Business Models, Great And Poor

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Includes: DAL, GM, KO, LUV, V
by: Income Surfer

Summary

Coca-Cola and Visa have been able to maintain high margins year after year.

Airlines and auto manufacturers operate in expensive, capital-intensive and highly cyclical industries.

Avoiding failure and bankruptcy among your long term investments is important to good results.

Several different aspects factor into the success of failure of a particularly investment. These factors include (in no particular order) the price paid, the brand strength, any durable competitive advantages, profit margin and the company's management. Several of these factors fall under the category I would call business model, and it's critically important to how I invest. A given company's business model plays a huge role in my decision whether or not to invest in that particular company. The companies in our group of long-term holdings are in varying industries, but they have several characteristics in common. Chief among these characteristics is that I expect my long term holdings to grow and prosper under a range of potential economic scenarios. You, me, and (most assuredly) the financial pundits on TV, have little idea what the economic climate will look like 3, 5, or 10 years out. Therefore, we need to have confidence in any companies we decide to own over the long term.

I contend it is the business model these companies employ, that gives us a great hint of how they will perform. Is the company subject to wildly fluctuating input costs? Is the company tied to the price of a commodity that they harvest or mine? Those could be warning signs, and would likely exclude the subject company from my group of long term holdings. For instance, while I own a large integrated oil company and a large global miner currently, I will be looking to sell those positions in the coming years. The reason why? Look no further than the collapse in commodity prices over the last 2 years. I don't think those two companies are going to go bankrupt or anything, but they lack the characteristics I want among my long term holdings. When I decide to own companies that harvest/mine or deal in commodities, I view the position as more of an extended trade.

A company doesn't need to have an amazing business model in order to be a profitable/productive company, but it doesn't hurt. Some businesses just don't lend themselves to scalable global enterprise, and that's ok provided you recognize it for what it is. My business partner and I are in the process of starting a new consulting and management firm, specializing in natural resources in our part of Florida. We don't have dreams that this entity will scale up and go national. It's a lifestyle business that will profitably meet our needs. For the long term holdings in my portfolio however, I want something more. Below I'll take a look at four businesses and discuss the business models of each.

Coca-Cola (NYSE:KO)

Coca-Cola is one of the long term holdings in our portfolio. Over the past century they have shown that the company can grow and profit under a variety of economic conditions. I can be fairly certain the same is also true for the next 20 or 30 years. Why? Well for starters, Coca-Cola's management has been able to maintain fairly high profit margins for many years. Those consistently high margins give management plenty of cash flow to allocate, which gives them flexibility. They can buy other business, reinvest in their own core business, return the money to shareholders, or a handful of other options. Those margins also give the company the ability to decrease the retail price in severe economic downturns, in order to both maintain sales and remain profitable. Coke is exactly the kind of company that can survive the deflation, a depression or a bout of significant inflation.

To figure out why, let's start with Coke's appeal, which starts with the brand itself. People around the world recognize Coca-Cola. That name recognition is very important. I also view the company's flagship soda line as an affordable luxury. No matter how bad a given economy is, I am certain that customers will find the pocket change needed to buy the flavor they know and love. So what if costs go up dramatically, during a time of high inflation? Well, Coke's management does have to manage fluctuations in the input costs of sugar, water, aluminum, and plastic. Profitability can also be impacted by global currency fluctuations, transportation costs, and labor costs. Those high profit margins, however, allow the company to remain profitable even if the input costs rise if they can't pass those costs on to the consumer for whatever reason. Unlike most of my long term stock holdings, Coke's cost structure is one of fairly high fixed costs and fairly small variable costs. Meaning that the production plants and trucks cost a good amount of money, but the incremental increase in cost to produce 1 million gallons of syrup or 10 million gallons of syrup is pretty darn small. In this case, the consistent global demand — again as a result of the Coke brand — is what allows this structure to work so well. Additionally, you'll notice that Coca-Cola requires very little innovation and few capital expenditures in order to stay in business.

Visa (NYSE:V)

Visa has a similar, although lower, cost structure to Coca-Cola. Although commonly misclassified as a financial company, it is primarily a financial services company. Better yet, it's a financial services company that has automated most of the services functions. The company had to shell out some big money upfront for the computing power and servers to process many billions of dollars worth of transactions, but once that happened the costs to scale up (and process more transactions) was very small. As the company has grown its revenue, a larger and larger percentage of that revenue has fallen through to the bottom line. Therefore the company's profit margins have increased as it has grown, and the company's transaction network has become more and more valuable as more nodes (be they merchants or customers) have been added.

I hear some of you saying, "yeah, but a decrease in transaction revenue (like during a recession) will also seriously reduce profits". You are not wrong. In a severe recession or depression, profits will fall substantially, but Visa can afford to remain profitable under such a scenario because of high profit margins. Visa also requires very little innovation and few capital expenditures to stay in business, although it is possible new technologies may eventually force it to lose market share. Visa has two trends which will really help propel it forward, namely:

  1. Many developed economies seem to be moving toward a cashless society.

  2. Most global transactions still take place using cash. This means that credit card processors and financial services companies still have plenty of room for growth internationally.

General Motors (NYSE:GM)

GM is a household name, at least in America. Until the 2008/2009 financial crisis, it was the largest American auto builder. It manufactured and marketed a host of brands, which had been acquired over the past 100 years. Despite its name recognition, I would argue that General Motors doesn't have a good business model. There are a few reasons why no auto manufactures are among my long term holdings. One of the biggest reasons is because this business is very cyclical and has huge capital expenditure and innovation requirements. GM can't just keep building the same cars and trucks, year after year. They need to improve those vehicles every couple years, by making them more fuel efficient or reliable. Introduce new features. If the vehicles don't improve along with their competitor's vehicles, GM will lose market share. These are high hurdles for the company to grow and become more profitable.

General Motors also runs a very capital intensive business. They need to invest billions of dollars in research & development, plants, assembly lines, and distribution networks, just to stay in business. They also have an expensive unionized workforce, although this concern has been reduced somewhat following the bankruptcy a few years ago. Management also has to adjust to fluctuations in input material costs like steel, rubber, and plastic. These materials are all part of a new car, and it's difficult to pass those costs on to consumers every year. I am sure there will be tremendously profitable years and staggering losses other years for GM's investors, but it's just not the kind of company that belongs in our portfolio over the long term.

Delta Air Lines (NYSE:DAL)

The airlines are another group of capital intensive businesses with an expensive unionized workforce. Delta gets to avoid the research & development costs that affect GM, because they operate instead of manufacture airplanes, but they still have huge costs to stay in business. The lowest costs an airline ever has, are on its first day in business. Each day there after, costs go up. Their fleet of airplanes gets older and needs more repairs/downtime. The staff gets more seniority and expects higher pay. Worse yet, it costs almost as much to fly their airplanes empty as it does to fly sold out flights. A cost structure like that provides little flexibility for management.

There are times, like over the last 2 years, where a decline in input costs (in this case, fuel) lead to a dramatic jump in profitability. The airlines were also helped recently by a reduction in competition, as a result of consolidation and bankruptcies, following the last financial crisis. The problem is that airlines operate a commodity business. As soon as they start making a little money because flights are full and costs are down, other airlines add more airplanes in a bid to scale up. Ticket prices then come down as a result of competitors wanting to take market share while filling their flights, and the vicious cycle starts all over again. There are profitable years, but there are also many poor years. As though the managers of airlines needed more cycles to pay attention to, passengers are also a highly cyclical lot. Business and leisure passengers don't fly as often when the economy is in a recession or struggling for whatever reason. The combination of all of these factors keep the airlines out of my portfolio.

I hope you have enjoyed my thoughts on the four business models above. Each industry, and company within that industry, have their own characteristics. Some, like Southwest Airlines (NYSE:LUV), even manage to perform pretty well despite their industries. When I invest for the long term, though, I am looking for companies that are predictable and operate in positive industries. I don't want the companies I invest in to constantly be at risk of failure and loss. Companies like that are too unpredictable and fickle for me. I keep my long term holdings to high margin companies that operate in stable industries and show predictable profits.

Disclosure: Long KO and V. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional.

Disclosure: I am/we are long KO, V.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.