Growth, and Other People’s Money
I saw the financials recently of a relatively small business that aspires to be a premium global consumer brand. Not only that, but it’s made some progress towards achieving that goal and may ultimately get there. But what was interesting to me was the trajectory of the company’s growth and what that might portend.
Rewind three years and this was a company that was growing ~25% annually with gross margins around 50% – well above the industry average. That’s a real success story: good growth with premium pricing. Those numbers suggest that there was a there there that’s really resonating with consumers.
At that time the company decided to take on outside capital so (1) the founder could take some chips off the table and (2) the company could invest in its balance sheet. That capital came from one of the big well-known firms through a fund that had less than 5 years left on its fund life.
What do you think happened next?
When I think about trying to build a valuable brand, I always think back to the time I met Brunello Cucinelli at an investment conference in Paris. His namesake fashion house was newly public at the time and he was trying to set expectations in the market. He told everyone at that conference that his company would never grow too fast, that he would aspire to gracious growth, and that he would protect quality, reputation, and margins at all costs. That, I suppose, is how you sell $2,495 cargo pants.
What an approach like this means for investors is that the returns in any individual year will never be extraordinary, but that over a lifetime of compounding, something of extraordinary value will be built. Would you invest? Obviously it depends on your time horizon and whether or not it matches Mr. Cucinelli’s.
Back to our aspirational consumer brand…
With a new investor that wanted to be out in less than 5 years, they mashed the pedal down on growth. Sales almost doubled the first year, and then doubled again. But gross margins dropped 1,200 basis points, profitability evaporated, and the business started to consume cash as inventory piled up on the balance sheet. Yes, you can achieve incredible temporary growth if you’re in-stock and slash prices.
And then the investor was back out in the marketplace trying to sell its stake at a valuation of 3x sales, believing it had earned 5x on its investment in just a few years.
Are you a buyer?
Running the numbers I could back into their valuation by assuming that the company could sustain its recent pace of growth while margins and the amount of inventory the company carried on its balance sheet reverted to previous levels. But that seemed to me an impossibility. Margin is one of the hardest metrics to recover in the marketplace. If you built your share on lower prices, your customer is not likely to stay with you when you raise them and raising prices is not something you can do when you have elevated levels of seasonal inventory. So what happens next is anybody’s guess.
My experience is that every company faces inflection points and that what happens next depends on what the organization is optimizing for. Very often what the organization decides to optimize for ends up matching what its investors are optimizing for. And while everyone says they’re a “long-term” investor, people define that term differently. This is why one should figure that out before taking someone else’s money and choose carefully before you do.
– By Tim Hanson