7 Powers - A Framework for Finding High Quality Businesses (Part 1 of 3)

7 Powers - A Framework for Finding High Quality Businesses (Part 1 of 3)

This week I start the three-part discussion on the framework for business quality analysis – 7 Powers, invented by Hamilton Helmer who distilled his decades of management consulting experience into a single book.

How a Business Creates Value

Before I share how Helmer defines Power, let us understand how a business creates value. Focusing on the first principles without getting into the accounting, a business needs to:

  1. Obtain financing – equity or debt
  2. Use the financing to buy warehouse, real estate, etc. (capital expenditure on long-term assets), and buy inventory, pay employees (working capital needs)
  3. Generate a profit
  4. Uncle Sam takes a cut called tax. (Profit less tax is also known as Net Operating Profit After Tax, because the finance industry loves jargons)

The leftover is free cash flow (shown above). The value of any asset, such as a business, is the present value of future free cash flows it can generate. So, free cash flow is value creation. (The decision on what to do with the free cash flow is called capital allocation, some of you probably are familiar with the concept)

A good business is then one that maximizes free cash flow generation without needing a lot of incremental capital.

To maximize free cash flow, we have the following levers:

  • Profit: maximize price, minimize cost (profound insight, no?)
  • Lower capital expenditure
  • Lower working capital intensity (eg. Apple collects cash from you up front but delays paying suppliers, resulting in negative working capital. Effectively suppliers are providing short-term financing to Apple)
  • Lower financing needs
  • Minimize tax (that’s an advanced topic that we should consult John “Cable Cowboy” Malone)

Definition of Power

Now coming back to the definition: Helmer defines Power as sustained differential returns (on capital) versus competitors, (ie. a good business consistently generates 30% return on invested capital, or ROIC, when its industry peers generate 5%, sustaining a 25% differential ROIC).

Two things to note: 1) Power of a business has to be assessed within the context of industry peers 2) Competition is not static: new entrants can creep up and management can mis-execute.

The duration of excess return against industry peers constitutes power: If a business generates 30% ROIC for one year and then it starts to generate 5% ROIC going forward, the business has no Power.

There are two requirements to Power:

  1. Benefit: Positive impact to free cash flow – I already discussed the levers previously
  2. Barrier: Presence of obstacle(s) that drives the inability or unwillingness of competitors to drive down the profit for the entire industry, because competitions in a low barrier industry will drive everyone’s value creation down to zero.

Without further ado, the 7 powers are:

  • Scale Economics
  • Network Economics
  • Counter Positioning
  • Switch Costs
  • Branding
  • Cornered Resource
  • Process Power

Scale Economics

Relative scale matters in relation to industry peers. Especially for high fixed cost businesses, the fixed cost can be spread over a larger units produced, resulting in declining total unit cost as business increases in size.

  • Benefit: Reduced cost (due to spreading fixed cost over a growing unit produced)
  • Barrier: costly for a new entrant to replicate the fixed cost but have a much higher unit cost due to a smaller sales volume

Below is a theoretical example of an entrant attempting to compete with an incumbent who sells 200,000 units a year: The entrant will have to lower its sales price to $4.00 per unit to gain market share. It costs $300,000 to replicate the incumbent’s fixed cost, but its unit fixed cost is much higher at $7.50 (vs $1.50 for the incumbent) assuming the entrant can sell 40,000 units a year as it can only spread the $300,000 fixed cost over 40,000 units when the incumbent can spread the same fixed cost over 200,000 units.

Different types of scale economics discussed in the book:

  • Volume / area relationships: Milk tanks and warehouses - the cost to make them is tied to surface area since the inside is hollow, but customers pay based on the volume (because that’s how customers measure the value of a milk tank), which is multiples of the surface area.
  • Distribution network density: Logistics network is high fixed cost. The incumbent built a network that can achieve an acceptable utilization level, resulting in lower delivery cost per trip and better value to customers in delivery time and graphic coverage. It’s very hard for a new entrant when the unit cost is higher since it cannot achieve same delivery volume and the incumbent provides a better product because of scale so customers don’t want to switch (more on Switch Cost in the future).
  • Learning curve: In a process-driven industry, it takes large amount of units produced and time to get it right and achieve best yield (number of functioning products per batch). It also requires massive capital and the right company culture (I will discuss the latter in Process Power section in a future article). Best example on my mind is Taiwan Semiconductor Manufacturing Corporation, an outsourced semiconductor circuit manufacturing company that commands 40% operating margin (let me know any other outsourced manufacturing company that commands a 40% operating margin, and I will capture it in a jar and study it)
  • Purchasing power: Classic examples would be Walmart and Costco. These big players are responsible for a big portion of their suppliers’ revenue, so Walmart and Costco can push down on pricing against suppliers and have lower unit cost. Furthermore, Walmart and Costco can pass the benefit to customers. In turn, customers want to come back to them, creating a virtuous cycle.

That’s enough for this week for you to digest (hitting 1,000 words already), I will discuss three more Powers in detail next week.

7 Powers is a widely known book. Feel free to triangulate other summaries on the book. Please tell me if I am missing anything or I am wrong.

If you are interested in learning more about professional equity investing (the "buy-side"), I have two other great articles for you:

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