Whenever looking at a new company, we always try to ask ourselves who is benefiting the most from the value the company is creating. It is clear that if a company focused on generating shareholder value only, in the long run, customers and employees would abandon it. There is a clear and difficult balance between these dimensions that is very difficult to assess, but it is of paramount importance to evaluate. It is as if the market was trying to play the shell game with us. Do not let it fool us.
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When looking at a company, we are always very curious to try to understand which part of the value chain benefits the most from a company's or industry's operations. I have lately been fascinated by this topic. What makes a certain industry have good returns? Barriers to entry? Software has almost no barriers to entry but average good returns. Operations efficiency? What is it?
I have come to realize that it is more difficult than it might seem at first look. It is something similar to the fact that some oligopolies do well, meaning high returns on capital, and many others, even duopolies, do not.
“Consider two of the world’s most famous duopolies: Coca-Cola and Pepsi in soft drinks; and Airbus and Boeing in aircraft manufacturing. The nature of their businesses is vastly different. Coca-Cola and Pepsi sell branded, fast-moving consumer goods. Airbus and Boeing develop high-technology equipment with long lead times. Even when it comes to market share, the pairs differ. Coca-Cola clearly dominates over Pepsi, while Boeing and Airbus share their market pretty evenly. In the aircraft business pricing is opaque, whereas in soft drinks it is far more transparent. It would not necessarily be obvious from these descriptions, but the margins and returns generated by the soft drink manufacturers have been meaningfully superior to those in the aircraft market.
Clues as to the relative attractiveness of the two industries appear by probing who the customers are and how the selling is done. In contrast to the soft drinks industry, the aircraft industry sells to a concentrated industrial customer base and every individual sale is negotiated hard. This puts pressure on pricing and, ultimately, industry profitability. In any sector, it is important to assess whether competition is as real at the micro-level as it appears at the macro-level. Sometimes what seems to be a competitive market is rather a latticework of smaller monopoly-like structures where all participants extract high profits.” (Cunningham et al, 2016)
In a commercial exchange, both parties consider they receive the same or more than the value they are paying or exchanging. A consumer buying a coke values the experience of the refreshing beverage more than the dollars he pays. An employee (or CEO) values his salary (including prestige or status) more than the time or human capital he makes available to his employer. Likewise, as shareholders, we accept an equity stake in a company for a given price because we expect to earn a return in excess of our opportunity cost. In a perfectly efficient market with dynamic pricing, the price of the coke would be exactly what I would be willing to pay for that experience, the executive and employee would be paid exactly the minimum wage they would be willing to accept and the shareholders would get a return equal to the cost of capital or interest rate.
This leads to the question, who keeps the additional economic value that inefficient markets are not able to adjust in each company or industry?
Customers are always right
One of the industries in which most of the value surplus is enjoyed by consumers is the airline industry. Since deregulation a few decades ago, the door was opened to new competitors. The business went from being a luxury service, exclusive to the wealthier classes, to a commodity accessible to almost everyone. From being an industry with a relatively profitable business for shareholders and where pilots constituted a social class by themselves, it became one in which the fundamental metric is the efficiency of operations.
The industry is capital-intensive. Airlines are landlords - or lessees- of aluminum - now carbon fiber- real estate. So measuring carriers against traditional profit-and-loss measures such as EBITDA or, worse, EBITDAR—earnings before interest, taxes, depreciation, amortization, and restructuring or rent costs—is on some level like a landlord measuring his profit before the cost of his buildings.
It is enough to look at the graph above to realize that airlines are not businesses that generally generate shareholder value. Let's have a look at the value chain. The aircraft manufacturers, Airbus and Boeing, are pretty poor businesses as we have seen. Aircraft leasing companies (Air Lease Corp. or AerCap) are financers that neither achieve high returns on capital. Executives and pilots do not have miserable life with very low salaries, but the excesses of the past are over. In the airlines, we find an industry with a fairly efficient market, where fierce capitalism and competition have had their way. Contrary to what we constantly hear in the media, capitalism and competition has made the end consumers the great beneficiaries, with flights so economic that it is cheaper to travel 400km by plane than by train. Something that many would like to prohibit and regulate in order to cover up the shortcomings of public railway companies.
However, despite being a terrible industry, we can always find a torch of light in the darkness. There are some outliers who have managed to overcome the difficulties and disrupted the market. Southwest, or Ryanair years later, have been an example of innovation. Epitomizing the pattern of low-price plus, Ryanair has continually leveraged its competitive advantages. Of late it has used the profitability and leanness of its cost-consciousness to obtain aircraft acquisition financing at vastly lower rates than rivals, who must pay more due to costly structural burdens such as pension benefits. Similarly, Ryanair has begun to encroach into primary airports and business travel, to an extent replacing Europe's retrenching legacy carriers. Ryanair's cultural embrace of low-cost operation yields margins and returns on capital unrivalled in the industry. It boasts steady and substantial earnings growth with earnings tripling over the past decade.
Astonishing offices, bonuses, and SBC
I am not reinventing the wheel when we all know the atrocities that are done day by day with the shareholders' capital under the assumption of attracting the best talent or incentivizing executives according to the market. Worst of all, we often jump through hoops and accept the status quo of an industry when it is solely our responsibility to be able to discern what is reasonable from what is excessive. And unfortunately, we have countless examples in too many industries. Program managers fresh out of college working at tech companies and uploading videos to TikTok. Sales reps at healthcare companies in the US with astronomical commissions that eat up a good chunk of shareholder value.
Something similar happens in investment banks. Incredibly good business models. But who gets the juicy multi-million dollar bonuses? The case of alternative asset management or private equity firms is even more striking, as most of them are still controlled by their founders. However, despite being the main beneficiary in extraordinary share revaluations, it seems that they also use the business to enrich themselves in a way that is far superior to that of the rest of the shareholders.
Examples below include KKR, Apollo and Blackstone:
The numbers are quite obscene when compared even to BigTechs that generate a much larger amount of profit. But again, one only needs to dive a little bit into the industry to find companies that are governed by different rules. This is not the time to talk about Brookfield or compare it to those previously mentioned (it may come in the future), but we certainly do not observe the atrocities of before.
Is this reflected in higher shareholder returns? If the thesis of the article were true, the answer should be yes. And it would be if we compare Brookfield to Apollo or KKR, but not to Blackstone, which has outperformed over the past decade. I think there are compelling reasons to justify this, but they are beyond the scope of today.
Looking for shareholder value
That the economic value is spread in different ways and stakeholders across the market are good. It allows us to exploit our hedge as investors, but it makes things difficult. As shareholders, we want companies where the economic value is concentrated on us. Let's take Apple. Consumers love their products. Otherwise, they wouldn't pay for it! Its workers are paid decently, as are all the suppliers it has helped to develop. Its executives have nothing to complain about. Nevertheless, the economic value remains largely concentrated on shareholder returns. Something very similar happens in the luxury industry.
Trying to understand how these dynamics work can help us uncover future value creation and outliers in real bad industries. Happy hunting.
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Cunningham, Eide, & Hargreaves (2016). Quality Investing: Owning the best companies for the long term. Harriman House Ltd.
Dichter, A. (2017). Between ROIC and a hard place: The puzzle of airline economics. McKinsey & Co. Link
IATA (2020). New study on airline investor returns: regional divergence impacting overall performance. Link
Great analysis … came to my mind today: what would be a gig also is looking into auto manufacturers: $TSLA vs traditional players ... let that sink in :)
Great take as always, thank you! Appreciate it!