Now that I have laid out the broad processes for storytelling and number crunching, it is time to get specific. In this chapter I begin by looking at business narratives, that is, the stories that are told about businesses and the process of building these stories. As you read this chapter, you will notice that much of it is focused on the storyteller, and if you are a listener, you may wonder whether these same lessons apply to you. After all, the interests of the storyteller and the investor can sometimes diverge. Thus, if you are a founder or a manager, you often want to push soaring narratives about your venture, since it may result in a higher value being attached to it. As the investors to whom the pitch is made, you not only have to examine the same narrative for credibility, since it is your money at risk, but you have to develop your own narrative for the company, which may diverge from the founder’s story. In my view, a good business story, that is, one that has staying power and backs up a successful business, is one in which listener and storyteller interests converge. If you are a potential investor in a publicly traded company, you often have to be both a storyteller, developing a narrative that underpins value, and a listener, probing your own story for its weakest links. The bottom line is that there is no room in investing for passive listeners and whether you are a founder, a manager, or an investor, you ultimately have to play the storyteller role.
The Essence of a Good Narrative
In chapter 4 I looked at the ingredients of a good story, and I can draw on some of those lessons when constructing narratives to back a business or an investment. In particular, a business narrative needs the following ingredients to work:
1. It has to be simple: A simple story that makes sense will leave a more lasting impression than a complex story in which it is tough to make connections.
2. It has to be credible: Business stories need to be credible for investors to act on them. If you are a skillful enough storyteller you may be able to get away with leaving unexplained loose ends, but those loose ends will eventually imperil your story and perhaps your business.
3. It has to inspire: Ultimately, you don’t tell a business story to win creativity awards but to inspire your audience (employees, customers, and potential investors) to buy into the story.
4. It should lead to action: Once your audience buys into your story, you want them to act, employees by choosing to come to work for your company, customers by buying your products and services, and investors by putting their money in your business.
The bottom line for a business narrative is that it is less about specifics and details and more about big picture and vision.
The Pre-work
Before a story is constructed for a business, there is homework to be done by both storytellers and listeners. You have to review the history of the business for which you are telling the story, understand the market in which the company operates, and have a measure of what the competition looks like.
The Company
The logical place to start building the narrative is with the company you are trying to tell the story about. If the company has been in operation for a while, you can start with its history, trying to get measures of past growth, profitability, and business direction. While you may not be bound by that history in constructing your narrative for the company’s future, you still have to be aware of the past.
With young companies, there will be less to learn from examining the past. Poring over the financial statements for a young start-up will usually yield the unsurprising conclusion that it did not generate much (if any) in revenue in the most recent periods and it reported losses while doing so. With these companies, you may learn more as an investor by looking at the founders/owners running the businesses and their histories and other more established companies in the same business.
The Market
The second step is looking at the larger market in which the company is operating or plans to operate. Table 6.1 contains a checklist of some of the questions for which you are trying to find answers.
Table 6.1
Market Analysis
| Category |
Questions |
Comments |
| Growth |
How quickly is the overall market growing? |
In addition to looking at the average growth rate over time, you also want to detect shifts in the market across product lines and geographies. |
| |
Are some parts of the market growing faster than others? |
| Profitability |
How profitable is this business, in the aggregate? |
Look at profit margins (gross, operating, and net) and accounting return trends over time. |
| |
Are there any trends over time in the profitability? |
| Investing for growth |
What assets do companies in this business have to invest in, to grow? |
With manufacturing companies, investment is generally in plant, equipment, and assembly lines, but with technology and pharmaceutical companies, the investment may take the form of R&D. |
| |
How much investment are companies making collectively in this business to generate their growth? How easy is it to scale up? |
| Risk |
How much do revenues and earnings vary across time? |
Volatility in your revenues/earnings can be caused by macroeconomic variables, which can include interest rate, inflation, commodity price, and political risk, or from company-specific variables. |
| |
What are the forces that cause these operating numbers to change? |
| |
How much debt (or fixed commitments) do companies in this business tend to carry? |
| |
What are the risks that companies in this business may fail? What is the trigger (debt payments due or running out of cash) that cause failure? |
With established companies in mature businesses, this analysis is relatively simple, since the market characteristics are observable (market growth, profitability, trend lines) and often forecastable. Your job gets more difficult if you have companies in evolving or changing businesses, with that change coming from a maturing of the business, a shift in consumer behavior (as is the case with the entertainment content business as consumers shift to streaming), changes in regulatory rules/restrictions (for example, the telecommunication business after deregulation), or geographic shifts. In these cases, you will not only have to make a judgment about the current state of the business but also how you see it evolving over time.
Perhaps the most challenging scenario is when you are trying to build a narrative for a young company in an evolving and shifting business. Thus, in valuing Twitter in 2013, I had to make a judgment about whether Twitter’s business would remain online advertising (its primary source of revenues in 2013) or whether it could leverage its user base to expand into retail or even convert to a subscription-driven model. As an investor looking at Twitter, you may be tempted to ask Twitter’s owners and managers for the answers, but recognize that they are as uncertain as you are and often more biased.
Some businesses are easier to assess and understand than others. In general, you will have an easier time assessing and understanding settled businesses than transitional ones and businesses represented by mostly publicly traded firms than businesses dominated by small, private companies. That said, the payoff to assessing and understanding businesses is greater when they are more difficult to assess than when they are simple to analyze.
The Competition
The final piece of this pre-work is to assess your competition, current and potential. Building on the dimensions of growth, profitability, investment, and risk that you estimated for the entire sector or business, you now look at variations on those dimensions across companies within the market. Table 6.2 contains questions that may better help you understand this process.
Table 6.2
Competitive Analysis
| Category |
Questions |
Comments |
| Growth |
Are there big differences in growth across companies within the business? |
If companies in the business are growing at different rates, you are trying to assess whether it is related to size, geography, or market segment. |
| |
If there are big differences, what are the determinants of these differences? |
| Profitability |
Are there big differences in profitability across companies within the business? |
If there are big differences in profit margins across companies, you are looking to see what types of companies earn the most and which ones the least. |
| |
If there are big differences, what are the determinants of these differences? |
| Investing for growth |
Is there a standardized investment model that is used by all companies in the market? |
As companies grow in this business, you are checking to see whether their investing needs decrease (economies of scale and networking benefits) or increase (with more competition). |
| |
If not, are there differences in profitability and growth across companies with different models? |
| Risk |
Are there big differences in risk (earnings variability and survival) across companies within the business? |
You are interested in whether there are variations in risk (operating and survival) across companies, and if so, what causes those variations. |
| |
If there are big differences, what are the determinants of these differences? |
After you have assessed the companies in the businesses, you will have to examine how your company fits into the competitive landscape and what you see as your pathway to profits. In making these judgments, it is easy to assume that while the rest of the world stays still, your company will move quickly from opportunity to opportunity, blazing new trails and generating profits, but that assumption is usually unrealistic. When you see large market opportunities, rest assured that much of the rest of the world does as well, and when you move decisively to take advantage of them, be ready for others to be making the same moves. You can learn from game theory, the branch of economics that looks at multiplayer games and tries to forecast how these games will play out, as a function of not just your moves but also those of the other players. You may not always be the best capitalized, cleverest, or quickest player in the game, and if you are not, it is good (though hard) to be honest in your assessment.
CASE STUDY 6.1: THE AUTO BUSINESS, OCTOBER 2015
In the chapters to come, I will value two automobile companies: Ferrari, in the next four chapters, to illustrate the sequence from narrative to value; and mention Volkswagen, in passing, to examine how a scandal may (or may not) upend a narrative. For both companies, I will be drawing on the auto business as it exists today and make assumptions about changes that are coming.
The auto business has a long history, tracing back to the early part of the twentieth century. Its growth provided the base for the building of industrial economies, and there was a time when as auto companies performed, so did the nation’s economy. Those glory days are now in the past, and the auto business today bears the characteristics of a bad business in which companies collectively earn less than their cost of capital and most companies destroy value. If that sounds like a brash overgeneralization, it is a view shared by Sergio Marchionne, CEO of Fiat Chrysler, one of the largest auto companies. Marchionne is not afraid to talk the language of investors and is open about the problems confronting not only his company but also the entire automobile business. While he has been arguing that case for a while, sometimes in public and sometimes with other auto company executives, he crystallized his arguments in a presentation titled “Confessions of a Capital Junkie” that he made in an analyst conference call.1 In this presentation he argues that the auto business has earned less than its cost of capital for much of the last decade and that without significant structural changes, it will continue to underperform.
So, what is it that makes the auto business so bad, at least collectively? Looking at the business broadly, here are three characteristics that underpin the business:
1. It is a low-growth business: The auto business is a cyclical one, with ups and downs that reflect economic cycles, but even allowing for its cyclic nature, the business is a mature one. That is reflected in the growth rate in revenues at auto companies in table 6.3.
Table 6.3
Revenues and Growth at Auto Companies, 2005–2014
| Year |
Total revenues |
Percent growth rate (%) |
| 2005 |
$1,274,716.60 |
11.54 |
| 2006 |
$1,421,804.20 |
30.44 |
| 2007 |
$1,854,576.40 |
−1.94 |
| 2008 |
$1,818,533.00 |
−13.51 |
| 2009 |
$1,572,890.10 |
15.47 |
| 2010 |
$1,816,269.40 |
8.06 |
| 2011 |
$1,962,630.40 |
7.54 |
| 2012 |
$2,110,572.20 |
2.28 |
| 2013 |
$2,158,603.00 |
−3.36 |
| 2014 |
$2,086,124.80 |
5.63 |
| Compounded growth: 2005–2014 |
Source: S&P Capital IQ.
During this period, the emerging market economies in Asia and Latin America provided a significant boost to sales, but even with that boost, the compounded annual growth rate in aggregate revenues at auto companies between 2005 and 2014 was only 5.63 percent.
2. It has poor profit margins: A key point that Marchionne made about the auto business is that operating margins of companies in this business were much too slim, given their cost structures. To illustrate this point, and to set up my valuation of Ferrari, I computed the pretax operating margins of all auto companies listed globally with market capitalizations exceeding $1 billion (see figure 6.1).
Figure 6.1
Operating margin for auto companies, October 2015.
Source: S&P Capital IQ.
Not only do more than a quarter of all automobile firms lose money, the median pretax operating margin is 4.46 percent.
3. It has high reinvestment needs: The auto business has always required significant plant and equipment investments, but in recent years the growth of auto-related technology has also pushed up R&D spending at auto companies. One measure of the drag this puts on cash flows is to look at net capital expenditures (capital expenditures in excess of depreciation) and R&D as a percent of sales for the entire sector (see figure 6.2).
Figure 6.2
Reinvestment as percent of sales for auto companies, 2005–2014.
Source: S&P Capital IQ.
In 2014, auto companies collectively reinvested almost 5 percent of their revenues back into their businesses, with R&D comprising the bulk of that reinvestment.
It is this combination of anemic revenue growth, slim margins, and increasing reinvestment that causes this business to deliver returns that are lower than its cost of capital, as is evidenced in table 6.4.
Table 6.4
Return on Invested Capital (ROIC) and Cost of Capital: Auto Companies
| |
ROIC |
Cost of capital |
ROIC – cost of capital |
| 2004 |
6.82% |
7.93% |
−1.11% |
| 2005 |
10.47% |
7.02% |
3.45% |
| 2006 |
4.60% |
7.97% |
−3.37% |
| 2007 |
7.62% |
8.50% |
−0.88% |
| 2008 |
3.48% |
8.03% |
−4.55% |
| 2009 |
−4.97% |
8.58% |
−13.55% |
| 2010 |
5.16% |
8.03% |
−2.87% |
| 2011 |
7.55% |
8.15% |
−0.60% |
| 2012 |
7.80% |
8.55% |
−0.75% |
| 2013 |
7.83% |
8.47% |
−0.64% |
| 2014 |
6.47% |
7.53% |
−1.06% |
In nine of the ten years between 2004 and 2014, auto companies have collectively earned returns on their invested capital that are less than their costs of capital.
Defenders of the status quo will undoubtedly argue that this poor performance is in the overall sample and that subsets of companies are performing better. To address this argument, I looked across auto companies in terms of market capitalization, geography, and market focus (luxury versus mass market); here is what I found:
1. Small versus large: When the auto companies are classified by market capitalization into five classes (see table 6.5), the largest auto companies have, on average, delivered higher margins than smaller companies, but the returns on capital are underwhelming across the board.
Table 6.5
Auto Company Profitability by Market Capitalization, October 2015
| Size class |
Number of firms |
Operating margin |
Net margin |
Pretax ROIC |
| Largest (>$10 billion) |
31 |
6.31% |
5.23% |
6.63% |
| 2 |
16 |
5.24% |
5.57% |
10.72% |
| 3 |
14 |
2.43% |
3.19% |
3.40% |
| 4 |
20 |
1.51% |
−0.40% |
2.02% |
| Smallest (<$1 billion) |
26 |
2.46% |
2.56 |
2.74% |
2. Developed versus emerging: Since much of the growth in auto sales has come from emerging markets in the last decade, there is the possibility that emerging market auto companies perform better than developed market auto companies. In table 6.6 I compare the two groups on profitability.
Table 6.6
Developed Versus Emerging Market Auto Companies, October 2015
| Classification |
Number of firms |
Operating margin |
Net margin |
Pretax ROIC |
| Emerging auto |
73 |
5.01% |
6.13% |
7.54% |
| Developed auto |
34 |
6.45% |
4.91% |
6.52% |
Again, the results are underwhelming. Emerging market auto companies are less profitable than developed market auto companies on an operating margin basis and score only a little better than developed market companies on net margin and return on invested capital.
3. Mass market versus luxury: The super–luxury car manufacturers (Ferrari, Aston Martin, Lamborghini, Bugatti, etc.), with huge price tags on their offerings, cater to the superrich and have seen sales grow faster than the rest of the auto industry and have been much more profitable. Much of the additional growth is coming from the newly minted rich in emerging markets in general and in China in particular.
In my valuation of Ferrari, I will draw on these general findings about the auto business in crafting a narrative for the company.
CASE STUDY 6.2: THE RIDE-SHARING LANDSCAPE, JUNE 2014
I became interested in Uber after reading a news story in June 2014 that indicated that Uber had been valued at $17 billion in a venture capital round. I posted my first valuation of Uber in June 2014, viewing it as an urban car service company with local (but not global) networking benefits. At the time my initial task was to assess the size and makeup of that market. One significant problem I ran into is that, at least in mid-2014, the car service market was localized, with different rules and structures in different cities and little in terms of organized information, making it a much more difficult business to assess than the auto business.
1. Market size: I started with an attempt at estimating the size of the total market by looking at the largest taxi market cities in the world (Tokyo, London, New York, and a few other large cities) and checking out both trade group sites and regulatory estimates of market sizes. Thus, for New York, I was able to get a measure of the total revenues in 2013 from yellow cabs and licensed car service companies from the New York City Taxi & Limousine Commission. Unfortunately, that information was not available for many emerging market cities, and my initial estimate of the urban car service market of $100 billion is partially based on guesstimates.
2. Market growth: The records also indicate that the growth in the market is low, about 2 percent in developed markets and perhaps 4–5 percent in emerging markets. That information again comes from markets where regulatory authorities keep tabs on and report cab revenues.
3. Profitability: The private cab companies that make up this market are generally reluctant to open up their books, but I used two numbers to back into the conclusion that this was a relatively profitable market, at least prior to the arrival of the ride-sharing businesses. The first comes from looking at the handful of publicly traded cab companies across the world and the pretax operating profit margins they report, generally 15–20 percent. The second is a judgment based on looking at the market prices of the rights to operate a cab, which is public information in some cities. In New York, for instance, a yellow cab medallion in December 2013 was trading at about $1.2 million, yielding an imputed profit of about $100,000–$120,000 per year.
4. Investment: The conventional way in which this business has been run is for an investor to pay for and win the rights to operate a medallion (an upfront investment), which is followed by buying a cab and, if the investor does not plan to drive the cab, hiring a driver (paying either a fixed salary or sharing a portion of the cab receipts). The investments are therefore in the cab medallion primarily, and in the automobile secondarily, and to grow, you have to invest in both.
5. Risk: The regulatory constraints on entry into the car service business had resulted in generally stable earnings and cash flows, though the state of the local economy can still exercise its effects on cab revenues. In 2002, when the New York city economy was in the doldrums, taxi receipts also dropped off, and more generally, the cab service business in the city has reflected the health of the financial service business over this period. The only reason that some cab companies were more exposed to this risk than others was because they had borrowed more money or leased their cars, and these fixed payments had to be made out of reduced revenues.
The car service business in June 2014, with its regulation and splintered competition, also meant that the big differences across competitors were created by regulatory restrictions rather than company characteristics.
The Story
Once you understand the structure of the market in which your business operates, you are ready to take the first step in valuation and construct a narrative about your company. Since it is an iterative process, my advice, if you are uncertain, is to start with a story and then revisit it as you run into roadblocks or contradictory data. Along the way, you will have to make choices, since your story can be big and soaring or narrow and focused, it can stay with the status quo or be built on challenging the established ways of doing business (disruption), it can be about a business that you expect to continue in the long term (going concern) or it can be for a finite period, and it can cover the spectrum of growth (from high growth to decline). Obviously the story you tell has to match the company, and I will look at ways to test for mismatches in the next chapter.
Big Versus Small
In a big story, you describe a business with an expansive vision that plans to be in many businesses and/or many geographic regions, whereas in a small one, your vision of the company is restricted to a specific business and/or a specific geographic area. No contest, you say? It is true that big stories create more excitement among employees and investors and may allow you to get a higher price attached to your business, especially early in the process. But big stories also create two costs. The first is that you will be drawn to be in many businesses at a time when you cannot afford to lose your focus, and that can have devastating effects on your company. The second is that you push expectations up, and if you fail to meet them, you will be punished.
I am jumping the gun here, but this contrast is one that I saw playing out in September 2015, with Uber and Lyft, two ride-sharing companies. While my initial valuation of Uber in June 2014 valued it as an urban car service company, its words and actions in the year following led me to rethink my narrative and treat it as a global, logistics company instead, thus expanding its potential market. In the same periods, Lyft narrowed its focus, first in its business (by asserting that it would limit itself to ride sharing) and then in its geographic focus (by deciding to grow just in the United States). I will revisit these companies in chapter 14 to see the effect these contrasting narratives have on their valuations.
Establishment Versus Disruption
If you are describing a company that follows established business models, that is, the status quo, in how it operates, your story is a simple one. You will still have to find a business dimension, such as having a lower cost structure or being able to charge a price premium, where you can differentiate yourself from the competition. In contrast, a company that plans to challenge established business practices is following a disruption model. Again, which one you pick will depend on the company you are valuing and the business you are targeting.
If a company already makes up a significant part of the status quo, it is very difficult to credibly make a disruption story about the company. This, for instance, would be why a story of Tesla as a disruptive company is easier to make than one about Volkswagen upending the status quo. In fact, if you follow Clayton Christensen’s adage that disruption generally comes from companies that have little to lose, you can more easily tell disruptive stories about companies early in the life cycle.
There is another part of the argument that also needs to stand up to scrutiny. It is very difficult to disrupt businesses that are being run efficiently. Not only will these established companies be better positioned to push back against disruption, but customers will be less likely to shift. If a business is badly run, insofar as the players in the business make little or no money while delivering products and services that leave their customers dissatisfied, you have the perfect storm for disruption. Thus, your case for disruption becomes much stronger with Uber, where the traditional cab business is an overregulated, underperforming mess and no one (cabdrivers, customers, regulators) is happy.
Going Concern Versus Finite Life
One of the advantages of telling stories about publicly traded companies is that you can keep them going in perpetuity, legal entities with infinite lives. While that is often the path you will choose when valuing publicly traded companies, there are times when an alternate vision may work better. If you are valuing a privately owned legal or a medical practice or a publicly traded royalty trust (where you get a share of a natural resource reserve until it is exhausted), your story should have a finite life span, and when that span is over you tie up loose ends (liquidate your assets) and end the story.
There are some who would argue that all stories about natural resource companies (oil, mining) should always be finite life stories, since these natural resource reserves will be exhausted at some point in time. Thus, if the story that you are telling about ExxonMobil is that it is an oil company, you may decide that a finite life span better fits the story. In contrast, if your story about ExxonMobil describes it as an energy company, where once the oil gets exhausted ExxonMobil will move into whatever the next energy source may be, the constraint may be lifted and you can treat it as a going concern.
The Growth Spectrum
The final choice you will face is where to put your company on the growth spectrum. With a start-up in a big market, the sky can be the limit in terms of growth, but with a declining company in a shrinking business, your narrative may very well require you to make the company smaller over time. Using just some of the companies that I will be analyzing in the next few chapters, a high-growth story clearly works for Uber or Tesla but not for Volkswagen. For companies like Amazon, this may be the most debated component of the narrative, with those who feel Amazon’s already large size will make high growth elusive attaching a lower value to the company, and those who believe Amazon will find new markets and businesses convinced it will be able to maintain its double-digit revenue growth. With JCPenney, a company that I will value in chapter 14, the question is not how high the growth will be but how much shrinkage the company will see as its base business continues to deteriorate.
CASE STUDY 6.3: THE UBER NARRATIVE, JUNE 2014
In June 2014, when I first tried to value Uber, I did not have much experience with the company’s products and its practices. In my research on how the company operates, I quickly came to the conclusion that Uber was not in the taxi business, at least in the conventional sense, since it owned no cabs and had no cabdrivers as employees. Instead, it played the role of matchmaker, matching a driver/car with a customer looking for a ride and taking a slice of the fare for providing the service. Its value, to its riders, comes from its screening of the drivers/cars (to ensure both safety and comfort), its pricing/payment system (customers choose the level of service and are quoted a fare), and its convenience (you can track the car that is coming to pick you up on your phone screen).
Figure 6.3 captures the steps in the Uber business model as I saw it in mid-2014, with comments on what it is that Uber offers at each stage and whether that offering is unique.
Figure 6.3
The Uber business model, June 2014.
Uber had been able to grow at exponential rates since its founding in 2009, with its CEO, Travis Kalanick, claiming that it was doubling its size every six months.
To get to a story for Uber, I went through a sequence of key parts of the narrative, and here were the judgments that I made on each one, at least in June 2014:
1. The business: Uber is and will remain an urban car service company. While it can expand into suburbia and into other businesses, the demand will be muted and it will not be cost-efficient for Uber to expand.
2. Market growth: Uber (and other ride-sharing services) will draw new customers into the urban car service markets, some from mass transit and some from private cars. That will push up growth in the urban car service market.
3. Networking benefits: Uber’s networking benefits will be local, that is, if Uber becomes the largest player in a particular city, it will find it easier to get even bigger in that city. However, that success will not benefit it in a different city, where a competing ride-sharing company may be the biggest player and enjoy local networking benefits of its own.
4. Competitive advantages: The decision to split the taxi receipts, 80 percent for the driver and 20 percent for the ride-sharing company, is arbitrary, but it is accepted as the standard, at least in the United States. Uber’s competitive position is strong enough that it will be able to maintain this sharing agreement and hence its pricing power.
5. Business model: Uber has a low–capital intensity model in which it does not own the cars that its service uses and has minimal infrastructure investment in the cities into which it expands. That model is assumed to be sustainable and Uber will continue with it.
6. Risk: Uber is a young company, losing money and in constant need of new capital. Its success in delivering growth and access to a healthy private capital market will keep the probability that the company will run out of money low, but it is still a business with substantial operating risk.
Could this story be wrong? Of course, but that is the nature of investing and business. In the next chapter I will start building the numbers that are consistent with the story.
CASE STUDY 6.4: THE FERRARI NARRATIVE, OCTOBER 2015 (AHEAD OF ITS INITIAL PUBLIC OFFERING)
The Ferrari story started with Enzo Ferrari, a racing car enthusiast who established a business in 1929 to assist and sponsor race car drivers driving Alfa Romeos. While Enzo manufactured his first racing car (the Tipo 815) in 1940, Ferrari as a car-making company was founded in 1947, with its manufacturing facilities in Maranello in Italy. For much of its early existence, it was privately owned by the Ferrari family, though it is said that Enzo viewed it primarily as a racing car company that happened to sell cars to the public. In the mid-1960s, in financial trouble, Enzo Ferrari sold a 50 percent stake in the company to Fiat. That holding was subsequently increased to 90 percent in 1988 (with the Ferrari family retaining the remaining 10 percent). Since then, the company has been a small, albeit very profitable, piece of Fiat (and Fiat Chrysler).
To illustrate how exclusive the Ferrari club is, in all of 2014, the company sold only 7,255 cars, a number that had barely budged over the previous five years. The company has its roots in Italy but is dependent on a superrich clientele globally for its sales, as evidenced in figure 6.4, where I graph out Ferrari’s sales by region in 2014.
Figure 6.4
Ferrari revenue breakdown.
Note that a significant slice of the revenue pie came from the Middle East, and that Ferrari, like many other global companies, became increasingly dependent on China for growth. As a by-product of this exclusivity and the pricing power bestowed by it, Ferrari also reported an operating margin of 18.20 percent in the twelve months leading into the IPO, more than triple the global auto industry average. Finally, the company had weathered the market crises of the prior decade remarkably well, with little damage to its sales, pricing power, and profit margins.
Building on this data, my story for Ferrari at the time of its IPO in 2015 was that it would remain an extra-exclusive automobile company, keeping production low and prices high. The benefits of this strategy are high operating margins, partly because of the high prices and partly because the company did not have to spend much on expensive ad campaigns or selling. It also will keep reinvestment needs to a minimum, since capacity expansion will not be necessary, though the company will continue spending on R&D to preserve its edge (on speed and styling). In addition, by focusing on a very small group of superrich people around the world, Ferrari may be less affected by macroeconomic forces than other luxury auto companies. In the next two chapters, I will convert this story into valuation inputs and value for the company.
CASE STUDY 6.5: AMAZON, THE FIELD OF DREAMS MODEL, OCTOBER 2014
Amazon is a truly extraordinary success story. Starting as an online bookstore in the 1990s, the company became the poster child for the dot-com boom in the last part of that decade and then, more impressively, survived the dot-com bust. In January 2000, close to the peak of the boom, I valued Amazon, on the assumption that it would grow its revenues fortyfold over the following decade and convert its operating losses to profits.2 In the years thereafter, the company more than delivered on the revenue growth but fell well short of my profit targets (set in 2000), as evidenced in table 6.7.
Table 6.7
Amazon Revenues and Profits: Forecasts Versus Actuals
| Year |
Revenues ($ millions) |
Operating income ($ millions) |
Operating margin |
| My forecast, 2000 |
Actual |
My forecast, 2000 |
Actual |
My forecast, 2000 |
Actual |
| 2000 |
$2,793 |
$2,762 |
−$373 |
−$664 |
−13.35% |
−24.04% |
| 2001 |
$5,585 |
$3,122 |
−$94 |
−$231 |
−1.68% |
−7.40% |
| 2002 |
$9,774 |
$3,392 |
+$407 |
−$106 |
4.16% |
2.70% |
| 2003 |
$14,661 |
$5,264 |
+$1,038 |
−$271 |
7.08% |
5.15% |
| 2004 |
$19,059 |
$6,921 |
+$1,628 |
−$440 |
8.54% |
6.36% |
| 2005 |
$23,862 |
$8,490 |
+$2,212 |
−$432 |
9.27% |
5.09% |
| 2006 |
$28,729 |
$10,711 |
+$2,768 |
−$389 |
9.63% |
3.63% |
| 2007 |
$33,211 |
$14,835 |
+$3,261 |
−$655 |
9.82% |
4.42% |
| 2008 |
$36,798 |
$19,166 |
+$3,646 |
−$842 |
9.91% |
4.39% |
| 2009 |
$39,006 |
$24,509 |
+$3,883 |
−$1,129 |
9.95% |
4.61% |
| 2010 |
$41,346 |
$34,204 |
+$4,135 |
−$1,406 |
10.00% |
4.11% |
| 2011 |
$43,827 |
$48,077 |
+$4,383 |
−$862 |
10.00% |
1.79% |
| 2012 |
$46,457 |
$61,093 |
+$4,646 |
−$676 |
10.00% |
1.11% |
| 2013 |
$49,244 |
$74,452 |
+$4,925 |
−$745 |
10.00% |
1.00% |
| 2014 (last 12 months) |
$51,460 |
$85,247 |
+$5,146 |
−$97 |
10.00% |
0.11% |
Note, though, that the absence of profits was not the result of miscalculation or bad circumstances but the consequence of a strategy Amazon had followed of going for higher revenues at the expense of profits. To accomplish this, Amazon had consistently offered new products and services (Amazon Prime, Kindle, Fire) at below cost to attract and keep customers.
In October 2014 my story for Amazon is that it is pursuing a Field of Dreams story line, promising investors that if the company builds it (revenues), they (profits) will come. In my narrative, I argue that Amazon will continue on its path of delivering high revenue growth by continuing to sell products or offer services at or below cost for the near future and will eventually start to use its market power to deliver profits, but its market power will be checked by the entry of new players into the retail business.
CASE STUDY 6.6: ALIBABA, THE CHINA STORY, SEPTEMBER 2014
To understand Alibaba, you should visit their flagship site, Taobao, a chaotic and colorful hub where both individuals and businesses can offer their goods, used or new, for sale, at fixed or negotiable prices. Though modeled on eBay, Taobao is different on two counts. The first is that it is far more tilted toward small and midsized retailers offering new products for sale than to individuals selling used items. The second is that Alibaba, unlike eBay, does not charge a transaction fee but instead makes its revenues primarily from advertising.
In 2010 Alibaba opened a new front in its business with Tmall, a site for a selective list of larger retailers, playing an expanded role in the process for a larger slice of the transaction pie. On this site, retailers pay a deposit to Alibaba to reimburse buyers who receive counterfeit goods, a technical service fee to cover the fixed costs of maintaining the store, and a sales commission determined by transactions value. Alibaba also developed Alipay, a third-party online payment platform akin to PayPal that has grown in the last few years to dominate the Chinese online payment market. As we value Alibaba for its IPO, though, it should be noted that investors will not be getting a share of Alipay, because it has been separated from the company and will be operated as an independent entity.
Alibaba has been phenomenally successful both in terms of helping online retailing find its legs in China and becoming extremely profitable while doing so. In 2013 the company generated almost $4 billion in operating profit on revenues of approximately $8 billion and its rapid evolution from small start-up to profitable behemoth are traced in figure 6.5.
Figure 6.5
Alibaba—the rocket takes off!
There are four ingredients that I see as key to Alibaba’s successful climb to the top of the Chinese online retail business.
1. Enter a growth market early and mold it to your strengths: In 1999, when Alibaba was founded, online retailing in China was in its infancy. While the largest U.S. online players (Amazon, eBay, etc.) either ignored or mishandled the market, Alibaba not only adapted to Chinese conditions but played a key role in the evolution and growth of the Chinese e-commerce market, as China has become the second-largest online market in the world. One key difference between the Chinese e-tailing market and U.S. online retail is that the former has historically been much more dependent on online marketplaces (as opposed to retailer-based online sites), largely because of Alibaba’s influence.
2. Differentiate and dominate: The story of how Alibaba beat eBay and Amazon is grist for strategic storytellers, but at its core, there are three reasons why Alibaba won (and eBay lost). The first is economic. By charging no transactions fees initially and depending entirely on modest advertising charges, Alibaba made itself a bargain to retailers, relative to competitors. The second is that Alibaba molded its offerings to Chinese culture and consumer behavior. The Economist’s characterization of Taobao as an online bazaar is apt, since the site is set up for online haggling between buyers and sellers. Third, the site is also attuned to the fact that the Chinese retail market is splintered, with thousands of small and midsized retailers who lack visibility, credibility, and payment-processing skills online, and Taobao offers all of those. The visibility comes from the traffic on the site; the credibility from Alibaba’s system of independent verification, paid for by sellers; and payment processing from Alipay. In 2013 about 75 percent of all online retail business in China was routed through one of Alibaba’s sites.
3. Don’t be greedy: While most online retail transactions in China go through Alibaba sites, the slice that Alibaba keeps for itself is very small. For Taobao in particular, revenues are just advertising charges paid by retailers to list on the site, a very small portion of the total transaction value. In Tmall, Alibaba does get a larger slice of the transaction revenues, because it charges a transaction fee, but it is still only 0.5 percent to 1.5 percent of revenues. While this small share may seem like a negative, it has proved to be one of Alibaba’s competitive advantages, since it has made it difficult for competitors to undercut Alibaba and offer better deals to customers and retailers.
4. Avoid pretense: Alibaba seems to generate these revenues with little effort (and marketing costs), and since the company does not aspire to be a technological innovator, its R&D and development costs are negligible. These factors result in the company’s most impressive statistic: in 2013 it had a pretax operating margin of almost 50 percent and a net profit margin of close to 40 percent, high by any standards.
In my story line for Alibaba at the time of their IPO in 2014, I see them continuing on the same path, with a dominant market share of the Chinese market and high profit margins. At the same time, I see their strengths in the Chinese market as potential weaknesses if they try to move into other markets, and consequently will value them as a Chinese online retail giant rather than as a global player. In chapter 7 I will consider Alibaba as a global player in an alternative narrative.
Conclusion
A good business story is simple, credible, and persuasive. Telling one, though, requires that you understand both the business and the market in which it operates. That requires not only collecting data about both but using the tools developed in chapter 5 to convert that data into information. The key to this process, though, is realizing that the data will not tell the story. You are the storyteller, and that means you have to be willing to make judgments, which though based on data and information, are still judgments. You can and will be wrong, but that is not a reflection of your weaknesses but a consequence of uncertainty.
If you are listening to stories told by those who seek your approval or your money, you have to replicate what storytellers do in terms of homework (understanding the business, market, and competition) and use that knowledge to find the weakest links. Ultimately, if you decide to invest in a business based upon a story, you have to make it your story, thus erasing the line between storytellers and listeners.
