One of Warren Buffett (Trades, Portfolio)'s book recommendations was "Outsiders," by William Thorndike Jr. The book describes the strategies employed by different CEOs that led to outstanding investment returns.
History is generally a good teacher if we take the time to understand it. One of the most interesting stories in the book was Telecommunications Inc. and the then-CEO, John Malone. His methods were out of the box for that time, and he is remembered as a pioneer in capital allocation strategy. TCI's stock returned 30.3% annually from 1973 to 1999.
Malone is known for introducing terms and concepts such as EBITDA to the business jargon.
For Malone, the combination of high growth and predictability of the cable industry was really appealling as it was quantifiable in terms of subscriptions and consumer behavior.
Malone graduated from Yale with a combined degree in economics and electric engineering. He also pursued a master's and Ph.D. in operation research. He agreed to run TCI in 1973 because he was offered a large equity stake, even though it would represent a salary cut of 60%. So what were the strategies that allowed for such explosive growth?
Understand the industry's economics: Malone recognized early that prudent cable operators could shelter their cash flow from taxes by using debt to build new systems and depreciate the costs of construction. These depreciation charges, together with the interest expense on the debt, reduced taxable income. This would become one of the pillars of his capital allocation strategy.
Change the strategy: During his tenure, Malone introduced a new financial and operating discipline. He told his managers that, if they could grow subscribers by 10% per year while maintaining margins, he would ensure they stayed independent. He also introduced frugality in the company, with few executives at corporate, few secretaries and peeling metal desks. The company had a single receptionist. When the executives traveled, they usually stayed together in motels.
Dealing with growth: After the company had grown significantly, by 1977, he replaced the bank's debt with a low-cost one. He was able to maximize the financial leverage and the leverage with suppliers. In an interview in 1982, he said, "The key to future profitability and success in the cable business will be the ability to control programming costs through the leverage of size." Given that around 40% of operating expenses for a cable television system are fees paid to programmers, the more subscribers a company has, the lower its programming cost and higher cash flow per subscriber. Thus, with size, players in the industry were able to reach important scale advantages and enter a virtuous circle where the cash flow was allowed to expand and the expansion increased the cash flow via lower costs.
Maximizing returns for shareholders: Given the profitability of TCI, Malone believed a high net income meant higher taxes; for him, the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, while funding growth and acquisitions with pretax cash flow. At a time when earnings per share was the name of the game in Wall Street, this unconventional approach provided an important competitive advantage. When there were market downturns, Malone opportunistically repurchased stock, but generally, he invested available capital in purchasing and acquiring less expensive rural and suburban subscribers.
These are just examples of how a CEO can create value: thinking outside the box, putting shareholders first, being frugal and avoiding luxuries. The actions implemented by Malone, who was a pioneer, are now spread across the industry. These practices serve as a great example of an outstanding capital allocator and also of the tenet that business operations and results go first, then the stock will follow.
What do you think?
