Upstream Value in Consumer Goods
Today: What companies in the consumer goods industry reveal about the power of the multitude.
The Agenda 👇
Could companies in the consumer goods industry be valued like tech companies?
The history of capitalism and value chains: from disintegration to integration
It’s all about the power of the multitude—all those networked individuals
Two traps every company should avoid in its pursuit of a bond with consumers
Why vertical integration is the way to go in the consumer goods industry these days
This is an edition discussing vertical integration in the consumer goods industry…
… it’s also another issue in what is emerging as a series dedicated to businesses having to deal with this powerful multitude of networked individuals I also wrote about last Friday.
I recently chatted with Charles Vercoustre, the co-founder of Spaō, a company focused on providing an healthy, sustainable, and tasty alternative to coffee—and one that’s part of our current batch at The Family. In the course of our conversation, Charles mentioned the idea that a consumer goods company controlling its whole value chain up the stream could be valued like a tech company. As you can imagine, that REALLY intrigued me, and so I decided to share a new round of reflections with you.
Let’s start with a reminder of where I stand. I believe that the history of capitalism can also be told as the history of vertical disintegration. As capitalist enterprises scale up, they are confronted with the challenge of not becoming overweight and they thus usually decide to divest certain links of their value chain. Larger scale is precisely what compensates for the loss of operating a given business in-house: it makes it possible for a dominant company to exert pressure on other players in the value chain. And by applying pressure on the right leverage points, they obtain what they need: either lower prices or higher quality—it’s what Tren Griffin, following John Malone, calls “wholesale transfer pricing power” (WTTP).
Indeed, why bother doing everything yourself when you can obtain what you want from others? I first wrote about this in The Corporate World in Retreat (March 2018):
An entire discipline, corporate strategy, was developed to help corporations consolidate their position in the economy. It helped them expand their reach and scale up without becoming overweight. Most people assume that the corporation’s edge is derived from simply being bigger: the bigger the size, the more value it can create and capture. But since we’re so amazed by size, we tend to overlook the fact that scaling up demands difficult trade-offs. In practice, a corporation can grow in size only if it offloads some weight by outsourcing certain assets, functions, and risks to other businesses.
Indeed we’re way past the time when large corporations were vertically integrated. The Standard Oil Co. was probably the last large corporation that was present all along its industry’s value chain, from upstream (extracting crude oil from its vast fields in Ohio) all the way to downstream (selling gas to consumers). Rockefeller’s empire was a precedent suggesting that a large corporation could successfully address large consumer markets while operating each line of business in the industry.
Following the Standard Oil example, Henry Ford designed the Ford Motor Company to be just as integrated, with the assembly lines at the core and the company selling directly to consumers through department stores, mail order, or sales representatives. But then General Motors, Ford’s nemesis, broke with that model. As discovered by its CEO Alfred P. Sloan, it only needed to control a few strong links in the value chain to impose conditions on third parties operating the other links. Owning certain strategic assets, the “one ring to rule them all”, was more than enough for GM to dominate the car industry.
(As an aside, I now call that “one ring to rule them all” a ‘grip’ over one’s value chain. See Thoughts on Value Chains, and Why You Really Need To Get a 'Grip'.)
Why was it so easy for so many corporations to retreat from large parts of their own value chains, specializing in one or two links while abandoning the rest? Because in most markets back in the Fordist Age, dominant companies more or less controlled the downstream extremity of the value chain: consumers! More precisely, they controlled what these consumers aspired to, and how much they were ready to pay for a given product. This could be controlled, or at least heavily influenced, by way of mass marketing and/or sheer market power.
I was referring to this as early as 2016, in The Five Stages of Denial (2016):
In a legacy industry, the end customer is always treated in the same manner. It’s the job of a mass production economy to impose the same product under the same conditions to all customers — and if you’re not happy with that, well, it’s still the same price! That’s what it took to grow the businesses of mass production: it was by stitching together long sets of standardized products on unlocked markets, secured through the banking system and the welfare state, that these economies were able to reach maturity and create ever-more added value.
I wouldn’t qualify consumer markets of the past as “certain” or “stable”. In fact, widespread instability has always been the mark of consumer markets. But such uncertainty continuously receded throughout the 20th century thanks to progress made on both the demand side (the banking system and the social safety net) and on the supply side (perfecting the art of strategic positioning on the market so as to withstand competition and strengthen a business’s franchise).
No wonder that, in the last quarter of the century, Warren Buffett made some of his most successful investments in the consumer space (as told by Adam Seessel in Fortune in 2019):
Buffett began his career nearly 70 years ago by investing in drab, beaten-up companies trading for less than the liquidation value of their assets—that’s how he came to own Berkshire Hathaway, a rundown New England textile mill that became the platform for his investment empire. Buffett later shifted his focus to branded companies that could earn good returns and also to insurance companies, which were boring but generated lots of cash he could reinvest. Consumer products giants like Coca-Cola, insurers like Geico—reliable, knowable, and familiar—that’s what Buffett has favored for decades, and that’s what for decades his followers have too.
But these days consumers have unleashed unprecedented power that has made it very hard for consumer companies to keep up. What changed? Remember the rule of thumb:
Now there’s more power outside than inside organizations.
In other words:
Consumers have access to much more information from more distributed sources.
They’re adding up new layers of information as they interact with one another.
They can decide to take action and move the market in unexpected directions.
Dealing with such consumers is the challenge today’s consumer goods companies are currently tackling:
They invest in content and build relationships with influencers so as to be in sync with the information to which consumers have access.
They orchestrate interactions between individuals so that they exchange information in the company’s ecosystem rather than elsewhere.
They eventually turn their customers into an active community so as to harness their power as a network and turn it into doing more and better business.
Yet even if you’re doing all of the above perfectly right, remember that it’s still an alliance in which you have to constantly bargain with ever more demanding customers. In other words, it all requires sensitivity, agility, and velocity. The fact that consumer goods companies are pursuing these goals explains why they’re embracing approaches such as the following:
Down the stream, it’s all about having that direct connection with consumers. Hence the preference for direct-to-consumer as opposed to intermediated distribution.
Up the stream, it’s all about being able to move as fast as consumers and respond to their constant demands about the upstream part of the value chain—they want to know how these goods have been produced, by whom, at what costs (environmental, social), and what the impact is of consuming these goods (especially if it’s food they are actually consuming!).
The point is to bet on exponential growth of market share rather than on increasing returns to scale linked to the company’s activity itself, as I wrote in Does Elon Musk Master Productive Uncertainty?
[Worth considering:] Startups that are in line of business where increasing returns to scale are not that impressive, but those returns are in a market which itself could be subject to exponential growth. In other words: the market’s growth will compensate for the somewhat slower growth at the scale of the individual business that eventually becomes the leader.
My vision is that in this new context of companies being able to pursue exponential growth on markets for consumer goods, there are two traps into which companies shouldn’t fall.
The first one is embracing an asset-light approach. On that one, let me simply quote Ben Robinson (featured in this recent edition) from his 2016 piece The myth of the small balance sheet:
The fact is that the situation is more complex than the balance-sheet-light theory allows. Successful models will vary in asset intensity. Digitization moves the primacy away from hierarchical models towards ecosystems. But within an ecosystem, some things are controlled while others are not; some assets are owned, others are not. What matters in the end is not the size of the balance sheet, but the route to customer.
I also wrote about this (see Principles for Capital Allocation), pointing out that being asset-light optimizes for scalability but leaves a business vulnerable to competition—or “without a moat”, as Jerry Neumann would write (in Productive Uncertainty):
In Schumpeter on Strategy I argued that companies create excess profit through innovation, and keep making this excess profit by protecting the innovation from being copied. In a perfectly competitive market, competition reduces economic profit to zero. For a company to have an excess, or entrepreneurial, profit, it must do something differently than its competitors. The resulting excess profit only lasts until the innovation is imitated by competitors. The sum of the excess profit from innovation through perfect competition I call excess value. Companies can lengthen the time between introduction of an innovation and imitation, and thus increase excess value, by creating barriers to entry, or moats.
This is why I don’t recommend retaining the asset-light model over the long term. It’s a good way to enter the market since it maximizes the potential for scalability in the presence of product/market fit. But once the company has grown into a larger market share, then comes the time for reinforcement—see NFX’s (Reinforcement: The Hidden Key to Building Iconic Tech Companies):
The effect of reinforcement is reminiscent of Metcalfe’s Law, which states that every new node on a telecommunications network compounds the total value of that network. Similarly, adding a new defensibility “node” compounds the value of the total defensibility of the company, especially if it’s a network effect.
That’s why a “castle” may be a better analogy for defensibility than competitive moats. You can only increase the difficulty of crossing a moat incrementally by digging a wider and deeper moat. But when you reinforce your moat with a castle wall, then reinforce both the moat and the wall with a tower, all the different components work together to increase the impact of each of the others. The defensibility of the castle as a whole undergoes non-linear improvement.
The other trap is to try and control every link in the value chain while still optimizing for the current state of the market, as Amazon did in the 1990s. The price to pay for this kind of efficiency was extreme rigidity (Amazon had a Walmart-like information system focused on doing retail in the most efficient way possible, but that was almost impossible to customize) and reliance on over-pressured suppliers, which can explode in your face at any moment.
As I wrote in a recent edition, Bezos himself was so terrified by the inertia that the over-optimized approach imposed on Amazon (in the wake of the dotcom bubble bursting!) that he immediately issued the legendary mandate that gave birth to Amazon Web Services: Amazon’s IT had to become flexible so as to enable constant innovation, and the way to go was web services communicating via APIs.
Therefore, the lesson here is the following: If you want control over the entire value chain so as to make the business more responsive to what consumers demand and thus more defensible against upcoming competitors, make sure you don’t pay the price in terms of inertia and that you don’t depend on unreliable suppliers (as Amazon once had with the painful experience of end delivery).
This whole context is what leads today’s new entrants to try and secure as much control as they can over their value chain, including by way of vertical integration. And this explains Charles’s idea that it’s legitimate to value consumer goods company like tech companies, provided they control their value chain from the direct relationship with consumers at the bottom all the way to the top:
Controlling the entire value chain makes it possible to respond to what customers demand, especially if that takes knowing more about what’s in the value chain.
At the same time, it also makes it possible to optimize every single link in the value chain—provided it’s only temporary and it can be reshuffled with the next (imminent) iteration.
Finally, it makes the company neutral as regards the distribution of power along the value chain: it can claim the entire profit pool without being subject to someone else’s ‘WTTP’!
No wonder why such companies, even if they don’t have much in common with actual tech companies, share characteristics with tech companies from a valuation perspective:
Their decisions regarding their positioning in their industry’s value chain make it possible to enjoy the same kind of increasing returns to scale—tipping the balance toward the Southern Side rather than the Northern Side of the business.
That being said, I’d like to dig deeper into that topic. Do any of you have reading recommendations on the right approach to valuing companies in the consumer goods industry these days?
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From Munich, Germany 🇩🇪
Nicolas
