Water, Algorithms, and Toilets

What business model innovation means for investors (and the world).

 

“What is that on her back?”

Half the van peered out to our left. The other half sat huddled over, praying that, by some small miracle, the indigestion we all seemed to have caught would pass. It was hot and stuffy in the van and it felt like the air conditioning was more intent on pumping hot air into the back than cooling us down.

“She is carrying water,” my expat friend informed me. “What, up the hill?” I remarked. Rwanda seemed like a very hilly place to be hauling water.

Outside, a young woman was making her way to somewhere, her long, colourful skirt brushing up against the dirt on the road. On her back was a blue plastic container. It looked a lot like the emergency gasoline containers we have in Canada, except this one contained water. The woman on the road was a customer of the nearby village’s commercial water business. Rather than collect dirty water from a well or a river, she was collecting her water from a local source that had been purified against unsafe bacteria.

To  a passive observer, this little container might have seemed like a rather pedestrian innovation. But to individuals who live in the region and to my friend, it is a major leap forward; one plain, blue container represents liberation from exposure to polluted water and waterborne disease.

Sometimes small changes can equal big impact.

Everywhere you look in the world, there are entrepreneurs and CEOs who are changing the face of the planet by innovating and building upon existing business models. While the scenario above took place in Africa, some permutation of it could have happened anywhere. To me, this young woman with her plain, blue container was a walking testament to the change that can be, and is being, brought to society through business model innovation. Unfortunately, blue container stories like this rarely make it into the Financial Times. “How Synnex changed its business model to generate 10% higher ROEs” just isn’t as exciting as “Greece is about to default,” so these stories rarely get the attention they warrant among investors.

But investors should be paying attention because business model innovation matters. Disbelievers need only bring to mind the late 1990s for examples of entrepreneurs unlocking a lot of value by optimizing their business models. Back then, a little startup called Google took some basic applied math and used it to re-design the web search business model. That move changed the future of the Internet, the whole advertising world, and made its founders billionaires. Around the same time, Paypal switched from a mobile currency platform to an online payment system and merged with the fledgling eBay. That shift helped revolutionize the online shopping experience and turned Peter Thiel, Max Levchin and Elon Musk into Silicon Valley rock stars. Many very significant changes to society have occurred because of rather prosaic business model changes, and they are happening all the time today.

Investors must remember that companies can live or die by their business models. A subtle change can mean the world of difference; it can have significant societal impact as we will see in Water: The Example, and it can mean the difference between a company achieving great success or tumbling into stunning failure, as demonstrated in Algorithms: The Opportunity and Risk. What ultimately matters is whether investors can identify those business models that will prove wealth-creating in the long run.


Water: The Example

There are enough strands of bacteria in the world to turn anyone into a full-fledged hypochondriac. Some are deadly; others merely render one’s intestines impassable. But what if you knew these bacteria were in your drinking water?

When one thinks of exciting new business models, safe drinking water may not spring to mind. But as it turns out, water delivery is a problem spurring much business model innovation. All over the world, enterprises in both the private and the not-for-profit sectors are experimenting with business models that attempt to address the challenges presented by water scarcity and cleanliness. These new models are good examples of what a design change can look like and what it can mean.

But first it is important to define what we mean by a business model. A business model is a description of the way a company creates value. It is an outline of how value is provided to customers, captured by the company, and how revenues, costs and profits are divided between the company and its supply chain. It is a set of choices and the consequences of those choices.

Let’s illustrate this point by breaking down the typical water delivery model. There are two main models for individual water consumption in North America: “free” tap water and bottled water. In the “free” tap water model the consumer is delivered water via an underground network of pipes that is operated by a government entity. Although the services seem to be virtually free (users only pay a nominal fee for the water consumed), this water is actually being paid for in municipal taxes (the revenue structure). In the bottled water model, a consumer goes to the nearest store and pays anywhere from $1 to $4 to a retailer in exchange for a bottle of water. This retailer then orders more bottles from a large manufacturer like Coca-Cola to replace the one just bought. Coca-Cola takes a cut, the retailer takes a cut, and the consumer gets 750mL of water in a plastic bottle.

These are the two typical business models for individual water consumption in developed markets. Neither one has changed much in many years. But as many are finding, these models don’t succeed in many developing markets where governments are ineffective at delivering clean, accessible tap water and the price of a bottle of water is astronomically above what the average consumer can reasonably pay. In these markets, existing models need to be adapted to local conditions and customer needs. This is where companies like Water Health International come in.

Water Health International [WHI] is a full-service  water  provider that operates in India and Africa. The company installs, operates and maintains local water purification plants on behalf of local communities. These centres strip the local water source of bacteria, viruses and parasites and bring it up to World Health Organization (WHO) drinking standards, while doing so at an affordable cost of less than $0.01 USD per litre. Communities make a one-time investment and earn it back as the residents pay for the water they use. In India, a $25,000 investment provides a typical community with their own WHI centre and service for 10 years.

But let’s break this business model down further. WHI operates what we would refer to as a one-time capital goods revenue model. While they are servicing the end user who is paying for the water, they are ultimately getting paid by the community groups that fund the project. It is a one-time model because they get paid a one-time upfront fee.

A business model innovation can be very good for customers or society without necessarily being more attractive to shareholders.   In the case of WHI, the innovation was clearly effective at tackling   a humanitarian issue. WHI’s business model was suitably designed to be scaled and allowed the company to expand to the 500 water systems, and over 500,000 regular end users, they manage today. Clearly they are providing massive value to society. Yet how attractive was this business model innovation, really, for shareholders? That is the debatable point. On the one hand, the innovation did allow the company to open up a market that had previously gone underserved. On the other, the WHI business model is rather mediocre. It relies on an ongoing stream of new customers to make purchase decisions and this can be a challenge. When all is said and done, WHI’s innovation probably gave more value to society than shareholders.


Algorithms: The Opportunity and Risk

It is a strange experiment to google “Google;” it feels like you’re about to break the Internet. This was the feeling I experienced when I sat down to research old Internet providers and opted to use the very search engine I was trying to research. Yet it was a non-starter to use another engine. When the world wants to search something, she uses Google.

Google could be the poster child for business model innovations done right. Since the years that the company was founded in 1998, Google has grown at an exponential rate to become one of the world’s most influential multinational companies. Today Google dominates the Internet search market with an estimated 60% U.S. market share1. In 2012, they generated more than $50 billion in revenue and $13 billion in profits before tax, all the while offering services that have become deeply entrenched in people’s lives. Imagine going a day at work without using either Google search, YouTube, Google Maps, Gmail or a phone that uses the Android operating system.

Much of Google’s success can be attributed to a small but powerful innovation they made when they first launched: algorithms. Before Google, search engines used to rank results by counting how  many times the search terms appeared on the page. The company’s founders, Larry Page and Sergey Brin, had the vision to tap into the wisdom of the “collective masses” to respond to a user’s question. They built technology that took math and used it to determine a website’s relevance by analyzing its relationships between other websites. This shift was subtle but huge. It allowed Google to make searching a lot smarter and it opened up the door for the company to offer paid advertising in a very targeted way. Not only did this model generate significant revenue for the company, it created a massive competitive advantage for them; Google’s search service has proven to be very difficult to copy.

Most business model innovation will never match Google’s success. Managers are taking a risk when they make these decisions, whether in a startup or in an existing business model. It is as probable that a decision will yield negative results as positive ones. Yet there are very real rewards for those who make this transition successfully. By making changes, a manager has the potential to create stronger barriers to entry or improve their competitive position (like Google), make their business more wealth-generating or less risky, or simply make what they are doing more difficult to replicate. All of these could be worthy reasons to switch a model.

Paladin Labs is a good example. A Canadian pharmaceutical company, Paladin Labs was started in 1996 by a young man named Jonathan Goodman, whose family had been in the business before him. Either because of sound reasoning or straight up luck, Jonathan designed his business in a way that made it inherently less risky and more wealth- generating than the conventional pharmaceutical model. How?

He decided that Paladin Labs would sell drugs but conduct no research and development and do no manufacturing. Instead, their whole model would be to acquire drugs that were developed by other companies, which have been approved in other jurisdictions, and market them to Canadians. And it turned out that this approach is very profitable. Today, Paladin Labs generates $270 million in revenue and profits before tax in excess of $65 million, yet spends no capital to actually research and develop drugs. They have removed the risk of failed R&D projects that most pharmaceutical companies face but have maintained their ability to compound a significant amount of wealth over time.

Of course, there are risks to change. Paladin’s successful innovation has been copied by other companies. Just because a company innovates, doesn’t mean that competitors can’t or won’t copy them. Moreover, a business change can just plain go wrong. The failure of the Canadian investment bank, Coventree, in 2007 is an apt cautionary tale in this regard.

Conventree was a niche investment bank that specialized in structured finance. It was a business that in many senses exemplified financial wizardry: extremely profitable and hard to understand. Their major innovation was securitization. Coventree purchased consumer loans - auto, credit card, and mortgages - from other financial institutions using the proceeds of short-term corporate paper that they   issued.

They repackaged these loans into Collaterized Debt Obligations (CDOs) which then served as the collateral for the corporate paper they were funded on. Revenue was generated by taking a spread between their funds (corporate paper) and the cash flow from their assets (the underlying consumer loans). It was an extremely profitable business. That is, until subprime mortgages turned south in the U.S. and the company could no longer roll over its corporate paper. Without the ability to fund themselves, their entire business model fell apart.

Coventree was a case in which business model innovation failed. It serves as a reminder that not all innovation will be a success. Some changes build on a competitive advantage, create a more profitable enterprise, or reduce risk. Others will do the opposite. That is why investors must understand how a model is changing and whether that will make a company more or less attractive.

 

Toilets: The Impact

When it comes to an investment process, it is better to concentrate on levers that can drive the most value. Investors need to be looking for big levers they can pull: like toilets in Africa.

I happened to be in South and East Africa this August for a combination of work and exploration. I did a lot of direct research into toilets while there, due at first to my shamefully weak stomach, and then later out of a genuine interest. Not until you are presented with holes in the ground do you start to realize how much value a toilet brings to your life. It was fascinating to learn how many individuals in Africa have no toilet, even when the costs to society of open defecation and poor sanitation are so staggeringly high. How could an individual have two mobile phones but no toilet at home? Clearly, this is an area that could have a big impact on African society if addressed – and many companies are.

Business models are like that for investors. They are levers that make a big impact. While it is interesting to survey how changes   to business models affect the world, there is a more fundamental reason why investors ought to be concerned with them: they are a big part of what drives investment value. Business models matter. And understanding them is likely to yield better investment lessons than reading macroeconomic headlines, as most of the risks presented in the news are either inconsequential in the long run or extremely difficult to hedge effectively in the short-run.

In the end, there are thousands of businesses in the world. Not many are sustainably wealth-creating and, of the ones that are, they haven’t all necessarily innovated their business models to become that way. Nevertheless, it is true that instigating business model innovation  is one way of pulling the lever on becoming a wealth-creating company. It is a lever we have seen successfully pulled many times before.

Ultimately, investors need to appreciate that some innovation works out and some doesn’t. WHI’s business model innovation created value in a separate arena than that of shareholders. Coventree created a high return business that proved much riskier than realized. Of course, it is obviously ideal when a business can emulate Google’s achievement and both improve returns and the world at the same time, but that is rare. More often, investors are lucky just to find businesses like Paladin Labs whose business model innovation has made them sustainably wealth-creating over time.

Even though successful business model innovations are in short supply, investors must keep in mind that little changes, even as small as a blue container on a young woman’s back, can make a significant difference – not only to the world, but in their investment portfolios as well.

 

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Kara AOB bio 500x500 2

Kara Lilly, CFA
Investment Strategist

October 2013

 

  1. Google’s market share: comScore July 2013 U.S. Search Engine Rankings