Munger’s following quote is his classic model of inversion at work:
“Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.”
More often that not I feel a good starting point for working out why a company has great results is to look at the value chain. If you are dominate in a part of the value chain then chances are you will extract profit from those around you in this chain.
This is basic Michael Porter Five forces stuff. What he calls the Supplier bargaining power. If you have large bargaining power in the value chain then it is in yours and your shareholders interest to maximise the value you can extract.
Anyone who has ever dealt with Coles or Woolworths will know the supplier power they have and they happily wield it.
As I was writing this a real time example is being played out with Google and the ITA flight aggregator database. Google bought ITA in 2011 for $700m. ITA aggregrates flight data from airlines across the world into a realtime database. There have been a host of businesses that API into this database and offer a pricing matching service. As of April next year Google announced they will shut down their express API service which allows platforms to access flight data from the ITA database.
Any businesses that have built their model on accessing the Google ITA API have realised pretty quickly who controls their value chain. It is in Googles interest to extract most of the profits from this value chain and that is what they have done.
There are loads of examples of this. When Twitter was starting out there were a host of Apps that API’ed into Twitter and monetised content. When Twitter took control of its platform these models died over night. To be fair Twitter has struggled to monetise its platform anyway.
An Australian example of this is Vita Group (VTG). Vita Group is a major seller of mobile and data plans. It has a close working relationship with Telstra (TLS) and operates a number of TLS branded stores. The following chart shows that the business was plodding along until in 2015 when NPAT really took off.
Once VTG hit scale around 2015 then EBIT margin expanded from averaging 3% between 2009-2015 to over 8% in FY2016 and FY2017.
Once VTG started earning these kind of returns then naturally Telstra (TLS) was interested. And when you are in a position of controlling the value chain then naturally it is in TLS’s interest to capture as much value as it can. And this what they have done as they have renegotiated the remuneration agreements with VTG.
VTG learnt the lesson pretty quickly that TLS had control over their business model. VTG shares peaked in the mid $5 region to today where they are trading around $1.30.
So what about the future? I dont think it is in TLS interest to kill VTG, VTG offers a distribution channel for TLS products. I think TLS will probably be happy to let VTG to earn a 4% EBIT margin around the average it did pre-FY2016, not the 8% plus it had in the last 2 years.
Putting it simply if you are earning 4% EBIT margin on $620m in revenue then NPAT would be around $17m. What would you pay for these earnings if TLS is basically restricting your ability to improve operating leverage as it controls the value chain?
For me the main lesson is to think about businesses that have had spectacular earnings in the last couple of years and are still riding high. The temptation of most analysts is to extrapolate growth from the previous year and not forecast and understand the drivers of this growth. Rather we should think why these out-sized profits are occurring and what could stop them in the future.