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The value of disruptors is different

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25 October 2018

by Alex Pollak
October 2018

Contrary to commentary found in Cuffelinks recently, investors are not naive when they buy shares in ‘expensive’ major global businesses that are using the latest tools to win customers. Those investors have chosen these companies, which now fall into the category of disruptors, because they have outgrown and are continuing to outgrow their nearest competitors. Investors have to pay up (in a valuation sense) to access them.

It’s not simply a power train

Earlier this month, Porsche (effectively a division of Volkswagen) announced that it will no longer produce the diesel engine in its popular Cayenne and Macan four-wheel drive vehicles. Investors who had bet that the 2015 VW diesel scandal would just ‘blow over’ were wrong, with Volkswagen off 40% since the cheating was revealed. Exhibiting the same share price trajectory is Daimler Benz, down 30% in three years to €57 per share. It wasn’t caught cheating (and you should unpick that phrase very carefully) but will probably also phase out the diesel over time.

If we were simply considering two companies together, in stasis, making the same electric cars, then maybe the valuation comparison would be closer. But the history of these two competitors, and their existing structures, means that their journeys will be different, and so will their share prices.

So while it may be tempting to simply view the car makers as moving from one power train (internal combustion engine, whether diesel or petrol) to battery or hybrid, it isn’t that simple. Well-established fossil fuel engine companies have extensive supply chains which produce tens of thousands of components, which means that any car maker will have to manage the costs in that process in tandem with the costs in the new process.

Like all manufacturing, how all these parts come together often isn’t just a matter of contract, it’s also about the hundreds of other things that need to come together to get the job done, some of which come with complex arrangements.

New technologies blow all this away – disrupt it, in fact – breaking down the industries just as they eat in to sales, creating new pockets of wealth all along the way.

If it were just as easy as adding on a business, Daimler and VW and BMW would not have fallen in the wake of the diesel problem. They would have rallied in anticipation of the new electric cars they would produce. But the real way it works is that existing managements, boards and shareholders don’t get paid for the value they create through disruption but are still penalised for the coming re-engineering that will be forced upon them.

Other industries are the same

It’s the same with Woolworths and Coles. These companies are optimised for sales in shopping centres controlled by Westfield and the like. A significant move online simply cannibalises their existing store sales without reducing the fixed costs of those stores. At the same time, creating an online fulfilment channel can be very expensive. The combination of lower throughput in the physical store and higher costs for online is a drop in profit.

Another example: Foxtel and free-to-air networks are struggling to make their existing one-to-many broadcast television models work, in part because Netflix and others have taught viewers to expect that their favourite content should be available any time, including with a fast forward or pause button. Foxtel can’t offer this with the same economics as its regular pay tv service – it hurts the advertising and subscription funded business model, which is based around as many people watching the programme at the same time as possible.

Globally, Walmart, the car companies, AT&T, and Procter and Gamble are affected. In Australia, it’s Telstra, Fairfax, Coles, Myer, etc. By the way, this is the reason that Murdoch sold out of content creation in the US and UK.

And banking? What will the banks do with their heavy management structures built to corral people during different credit cycles at a time when the world’s understanding of money is that it is truly a digital commodity? How many operatives does it take for a consumer to send money over a mobile phone?

Then we come to Tesla, the subject of a recent commentary on Cuffelinks. The company is capitalised at US$50 billion, 10%-20% below Daimler and VW. But Tesla doesn’t have tens of billions of dollars of capital tied up in obsolete plant or sales channels geared to that plant.

Of course, we know that the market has discounted the value of Daimler, so that its enterprise value is just twice its EBITDA. So in theory, the share price of the company already reflects the current situation. Maybe. But whether Tesla is expensive because it is valued at more than Daimler is not something that can be divined by cherry-picking a few statistics, such as the number of cars produced per dollars of capitalisation.

Meanwhile, Tesla has just produced 80,142 cars in the quarter to 30 September 2018, implying an annual run rate of over 300,000 cars. It will probably produce a million cars by 2022 at US$60,000 per car. Is the market ready for a company which is generating US$60 billion in annual sales, with gross margins in the high teens? Maybe not.

In a perfect world, we could all just buy companies on low multiples and sell them as they went up. But the world is not perfect, and investors must operate according to the circumstances. Wishing the investment problem would go away, and making negative return in the process, isn’t a preferred option.

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