Nothing is what it seems.
Delta aren’t in the airline business. Google isn’t a tech company. McDonald’s don’t sell hamburgers. And movie theatres don’t care about movies.
I’ll start with an example you’re probably familiar with. Have you heard of Google? (If not, do what some people do: go to Yahoo.com, then search for ‘Google’. Thank me later.)
Google is not a tech company in the traditional sense. Remember when tech companies used to make software, and then people or companies would buy that software? That still exists: companies like Dropbox, Slack, Atlassian, and many others offer Software as a Service, where you pay a recurring fee to use that software. That’s nice and simple.
Google doesn’t do that. I’ve never paid a penny for Google Search, Gmail, Google Maps, Google Calendar, or YouTube. Google is not in the business of selling its technology.
Google is an advertising company that builds technology to attract users, so it can sell ads. We’re all familiar with this model. We’ve all watched The Social Dilemma and learned how harmful this is. We’ve all heard the adage, "if you don't pay for the product, you are the product."
This isn't a new business model. For decades, newspapers and magazines have existed to capture your attention, then monetise that attention through advertising.
The difference is that companies Google and Facebook can do it much more effectively, with much more data, and run second-by-second auctions for that attention.
OK, so far, nothing ground-breaking.
But there are other companies just like this, where the business they operate isn’t the real business. They operate what I call hidden business models.
Let’s look at a few more.
The main business of an airline seems simple: fly a plane from A to B, and sell tickets to passengers who are in A and want to be in B.
There are complications: you need to charter a plane, hire a crew, book a landing slot, buy the fuel, and sell peanuts and scratch cards on board. But it's a straightforward transport business. Except, it's much more than that.
"In essence, airlines have two businesses: the first flies people between destinations, and the second peddles those people to banks for a fee," says the FT.
This is the airline’s hidden business model:
And this is the part of the business that is really profitable.
Byrne Hobart writes:
The Financial Times pegs the value of Delta’s loyalty program at a whopping $26 billion, American Airlines at $24 billion, and United at $20 billion. All of these valuations are comfortably above the market capitalization of the airlines themselves — Delta is worth $19 billion, American $6 billion, and United $10 billion. In other words, if you take away the loyalty program, Delta’s real-world airline operation — with hundreds of planes, a world-beating maintenance operation, landing rights, brand recognition, and experienced executives — is worth roughly negative $7 billion. But the economics of the loyalty program don’t work without a robust airline operation.
Here are some hard numbers, again from the FT:
"Strong financial figures underpin the hefty valuations. Pro forma financials for Delta’s SkyMiles show gross revenue of $5.7bn and net income of $2.5bn in 2019, for a profit margin of 42 per cent."
You too can have a multi-billion dollar business with 42% margins! All you need to do is run an airline business on the side.
I love going to the movies.
The big screen, the surround sound, the audience gasping or shouting. It’s a great experience.
What I hate is having to pay way over the odds for popcorn and a drink because I forgot to bring some from home.
Which, unsurprisingly, is exactly how they make their money.
In fact, Time Magazine estimates that the profit margins on concessions are around 85%. When you pay $10 for popcorn and a soda, a whopping $8.50 of that is pure profit.
That’s because the business of selling tickets to movies isn’t that good. The Hustle explains that around 70% of the ticket price goes straight to the distributor, rather than the movie theatre. And that doesn’t account for other costs like rent and staff.
The business model becomes:
So we’re left with cinemas that adhere to an old industry adage: “Find a good place to sell popcorn and build a movie theater there.”
You’re probably familiar with the insurance industry: you’ll have car insurance, or home insurance, or life insurance.
Again, it’s an industry that seems simple. Take in premiums. Pay out claims and expenses. Hope that Premiums minus (Claims plus Expenses) > 0.
But there’s more to it than that.
In between customers paying premiums to the insurer, and the insurer giving that money in the form of claim payouts, the insurer gets to hold that money. It gets to decide what to do with that money. And so most insurers will invest it: in stocks, bonds, property, and all sorts of other asset classes.
This is what legendary investor Warren Buffett calls ‘float’, and it’s massively profitable.
Here’s an example from a company that I’m familiar with, because I used to work there. Below is an extract from the annual report and accounts of NFU Mutual, a smaller insurer here in the UK:
Let’s break this down.
But wait, there’s more!
Actually the company made £573m total profit for the year, an additional £406m over and above its underwriting profit. How can that be?
It’s the investment returns the company made from holding customers’ money in between being paid the premiums, and paying out the claims.
In fact, the company’s long-term aim was a 98% Combined Operating Ratio, which roughly broke down as 20% expenses, and 78% claims. The aim was to break even on the insurance business, and use the investment part of the business as the driver of profits.
There are a few more notes in the depths of the accounts that explain this a bit more:
You can ignore everything except the second and third lines: the gains and losses from investments. These dwarf any other numbers on the P&L, revealing that insurance companies aren’t in the insurance business, they’re in the investing business.
Their model is:
That’s why some insurance firms slash prices to try and get new customers in: they can have a combined operating ratio above 100%, and lose money on the underwriting, as long as the investments continue to generate profits.
Let’s finally turn to one of my favourite companies, McDonald's. I’ve read the book and seen the movie. I’ve eaten McNuggets in New York, London and Paris. I’ve considered becoming a franchisee before I balked at the £100k investment required.
By now you’re probably catching on, and realising that McDonald’s isn’t in the burgers and nuggets business, and you’re right.
McDonald’s is a real estate company.
Around 85% of their 36,000 worldwide locations are franchised. This is a wonderful way to run a company like this: franchisees put up a lot of the up-front capital, buy the stock, sell the burgers and fries, pay the employees and the rent, and keep the profits.
That’s great for the franchisee: they actually do make money by running a restaurant, at an average of $154k per year per restaurant. But McDonald’s Corporation makes money in two ways:
It’s this latter part that is the engine of McDonald’s profits. That’s why former McDonald’s CFO Harry J. Sonneborn, is even quoted as saying, “we are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.”
So McDonald’s real business model is:
Let’s break down the numbers.
According to Wall Street Survivor, McDonald’s 2014 revenues were around $27.4bn, which was about one-third was franchise income, and two-thirds was from company-operated restaurants.
But in terms of margin: the company-operated restaurants generated $2.9bn profit, while the franchisee income generated $7.6bn. That’s profit margins of 82%.
That’s almost as good as selling popcorn and a soda for $10.
I find things like this fascinating: they reveal what’s truly rare and valuable.
Running a flight from Atlanta to Houston? Selling a hamburger? Showing a movie? Those aren’t particularly difficult, and they’re subject to a lot of competition, so they don’t generate high returns. But hidden within those businesses are valuable, profitable gems: a customer’s willingness to pay for popcorn, or a bank’s desire to acquire your customer for their business. Assets which you can exploit for fun and profit.