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Andrew Kuhn May 10, 2017

It’s All About the Long Term: Amazon’s 1997 Shareholder Letter

“Jeff Bezos is the most remarkable business person of our age, I’ve never seen a guy succeed in two businesses almost simultaneously that are really quite divergent in terms of customers and all the operations.” – Warren Buffett I really do agree with Warren in the statement above. Anyone who knows me, knows I am a complete Amazon advocate. Not only does my firm own Amazon stock, but I am a frequent user of the website and really have developed into some sort of fanboy....

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Geoff Gannon May 10, 2017

Geoff’s Mental Model #1: “Market Power”

The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
– Warren Buffett

A business with market power is a good business. A business without market power is a bad business. In that quote, Buffett gives a clear definition of market power when he says: “if you’ve got the power to raise prices without losing business to a competitor” you’ve got a very good business. Basically, if you’ve got the power to raise prices without losing business to a competitor, you’ve got market power.

Market power is not an internal advantage. It is not a technological advantage, a better corporate culture, or a process improvement your competitors have yet to figure out. Market power is external. It is a strong bargaining position versus those folks a company must sit across the negotiating table from.

Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.

Market power is often misunderstood as being an advantage one competitor has over another. That’s the wrong way of thinking about it. Businesses don’t squeeze profits from competitors. Businesses squeeze profits from customers and suppliers.

Often, competitors engage in rivalry that undermines each other’s bargaining position with customers and suppliers. In such industries, customers can play one competitor off against another. By doing this, they can negotiate for higher product quality, lower prices, longer payment terms, etc.

However, there are industries free from that kind of rivalry.

As investors, those are the industries we want to focus on. The best businesses in the world are in the best industries in the world. And the best industries in the world are those where the rivalry between competitors does not undermine the market power these businesses have over their customers and suppliers.

 

Dependency: Mini-Monopoly

All publishers have a mini-monopoly over each title they publish.

In children’s books, if you’re a bookstore that wants to carry Harry Potter – you have to pay Scholastic (SCHL) whatever Scholastic wants to charge for that title. Scholastic is your sole source of Harry Potter books. The only power you have in the market for Harry Potter books is to either accept or decline a take-it-or-leave-it offer from one seller. There are no competing offers you can consider.

In videogames, if you’re a gamer who wants to play World of Warcraft – you have to pay Activision-Blizzard (ATVI) whatever monthly fee Activision wants to charge for that MMORPG. Blizzard is the sole source for your WoW fix. The only power you have in the market for World of Warcraft access is to either accept or decline a take-it-or-leave-it-offer from one seller. Those who decline the …

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Geoff Gannon May 10, 2017

EBITDA and Gross Profits: Learn to Move Up the Income Statement

“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a new vocabulary…EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash generating ability of a business…”

  • William Thorndike, “The Outsiders”

 

“I think that, every time you (see) the word EBITDA you should substitute the word bullshit earnings.”

  • Charlie Munger

 

The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

A company’s EPS (which is just net income divided by shares outstanding) is often referred to as its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom line. This may sound like a quibble on my part. But, let’s stop and think about it a second.

If EBITDA is “bullshit earnings” because it is earnings before:

  • Interest
  • Taxes
  • Depreciation and
  • Amortization

Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:

  • unrealized gains and losses on available for sale securities
  • unrealized currency gains and losses
  • and changes in the pension plan?

I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only numbers reported to shareholders.

Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There is an entire income statement full of figures shown to investors each year.

Profit figures further down the income statement are always more complete – and therefore less “bullshit” – than profit figures further up the income statement.

So:

  • EBITDA is always less bullshit than gross profit.
  • EBIT is always less bullshit than EBITDA.
  • EPS is always less bullshit than EBIT.
  • And comprehensive income is always less bullshit than EPS.

Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net income per share). Buffett wants to report the least bullshit – most complete – profit figure possible.

So, if profit figures further down the income statement are always more complete figures, why would an investor ever focus on a profit figure higher up the income statement (like EBITDA) instead of a profit figure further down the income statement (like net income)?

 

Senseless “Scatter”

At most companies, items further up the income statement are more stable than items further down the income statement.

I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The measure of stability I am going to use is the “coefficient of variation” which is sometimes also called the “relative standard deviation” of each series. It’s just a measure of how scattered a group of points are around the central tendency of that group. Imagine one of those human shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest would rate a 0.01. A bullet hole that …

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