In the last post - When STGU Go Down: An Unlikely Case Study - we examined Medifast, which is a company I described as a bad business that benefits from a good business model. We contrasted Medifast with Carnival, which I described as a good business with a bad business model.
What was so bad about Carnival? We identified their extreme levels of financial leverage and operational leverage that have amplified fundamental issues facing the business and have limited management’s ability to respond to crisis.
What was so great about Medifast? We identified their low degree of financial leverage and operational leverage, which allows their management team a wide array of options when dealing with business issues.
Does this mean Medifast is devoid of leverage in its business or business model? No, that’s not necessarily true.
I contend every business benefits from some kind of leverage in its ecosystem. You just have to find it.
What is Leverage?
This is a tough question. If you ask 100 people you’ll get 100 answers. The traditional answer is debt of some kind that shows up on the financial statements. A broader answer is any scenario in which a company utilizes other people’s money (OPM) when conducting business.
I think this is a good definition of leverage:
“Leverage is using other people’s money or resources to one’s benefit.”
In my opinion there are two types of leverage: Explicit leverage and implicit leverage.
Explicit leverage is what Carnival has. They have debt listed on their balance sheet and they have operational leverage that is easily discovered in the income statement. This leverage is explicitly Carnival’s responsibility. Carnival uses these funds to make a profit and uses those profits to maintain good standing with their lenders.
Implicit leverage is sometimes harder to identify and can come in a lot of forms. For Medifast, remember when I said the business model utilized its customers as an outsourced sales force and warehouse? That’s Medifast using OPM to their benefit.
We found the leverage in Medifast’s model! They utilize implicit leverage provided by customers, albeit compulsorily.
This type of leverage is a great benefit to Medifast and is non-recourse to the company. As a result, they have no lenders who can show up and take the keys to the company, unlike Carnival. By utilizing implicit leverage, Medifast is shielded from any claims from its pool of leverage and can make money in peace.
Other Examples of Implicit Leverage
Asset Managers - Asset managers of all kinds utilize OPM for fee income.
Home Builders - While also carrying high levels of explicit leverage, home builders rely on customer balance sheet expansion for profit.
Medical Device & Pharmaceutical Companies - Product and service providers to the healthcare system benefit from the financial intermediation of healthcare. (Said another way, insurance companies and Medicare are fulcrums of leverage in healthcare)
Stock Based Compensation
The most common other source of implicit leverage is Stock Based Compensation (SBC). In this case, instead of a company borrowing explicitly from a bank or relying on customers for implicit credit, the company leverages the skills and abilities of its own employees.
Here is how leverage in SBC works:
Let’s say you are an engineer and the market price for your skills is $150,000 per year. Company A, a non-utilizer of SBC, might pay you exactly that rate in cash per year. Company B, a utilizer of SBC, might pay you $100,000 in cash and $75,000 in stock.
What does that $75,000 per year in stock cost Company B? It costs the company nothing to create new shares out of thin air, so $0. (Note: There is a cost, but we will get to that.)
So Company B can get the same skills and abilities into its operation for $100,000 cash that would cost Company A $150,000. Leverage!
What’s the Catch?
Like any kind of leverage there is a cost. Carnival’s financial leverage gives lenders a lot of control. Medifast’s customer-borne leverage subjects them to the financial wherewithal of their customers.
Stock based compensation expense falls not on the company but on the shareholders via dilution. Michael Burry, the famed investor, wrote on the subject in his column on MSN Money (linked below, CTRL+F “Stock options”).
For many tech companies, options compensation is a big issue. In a rising market, the net income tax benefit can be quite large - but it only reflects 35% of the actual cost of paying employees with options. How does it cost the company? Because the company must either issue new stock or buy back stock for issuance to employees in order for the employees to obtain this stock at a discount.The cost is borne by shareholders. The per share numbers worsen, while the absolute numbers improve (after all, issuing stock at any price is a positive event for cash flow if not shareholders).
I agree with most everything Burry says, but reach a slightly different conclusion. I actually think SBC can be a competitive advantage.
Assuming the share price is relatively consistent (or rises), companies that use SBC as implicit leverage maintain a competitive advantage over their competition. In the example above, Company B gets an engineer’s services for 30% below market in cash terms.
Not only are companies that utilize SBC getting value in that sense, they conserve precious resources, which can be utilized for other purposes - innovation, customer acquisition, marketing, etc. (Example: While Company A is paying the engineer market rate, Company B is out using the cash it saved to steal Company A’s customers.)
This sounds like optionality! Remember that concept from the last post? The more options you have in business, the better you are going to do.
Burry would push back on my assertion above and say:
“Look, the shareholders are paying that engineer market rate for his skills, so this is all a wash. It’s just a reallocation of costs off the cash flow statement and onto shareholders.”
I counter that argument by saying the value of managerial optionality (i.e. having more cash available and therefore more options than Company A) is a vastly greater benefit than any sum that is being re-allocated to shareholders. And the benefits accruing to the company will ultimately fall to shareholders.
I assert that under many conditions SBC becomes a competitive advantage by providing access to talent below market rates and providing managerial optionality to management.
Notice I hedged my previous statement… under many conditions, not all. I also said that companies utilizing SBC have a competitive advantage assuming the share price is relatively consistent (or rises).
If the share price is falling or has fallen, what is the likelihood the engineer we used in the example above will decide to take his talents to Company B? Not good unless Company B coughs up more cash. In that case, goodbye managerial optionality.
What happens to the currently employed engineers who are now on paper making a lot less than their counterparts at Company A? They might leave.
You see where this is going. Just like all kinds of leverage, there is an upside and a downside. The downside outcomes are all devastating, but with SBC perhaps not existentially so.
Companies that utilize SBC can quickly turn into a confidence game of sorts. I argue this can be a good thing. Burry might tell me I am crazy and say it’s clearly a bad thing. To be fair, there are two sides to every story!
Admittedly, SBC is a confidence game that is not unlike playing Craps… Everyone wins and loses together!
Here is how the game works: The higher the stock price, the more managerial optionality the company has, the more value can be created or market share can be taken which eventually accrues to shareholders, the higher the stock price, the better the talent that is attracted… And so on. And vice versa. It works in reverse too.
This becomes a reflexive feedback loop of market share gain, value creation and stock price appreciation. The best example of this reflexive feedback loop is Amazon, as we saw in the Amazon: The GOAT STGU post.
What’s the Point?
I have no problem with SBC much in the same way that some investors have no problem with financial leverage. As long as you understand that it is leverage and is a fulcrum from which a company can create value, then there is no problem with it.
I tend to like SBC because it is implicit leverage, meaning the leverage is non-recourse to the company and won’t cause existential threat to the equity. I also like SBC because it comes with implicit managerial optionality. Implicit options can sometimes become extremely valuable.
Finance bros have a term that applies here. It is called convexity. Convexity describes the rate of change of change. Now that’s not a very helpful description. It is easier to walk through an example. You can also click the link above for a more detailed and official definition.
Let’s say Company B uses SBC and exercises its managerial optionality over Company A for a single year. What’s the benefit? It might be small, maybe 1 point of market share captured from Company A or a single customer stolen.
Now let’s say Company B uses SBC and exercises its managerial optionality over Company A for 10 years in a row. What’s the benefit? It might be gigantic, well more than 10 times a single year’s benefit.
That is convexity in a nutshell. It is when changes in underlying assumptions lead to disproportionately large changes in outcome.
I argue that SBC as a form of leverage is superior to alternatives because it poses no existential threat to equity holders and it embeds an implicit option in the equity that makes the equity positively convex. This positive convexity can lead to disproportionately large equity returns over long enough time frames.
In plain English, when a company that utilizes SBC as leverage starts to win, they can really really win.
SBC and other forms of implicit leverage will be an important topic to keep in mind as we start looking for STGU in the market.
I hope you all enjoyed today’s post. Eventually we are going to start looking at individual STGU and we might just start in the next post.