March 27, 2024

A Royalty On The Growth Of Others

I've remarked in the past that I discuss with you some of the best businesses on earth, such as Snowflake (SNOW), Adyen (ADYEY), or (MNDY), the latter two of whom I've rated buys over the last six months. As an aside, I do plan to rate Snowflake a buy when its valuation sufficiently "enters the strike zone;" that said, it's still worth considering Snowflake alongside Adyen and Monday within the context of this short note.

Like other controversial opinions I have, with which many would disagree, e.g., "competition is not a bear thesis," there's nuance to my assertion that we own the best businesses on earth (as there is nuance to my assertion that competition is not a bear thesis).

Very notably, my assertion that I discuss with you some of the best businesses on earth implicitly conveys the concept that our companies have differentiated products/platforms that are not easily replicable; especially so because the incumbents within the industries within which our businesses operate are usually hamstrung by "The Innovator's Dilemma." This thinking is a key component of LAS' Inverse Bubbles investment framework that I will discuss with you over time.

Not only have our businesses fielded differentiated, industry/category-defining products/platforms, which have created the meteoric growth our companies have experienced over the last five to twenty years, but also, very importantly, usually the incumbents within our companies' industries have established "value networks" (centers of profitability) based on specific product attributes and their corresponding unit economics.

S1 Has Fielded The Number One Rated CNAPP Product According To Gartner Product Reviews

For instance, I recently shared that Affirm's CTO stated something to the effect of, "There's $1T in revolving credit card debt in the U.S., and none of it should exist."

In stating this, he meant that consumers have a vastly different experience in using Affirm's credit product, which charges no late fees, no hidden fees of any kind, and lower rates than credit cards, and uses simple interest, as opposed to revolving on a credit card, which does charge late fees, hidden fees of various kinds, and often usurious interest rates, and uses compound interest.

While these are just words on a screen within the context of this note, there's tangible, indisputable, physics-based energy dynamics (put another way, economics) underlying the assertion of Affirm's CTO, and my subsequent elaboration of his assertion.

Capital One, a purveyor of legacy credit products, such as a revolving credit card, has built its unit economics, which flow into its free cash flow per share (net income or EPS, roughly), on higher interest rates than Affirm charges. It has built its unit economics on late fees of various kinds and junk fees broadly, which Affirm does not employ to create its unit economics, and ultimately free cash flow per share. Capital One employs compounding interest, as opposed to the more consumer-friendly simple interest that Affirm employs, to create the economics of its business.

In order for Capital One to compete with Affirm directly, it would need to rip out the entire foundation of its unit economics; of its credit card franchise, and install a totally new foundation, which, as you likely intuited, would very likely create collapsing free cash flow per share (roughly EPS) in the process, and a rapidly declining share price for all of Wall Street to observe in horror.

This is a real life, ongoing example of "The Innovator's Dilemma" that Clayton Christensen illustrated for the world his book aptly titled "The Innovator's Dilemma." (It's worth a read, though it is quite dense.)

Tying this into my assertion that we own the best businesses on earth, it's important to note that the best businesses on earth might not be those that have the biggest margins as of today or the most well-defined and universally accepted economic moats (competitive advantages).

The best businesses on earth, as measured by 1) their ability to grow at an elevated rate and 2) the consumer surplus they create (both of which are inextricably linked), have created materially better products, resulting in materially larger consumer surplus (as in the example of Affirm vs Capital One depicted above), and have the ability to grow at rapid rates for extended periods of time within the established industries in which they operate; in which they will siphon dollars from incumbents, such as S1 and Crowdstrike performing Splunk rip and replaces via their next gen SIEM platforms.

So while McDonald's (MCD) may have more than 2x the sales of Chipotle (CMG) as of today, the reality is that Chipotle's product is vastly more attractive to many consumers than the product McDonald's offers, and, in order to compete with Chipotle, McDonald's would need to totally restructure its product and corresponding unit economics, jeopardizing the entire franchise in the process.

Again, through this process of unit economic and product restructuring, Wall Street and investors would watch in horror as margins compress and chaos ensues (note Adyen's recent 50% decline in the span of 72 hours resulting from just near term reinvestment, much less total overhaul of the business' economics).

In this example, McDonald's superior margins and larger total sales belie the fact that Chipotle has a better product (more nutritionally diverse; better taste-adjusted calorie/$) that creates greater consumer surplus, affording Chipotle the ability to grow at elevated rates for many years to come, while also generating robust free cash flow.

We've seen this dynamic play out for Tesla (TSLA), Adyen (OTCPK:ADYEY), Snowflake (SNOW), and many of our businesses in the last 10-20 years or so. While market participants doted on the incumbents with better margins and bigger sales and more resources with which to compete with the fast-growing new entrants, the underlying reality was that new entrants had fielded the superior products, along with their unique, differentiated unit economics, and, in light of their superior products with superior economics, they were the better business; with which the incumbents would ultimately struggle to compete due to their established product unit economics.

Hence, I often remark, "I discuss with you some of the best businesses on earth."

One day, these companies will be the incumbents, with established value networks (product unit economics), via which they pay a quarterly dividend obligation, and these companies will be the ones being slowed by dynamic, innovative new entrants.

A Royalty On The Growth Of Others

As I noted in the bullets, I recently happened upon a quote from Mr. Warren Buffett in which he stated that "the best business is one that is a royalty on the growth of others."

In remarking this, he meant that the best business is one that has fielded a product that requires little additional capital to generate the next incremental sale, ultimately layering more and more high margin revenue onto an already attractive business.

I will use an example in just a moment to elaborate this idea.

To further buttress said oft-shared assertion that I share with you the best businesses on earth, it's worth looking at our companies through the lens of Mr. Buffett's quote.

For those who'd like to remind themselves of what a royalty is, I would invite you to watch the brief video shared in the link just below.

  • Defining a royalty
  • (The short video even uses software businesses as an example, and, of course, I often share that software is a great, easy-to-understand business in which to invest, and our software companies are "insanely well-capitalized.")

Many of our businesses operate models with this precise royalty structure in which, as our customers grow, our businesses grow, while also adding more customers, who themselves grow over time, resulting in a compounding wave of growth that produces the incredible hypergrowth we've witnessed from companies such as Adyen, Snowflake, SentinelOne, Crowdstrike, and

Growth Of One Snowflake Customer's Revenue Contribution Over 11 Quarters

Snowflake 2023 Investor Day

  • Snowflake's sales grow rapidly via this customers' growth in usage, which requires relatively little additional capital from Snowflake.
  • The customer pays Snowflake a royalty to continue to store and manipulate data on Snowflake's platform, and, over time, as the customer grows, Snowflake's royalty grows, quintessentially embodying Mr. Buffett's thinking.

As I promised a moment ago, let's now walk through an example using Adyen.

Once Adyen has added a customer, that customer may use X amount of Adyen's services, just as the aforementioned Snowflake customer starts by using a relatively small X amount of compute & storage, resulting in Adyen generating, as a totally random number, $10M in sales in, for instance, its first quarter with the new customer.

Without any further effort or additional capital (excepting the relatively small amount of capital needed to render the service at greater scale), Adyen's customer, for instance, Uber, could grow sales at 50%, and, as a result, Adyen's sales coming from Uber would grow to $15M.

Adyen's royalty on Uber's business would grow as Uber grew.

"The best business is one that is a royalty on the growth of others."

In this example, Adyen has "a royalty on the growth of Uber's business," and, of course, this could be said for all of Adyen's customers.

What's more, while that royalty growth continues, Adyen would also add new customers, layering on even more business, and, as if it couldn't get any better, Adyen could upsell existing customers on new products, on which Adyen would receive a growing royalty as well.

This incredible triple pronged growth engine applies to many of our companies, e.g., S1, Crowdstrike, Marqeta, Axon, and the list goes on, and it results in meteoric sales and profits growth for those that execute it well (Marqeta has not done so in recent years!).

Specifically, this triple pronged engine of growth has created the almost unbelievable growth Adyen has experienced over the last decade, which I delineated for you when the stock traded at $6.80/share:

Adyen Grows Its Operating Income From $45M to $700M in The Last Eight Years. A Stunning Feat Of Business Growth

And, very importantly, we should remember the ideas with which I introduced this note.

While the above royalty structure is nice, it's made even better when incumbent competitors are hamstrung by "The Innovator's Dilemma." It is made even better when competitors have established "value networks," i.e., books of business that are constituted by specific unit economics that would need to be totally restructured in order to effectively compete with, for instance, Adyen (OTCPK:ADYEY) or Affirm (AFRM) or Axon (AXON).

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