Saturday, 13 January 2018

The real (and misunderstood) economics of disruption

We are currently living in an era of putative radical disruption. New players such as Elon Musk's Tesla Motors are - it is argued - disrupting the automotive industry; online e-commerce is disrupting bricks and mortar retail - some would argue mortally; solar is disrupting the conventional power generation industry (so it is argued); Netflix is disrupting the media distribution and content industries; and WeWork the office space industry. I could go on. It is now reported that hundreds of privately-funded 'Unicorns' with mark-to-capital-raising valuations in excess of US$1bn now exist, all promising to uproot formerly incumbent and highly profitable established 'old world' businesses.

I am not denying that big changes are happening, nor that the likes of Amazon will not structurally change the growth and profitability characteristics of a number of industries for many years. But I do feel that the likely long term disruptive impact of many of this cycle's popular Unicorns and other loss-making upstarts is being grossly exaggerated, alongside the concomitant emergence of some very fuzzy thinking as this cycle's excesses progress. This includes the emergence of some important and widely-held misperceptions about how technology, innovation, and disruption intersect with business economics, and what a viable and valuable business actually looks like.

One of the these important misunderstanding, in my submission, is this: generally speaking, in normal economic and capital market conditions, businesses survive and thrive not by innovating to provide the best product or service (a uni-variate optimisation), but rather by providing the best product or service relative to the economic price that those products or services can be supplied to customers (an economic price is one that does not require continuous subsidisation by the capital markets).* The latter is a dual-variate optimisation of performance and cost, and is the one that matters in the long run in real world competitive markets. On a practical level, what this means is that the most economically successful goods and services are often not the best products, but the ones that are merely good enough. These products are economically competitive.

As consumers, we all have first-hand experience with dual-factor optimisation. When shopping for a given item - say a new TV or automobile - we are well aware that there is a quality vs. price trade off. Our interest is not to purchase the 'best' product (i.e. a uni-variate optimisation), but rather to optimise the multi-variate calculation of what is the best choice relative to its price. Affordability considerations aside, very often when we make this assessment, we are generally inclined to purchase the item that is good enough when available at a much more attractive price than premium alternatives. In the marketplace, good enough usually wins (for the mass market at least).

This is very often forgotten during good times when start-up euphoria runs high. Much like in the late 1990s, where all manner of putatively radically disruptive upstart businesses were funded, we are currently living in an era of extremely permissible capital markets. A consequence of this is that many businesses that would not be able to survive in normal competitive market conditions, because they do not provide economically competitive products that are good-enough and are priced at sustainable and affordable levels, nevertheless not only get funded, but are provided with a steady stream of additional funding that allow them to continue to grow despite the fact that they are losing buckets of money (they lose buckets of money because, in order to grow, they under-price their products relative to their cost of delivery).

The problem for these would-be disruptors is that history shows that capital markets are fickle and prone to closing from time to time, and in a similar fashion to what happened during the bust, it is likely that as soon as capital market conditions change, many of these hyped 'disruptive' businesses are likely to rapidly fail. The long term winners will likely be companies that have existing profitable and cash flow positive businesses - often 'old world' businesses, but also existing tech giants such as Google and Facebook which are monstrously profitable - that will have the financial resources to acquire and implement new technologies and incorporate them into their existing product suite. This is also what happened after the bust, where 'old economy' stocks that had been left for dead proved to be significant share market winners in the aftermath of the bust.

Remembering what a good and economically sustainable business looks like

It is not hard to start and grow a business if you have unlimited financial resources. If you gave me a blank cheque and said 'start a thriving restaurant', it would be easy. I would go rent the best location I could find, no matter the price; hire the best chef I could find and pay him or her whatever I needed to pay him or her to procure their services; hire the most exotic interior decorators, and spend a fortune fitting the place out; and then hire and train the best waiting staff and in large numbers. I would purchase the best and freshest ingredients in large quantities, not worrying about waste, to ensure the best food quality and availability. I'd hire the best restaurant manager I could find and ask them to name their price. And I would spend a fortune on promotion and marketing. And lastly, I would price my meals at an extremely competitive and affordable rate vis-a-vis other restaurants on the market.

The restaurant would inevitably grow quickly and optically appear quite successful. The food and environs would be great; everything on the menu would be in stock; service levels would be high; and prices would be reasonable. It would be 'taking market share' by 'disrupting incumbent operators'. But it would likely be hemorrhaging money and/or delivering an extremely unsatisfactory return on capital. And if it was, it would be a failed business. 

It would be a failed business because running a successful business is not about providing the best product or service to customers at any cost. It is not about innovating per se. It is about finding a way to sell good-enough products and services to customers in a profitable manner at a price level that customers can afford. 

Producing and selling a good or service to customers irrespective of cost, profitability, and returns on capital, is easy. Just spend a lot of money (preferably external investors' money). However, doing it profitably while earning an acceptable return on capital is hard. This distinction is often completely forgotten during boom times when all investors care about is user or revenue growth. It can result in fast growing but loss making businesses being awarded enormous valuations on account of their apparently attractive growth profiles. But a business that has a lot of revenue but no realistic prospect of making money is worthless - irrespective of how exciting and innovative the products or services appear to be, and how fast user numbers or revenue is growing.

The only way such a business can continue to operate and grow is to have shareholders that are prepared to continue to tip more and more money into the business to finance operating losses and expansion. In a funding environment analogous to today's VC funding environment, my budding restaurant business might spend US$5m opening the restaurant (vs. say US$1m for conventional restaurants), and might lose US$500k a year operating it, but it would be able to boast of rising revenue, user numbers, and rising market share.

The playbook is to then go back to investors and say, look how fast we are growing. Please give us more capital to keep expanding (and financing operating losses), and let's value the business on a revenue multiple to boot. If revenue was say US$5m a year, let's value such a hyper-growth company at 5x sales and increase the company's value to US$25m to reflect that growth. Investors tip the money in, and more money is wasted opening more uneconomic restaurants, but with booming revenue growth, the cycle can be repeated at ever-higher funding valuation rounds. Meanwhile, 'old world' competing restaurants, which are still producing high levels of organic cash flow and profitability, start to see margin and market share pressures emerge, and their share prices are penalised. They are being 'disrupted', it is argued, and yet it is the old-world restaurants that are still making money.

Something analogous to this situation exists in the world of e-commerce and B&M retail at present. The current view is that e-commerce with home delivery will crush any and all B&M retailers. Maybe it will. But for now, there is still limited evidence that delivering groceries and most every-day merchandise to customers' doors is economically viable (almost all pure-play e-commerce businesses lose money; Amazon breaks even only because of its highly-profitable AWS business and online book and e-book business).

Delivering to the customer door is extremely labour intensive and costly (at least until drone delivery or other automated solutions are found), and to date it has been hard to get customers to pay a price that reflects the economic cost of delivery. It remains to be seen if a hybrid solution of online sales with in-store pick up actually ends up being a 'good enough' economically viable solution. If so, the strongest B&M players could well be in much better shape long term than is currently assumed.

How have so many worthless businesses been able to be so amply funded? Well, until the chickens come home to roost, everyone in the startup funding ecosystem is happy. The investors (primarily VC funds, funded by dumb money from the likes of Middle Eastern Sovereign Wealth Funds, or Softbank) are happy because they mark their returns to the business valuation implied by the most recent funding round. It does not matter if this valuation is entirely fanciful and unsupported by economic realities. This allows VC funds to report high (paper) returns to their investors (despite the fact that most of their investees are bleeding cash), which allows them to both extract large bonuses and use rosy past performance numbers to attract yet more funds. This, in turn, gives them the financial firepower to keep recapitalising their loss-making investees at higher and higher valuations in subsequent funding rounds.**

It is exactly this dynamic that has lead me to conclude that there is a genuine bubble in the VC-funded tech space at present. There is not only apt to be massive carnage when the VC funding cycle turns and these businesses start to run out of cash, but it will also mean that many 'old world' businesses that are currently still highly cash generative will appear much less vulnerable to disruption than they presently appear to many investors.

Some of the worst offenders

One of the worst offenders is Elon Musk. Don't get me wrong - I love Elon Musk, and to his credit, he has been quite transparent right from the start that his motivations for running Telsa and Space X, as well as his other more recent ventures, are non-pecuniary in nature.*** Musk is an inspiring figure. He is trying to make the world a better place. He is innovating and challenging prior norms. He is to be credited for that - he is a remarkable individual, and I am rooting for him. And some of his businesses may even succeed in innovating their way to economic viability in the long run. But the way he views the world and is running his businesses are one in which he has 'science fiction' rather than 'economically viable' goggles on. For this reason, Musk may do great things and innovate successfully, but he will quite likely lose most or all of his shareholders' money in the long term.

Musk's apparent susceptibility to the fallacy I have described can best seen in his plans for underground tunnels that slingshot cars through underground vents to speed up commute times in California. Musk has bemoaned the fact that it takes 45 minutes to drive across town. Surely we can do better, he argues. Yes, we probably can by building underground tunnels. That will be better. But it will be orders of magnitude more expensive - uneconomically so in my view (even conventional toll road tunnels in Australia servicing high traffic routes have, in the past, suffered massive financial losses, let alone sci-fi-esque tunnel networks). Being able to drive across town in 45min might take longer than many people would prefer, but it can be done at extremely low cost and is therefore a good enough solution for most people. Consequently, this project is doomed from the start, and that ought to have been immediately apparent to Musk if economic realities were a driving force behind his thinking.

The fallacy I described above is also very evident in the way both Musk and Peter Thiel have bemoaned the lack of innovation and progress in commercial aviation in recent decades. Indeed, they have argued that we have in fact regressed, because in the 1990s, Concorde was around and providing supersonic travel, whereas today's deprived consumers need to content themselves with subsonic regular travel speeds topping out at 900km/h.

However, there is a very good reason why Concorde is no longer around, and why we do not have supersonic travel today (it was not just because of the company's high-profile 2000 crash - that was merely the final nail in the financial coffin). Although Concorde provided faster travel speeds (being able to cross the Atlantic in just 3hrs, compared to 5-6hrs today), it did so at approximately triple the cost. Particularly when modern business class seats complete with flat beds became available in regular subsonic airlines, travelers began to prefer to overnight the flight and sleep on board, and the time saved on Concorde paled in comparison to the extra cost involved. Regular commercial aviation provided a good enough solution at a better price point - i.e. it optimised the dual-variate calculus much better than Concorde's uni-variate solution - and this was the cause of both Concorde's demise, and the lack of the re-emergence of a supersonic airliner in the intervening 17 years.

Wendover Productions (a YouTube channel I highly recommend) has an interesting short-form educational video on the topic (see below). There are very good reasons why airline speeds have topped out a 900km/h - travelling at 800-900km/h is the most economically efficient speed at which to fly, in terms of optimising fuel costs. Supersonic jets for use in civil aviation do not exist because they are not economically competitive.

This hints at another theme I have touched on in past posts - the fact that most consumers have more excess time than excess money at their disposal. Billionaires like Musk and Thiel forget that they are in the comparative minority in having far more money than time. Musk and Thiel would rightfully pay tens of thousands of extra dollars to shorten aerial commute times, but they are in an extreme minority in their willingness to do so. The commentary at the end of Wendover's video says it best - while flight speeds have not increased, the cost of travel has declined by about 50% over the past several decades, and the barrier for most consumers ability to travel is cost, not time. 

In other words, there has in fact been significant innovation in the airline industry - it is just that the commercial aviation industry has optimised for cost, not for time. They have done this because they are normal businesses operating with normal economic considerations and pressures (unlike the bubble VC-funded tech industry), and have been responsive to market forces, not pie-in-the-sky science fiction fantasies.****

It is not clear when sanity will return to private tech funding markets. The boom could go on for some time yet - at least until Softbank has succeeded in losing most of the money investors have tipped into its >US$90bn "Vision Fund" (Masayoshi Son appears to me to have lost his mind - using the coming singularity to justify investing in Uber and WeWork at nosebleed valuations makes absolutely no sense to me - Uber might not even survive the coming transition to autonomous vehicles, let alone a putative coming singularity; the consequences of the latter's arrival are also, by definition, incapable of being predicted, so could just as easily be bad than good for Son's investments). However, sanity will eventually return, and it may well be many of the disruptors that find themselves (financially) disrupted.

Comments and questions welcome,


*There is also the separate issue of competition and competitive advantage (not touched on here). I attended a tech conference once where one of the acclaimed tech industry insiders in attendance was asked during a panel discussion what makes a great business. He clearly had not thought much about it and was unable to offer a reasonable answer. The correct answer, in my submission, is that a great business one that is able to do something (valuable) that most other businesses cannot do. Even if you can provide a economically competitive product, if everyone else can do so as well, there is no reason to expect that you will make much money doing it. Many participants in the world of e-commerce do not seem to understand this reality, and instead remain singularly focused on growth.

**This, by the way, is the real reason for the dearth of tech IPOs in recent times - a much-discussed topic. The real reason is that as soon as a company is IPOed, the price discovery mechanism becomes democratized and VC funds lose control of their ability to set valuations, and prices are thus apt to crash - much as has occurred with Blue Apron, which is down 70% since IPOing mid last year as losses have continued to mount. IPOs reveal emperors to have no clothes. That's the problem. Current private market tech valuations will not withstand the scrutiny of public markets, and VC firms know it

***For this reason, the foregoing criticism is better thought of as a criticism of the way investors perceive and value Musk's companies, rather than a criticism of Musk himself. In addition, Musk calls to my mind George Bernard Shaw's quote: "The reasonable man adapts himself to the world: the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man". Musk might end up being profoundly economically successful with endeavours long term if he successfully innovates himself into viable, cash flow generative business models before capital markets turn. However, to date he has singularly failed in this regard. Telsa is making great cars and innovating, but is bleeding cash at an unbelievably high rate. I wish him well, but I have no interest in investing in his companies. 

****Given the above, it is not surprising to me that Thiel - although having a formidable intellect (he is a 2,400 ELO rated chess player) and highly successful VC tech investor - was a complete failure as a fund manger. His hedge fund had disastrous performance and had to be shuttered.

1 comment:

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