The hallmarks of a great investment are predictable, defensible, and growing cash flows. As equity investors, one takes ownership of the company to co-own and thereby capture the equity upside of a company. The market cap of a company, at its very essence, is the value of future cash flows promised to equity shareholders. Therefore, the best investment is that where every dollar of your investment goes in creating the maximum amount of market capitalisation, in the shortest amount of time.
Consumer brands offer a truly unique investment opportunity. Consumer brands offer a virtuous cycle that enable these predictable, defensible and growing cash flows. Firstly, a ‘brand’ is the ultimate moat. The ability to penetrate a consumer’s mind to create top of mind recall and repeat purchase allows impenetrable defensibility. That ‘brand’ effectively shows up in high returns on capital (ROCE), which is unparalleled in most other industries. ROCE is simply the ratio of the profit margin to the steady state capital needed to run that company. What that effectively means is that brands are generally high margin businesses and can grow with very little capital investment. This in turn lowers the need to raise external capital. Not only that, it’s one of the few industries where scale begets more scale and re-investment potential is almost endless. Scale, in turn, provides pricing power, which further increases returns. This, thereby, creates an almost endless virtuous loop, that can theoretically create ever growing and predictable cash flows.
Now, traditionally, it has been thought that brands are linear businesses, and therefore, don’t make sense for investments at early stages of the business as they are harder to get off the ground. However, new-age distribution and asset-light, technology led approach to business building has fast changed that. Traditionally, achieving product-market fit took years and lots of R&D dollars. Today, through online distribution, tight feedback loops with the customer and cheaper costs of production via contract manufacturing that has become a thing of the past. Not only that, given modern retail and online commerce together account for a double-digit percentage of retail in India, scaling to $20-30M in revenue can happen in a matter of months too i.e. non-linearity. Returns on capital too, are fast beginning to mirror technology/internet business, but more on that later.
In summary, for the first time in history, consumer brands have the holy grail of deep markets, non-linearity of growth and capital efficiency.
How businesses were traditionally built?
Traditionally, business were built over twenty, thirty years, often, quite literally, one brick at a time. Let’s take one of our fund’s oldest investments - FedEx. FedEx, which is now an iconic logistics company, was a pioneer in creating delivery systems for time sensitive shipments. In 1965, Frederick W. Smith (unabashedly, a fellow alum of Yale University), wrote a paper that would go on to define modern day airfreight shipping. In 1973, he went on to found FedEx, and started with a 389 member team, 14 aircrafts and 186 packages going to 25 cities. Over the next 2 decades, Smith would go on to build the first company that de-coupled the reliance of shipping companies on passenger routes and create an air-shipping empire that drastically increased speed and reliability.
At its peak, FedEx was growing at 40% year over year and is said to be one of the first U.S. companies to reach a billion dollar in sales without any M&A. Not only that, it has arguably built one of the strongest and most recognisable consumer brands globally, one very hard to displace, so much so that ‘FedEx’ itself has become a verb in common parlance.
Despite all the success, the company took vast amounts of capital to build out, what is now, the world’s largest all-cargo air fleet of planes as large as Boeing 777s and the Airbus A300s. It also employs over 200,000 people, in over 2,000 offices using almost 700 aircrafts and over 85,000 vehicles.
FedEx is a true pioneer and a great success story, built painstakingly over several years. However, it is not alone. There are numerous stories of revolutionary companies built in the twentieth century, in the U.S., Europe and Asia, that have employed a similar playbook. This playbook, while very successful in the long run, has yielded relatively lower returns on capital, both due to lower profitability (higher fixed costs and operational complexity), as well as the higher need for capital investments in hard assets. FedEx, for example, has remained in the low teens when it comes to its ROCE, much like several of its offline peers of the time.
The modern-day business-building playbook
The use of modern technology across the value chain, has created permanent structural changes in businesses and how they are being built today.
Lets begin by talking about ‘pure’ technology companies. While pure technology companies can be consumer brands too, for the purposes of this thesis, I distinguish pure technology companies for having no physical product or ‘real world’ presence whatsoever.
During the course of the 1990s and 2000s, ‘pure’ technology companies have changed the landscape for all founders and investors. Social networks or Software (Saas) companies have come and grown to several hundred million dollars in revenue in the span of a few years, while having high gross margin profiles (80%+) and take very little incremental capital to run a sustainable business (50%+ ROCE). This, in turn, has therefore, created ‘unicorns’ ($1B+ market cap companies) often in the span of a couple of years.
Most investors globally would agree that these attributes—ability to scale non-linearly, high margin and ROCE—are very inherent to technology businesses. We, however, believe that this business-building approach and thereby attributes, are becoming increasingly common in physical consumer brand businesses too.
The world is rife with examples of traditionally slow growing, high capital intensity businesses that have created immense value very quickly, using this new playbook. Some notable examples that come to mind in traditional industries – Eyewear: Warby Parker, Real estate: Oyo rooms, Cosmetics: Glossier, Logistics: Delhivery, Home: Casper, among many others.
To truly understand, how this is being done, let’s pick apart the fundamental elements of an ideal value-creative investment:
- Large revenue pool and growth potential
- High profitability
- Capital efficiency
Undeniably, most consumer sectors have endless revenue pools, whether food, fashion, FMCG, personal care, housing, education, healthcare, etc. In addition, online customer acquisition and distribution channels, make it both easier and faster to scale companies than ever before.
Now, coming to profitability. This is where it starts becoming interesting. Traditionally, most industries have consisted of largely offline distribution systems, which are littered with middlemen and consequently large amounts of margin leakage. First, the use of technology in distribution, whether online or otherwise, causes far larger portions of the profit pool to be tapped by the brand itself. Example – in FMCG, traditionally distributors, retailers have taken upwards of 20-30% of the end sales, however, online distribution and in-house sales management using technology allows the brand itself to capture significant portions, if not all, of these pools. This is what we call profitability due to ‘increase in efficiency’
Second, technology also allows for actual value creation, or profit pool creation. Both via use of technology in product creation, and through use of technology in better customer feedback management and service. Companies today can create profit pools that didn’t otherwise exist. Example – luggage brand Away, has taken an otherwise commodity product, a suitcase, and created a lifestyle brand. The lifestyle brand allows it to have pricing power, thereby a much higher gross margin profile than its peers. The very reason it is able to create a lifestyle brand is because of technology – the aspirational social media profile, the close connectedness with its consumer through 1:1 dialogue, shorter and tighter product cycles and a delightful after sales customer experience.
Finally, capital efficiency. Most examples above of new-age consumer companies have one important thing in common – they are all asset-light companies. Increasingly, these companies are choosing to only keep the most important parts of the companies in-house. In most cases, this means they are only choosing to control the product R&D and customer service playbooks. Own your customer. In most cases, this alone is the mitochondria of a consumer brand. As manufacturing has become more commoditised, most companies have chosen to rely on third party contractors, while placing tight technology led controls to monitor quality. Not only that, technology has also induced supply-chain efficiencies by much shorter product cycles and better working capital management. This means both the fixed assets and working capital requirements remain low, while delivering the highest possible customer experience.
To sum up this secret sauce, let me take the example of one of our own investments in India called Country Delight (CD). CD, is a new-age fresh foods brand, and perhaps, one of the first, if not only, subscription led, vertically integrated online brands. It encompasses elements of all the points above about new-age businesses. CD has taken dairy, an un-sexy industry with low ROCE, low margins and turned it upside down by creating a super high quality product, pricing power, high gross margins, non-linear scaling through online only distribution and extremely high capital efficiency via an asset light model and long term customer lock-ins through a subscription led commerce model. While, it is still a growth stage company, the potential to scale is enormous in a $100B+ market that remains largely untouched for several decades.
I began by talking about maximum (sustainable) value creation, in the shortest amount of time being the holy grail of investing. So how do new-age businesses do that? The short answer is that, for the first time, we are seeing $100M+ revenue, profitable businesses being created from scratch in under 5-year time frames. Let’s take the example of such a typical consumer brand - a $100M revenue, growing 40-50% year over year, with a 50%+ gross margin. Taking a conservative PEG ratio of 1, and a net income profile of ~20%, gives us a 8-10X revenue multiple. This results in a notional billion dollar, or thereabouts in valuation i.e. a ‘Unicorn’. Admittedly, there are several assumptions baked into this example, and comes at the risk of over-simplification and cyclicality risks. It is only meant to illustrate the directional value creation capability of these new-age businesses and how they make for very strong investment cases, whether the end result is a billion dollar market cap, or even half of that.
While we have spoken a lot about the structural and business model changes, which are here to stay and very much a part of new businesses, one would be remised if we didn’t talk about the fundamental behavioural and mindset shift required, which often gets overlooked. It all starts with the founder’s mindset. Increasingly, founders of these companies are the first generation of business people who have grown up on technology. They have never known life without the internet. They are often untainted by the industrial past of mid-20th century businesses. This allows them to view every industry with a lens of the present and future. It allows them to have unconstrained thoughts about building and scaling these businesses. This, in turn, translates into conventional businesses being tracked and monitored along the lines of internet businesses. A lot of our consumer companies track MAUs, DAUs (monthly and daily active users), social engagement, virality, user retention cohorts et. al. much like a social network or pure technology company would. This is not purely cosmetic, but actually translates into growth and economics that mirror technology businesses over the long term.
We believe we are just scratching the surface of this opportunity. Large portions of the GDP remain untouched and undisrupted globally. With the quality of entrepreneurs we are seeing today, the potential to build and invest in truly high quality, disruptive and valuable consumer businesses is very much here and now.
Views are personal.
The author is vice president, and consumer, media and gaming sectors lead at Matrix Partners India.