Tuesday, September 11, 2007

Skimming the cream

Why is Google such a good business? Because they skim the cream in terms of Internet revenues. Microsoft was one of the first to do this when they decided early on to just sell software. At that time there was no independent software industry -- computing was fully integrated so you bought everything you needed from one company -- most of the time that was IBM.

Microsoft realized that the true value add was in the software so why not just concentrate on that part. That's the cream -- by focusing on just operating systems, large scale applications as well as some programming tools, Microsoft was able to generate very high operating margins -- as in nearly 50% at their peak a few years ago.

Google is similar -- they generate most of their revenues from online search advertising which is the highest value added part of online revenues because most of the time when you are searching you are looking for something -- often something that someone else sells. How powerful is that information -- to know when someone is looking to buy something a high percentage of the time? That is incredibly valuable info and that is why some companies pay huge key word prices -- because what looks huge is actually a much smaller customer acquisition cost than other methods (offline advertising, promotions, store displays, etc).

I was reminded of this concept of skimming the cream when looking at a company called Landstar. They offer trucking services without the trucks -- non-asset based services is the term. They use independent truckers and serve as a middleman between them and those with goods to be shipped. They earn low margins but they don't have much in the way of assets so they can earn a high return on assets and a good return on equity. They also produce good cash flow too. In fact their cash flow is so good that they have bought back over 40% of the stock in the last 10 years -- a slow motion LBO I guess. Their costs are all variable just like revenues so margins are pretty consistent but revenues fluctuate with the economy -- now is not the best time to be almost all US based revenues in a heavily economically cyclical business like trucking. Still its a neat business and one to keep an eye on -- I think CH Robinson (CHRW) is similar.

In a way skimming the cream is also what Amphenol (APH) does -- completely focused on the higher margin parts in the business. I listened to a webcast of a recent presentation they made and learned a couple of insights. They divided up their markets into 2 parts -- the top 10 competitors of which they are number 3 and the next 1000 competitors. The top 10 have a bit more than 50% of the market, which leaves the rest of the market spread amongst 1000 others. They should have some advantages over the bottom 1000 including scale, customer relationships, broad product line etc. I still don't know for sure how much of the market is 20% margin but I now believe it is bigger than I first thought. Their scale (size) and focus on costs means they could be earning 20% margins on revenues that some of those 1000 competitors are only earning 10% on.

They are focused on organic revenue growth of 2X the industry and profit growth of 2X revenues -- if they could maintain that pace the stock is a bargain.

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