LimJianYang
Analysis

Great Business Models

#investing#margin-of-safety#management#ownership

Note: The ideas described here may not be accurate as I’m still learning about them. If you see any errors, please feel free to correct me!


Serial Acquirers

1. Vertical Market Software (VMS) Serial Acquirers

While there are terrific moats around our individual business units, the barrier to starting a “conglomerate of vertical market software businesses” is pretty much a cheque book and a telephone.

— Mark Leonard, President of Constellation Software

1.1 Introduction

Suppose you’re flush with cash and wondering how you can grow it. You chance upon a software company that creates customized software solutions for specific clients in one industry, solving a very niche problem. You notice that this company has a high customer retention rate due to how integral its software is to the client’s operations. Clients must pay recurring fees to keep the software updated and running smoothly. As we in the tech sector know, software evolves rapidly through new features, security updates, or compatibility enhancements. This means clients are likely to continue paying for the software as long as it solves their problems.

Impressed, you decide to buy the company. You realize this is a wonderful business model! Acquiring more companies with sticky revenues results in highly predictable cash flows in a capital-light model. Additionally, buying companies in the same or adjacent industries garners expertise in those areas, making you the go-to source for customized software solutions. You can then use the cash flows from these acquisitions to buy even more companies, growing your empire.

Rinse and repeat.

1.2 Benefits of Specialization

VMS focuses on niche software solutions tailored to the specific needs of particular industries and clients. It operates like a group of organized freelancers who solve problems that Horizontal Market Software (generalized software) cannot address. Once a contract is signed and software is delivered, it becomes difficult for the client to switch providers. This “stickiness” translates into recurring revenue, long-term customer relationships, and opportunities for cross-selling and upselling. Key benefits include:

  1. Reduced Competition: Niche markets generally have fewer competitors, minimizing customer churn due to price wars or feature parity.
  2. Enhanced Customer Loyalty: By addressing specific pain points with tailored solutions, VMS providers build strong relationships and high switching costs. Deep industry expertise strengthens these relationships further, reducing churn rates.
  3. Premium Pricing: Specialized solutions justify higher price points due to their precise value, improving profit margins. Clients willingly pay more for perfect solutions, creating win-win scenarios.
  4. Recurring Revenues: Maintenance costs, updates, and support services generate predictable recurring income streams.
  5. Knowledge Sharing: Companies under the same umbrella can share best practices and learn from each other’s successes and failures, improving overall efficiency, reducing costs, and enhancing products.

1.3 Acquisition Criteria

The secret sauce of VMS companies lies in disciplined acquisitions. These companies seek targets that complement existing operations, ensuring synergies and growth potential. Key criteria include:

  1. Good management that thinks like owners.
  2. Reasonable valuation (e.g., low EV/NOPAT).
  3. Potential returns above their hurdle rate.

The combined company has to also generate synergies that increase cash flows or reduce costs more than the premium paid for the acquisition.

Acquirers often incentivize acquired company leaders to remain invested post-acquisition by allowing them to retain significant stakes in their businesses. For instance, Kelly Partners Group ensures that partners of acquired companies retain a 49% interest in their original company.

1.4 Conclusion

Creating a VMS conglomerate isn’t easy. It requires disciplined capital allocation, a strong pipeline of potential targets, and effective integration to avoid “diworsification.” Management must ensure that acquired companies are well-incentivized to align with the overall company’s goals.

1.5 VMS Companies

  1. Constellation Software Inc. (CSU.TO)
  2. Kelly Partners Group Holdings Limited (KPG.AX)
  3. Topicus.com Inc. (TOI.TO)

2. Other Serial Acquirers

The model is not exclusive to VMS companies. Other serial acquirers employ similar strategies.

Terravest (TVK.TO) acquires small propane tank manufacturers at reasonable valuations and optimizes them through:

  1. Cost Reduction via Economies of Scale: Terravest consolidates steel purchases, bypassing middlemen, and shares services like HR, IT, and finance.
  2. Price Increases through Ready Inventory: Centralized inventory reduces lead times and increases pricing power, allowing Terravest to charge premiums for shorter lead times.

Post-acquisition restructuring leads to higher margins and returns on capital, creating win-win scenarios for both Terravest and the acquired companies.


Scale Economies Shared

Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful. But in the center of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no one replies give it back to customers – how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long-term success.

— Nick Sleep, 2004 Partnership Letter

This section will be largely referencing Nick Sleep’s Investment Partnership Letters.

The simple deep reality for many of our firms is the virtuous spiral established when companies keep costs down, margins low and in doing so share their growing scale with their customers. In the long run this will be more important in determining the destination for our firms than the distractions of the day.

— Nick Sleep, 2011 Partnership Letter on Amazon

Amazon’s virtuous upward spiral

while True:
    increaseSelectionOfGoods()
    improveServices()
    lowerPrices()
    companyCash -= 1

    customersHappiness += 1
    customersLoyalty += 1
    customersTrust += 1
    
    customersSpendMore += 1
    customersTellFriends += 1
    friendsSpendMore += 1

    companyRevenues += 3
    companyMargins += 3
    companyCash += 3

These companies always put their customers first. They are givers before they are takers, and they always strive for win-win relationships with their customers. Such an obsession with customer focus increases customer loyalty and retention, which in turn drives recurring revenues for the company. The company uses these funds to reinvest for the benefit of the customer, thereby attracting even more customers, and the cycle repeats.

By giving more, they ultimately receive more.

Membership Model

Both Costco and Amazon use memberships to ensure that their customers remain loyal. This is a win-win situation for both parties. Customers gain access to cheaper goods and services, while the companies benefit from a recurring revenue stream and a loyal customer base. For Costco, memberships allow them to study customer preferences and anticipate demand more effectively. This helps them negotiate better prices with suppliers, as they can accurately predict what and how much customers will buy. Costco then purchases goods in bulk and passes the cost savings back to the customer. This approach contrasts with many companies where sellers retain cost savings for themselves. For many members, the savings from a Costco membership far outweigh the membership fees, and great deals are readily available.

This model requires good management that stays focused on the win-win dynamic. Companies could temporarily boost short-term profits by sharing fewer cost savings with customers. However, customers would notice, eroding the trust and loyalty built over the years. While such tactics might benefit the company in the short term, they would ultimately harm its long-term success.

Scale Economies Shared Companies

  1. Costco Wholesale Corporation (COST)
  2. Amazon.com Inc. (AMZN)
  3. Coupang Inc. (CPNG) — South Korea’s Amazon
  4. MercadoLibre Inc. (MELI) — Latin America’s Amazon
  5. Adyen N.V. (ADYEN.AS)

True Luxury

To be continued

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