Today, it seems like every company is labelled by their perceived vulnerability to disruption, and everything can be categorized as either the disruptors (the good companies) or the disrupted (the bad companies). While it’s clear that there are companies who are turning some industries on end (namely Amazon), being a disruptor doesn’t constitute a great investment, and there is real value in investing in an incumbent in times like these. In fact, it’s at times the change that these companies impart on an industry that makes them bad investments.
Southwest Airlines – An Original “Disruptor”
Southwest Airlines (NYSE:LUV) shook up the domestic American airline industry throughout the seventies and eighties, with many practices within the industry, such as not serving food on short flights or extreme price competition becoming the norm as a result of the company’s disruptive rise.
In 1971, the airline flew its first commercial flight from Houston to San Antonio after having been in existence for four and a half years. From then on the company has never reported a full year with a net loss, while competing in a vicious airline industry. In short, Herb Kelleher, founder of Southwest, recognized the untapped market within Texas for commercial flights. At the time that the company was created in 1967, flights were expensive, with two airlines operating in Texas, catering mostly to businessmen, charging high prices. Kelleher saw the opportunity to provide short-haul, cheap flights to Texans and raised $500,000 to buy the airline’s first plane.
Entering the market in 1971, Southwest flew short-haul flights within the state of Texas at an average discount of 45 percent in comparison to competitors. How were they able to maintain profitability? This is where Kelleher’s innovation comes into play. Firstly, Southwest flew a very efficient four plane schedule – using only three planes. Their planes would be in the air up to 12 hours per day, with only ten minute turnaround times from when planes touched down on the tarmac to the moment they took off on another trip. This resulted in decreased maintenance, upkeep, and initial capital outlays in comparison to owning four planes.
Once Southwest was legally allowed to fly outside of Texas, Kelleher had another great idea – not offering meals on short flights – a practice that is the norm at every airline today. This allowed Southwest to charge up to $400 less on medium-distance flights, while remaining profitable. Even when other low cost competitors entered the space, Kelleher was able to think his way out. As similar fares were available at other airlines, Kelleher stressed customer service and additional product offerings. At one point, Southwest offered customers a bottle of Wild Turkey Bourbon if they bought a fully priced ticket. You may be thinking: who would really care that much about a bottle of bourbon? In Texas, apparently everyone, as Southwest was the largest liquor distributor in Texas at one point.
These are just a few examples of ways that a small, regional airline began to radically change a largely monopolized industry through innovation and creativity. Southwest’s eccentric, crafty founder has been able to consistently drive returns for shareholders of Southwest, growing the company’s share price at a 17.4 percent CAGR over a 37 year period. In other terms, $1 invested in Southwest in January of 1980 would be worth $324 today. That same dollar invested in an S&P 500 index fund would be worth just $22 today.
The point of this quick history of Southwest is not to say that Kelleher was the smartest CEO within the airline industry (which he may have been), or that the airline industry is where investments should be made (it is highly competitive and not highly profitable), but to understand that opportunities for innovation are present in many industries. Not only is it great to be able to identify these opportunities for investment, but to also find businesses already existing in the industry that are defensible and agile when reacting to disruptors in the space.
The Modern “Disruptors” – Winning on the Scoreboard, but not the Field
In less than a decade, ETFs have become one of the most popular investment vehicles ever, allowing investors to track the performance of an underlying index at a very low cost, making investing accessible to the masses. ETF AUM reached $4 trillion this year, while traditional asset managers scrambled to justify charging astronomical fees for mediocre performance. The story is attractive – markets are now accessible to the masses, justice is being served to the 2 and 20 hedge fund managers, and all the manufacturers have to do is charge an “entry fee” to be granted access to an index-tracking product. Clever investors, recognizing it’s the ETF manufacturers at the other end of this exodus from active management, can feel secure in the notion that they’re ahead of the curve in identifying a great business – or can they?
Part of the narrative is that traditional asset managers have been threatened not by companies doing their job better, but by not doing their jobs at all, charging an extremely low fee so you can track the same indices as everyone else, implying extremely low variable costs. Low capital intensity is a feature of an excellent business, but what’s important to see is that investors are paying to track the same index as everyone else. This means that the majority of ETFs are indifferentiable based on holdings, and even looking at the market, it’s easy to see that there’s very little differentiation to be done with regards to product features. Consider that there are four ETFs tracking the S&P 500, and multiples of that holding a similar basket of large cap equities, differing on nothing but a few securities (that, under the principle of an ETF, are almost immaterial individually) and name. And while niche ETFs do exist,
So what is there to differentiate on? Why will one fund manufacturer win over the other? The answer can be found in why active managers are losing – price. The ETF manufacturing industry is characterized by a race to the bottom in fees, and these companies have effectively become price-takers. If this doesn’t seem material, consider that in June of this year, Guggenheim announced it would slash the cost of its largest fund in half, from 0.40% to 0.20%, just after Wisdom Tree cut fees on four of their ETFs by nearly 50%. Including this move, Guggenheim has given up an estimated $27 million a year in profit, which is 1/3 of their profits. The phenomenon is called “preservation through cannibalization” – these companies are looking at their competitors and saying, “you can’t eat us, because we’ll eat ourselves first.” A great business is either able to be the only low cost competitor, or charge a premium for a differentiated product – not be one of many low cost competitors, selling a commodity.
And even if investors are alright with a race to the bottom, the investment industry has always had low barriers to entry, and ETFs aggravate this. I could arguably launch an ETF tomorrow, my only problem would be distributing it through advisors. And while the distribution challenge cannot be forsaken, and does affront some kind of barrier to entry, consider the increasing exoticism of new products. ETFs exist for forensic accounting (NYSE: FLAG), merger arbitrage (NYSE:CSMA), global warming (NYSE:LOWC), obesity (NYSE: SLIM), and millennials (NYSE: MILN) – illustrating that, if you have an idea, you could have a slice of ETF profits. This might seem contrary to the idea of homogenous ETFs discussed earlier, but in reality, the majority of niche ETFs are just indices sliced differently. And while there is something to be said about scale advantages afforded to incumbents, the erosion of these company’s returns speak for themselves, driven mainly by a decrease in NOPAT margin, showing the inability to charge a premium for their products, and a loss of market share.
Low barriers to entry, coupled with a commoditized product and race to the bottom in fees (revenues!) hardly constitute a great business. It’s important to look past growth in volume, or the allure of change in and of itself, and look at how these changes affect the competitive dynamics and economics of the industry.
Netflix has undeniably disrupted the media industry, allowing customers to pay a small fee and binge watch anything, anytime and anywhere. And, much like ETFs, Netflix has transformed the customer experience, but this doesn’t make it a great business.
Revenues are generated from two sources in the traditional media value chain – subscription fees, and advertising. And time is money on TV – if customers want to watch a season of a show that airs over three months, they have to pay 3 months of subscription fees, plus have their viewing interrupted by advertisements. This dynamic benefitted content manufacturers and networks not only with regards to airing content, but with regard to producing content – pacing episodes allows media companies to set their own production schedule. Netflix has done away with almost all elements of this dynamic – you could arguably watch one show in one day, with no ads. And if there’s nothing left to watch, it’s easy to cancel the subscription, meaning that Netflix has to continue to either acquire or create new content to retain customers. The lumpiness in Netflix’s operating margins is a clear illustration of the importance of releasing content – margins dip when new content has to be bought or created, implying a capital-intensive business model. Providing streaming to the customer requires a stream of supply – which comes at a cost. Investors who attribute Netflix’s cash burn as “upfront costs” are completely ignoring the fact that these are Netflix’s costs of doing business.
There’s a disconnect in the pricing model as well – when purchasing or producing content, Netflix doesn’t get any more of a discount than any other media buyer or producer would, just because the content is streamed online. And while Netflix arguably saves on distribution costs, these savings are passed onto the consumer – the low monthly fee is integral to the company’s value proposition. This means that Netflix is paying what all other media companies are to either buy or produce content, but are getting less from consumers – hardly an attractive business model.
The (Temporarily) Amazon-Proof
Amazon is undoubtedly ravaging retail – but that doesn’t mean that there aren’t companies who are more resilient than others. To cut through the noise of who is truly being disrupted beyond repair, look only at the business model, and the needs of the customer.
Auto parts are an excellent example. There are two markets for auto parts – the “do it yourself” market, and the “do it for me” market (taking your car to the mechanic). Obviously, the DIY market is more susceptible to disruption from Amazon – if I want to install new windshield wipers, I’m probably okay with waiting an extra day or two to get it cheaper off Amazon.
But what about the DIFM market? Over 50% of parts sales are of “failure parts,” meaning that the car cannot work without it, meaning that you as a consumer are less confident in installing that part by yourself. This is especially true for more mission-critical (and also higher margin) products like brakes, where both the compatibility of these parts with your specific car model, and the correct installation are the most important things. And consider the consumer thought process when bringing a car to a mechanic – you want to drop it off in the morning, and pick it up that afternoon, and you understand that the price of any parts used on your car will be passed on to you. And as a mechanic, it is in your best interest to keep cars moving through your shop as fast as you can. What this means is that for the DIFM market, timeliness and advice are the most important factors, and not price.
When a car comes in for repair at a shop, the mechanic will call a number of parts retailers, and will often order the same car part from multiple distributors – whoever gets the part to the shop first wins. This dynamic is extremely resistant to disruption from Amazon, at least for the time being – there is no profitable way for Amazon to stock local warehouses with all the parts necessary to service cars in that area, and deliver those parts to repair shops within 30 minutes. However, if you look at any 52-week low list over the past summer, you’ll definitely see the big three auto parts retailers, Auto Zone, Advance Auto, and O’Reilly, mostly over concern of disruption from Amazon. O’Reilly has a 50/50 split between DIY and DIFM customers, the most DIFM exposure of any of their peers, yet has sold of 30% YTD. The fact that price is not a basis of competition, as demonstrated by the increase in their gross margin over the past 10 years, both negates Amazon as a real competitor, and calls into question whether the sell-off has been justified.
And as parts stay on the road for longer (on average 2 years longer than 10 years ago), and the increasing complexity of new cars, the need for advice and service should increase. While autonomous vehicles could one day disrupt the entire auto industry, the very basics of the auto parts business model afford it a unique resilience against the biggest disruptors of today.
The Art of Self Disruption
There are absolutely some companies who have conceded their competitive advantages to disruptors – however, the fact that a company faces disruption is not an indicator of a bad business. In fact, there can be tremendous value in a strong management team that is willing to disrupt themselves.
Power Corp, considered by some to be the Berkshire Hathaway of Canada, is notorious for strong capital allocation, but is also known to be risk averse, and frankly, a boring company. The best managers have the foresight to prepare for the future, even if it means short term earnings compression, an attitude demonstrated by Power when they set up Portag3 in October of last year, an in-house venture fund whose only mission is to disrupt their traditional insurance and mutual fund business lines. The company has set aside $250 million for the fund, and also spent $100 million to acquire and incubate WealthSimple. Admittedly, we haven’t been able to observe the results of their efforts yet, but the idea of self-disruption is contrary to the binary idea that so many of us have about the disrupted and the disruptors, and the merits of each of those as an investment. Consider that in the late 1990s, American Airlines’ subsidiary, Sabre, set up a team whose only mandate was to figure out how their travel-agent based business model could be disrupted – the result was what is today known as Travelocity.
What does it all mean?
In conclusion, it seems that in the past, there have been many disruptors that have fundamentally changed the way that we view the industry in which they operate in – while also making a hefty profit. Modern “disruptors” have used technology and new strategies to gain scale in many saturated markets, but have not focused on profitability. The true litmus test of the new generation of “disruptors” will be seen over the next decade as these companies mature past their growth stage and must find a way to increase profit margins and drive returns for shareholders.