LM03 Business Models & Risks

Part 1

1. Introductory Context/Motivation

This reading covers:

• What is a business model
• The types of business models
• The financial implications of business models
• Risks faced by companies – Macro risk, business risk, and financial risk

A well-defined business model helps analysts in understanding a company’s operations, strategy, target customers, key partners, prospects, risks, and financial profile. Many companies have conventional business models that are easily understood, such as manufacturer, wholesaler, retailer, restaurant chain etc.

However , the advent of digital technology has changed the way most businesses operate, and enabled disruption of existing business models. Many companies now have business models that are complex, specialized, or new.

2. What is a Business Model?

A business model describes how a business is organized to deliver value to its customers:

• who its customers are,
• how the business serves them,
• key assets and suppliers, and
• the supporting business logic.

A business model explains what the company does, how it operates, and how it generates revenue and profits, as well as how it differs from competitors. It provides enough detail to understand the basic relationships between these key elements, however, it does not provide a full description. For a full description (such as detailed financial forecasts) we would have to refer to a business plan.

A business model should have a value proposition and a value chain.

• The firm’s “value proposition” refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over those of its competitors, given relative pricing.
• The firm’s “value chain” refers to how the firm is structured to deliver that value. It refers to the systems and processes within a firm that create value for its customers.

This is illustrated in Exhibit 1 from the curriculum.

Business Model Features

The key features of a public company’s business model are often provided in annual reports or other disclosure documents. As an example, the curriculum presents the ‘business description’ from Tesla’s annual report.

“We design, develop, manufacture, sell and lease high-performance fully electric vehicles and energy generation and storage systems, and offer services related to our products. We are the world’s first vertically integrated sustainable energy company, offering end-to-end clean energy products, including generation, storage and consumption. We generally sell our products directly to customers, including through our website and retail locations. We also continue to grow our customer-facing infrastructure through a global network of vehicle service centers, Mobile Service technicians, body shops, Supercharger stations and Destination Chargers to accelerate the widespread adoption of our products. We emphasize performance, attractive styling and the safety of our users and workforce in the design and manufacture of our products, and are continuing to develop full self-driving technology for improved safety. We also strive to lower the cost of ownership for our customers through continuous efforts to reduce manufacturing costs and by offering financial services tailored to our vehicles. Our sustainable energy products, engineering expertise, intense focus to accelerate the world’s transition to sustainable energy and achieve the benefits of autonomous driving, and business model differentiate us from other companies.”

In this paragraph, Tesla describes many features, including its products and their attributes, key channels, and its emphasis on innovation and vertical integration. Let’s take a closer look at the features.

Customers, Market: Who

A business model should identify the firm’s target customers:

• What geographies will be served?
• What market segments will be served? (e.g., high income suburban families)
• What customer segments will be served? Is this a business (B2B) or consumer (B2C) market?

In the Tesla example, the business description does not specify which customer segments are being targeted. This is most likely because Tesla’s target market is shifting over time toward the mass market, as costs and prices decline.

Firm Offering: What

A business model should define:

• What products and services are being offered?
• What differentiates these offerings from competitors?
• How are the needs of its target customers being met?

In the Tesla example, instead of using a broad description such as “electric car” to describe its product offering; Tesla has used a more precise description that is useful to analysts – “high-performance fully electric vehicles and energy generation and storage systems”.

Channels: Where

A firm’s channel strategy refers to “where” the firm is selling its offering and how it is reaching its customers. Channel strategy typically involves two main functions:

• Selling the firm’s products and services
• Delivering them to customers

When evaluating a firm’s channel strategy, it is important to distinguish the functions performed, from the assets that might be involved, and different firms that might be involved in performing those functions or owning those facilities. Exhibit 2 from the curriculum, illustrates this concept.

Many “product” businesses, employ a traditional channel strategy, that reflects the flow of finished goods (e.g., from manufacturer to wholesaler, retailer, and end customer). However, some manufacturers may employ a direct sales strategy, selling directly to the end customer. This strategy bypasses (or disintermediates) the distributor and retailer. Typically, direct sales involved the use of the company’s own sales force and was very expensive. However, with e-commerce, direct sales have now become a cost-effective strategy. Exhibit 3 from the curriculum compares the two strategies.

When an intermediary is involved, that intermediary may work on an agency basis, earning commissions, rather than taking ownership of the goods (e.g., auctioneers such as Sotheby’s that deal in fine art).

The drop shipping model in e-commerce allows an online marketer to have goods delivered directly from the manufacturer to the end customer without taking the goods into inventory.

Companies often use several channels in tandem. With an omnichannel strategy, both digital and physical channels are used to complete a sale. For example, a customer might order an item online and pick it up in a store (“click and collect”).

It is important to understand how a firm’s channel strategy differs from those of its competitors. For example, Tesla mentions its direct sales strategy, which differs from the franchised dealer model used by most automakers.

Pricing: How Much

A business model should answer the following questions related to pricing:

• Does the firm price at a premium, parity, or discount relative to competitors?
• How is the firm’s pricing justified in its business model?

Based on pricing power companies can be classified into:

• Price takers – Companies with little differentiation are “commodity” producers who must accept market prices dictated to them. Such companies focus on other sources of value such as employing a discounting strategy to build scale and a cost advantage (e.g., Walmart).
• Price setters – Companies with high differentiation can command premium pricing and face significantly less pricing risk from competitors.

Most firms try to differentiate their offerings in some way to achieve some degree of pricing power. For example, Tesla focuses on the “total cost of ownership” which factors in government subsidies and lower operating costs for electric vehicles as an offset to higher purchase prices.

Pricing and Revenue Models

Pricing approaches are typically value based or cost based.

• Value-based pricing attempts to set pricing based on the value received by the customer. For example, Tesla can command a premium price because they have low operating costs, which is a source of value for their customers.
• Cost-based pricing attempts to set pricing based on costs incurred. For example, an environmental law firm may charge clients by the hour because it is difficult to predict how many hours (cost) will be required and how much value the client will receive.

Price Discrimination

Price discrimination refers to situations where firms charge different prices to different customers. The objective of price discrimination is to maximize revenues in a situation where different customers have different willingness to pay. Common pricing strategies in this category include:

• Tiered pricing charges different prices to different buyers, most commonly based on purchase volume.
• Dynamic pricing charges different prices at different times. For example, off-peak pricing offered by hotel rooms and airlines, and movie tickets; and surge pricing offered by ride sharing companies.
• Auction/reverse auction models establish prices through bidding.

Pricing for Multiple Products

Firms selling multiple products frequently use the following pricing models:

• Bundling refers to combining multiple products or services so that customers are incentivized, or required, to buy them together. For example, cable TV and internet services, prepackaged set of kitchen utensils.
• Razors-and-blades pricing combines a low price on a piece of equipment and high-margin pricing on repeat-purchase consumables. For example, razors and blades, printers and refill cartridges.
• Optional product pricing applies when a customer buys additional services or product features, either at the time of purchase or afterward. For example, deluxe interior for a car, a side order with a restaurant meal.

Pricing for Rapid Growth

• Penetration pricing: A firm willingly sacrifices margins in order to build scale and market share. For example, Netflix subscriptions, Amazon e-readers.
• Freemium pricing: Allows customers a certain level of usage or functionality at no charge. For example, mobile games, software applications.
• Hidden revenue business models: Provide free services to users while generating revenue elsewhere. For example, media sector which provides free content and paid advertising.

Alternatives to Ownership

Some business models create value by offering an alternative to purchasing an asset or product, such as:

• Recurring revenue/subscription pricing: Enables customers to rent a product or service for as long as they need it. For example, TV channels, telecommunication services.
• Fractionalization: Creates value by selling an asset in smaller units or through the use of an asset at different times. For example, web hosting which allows sharing of server capacity, Office sub-leasing/co-working.
• Leasing: Involves shifting the ownership of an asset from the firm using it to an entity that has lower costs for capital and maintenance. For example, real estate, aircrafts.
• Licensing: Gives a firm access to intangible assets (e.g., brand name, song, patented formula) in return for royalty payments.
• Franchising: It is a more comprehensive form of licensing, in which the franchisor typically gives the franchisee the right to sell or distribute its product or service in a specified territory and to receive marketing and other support.

Value Proposition (Who + What + Where + How Much)

A firm’s value proposition refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over those of its competitors, given relative pricing.

Value propositions can arise from:

• The product itself – e.g., performance, features style etc.
• Service and support – e.g. access to repairs, spare parts etc.
• The sale process – e.g., purchasing convenience, no-hassle return
• Pricing relative to competitors

In the Tesla example, its electric car value proposition highlights the advantages of its electric propulsion system: zero emissions and high performance (strong and silent acceleration) and technological sophistication (e.g., self-driving capabilities, frequent enhancements via software upgrades).

Business Organization, Capabilities: How

In addition to specifying a firm’s value proposition, a business model should also specify “how” the firm is structured to deliver that value. It should address the following questions:

• What assets and capabilities (e.g., skilled personnel, technologies) does the firm require to execute on its business model?
• Will these be owned/insourced or rented/outsourced?

Value Chain

The “how” aspect of a business model is also referred to as a firm’s value chain. It refers to the systems and processes within a firm that create value for its customers.

A value chain includes only those functions performed by a single firm. Some of these functions may be valued by customers but may not involve physical transformation or handling the product.

A firm’s value chain is different from a supply chain. A supply chain refers to the sequence of processes involved in the creation of a product, both within and external to a firm. It includes all steps involved in producing and delivering a product, regardless of whether those steps are performed by a single firm.

Value chain analysis provides a link between the firm’s value proposition for customers and its profitability. It involves:

• identifying the specific activities carried out by the firm,
• estimating the value added and costs associated with each activity, and
• identifying opportunities for competitive advantage.

Profitability and Unit Economics

A business model should specify how the firm expects to generate its profits. To understand the profitability of a business, the analyst should examine margins, break-even points and unit economics (which is expressing revenues and costs on a per-unit basis).

The curriculum provides the following examples for unit economics:

Example:

A producer of bottle caps might sell its product at 2.5 cents per unit, with direct costs for material and labor of 2.0 cents per unit and a contribution margin (selling price per unit minus variable cost per unit) of 0.5 cents per unit. If the firm has fixed costs of USD500,000 per year, what is its unit break-even point?

Solution:

Break-even point (unit) = Fixed costs/Contribution margin

= USD500,000/0.5 cents

= 100 million units.

Example:

A restaurant chain might have an average order of EUR50, with ingredient costs equal to 50% of sales. If fixed costs are EUR250,000 annually per outlet, what is the firm’s unit break-even point and operating margin at 20,000 orders per year?

Solution:

Break-even point (order) = Fixed costs/Contribution margin

= EUR250,000/EUR25

= 10,000 orders/year.

Operating margin = 20,000 orders × EUR50

= EUR1,000,000 revenues – EUR500,000 ingredient costs (50% of sales) – EUR250,000 fixed costs

= EUR250,000 operating profit, or

= EUR250,000/EUR1,000,000 = 25%.

Tesla’s business model is based on declining unit revenues and costs over time as volume increases and technology improves. This is expected to result in a virtuous circle: Lower prices allow Tesla to expand its addressable market and market share, while lower costs allow profits to rise and create a competitive barrier.

3. Business Model Types

Each industry tends to has its own set of established business models. Firms in the goods-producing sectors are generally easy to classify based on how they fit into the supply chain. For example, manufactures, wholesalers, retailers, suppliers etc.

However, service businesses are more diverse. For example, the financial services sector has many established business models, as shown in Exhibit 5.

Some firms combine these models together (e.g. universal banks) while some specialize in a particular model (e.g. discount brokers).

Business Model Innovation

Digital technology has transformed the “where” and “how” elements of business models in established markets, by drastically reducing the cost of communicating, exchanging information, and transacting between businesses.

• Location matters less: customers can easily buy from firms having no local physical presence.
• Outsourcing is easier: for similar reasons.
• Digital marketing: makes it easy and cost-effective to reach very specific groups of customers, regardless of location.
• Network effects: (discussed later) have become more powerful and accessible to firms.

Business Model Variations

There are many business model variations such as:

• Private label or “contract” manufacturers that produce goods to be marketed by others.
• Licensing arrangements in which a company will produce a product using someone else’s brand name in return for a royalty. For example, toys and apparel based on famous film characters.
• Value added resellers that not only distribute a product but also handle more complex aspects of product installation, customization, service, or support. For example, heating/air conditioning systems resellers.
• Franchise models in which distributers or retailers have a tightly defined and often exclusive relationship with the parent company.

E-Commerce Business Models

E-commerce is a broad category that includes a wide range of internet-based direct sales models. A few key variations of e-commerce business models include:

• Affiliate marketing generates commission revenue from sales made on other people’s websites. E.g., CJ Affiliate.
• Marketplace businesses create networks of buyers and sellers without taking ownership of the goods during the process. E.g., eBay.
• Aggregators are similar to marketplaces, but they re-markets products and services under their own brand. E.g., Uber.

Network Effects and Platform Business Models

The term “network effects” refers to the increase in value of a network to its users as more people join. Many internet-based businesses are built on network effects. For example, social media, ride-sharing services, online classified etc. Network effects are also applicable to older, non-internet businesses such as telephone services, credit cards etc.

Network effects can be described as:

• Multi-sided: applicable to two or more groups of users. For example, buyers and sellers on an online marketplace.
• One-sided: Users are a single, homogeneous group.

A platform business is defined as a business based on network effects—that is, where the value of its service or product is enhanced by the addition of customers or users. They are different from traditional or linear businesses. With a linear business, value is added by the firm; with a platform business, value is created in the network, outside the firm.

Crowdsourcing Business Models

Crowdsourcing business models enable users to contribute directly to a product, service, or online content. For example, Wikipedia, Google Maps, Tripadvisor.

Hybrid Business Models

Some companies employ hybrid models that combine platform and traditional “linear” businesses. For example, Tesla sells cars via a linear model, but its customers benefit from an expanding network of charging stations.

4. Business Models: Financial Implications

Businesses have very different financing needs and risk profiles depending on both external and firm specific factors. These factors influence the firm’s ability to raise capital.

External Factors

External factors include:

• Economic conditions: They affect almost all businesses. Important macroeconomic variables to consider are GDP growth, exchange rates, interest rates, the credit environment, unemployment, and inflation. Some businesses are more sensitive to certain factors than others; for example, a wind farm business is likely to be more sensitive to interest rates than to the overall GDP growth.
• Demographics trends: They influence the overall economy. Most mature, urbanized economies have aging, declining populations and labor shortages. While most emerging markets have high population growth and high labor availability. As compared to economic forecasting, demographic forecasting can be done with higher accuracy because the underlying drivers (birth, death, and immigration rates) change very slowly.
• Sector demand: These characteristics vary by industry. Some industries, such as consumer staples, have very stable and predictable demand, while others, such as industrial machinery, are more cyclical. The business cycle has less of an impact on the demand for non-discretionary and immediate consumption products than it does on demand for long-lived products. For example, toothpastes versus cars.
• Industry cost characteristics: Some industries, such as hotels, utilities, and airlines, are inherently capital intensive, whereas others, such as many internet-based and service businesses, require very little capital.
• Political, legal, and regulatory environment: This includes the institutions, laws, regulations, and policies that affect the business. Some regulations may affect all businesses, while others may affect specific industries or firms.
• Social and political trends: Changes in public opinion and taste can signal changes in consumer buying behavior and the political/legal environment. For example, green products, renewable energy etc.

Firm-Specific Factors

Firm-specific factors include:

• Firm maturity or stage of development: A startup typically requires more external capital and has more business risk than a mature business.
• Competitive position: All else equal, a company with strong barriers to competition (referred to as a “wide moat”), will have lower business and financial risk than a company that does not have strong barriers. Similarly, a market leader will enjoy brand and scale benefits over smaller competitors.
• Business model: A company’s business model influences its decisions about which assets to “own” and which assets to “rent”. In this context, commonly observed business models are:
  • Asset-light business models: The ownership of high-cost assets is shifted to other firms. For example, hotels, restaurants that use the franchisee model; the assets are owned by the franchisee rather than the parent company.
  • Lean startups: This model extends the logic of the ‘asset-light’ model to human resources. The company outsources as many functions as possible. For example, technology companies often adopt this approach.
  • Pay-in-advance: Companies generate cash from sales before paying suppliers. This model reduces or eliminates the need for working capital. For example, Amazon.

5. Business Risks

Financial analyst and investors must consider risk factors that can cause investment returns to be different from expectations. Risk can be categorized into:

• Macro risk: Arises from the economic environment in which the business operates
• Business risk: Arises from the business itself
• Financial risk: Arises from the way in which the business is financed

6. Macro Risk, Business Risk, And Financial Risk

Macro risk refers to the risk from political, economic, legal, and other institutional risk factors that impact all businesses in an economy, a country, or a region. The primary macro risk affecting most businesses is the potential slowdown or decline in economic activity. Depending on its geographic location, other country risk factors such as exchange rates, political instability, or gaps in the legal framework may also be important for a business. Some business such as consumer staples are less sensitive to economic activity, whereas, others such as capital goods are more sensitive.

Business risk is the risk that the firm’s operating results will be different from expectations, independently of how the business is financed. In accounting terms, we can say that business risk reflects the risk at the operating profit (EBIT) level. EBIT can be lower than expected due to lower revenues and/or higher than expected costs.

Financial risk refers to the risk arising from a company’s capital structure, specifically from the level of debt and debt-like obligations (such as leases and pension obligations) involving fixed contractual payments. Debt(financial leverage) causes net profit to vary more than operating profit, on both the upside and downside.

Risk Impacts Are Cumulative

The impact of risks on a business are cumulative. A company’s operating results are affected by both macro risks and business risks. Likewise, a company’s net earnings reflect the combined impacts of macro risks, business risks and financial leverage.

7. Business Risk: A Closer Look

Industry Risks

Industry risks apply to all companies in the same industry and include risk factors that are likely to affect the industry’s overall level of demand, pricing, and profitability.

• Cyclicality: Many industries such as discretionary goods, housing, durable goods (e.g., autos and appliances) and capital equipment exhibit cyclicality. These products are generally long lived, which gives the buyer the flexibility to decide when to replace them.

Firms try to reduce the impact of cyclicality in different ways:

• Some enter into long-term customer or hedging contracts
• Some try to minimize fixed operating costs (e.g., through outsourcing)

Cyclical firms tend to have more conservative capital structure policies, with little debt as compared to less cyclical firms.

• Industry structure: Industry structure can impact the overall risk of an industry. Lower concentration (the presence of many small competitors) generally results in a high degree of competitive intensity.

The Herfindahl–Hirschman Index (HHI) is frequently used to measure industry concentration. It is calculated by squaring the market share of each firm competing in a market and then summing the resulting numbers. High numbers indicate high concentration and vice-versa.

• Competitive intensity: High competitive intensity can reduce overall industry profitability. Analysts usually track return on invested capital (ROIC) and operating profit margin (EBIT/revenue) to determine how the industry profitability is changing over time.
• Competitive dynamics within the value chain: Analysts use Michael Porter’s “five forces” model to identify and analyze five competitive forces that shape every industry and to determine the impact on an industry’s profitability. The five forces are:
  • Competition in the industry
  • Threat of new entrants
  • Bargaining power of suppliers
  • Bargaining power of customers
  • Threat of substitute products
• Long-term growth and demand outlook: Long-term growth can contribute to an industry’s long-term profitability; however, sudden and unexpected declines in growth can result in excess capacity and aggressive competition. Long-term growth trends are determined by the level of innovation, the dominating business models, and the age/maturity of the industry.
• Other industry risks: This includes regulatory and other potential external risks.

Industry Definition

It is important to define the industry appropriately. If an analyst defines an industry too broadly, then conclusions drawn from the industry analysis may be too broad to be useful.

In general, a narrower industry definition is preferable. However, defining the industry too narrowly can make it difficult to obtain accurate data on demand and competition and to draw conclusions about risk factors affecting the industry as a whole.

Company-Specific Risks

Company-specific risk vary based on the nature, scale and maturity of the business. They can be categorized into:

• Competitive risk: It is the risk of loss of market share or pricing power to competitors. It reflects a lack of competitive advantage. Typically, companies with strong competitive advantage tend to have higher margins and lower business risk.

The typical sources of competitive advantage are:

• Cost advantages which can be based on scale, a superior production process, proprietary technology, or other factors.
• Product or service differentiation which creates value for customers.
• Network effects which make the products or service more useful when they are widely adopted.
• Switching barriers which make it more difficult or more costly to switch suppliers.

The larger and more durable these advantages, the lower the level of competitive risk.

Competitive risk can also arise from “disruption”, where new competitors use new technology or business models to take market share from existing firms.

• Product market risk: It is the risk that the market for a new product or service will fall short of expectations. This risk is generally more relevant for early-stage firms than for mature, well-established firms.
• Execution risk: Refers to the possibility that management may not be able to do what is needed to deliver the expected results. Typically, early-stage firms have less room for management error and therefore have higher execution risk.
• Capital investment risk: Refers to the potential for sub-optimal investment by a firm. This risk is generally more relevant for mature businesses that generate substantial cash flows but lack natural reinvestment opportunities in their current business.
• ESG risk: Refers to risks arising from environmental, social and governance factors.

Instructor’s Note: This topic is covered in detail in a separate reading.

• Operating leverage: Refers to the sensitivity of a firm’s operating profit to changes in revenue. Firms with high fixed costs and low variable costs have high operating leverage. High operating leverage can be good for successful, growing businesses; but problematic for struggling, declining businesses.

8. Financial Risk

Financial risk refers to the risk arising from a company’s capital structure, specifically from the level of debt and debt-like obligations (such as leases and pension obligations) involving fixed contractual payments. Debt(financial leverage) causes net profit to vary more than operating profit, on both the upside and downside.

High financial leverage increases the probability that the firm will be unable to secure needed financing (financing risk) or that it will fail to meet its financial obligations (default risk).

Financial risk reflects the cumulative impact of macro and business risk.

Different businesses can support different levels of financial leverage. Businesses with stable and predictable cash flows can generally support a high level of financial leverage. For example, an electric utility company.

Measuring Operating and Financial Leverage

Leverage is the use of fixed costs in a company’s cost structure. It has two components:

• Operating leverage: Fixed operating costs such as depreciation and rent create operating leverage.
• Financial leverage: Fixed financial costs such as interest expense create financial leverage.

For highly leveraged firms, i.e., firms with a high proportion of fixed costs relative to total costs, a small change in sales will have a big impact on earnings.

Operating leverage captures the sensitivity of operating profit (EBIT) to changes in revenue. It can be calculated as:

Operating leverage = Contribution/EBIT

where: Contribution = Sales – Variable costs

Financial leverage captures the sensitivity of net profit to a change in operating profit. Earnings before taxes (EBT) are frequently used instead of net profit, because taxes fluctuate. Therefore, financial leverage can be calculated as:

Financial leverage = EBIT/EBT

The total leverage of the company can be expressed as:

Total leverage = Operating leverage × Financial leverage

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