. It paid a peak multiple for peak returns. This may be an "asset-lite, high touch" business but that doesn't mean it will produce steady returns or that they got a good deal.

Franklin and Berggruen, Platform's founders, have the right to receive new shares if Platform's stock appreciates. If Platform's market cap increases by ____ through price appreciation, the founders will get new shares worth 20% of ____. So if Platform's market cap increases by a billion, they'll get 200mm worth of new stock. Their compensation scheme is similar to what Sardar Bigliar has done to enrich himself at BH but worse in a way. If Platform's stock prices rise for reasons that have nothing to do with Franklin's and Berggruen's actions-- for instance, if it rises because all chemical companies are being revalued higher-- then they'll still get to extract money from Platform's other investors.

In the past few years, many of the best-performing stocks have been "platform companies" run by "incentivized-owner operators," and the good performance has made them popular with investors. I think Platform is a promotional scam that's intended to take advantage of investors' hunger for this kind of company. It's what Eric Falkenstein calls a Batesian mimic. When the next recession hits, I expect Platform to blow up. Until then, the founders will take all of the excess returns for themselves.

CP said...


"Holders of our Series A preferred stock are entitled to receive dividends on their Series A preferred stock in the form of shares of Platform’s common stock equal to 20% of the appreciation of the market price of Platform’s common stock over our initial public offering price of $10.00 multiplied by the total initial public offering shares. In 2014, the dividend price was $22.85 (calculated based upon the average of the last ten trading days of the year’s volume weighted average share prices), and the shares were issued based on the volume weighted average price of $23.16 on December 31, 2014. In subsequent years, the dividend amount will be calculated based on the appreciated stock price compared to the highest dividend price previously used in calculating the Series A preferred stock dividends. Dividends are paid as long as Series A preferred stock are outstanding. The life of the Series A preferred stock can be extended up to 3 years at the request of our founders and with the consent of the Board. Each share of Series A preferred stock is convertible into one Platform’s share of common stock at the option of the holder and has certain voting rights."

That's kind of amusing... when Horizon Kinetics calls something an "owner-operator", you (or at least I) visualize them owning good ol' common stock just like everybody else.

CP said...

Lol, Brooklyn Investor:

CP said...

"Platform company" means that people are paying for hypothetical future earnings in advance. Specifically, hypothetical future earnings from roll-ups.

Paying in advance and roll-ups are big right now.

Nothing to do with business/profit models though.

I think Horizon Kinetics are very smart guys who don't care about market cycles. You can't talk about that stuff after a six year continuous rally. You'd get fired for talking about the indicators Hussman uses.

Anonymous said...

Loved this book as well. Certainly deserving of the 5/5

CP said...

CP said...

A couple more names that could fit in this category:
*First Data

A lot of the business of being a bank (at small/community banks) is done by Fiserv:
"more than 1 in 3 U.S. financial institutions rely on Fiserv for account processing solution"

Makes sense... when we look at a little rural bank with $50 million in assets and a dozen employees, they aren't coding their own mobile deposit app.

See the kind of solutions being offered by FISV:

Check out their recent investor presentation. The number of banks & credit institutions has been shrinking 4% a year, but IT spend is growing.

Parabolic stock price rise:

From 10-K:
* In 2016, we had $5.5 billion in total revenue, $1.4 billion in operating income and $1.4 billion of net cash provided by operating activities from continuing operations. Processing and services revenue, which in 2016 represented 84% of our total revenue, is primarily generated from account- and transaction-based fees under contracts that generally have terms of three to five years and high renewal rates.