Some distributors I looked at a while back were the tobacco leaf merchants. Not much has happened with either business in the past several months besides some depressed results due to lower volume in an oversupplied market. Universal is cheap on straightforward measures like P/E and P/B, while Alliance is cheap because Baupost owns it and the share price has dropped a lot (that’s sarcasm). I tried to figure out Universal since it looks safer and about 80% of its inventory is committed to customers, so they won't wake up tomorrow with completely obsolete and worthless assets.
At 8x earnings, there is downside risk to profit compression minimizing. I think they still have a role in the tobacco leaf, but things change. The encroachment of cigarette companies on their turf highlights the issue with distributors. A company like Altria (MO) only wants to deal with a few suppliers, so compressing the thousands of relationships with farmers, it becomes one relationship through Universal – this is worth a couple basis points of margin. There are the hidden costs of employees tasked with all the purchasing and financing of small tobacco farmers, as well as tying up capital in the entire process. Some companies want to remain asset light and just focus on the highest return portion of the value chain.
On one hand, Universal deals with thousands of suppliers, but ultimately supplies only several variations of the same product to a few people (several grades of several leaf types, maybe 100 actual SKUs, although management would probably say it's more complicated than that). The issue with this stock is that the future is uncertain. There seems to be an inherent structure of the tobacco leaf industry that creates space for a middleman to exploit, but many cigarette manufacturers are chipping away at it. It has existed for decades, but now there are things like the Internet. Universal probably has a strong position in Mozambique over the next decade, where they deal with thousands of small farmers who they have taught to cultivate tobacco. The cow paths have already been trodden in more developed countries like the U.S. and Brazil, so the barrier to a British American or Japan Tobacco setting up their own operation is a lot lower. They can and they have. This is the ongoing concern. It could certainly stabilize for several years, but I simply don’t comprehend how it gets better.
I’m not interested in the merits of the investment as much as what it reveals about the pitfall of being in such a position as a businessman. My impression is that the business can’t get any better over the long term. The supply and demand imbalance in tobacco inventories will change, but there doesn’t seem to be much growth since overall volume is declining in most markets. One of the justifications I’ve seen for Baupost’s position in Alliance was that a merger in 2005 would create margin expansion (note that I don’t know Baupost’s actual justifications), as there would only be two major tobacco leaf merchants left. That simply hasn’t been what has unfolded. Quite the opposite. The customers are now trying to circumvent the middlemen. A side note is that this is the type of inversion Charlie Munger references. The factual basis for margin expansion is actually the same as that for margin compression, just looked at from the inverse (customer to supplier rather than supplier to customer).
Customers aren’t the only agents interested in cutting out the middleman. Nate, over at Oddball Stocks, posted about ADDvantage Technology Group (AEY) and why it was cheap the other week (side note: also a blog worth adding to your RSS feed if you haven’t already). Like Universal, ADDvantage trades at a low P/E multiple. They are a distributor of cable industry hardware. They recently revisited their relationship with Cisco (CSCO) and got the short end of the stick it would seem. Neither the customers or suppliers are minnows, but ADDvantage is. Both ends of the spectrum probably have their own sales and procurement teams that deal with each other. Cisco was clearly the party with more power in renegotiating their contract with ADDvantage. I think being weak is a losing business proposition in the long term, but who am I to make such bold pronouncements?
ADDvantage's “competitive advantage” is being “on hand, on demand.” I’m no expert, but I think translated into English, they are just some other company’s off-balance-sheet working capital. This is one definition of a distributor at the negative extreme. It doesn’t do much justice to the logistical feats involved or the possible purchasing power a distributor can achieve through economies of scale. Perhaps I’m oversimplifying, but the key distinction between a distributor that might make a good investment and one that won’t is whether or not they are a provider of working capital or a provider of a service. In reality it is a combination of both, but it is safer to focus on those that provide a service.
Geoff Gannon mentioned a very interesting distributor name Bunzl (BNL) in an article a while back. Bunzl distributes a bunch of products like plastic bags to supermarkets. Supermarkets sell food. They are themselves middlemen in a sense, but let’s focus on Bunzl. Bunzl basically thinks of itself as providing a service. They are tasked with all the nonsense that goes along with a supermarket having the proper plastic bags in the produce department and the proper plastic bags at the deli counter. In their materials, Bunzl references the “hidden costs” of purchasing supplies for a business as their business.
Supermarkets don’t want to worry about this. They’d need to hire someone to find these products, make sure they stay in stock, and likely end up with less pricing power vis-a-vis suppliers. Bunzl’s products don’t arrive on the same truck as the Cheerios, nor is it entirely logical for them to do so. Supermarkets or food manufacturers don’t specialize in these products and likely have no interest in doing so. This is as much a function of working capital (which I think is negligible in the grand scheme) as it is the hidden costs of taking on the responsibilities of handling the task and its incongruity with the functions of any other participant in the value chain. There is as much a service being provided as a product by Bunzl, and they basically focus on a high number of SKUs with low values. Owens & Minor (OMI), which I wrote about a long time ago, does a similar thing for hospitals. The medium is the message, whereas for Universal, they are mostly just the medium.
One thing I’ve been spending a lot of time thinking about is competition. Competition is really real. Don’t think any company in your portfolio doesn’t have a target on their back. Andy Grove, friend of the blog and founder of Intel, summed up his business philosophy with “only the paranoid survive.” A company’s existence is not the result of divine providence. It has to fight as much as it has to hope that it doesn’t get taken out of the equation. Think about phone books, which found themselves completely usurped by a superior medium called the Internet (great article on Yellow Media, a Canadian Dex One or Idearc, h/t Can Turtles Fly?).
My point is that being a middleman is a tricky business to pull off over an extended period of time. You have to fight for your right to profit. It helps to have some type of asymmetry in suppliers and customers, creating a space for a middleman to compress the numbers of suppliers an end user has to deal with or the number or vice versa. To the extent that the asymmetric relationship isn’t the primary focus of the business — Bunzl and supermarkets — there is probably a competitive advantage. The dynamics differ slightly due to the economics of the healthcare industry (end user doesn’t always pay and the general mess), but Owens & Minor, a business I mentioned briefly a long time ago, fits the bill as well.
An interesting area where middlemen compress the number of customers a supplier has to deal with is Gamestop (GME) and Netflix (NFLX). Both are at the opposite ends of the problem. One is stuck in the retail era and the other seems to have moved too fast with the digital era. Both allow content producers to develop relationships with a small number of distributors who reach a large number of customers. Gamestop is often spoken of as a value investment, whereas Netflix was anything but, until recently.
I don’t want to delve into the details too much. I think a bunch of people have delved into the details about both companies already. It’s useless. Everyone wants their lunch money and they have little leverage. How could you own these businesses for more than two to three years if you know for a fact that the business environment in five years won’t look anything like it does today (I assume the share price in two to three years will try to reflect what the business will look like in another two to three years). Ownership versus access. I don’t think anyone can “solve” riddles like that in a way that isn’t delusional. They are certainly worth something, but it's hard to know with any accuracy.
There is such a fine line in judging what a business will look like in the future and just engaging in mental masturbation akin to the mere seconds between having gone all in with a bad hand and then getting your bluff called. That’s competition. Nobody is opening up their wallet for the world to pluck dollar bills out. This one of the many ways to interpret a Buffett quote (sure plenty others have said it too): “If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.” I don’t see how people underestimate competition. Gamestop isn’t flatfooted, because they are having a go at the online business. They are not entitled to this though. The brick and mortar position can't be extrapolated into the digital business.
There is going to be an inherent bias in your interpretation of this event:
“If you purchase your copy of Deus Ex: Human Revolution at a retail store, you're supposed to receive a code that allows you to play the game for free using the online gaming service OnLive. It's a neat giveaway, and it certainly gives gamers an incentive to try the service, but a leaked memo seems to show GameStop's fear of digital delivery: employees are allegedly being asked to open every game and remove the coupon.”
Is Gamestop desperate or being a fierce competitor? I don’t have a position either way, but I’m negatively predisposed to middlemen that can be pushed out of business. The used game business is a feedback loop that is about to be interrupted by digital platforms. Gamestop is in no way entitled to this platform and it is even cheaper than a retail presence (Gamestop doesn’t sign long leases, so I wouldn’t worry about them following the traditional path of discarded retailers in getting saddled with a bunch of operating leases, i.e. most retailers that pop up on an NCAV screen). It would be stupid not to think that plenty of businesses have their eye on this future medium of online distribution.
One is that Electronic Arts (EA) is pushing its own digital distribution business quite hard. They are failing due to customer service. Look at all the threads on Reddit about Origin (the name of the platform) — resoundingly negative, but it has somehow found some traction. Now a game producer like EA would love nothing more than to just have direct access to their customers. They can sell expansion packs and tons of other add-ons direct to consumers. By owning the middleman/distribution medium (web portal), they get a larger slice of the profits, a potential increase profits, and only have to invest a small relative amount in an online presence versus brick and mortar — the relative scalability is immense. This could lead to a pretty high ROIC if they decide to exercise a monopoly on the digital distribution of their own games. Even though the feedback is awful, EA is in a great position to give preference to its in house distribution platform over Gamestop’s. The same applies for other online game stores like Steam (privately held).
Netflix is a middleman that just lights a fire under me. I’m very extreme in my moderation over this business. I’m quite adamant that it’s a complete and utter crapshoot to even accurately figure out what this business is worth in a year (accuracy versus precision is one of those simple concepts that people need to think about when investing, myself included). We know Netflix underpaid for inputs (content) in the past, so the profit margin they achieved is clearly unsustainable. Starz thought it was found money when they first signed a Netflix contract a few years back. Nobody is making that mistake anymore. Even if this is an implicit acceptance that Netflix is here to stay, it is also implicit that studios intend to fully exercise their leverage.
Netflix is a classic middleman. They bridge the gap between content creators and content consumers. What is appealing in a very shallow sense is that Netflix’s overhead is comparatively lower than a cable company’s. This was a similar advantage to satellite TV relative to literal cable companies, although satellites require more upfront capital. Netflix — or anyone for that matter (my point) – can design a nice website, a little algorithm to predict what movies you like, rent server space from a cloud provider, and pipe content through a “platform.” Amazon — if they do it correctly — is well positioned with in house capacity to accomplish all of that. And they have your credit card information and a willingness to destroy their own existing markets to create new ones. I wouldn't want to own Amazon, but I wouldn't want to be in their way.
Netflix is on the verge of reporting a net loss in coming quarters. They say they are investing in the future. This is silliness. The content producers just put them in their place. I wrote about how I think quality content will always find an outlet regardless of the medium the other week. As Netflix has to raise its prices to cover its content costs, that lowers the barrier to entry. It’s much easier to undercut a $20/month plan than it is an $8/month one. A company like Starz is not interested in devaluing its content with an $8/month random access offering, but the more premium the pricing gets the more premium content will make itself available through an online platform. High pricing also makes it harder to compete with more entrenched cable companies, as the product becomes a substitution and not a separate good.
At the Liberty Media Annual Shareholders Meeting (decent listen overall, Malone is a sharp guy – no Buffett, but he is more intelligent than your average CEO), John Malone had this to say (an individual I discussed this topic with pointed me in the direction of this quote):
"The sequential distribution of movies has to go through various organisms in order to optimize value. Taking [your content] and dumping it in at wholesale on random-access basis [Netflix] really undermines long-term perceived value. As a content investor or owner, that's the biggest problem we have with the Netflix approach."
We know that Netflix will pay a full price for its content, but Netflix does not exist by divine providence and nobody is clamoring to put their content on their site. They have to compete with more than just other online viewing platforms. It is still a very nascent business. As Malone states, content producers want as much competition as possible for their content, but they aren’t interested in giving it away to anyone. When Universal or Alliance were possibly trying to expand their margins due to fewer middlemen, the cigarette companies went out in the field and procured their own leaf needs in areas where the merchants had established a presence. Netflix is not entitled to anything. Their profits are tolerable up to the point where someone else with power in the equation decides that they want a bigger piece of the action. Netflix isn't the only game in town, and it isn't a game anyone has to play unless they are comfortable doing so. The only "power" Netflix has is its hope that spending a lot of money will result in them making a lot of money. The only leverage they have to offer is money.
Perhaps this post is a ramble and/or could be broken down into several posts - a stink piece rather than a think piece. Middlemen are fascinating. There are plenty of high return middlemen that have been fantastic investments – Fastenal, Autozone, TJMaxx, W.W. Grainger, Henry Schein and tons of others that require a flexible definition. I doubt my ability to identify the good ones before everyone else does, but talking about bad ones is a nice way to learn some lessons that would otherwise be taught through losses. It’s also very important to note the effects of competition over time and where things have gone wrong.
I could of course be terribly misinformed about this all, so I'd be interested in any thoughts, comments, or examples you have to share.