Value Investing

Middlemen As Compounders

By Investment Master Class

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Middlemen have historically been essential to success for most supply chains. Traditionally, manufacturers have relied on these businesses to assist in distribution, to develop their markets (or to leverage existing ones), especially when the manufacturer has lacked either the resources or the customer base to 'go it alone.'

I recently read a great interview with John Huber of Saber Capital on, where he opined on the changing role of middlemen in the value chain. Mr Huber's investment focus has evolved over the years to the point where, like many great investors, he seeks only quality businesses or 'compounding machines'. These are businesses whose value is likely to grow over the years. This investing style is in contrast to those investors who try to buy stocks cheaply regardless of whether the company's value is likely to grow or shrink. Those shrinking businesses are often referred to as 'melting ice cubes' - think yellow pages, newspapers, free-to-air-TV companies, etc.

Mr Huber recognises new technology is disrupting existing business models. Businesses are changing, and the internet is disrupting almost all businesses as old moats get filled in and barriers to entry are broken down. In many cases it is the middleman who face existential risk. Think of the cable-TV-company being disrupted by Netflix, the retailer disrupted by Amazon, the music store disrupted by I-tunes, the travel agent disrupted by Expedia, etc.

Mr Huber gives the example of Footlocker, whose role as a middleman to buyers, is being marginalised by the internet. I'll let him explain...

".. Foot Locker still has a value of around $4.5 billion, even after a 60% decline in its stock price. The risk to the business is significant for a number of reasons. Fewer customers are visiting malls, and more significantly, brands like Nike are rapidly expanding their sales directly to customers, which reduces the value of Foot Locker’s reason for existence. A middleman adds value when he acts as a source of customers for suppliers and/or a source of product for customers. When the suppliers and customers can easily find each other on their own, the middleman has no purpose.

Foot Locker’s markup on any given product is no longer justified if it exceeds the cost of Nike selling it directly to customers. Foot Locker still might be adding incremental volume for some brands, but to the extent that the biggest suppliers can cut out their retail partners without a negative long-term impact to volume, then Foot Locker’s overall value proposition will be seriously impaired. Instead of adding value to each transaction by creating a sale that wouldn’t have occurred without them, they are now operating on borrowed time - extracting value from each sale that could have occurred without them.

But the company’s balance sheet and free cash flow is adequate enough that these risks won’t likely come to fruition over the next couple years, and with the stock trading at a very low multiple of cash flow, it appears cheap. But the value of that business, at least in my view, is slowly eroding. And in business, slow erosion can give way to a landslide without much warning. It is possible to buy this stock and sell it at a profit after a short period, but I think if we look back in five years, we are unlikely to see a situation where Foot Locker is a much more valuable enterprise than it is now." John Huber

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The most obvious example of technological advancement impacting distribution channels is the internet. Last year, I picked up an interesting new 'mental model' from Jeffrey Ubben of ValueAct. In an investor letter, Mr Ubben detailed his new focus on businesses that were using the internet to bypass middlemen.

"We often describe ourselves as business model-centric, not industry-centric. This is evidenced by the amount of time we spend analyzing business models, including how companies produce goods and services, how they interact with customers and how they get paid. These dynamics change slowly, but their impacts are profound on the companies' returns on capital, and can very often overwhelm macro-economic cycles and be more long-lasting in effect.

One common theme we have explicitly chosen to invest in across multiple industries is direct customer engagement and disintermediation. Said another way, we look for opportunities where a company can remove intermediaries that distribute, resell, install, service and maintain their products. In the case of a company with diffused customers and limited internal resources, the "middlemen" can be extremely helpful. However, this help comes with a cost as the middlemen need to get paid, extracting economics from the industry. They also own the customer relationships, often leaving the supplier in the dark as to the customers' identities, locations, behaviours, preferences and level of activity. In the case of intangible goods, such as software or media, this loss of control can lead to widespread piracy. A direct relationship with the customer can enable more specific market intelligence, fostering faster, iterative product development cycles that work to further align interests between companies and their customers." Jeffrey Ubben

Jeffrey Ubben specifically mentioned SAS businesses which now benefit from having a "direct connection with the end-users, allowing a real time study of usage patterns, near-continuous product updates and a host of other features.  This was not possible when their software was indirectly distributed and ran on the island or a PC or a corporate data centre."

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Its not all bad news for middlemen however.

Mr Ubben's analysis led me to an interesting medical device company who, rather than cutting out the middleman, has implemented cloud-connectivity which is creating a win-win environment for the business, the end customer and the middleman. By internet-enabling their medical device, for the first time the business has a direct relationship with the customer [a patient] which was previously the exclusive domain of the middleman [a home-care services provider].

This new customer connectivity is a win-win for all parties involved. The medical device has been cloud-connected and sends the patient's engagement and health data directly to the device manufacturer. This data is also made available to the home-care services provider via an on-line data analytics package and to the patient via an internet application.  When a patient engages with the app the company has found patient engagement levels significantly improve - to the point where one country's Government recently allowed higher reimbursement for cloud-connected devices.

The medical device uses durable add-on equipment (consumables) which needs regular replacement. By accessing patient data via cloud-connectivity, the medical device manufacturer is able to automate the replenishment cycle resulting in a 50%-60% labor saving for the home-care provider. This has led to increased sales of the high-margin consumables and allowed the home-care provider to both focus more time on non-engaged/non-compliant patients and also to find new patients in what is a largely under-penetrated end market.

The home-services provider is more productive, the level of patient care improved, and more patients are being located to purchase the medical device. Not only that, but the home-care provider is now far less likely to opt for a new competitor product given the alignment with the medical device manufacturer's data management system. Ultimately, the company's moat has been significantly widened.

The other mental model I like, and one that Jeffrey Ubben recognises above, is a model with a 'diffused' customer base. These are most attractive when the product has a reputation for reliability, where quality control is paramount, the product is a small cost versus the end cost [i.e. interior wall paints vs labour cost, small plumbing components, aeronautical parts, etc], the end market is fragmented and the product's use is service-based. Allan Mecham of Arlington Value Capital expanded on this concept in an interview with the 'Manual of Ideas'...

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"I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers".

Its important to identify with these dynamic changes to industries and middlemen, particularly when they relate to either businesses you own or ones you are considering investing in. Whilst not all middlemen are being affected by these changes, many are, resulting in potential 'melting ice-cubes'. Its not a bad idea to add this criteria to your checklists, to ensure you can spot the risk before taking on a company with potentially shrinking value, or even identify the same risk with ones you already own. Your investments could quickly move from the foot locker to the hurt locker if you don't.