Which quadrant are you?
More importantly, which quadrant do you want to be? How well you answer this question will determine your success with investors and acquirers.
Returns
Returns are ultimately judged by cash flow and the key financial metric is Free Cash Flow which is your Operating Cash Flow less your capital expenditures. Free Cash Flow is what you have to make debt payments and dividends. Margins are important, but they are not enough. Companies can be profitable, but still go bankrupt. You need cash to pay your bills and pay back debt. And you need cash if you want to make distributions to yourself. While improving margins helps you increase your Free Cash Flow, when investors and acquirers judge the quality of your machine, cash flow is what counts.
“What about EBITDA? All the multiples are off EBITDA” you might be saying. Acquirers, especially PE acquirers, know what Warren Buffett knows about EBITDA. It can be gamed and the truest expression of the operating health of the company is free cash flow. But in this case, you can have your cake and eat it too. Producing strong free cash flow will almost certainly mean producing healthy EBITDA.
Capital Inputs
Why did Costco stock increase by 45% (as compared to 26% for the S&P) and trade at a 45 PE in 2023? It’s not because they have a high FCF / Revenue %. A big reason is investors understand Costco is super capital efficient. One key piece of evidence is their Inventory Turnover Ratio of 11.8. Think about that. They turn their inventory 12X per year. Their winning solve to the equation is low returns, but super high capital turnover.
Where is your subsegment?
You want to understand which quadrant your subsegment occupies for the broader market (like the quadrants above). For example, luxury is going to be high FCF and mass retail high inventory turnover. But we can’t all sell Birkin bags for $25,000 just as we all can’t turn our inventory once a month. Your strategy is going to be constrained by the market forces applied to your subsegment.
Which quadrant do you currently occupy in your subsegment?
Now, plot a fresh quadrant and then populate it with just your subsegment or competitive set. You won’t know anyone’s FCF/Revenue % or Inventory Turnover Ratio, so use margins as an approximation for returns and then make your best guesses.
Most importantly, which quadrant do you want to be in?
You really only have three choices.
- High FCF/Revenue & Low Capital Turnover
- High Capital Turnover & Low FCF/Revenue
- High FCF/Revenue & High Capital Turnover
No one is investing or buying (at premium valuations at least) in the 4th quadrant of Low FCF/Revenue & Low Capital Turnover.
Deciding on where you want to be in the quadrants and then delivering the evidence of progress becomes your strategy and narrative.
“We are going to become the dominant brand in our market segment by achieving best in class Free Cash Flow generation and Capital Turnover. Three years ago, we were here on both those metrics. And in three years we will be there.” Or
“Our ability to increase capital turnover used to be constrained by our supply chain. Because we have moved to production to the US, we have been able to dramatically increase capital turnover. We were here, we are now here and in three years, will be there. The impact on unit margin was this, but through higher turnover and X, Y and Z, we will do…”
You get the idea. You will be able to frame your narrative to investors and acquirers in language that not only helps them understand how good your machine is, but also helps them understand your unique positioning and competitive moats. Even better, you will be able to translate this narrative into goals that have meaning for teams and individuals.
I chose the companies for the quadrants because I wanted examples for each quadrant that would be familiar. Hermes is in class unto itself. As is Costco. And LULU and ELF had terrific 2023’s.
Table of select metrics from example companies
For more detail on all this, check out the Payoff Playbook post.
Source
I pulled this data from the Elephant Herd Index.
blog post about the Index: https://elephantherdconsulting.com/blog/blog-database/introducing-the-elephant-herd-index
google sheet: https://docs.google.com/spreadsheets/d/18oStHdBC1cpfd85xRvGY-ihOzFI4KsR8eQvIgUpKYcU/edit?usp=sharing
The ultimate source of the data is koyfin.