Provident Investment Management

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Just Scale, Baby


Our neighbors recently engaged in a longtime summer tradition, the lemonade stand!  It was well done with homemade signs and cheerful service.  The price these girls asked for a cup of lemonade was in line with the current lemonade market, though when I think back to my youth a quick calculation would indicate we should all be glad the Fed uses the PCE Index instead of the Neighborhood Lemonade Index in gauging inflation.  Otherwise, we might be looking for a return of the hawkish Paul Volcker as Fed Chairman.

 The stand reminded me of my own occasional foray into the business as a child.  I would guess my experience mirrored your typical lemonade stand—tremendous excitement when you get a customer, but painfully long intervals between transactions.  Usually after a couple of hours I’d lose patience and close up shop.  One day I had an idea to drive more traffic.  I would sell a better-known product at a heavily discounted price!  There was a fresh case of Coca-Cola in the garage that my parents had recently purchased, so the timing could not have been better.  With a superior branded, packaged product, I set up shop and got to work selling cans of Coca-Cola below cost.  This actually worked great for me—it was pure profit.  However, it was obviously not so great for my parents, who served as my unwitting venture backers supporting a highly flawed business model.

 The Coca-Cola stand saw even greater demand than expected, as transaction frequency dwarfed what I had experienced selling plain old lemonade.  I sold out rapidly as word spread throughout the neighborhood.  Needless to say, when my parents found out what I had done they weren’t exactly thrilled.  But I had achieved what I wanted!  Drive demand and get some customers!

 After giving this some additional thought decades later, I may have missed a golden opportunity.  Based on the current business environment, I just needed more vision to see how promising my Coca-Cola stand really was.  There was tremendous demand for what I was selling—the primary issue was I wasn’t thinking big enough! I should have considered ubiquitous beverage stands, building a presence so that I could be selling Coca-Cola on every corner at unprofitable prices, in turn driving customer loyalty.  Once I “owned” the customer, driving repeat business, I could then figure out some way to tack on profitable products and ultimately make money.

 Ok, maybe I didn’t lack vision because this plan seems unlikely to work.  Nonetheless, today the ubiquitous Coca-Cola stand plan doesn’t seem that out of place.  A “growth at all costs” strategy certainly seems to be in favor.  There are a host of companies losing huge amounts of money in an attempt to achieve the scale necessary to become dominant market participants.  While some of these companies will succeed, others are trying to scale with no real plan to profitability at all, likely dooming them to failure.  You may think I’m exaggerating but consider the case of MoviePass.

 MoviePass was a company selling subscriptions for $10 per month allowing the subscriber to visit movie theaters once a day for an unlimited number of days.  In order to supply its customers, MoviePass bought tickets at list price and then gave them to subscribers.  Yes, this certainly looks like a suboptimal business model—the simple math shows that MoviePass would be losing money if a subscriber went to even two movies per month.  The company knew it was likely to lose money on every subscriber, but it wanted to obtain a large, loyal, and dedicated user base.  Once the user base was large enough it would then find a way to profitably monetize those users.  Hey, this model sounds alarmingly similar to my Coca-Cola plan! At its peak MoviePass had three million subscribers—it turns out people enjoy things that are sold below cost.  The story unsurprisingly did not end well, as MoviePass was recently shut down.

 The list of unprofitable companies trying to achieve significant scale is long—Uber and WeWork are two examples regularly in the news.  Some will be successful, but what these companies are attempting is incredibly challenging.  The significant number of aspiring scale players can be attributed in part to abundant capital, which allows for continued growth despite a lack of positive cash flow, as well as the success of other scale companies that have become household names, like Amazon and Netflix.  The value of a business, however, is ultimately determined by its ability to at some point generate meaningful cash flows.  While significant scale may allow for substantial cash generation in the future, the market may have gone too far in thinking scale alone automatically turns on the cash spigot.  You still need a money-making model.

 I’m sure Jeff Bezos of Amazon or Reed Hastings of Netflix would agree it’s not as simple as getting scale.  Furthermore, companies like Amazon and Netflix are the exception, not the rule.  Even for these companies the journey has not been without significant turbulence.  Revisionist history is that Blockbuster got run over by Netflix because it didn’t adapt, but Blockbuster did have its own online offering that actually almost killed Netflix.  It likely would have succeeded in doing so prior to the involvement of an activist investor that resulted in a change to Blockbuster’s management and a shift away from its promising online strategy.  Netflix CEO Reed Hastings later admitted to a former executive who had run Blockbuster Online that it had Netflix “in checkmate.”  Similarly, Amazon’s story would not be the same without the success of its cloud business, which the company stumbled upon but smartly understood the potential of once it did.

 It will be very interesting to see what percentage of these aspiring scale players ultimately achieve success, and undoubtedly some will.  The ambition is impressive, but what many of these companies are trying to accomplish is very, very difficult.  Jeff Bezos has repeatedly said his ultimate financial measure is free cash flow per share.  The laws of math/finance say the importance of that measurement is not unique to Amazon.  Tremendous value can be created by companies that are cash flow negative today, provided the future holds meaningfully positive cash flows supported by scale and, more importantly, a sensible business model.  MoviePass could have been multiple times larger and the business still would not have made any sense.  Given the sheer number of companies pursuing growth at all costs it is inevitable some are doing so with a business model that is ultimately flawed, just like my Coca-Cola stand.

James M. Skubik, CFA