Balance Sheets & Digital Era Businesses.
Anthemis Venture Design. Pillar 2: New Routes to customers.
[This is the second of three essays that explain the process of Venture Design at the Anthemis Foundry, where we help create digital era financial services businesses on demand. The first is about the primary importance of ecosystems and identifying the first step on the route to new customers. The third is about systems centric design — a proprietary design methodology that combines designer intuition, user centric design and market analysis which can be applied to all actors in an ecosystem at any scale — individuals, groups of individuals, companies and the ecosystem as a whole.]
tl;dr As we move from an industrial economy to an information one, the entire business landscape is being altered. Some of the opportunities created can be captured without having to control everything affected and these businesses, such as Internet platforms, are the most immediate opportunities to create scale. There’s no overall trend to smaller balance sheets, however, just different routes to customers. As we move from Internet companies to Internet era companies, new routes to customers may involve having to have more components of the delivery of a product or service on the balance sheet.
The Business Fitness Landscape
The off-balance-sheet theory goes something like this: “Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate, therefore there is a trend towards small balance sheet companies”.
Here I’ll suggest why it’s a false maxim and how that insight forms the second pillar of our core strategy. At the Anthemis foundry we look at digital era rather than digital technology opportunities, and from the perspective of the business landscape or ecosystem, rather than the technology. We then look for new routes to customers where the landscape has changed.
The idea of viable things fitting into a mapped ecosystem, is a real one used in evolutionary biology. Fitness environments such as the above form a landscape with peak fitnesses that determine where there are opportunities for things such as species of animal. In reality these environments are multi-dimensional and so are abstract ‘phase spaces’ rather than 3-dimensional mountain ranges.
An ecosystem view of the changing business environment could similarly reveal new hills as new opportunities for corporations, however without knowing what the variables that determine the business environment are, this remains a metaphor.
With the right model, routes between the hills and valleys could indicate flow of information or goods or even incentive alignments and these would lead to the scientific mapping of new routes between businesses and customers.
For now this is based on grunt work and intuition and is an art. But one day it could become a science.
Beyond Technology Companies
The small balance sheet company does look like a trend, until you look at the wider picture to include not just digital platforms but the newer wave of digital era companies, where the Silicon Valley approach and culture is applied to businesses which are not Internet ones.
It’s necessary to look at the wider picture, because the notion of an Internet company is becoming increasingly irrelevant, If you are going to include Airbnb, why not Tesla and if Tesla, why not Inditex (Zara’s parent company)?
Many, so-called Internet businesses (Uber, Airbnb) don’t sell technology, they leverage it and they operate in markets outside of technology, increasingly, there is no such thing as an Internet or digital business, aside from firms that exclusively develop and sell technology.
A good example of how ‘digital’ companies are becoming the default, to the extent that all surviving companies will be digital era companies is in advertising. Advertising is generally split into sectors such as: print; Out Of Home (billboards); TV etc. Digital has traditionally been added alongside, as if it is a separate medium. But when most newspapers are consumed on a screen, when billboards are screens and the only traditionally screen based medium, TV ,is consumed via an internet platform on a computer display, digital is not a sector of advertising it is all advertising. ‘Digital’ agencies which were, until recently, specialist are the only viable type of agency in the longer term, so they won’t be called digital and the idea of a head of digital at the client side is a temporary post, while the rest of the business catches up.
When looking at the Financial Services sector, as we do at Anthemis, the wider picture of how these digital era, non technology sector businesses, operate at the structural level, such as how large their balance sheets have to be, becomes very important.
And looking at how digital era businesses are structured across sectors, there is no trend to small balance sheets.
Digital Era Company Examples
Cars
Tesla is a large balance sheet company. Unlike Apple, Tesla doesn’t just design its cars in California, it builds them there. This increases its balance sheet. Unlike almost every other US car manufacturer it sells directly to customers rather than wholesale, through dealers. This further increases its balance sheet. Tesla goes even further than this having to build its own global network of fuel supply through supercharging stations. This is as if Ford had to own its own gas stations throughout not just the US but every global market it entered. This constitutes the mother of all large balance sheet businesses, and because Tesla is public, its balance sheet is too, so this can be verified.
The reason for this large balance sheet approach, is to secure what Tesla needs to control to disrupt the existing status quo from infrastructure to middle men. The business landscape that the car industry sits in is changing away from oil to electricity, and although Tesla has to build its own electric ‘gas stations’ to bootstrap its own ecosystem, it is doing this in a more efficient way than having to control the supply of oil. If you like, Tesla’s proposition is to be the smallest, large balance sheet approach.
Rockets
The same trend occurs in Elon Musk’s other business, SpaceX. The only way to disrupt the cosy relationship of government subcontractors who will charge NASA (and therefore SpaceX) very large margins for rocket components is to make everything yourself. In manufacturing parlance, SpaceX is an extremely vertically integrated company and this translates to a high balance sheet.
Planes
Moving from cars to rockets to planes, the trend for the last few decades has been for lower balance sheet businesses for carriers who lease rather than buy, a significant percentage of their fleet.
The major digital era disruption to this business has been from European low cost carriers who have quite literally found new routes to passengers through smaller airports, but also through optimised ‘digital native experiences’. It is no accident that easyjet’s planes were branded with their web address in massive letters. Like mobile only banking, the premise is for lower cost interaction with a website rather than telephone support and legacy workflows that ruin the online experience don’t have to be dealt with. As an example, seats and boarding passes for multiple journeys can be allocated and downloaded at the point of purchase, rather than having to revisit a website 24 hours before departure, as is the case with nearly all traditional carriers.
Despite the level of innovation, there has been no acceleration of the trend to lower balance sheets through plane leasing from lower costs carriers. In the case of Easyjet, around half their fleet of over 200 planes at a price of $90m are owned. As a result it is definitely not true to say that the world’s biggest airlines don’t own any planes. In fact the opposite is true — the world’s biggest plane owners don’t have any passengers.
The largest aircraft owners are aircraft leasing companies. GECAS (General Electric Capital Aviation Services) and the largest of them all, owns around 1,700 aircraft, operated by 230 airlines around the world.
Other low cost airlines, such as Ryanair, who are fond of owning most of their aircraft don’t do it in the same way that legacy carriers traditionally did — buy and hold for the full lifespan of the plane (30 years). Ryanair negotiated procurement deals with Boeing (by buying large packs of planes, all B-737s), used them for around 5 years, and then sold them before their price dropped too low, much like a company car.
In summary, the balance sheet dynamics of digital era airlines and their planes is much more complex than Uber and cars and is neither a high nor a low balance sheet approach. The correct balance gives flexibility in that particular ecosystem. If we look at the European equivalent to the big US tech platforms there is this same dynamic.
Singularity Companies
Inditex — a European singularity company.
No matter how disruptive low cost airlines appear to be, they are not giant businesses in comparison with the big Internet platforms. Easyjet is worth $10 billion, which is roughly the same size as the biggest European Internet companies but 50 times smaller than the biggest US ones.
Unfortunately this scale of company does not sit at the top of the food chain, and so the biggest European tech companies get eaten by their American counterparts (e.g. Activision’s acquisition of King). The tech platform companies such as Google, Facebook or Amazon sit at the center of ecosystems, like singularities at the center of galaxies, swallowing everything that crosses an invisible horizon that defines what needs to be in their control. Europe has no singularity companies, and so the focus on so called unicorns (new $1 billion technology companies) is a dangerous distraction.
A stat mentioned in the previous essay in this series, to spell out how bad the situation in Europe is with regards to moving towards the Information economy is the value of the top three Internet companies by continent: Americas c. $1 trillion; Asia c. $0.5 trillion; Africa $60 billion; Europe < $20 billion.
This situation becomes dramatically better when you consider digital era companies that have exploited changes to the business landscape as a result of increased communication.
An example of this is Inditex, the parent company of Zara, a $100 billion company with global reach that is largely unheard of in the US outside of Metropolitan areas such as New York. The US is a market that doesn’t fit its business model (largely due to cultural issues around more formal clothing) and explains part of the reason why it exists at all, due to absence of a US competitor. Inditex is one of the very few digital era European companies that rivals the biggest US or Asian ones in size and it has done so by capturing the efficiencies in supply chains that are only really possible because of global communication technology.
Inditex is a pioneer of ‘fast fashion’, quickly imitating the latest catwalk fashion and speeding cheaper versions into stores. If companies such as Google have connected information together, creating a more efficient information flow, Inditex has done the same for physical supply chains.
Inditex stores carry very little excess inventory, allowing store managers to request more supply if needed and encouraging them to create Internet style feedback from customer reactions, in physical stores. Inditex staff are specifically trained to tease out this information which is reported to headquarters every day, by store managers and passed to a large team of in-house designers who in turn send designs to factories to produce new lines on a near continuous basis rather than twice a year. Many luxury fashion companies such as Prada or Louis Vuitton now produce four to six collections instead of two per year, because of Zara.
Like Easyjet, what Inditex chooses to take on its balance sheet is complex and adaptive. Unlike a company such as Apple, half of it’s product is produced by factories which it owns and are near to its HQ in Spain. The remainder is produced either in near-shore locations such as Portugal, Morocco, Turkey or more remote countries such as China, Bangladesh, Vietnam and Brazil. The decision of where to manufacture is a supply chain optimisation one, where high trend items are made locally and the turnaround from design to being in the store can be as little at two to three weeks.
With manufacturing coverage across an entire ecosystem, Inditex is organic and flexible and sometimes higher labor costs are offset by faster turnaround and less excess inventory.
Aside from owning factories, Inditex has another area where its balance sheet is unusually large — real estate. Ironically Zara is a digital era brand that spends almost nothing on advertising, with almost no marketing department and no promotion of designers as brands in themselves. Zara’s designers are anonymous and part of this is because they clone rather than design. In many ways, Inditex is the Rocket Internet of retail.
To accuse Inditex of being a cheap, unsustainable proposition, is missing the point however. As Masoud Golsorkhi, the editor of Tank, a London magazine about culture and fashion put it to the New York Times: “To the luxury brands, they are copycats, they are like mushrooms feeding off the main body of fashion…I was of the same mind myself, but I have grown out of that because I realize that the fashion companies also copy each other. In the end, no one’s original.”
Because of the cloning strategy, Zara needs to leech off the marketing of the things it is cloning rather than build its own campaigns, and this is where real estate comes in. By saving on advertising, Zara puts physical stores in the most expensive locations in physical proximity to luxury clothing brands whose retail strategy is to keep as far away from businesses like Zara. Zara paid $324 million to buy space at 666 Fifth Avenue in New York, a building which was once the most expensive ever sold in Manhattan.
“[Inditex] have done process innovation very well,” says Nelson Fraiman, a professor at Columbia Business School who has studied the Inditex model. “Product innovation? No. But tell me one Chinese company that has done product innovation very well. They are brilliant at process. I think you should give a cheer for process innovation.”
Inditex have found new routes to customers in an information era, changing ecosystem. They have done this by adjusting their balance sheet where needed, but not by outsourcing everything and reducing it to a minimum.
Fintech Companies and Balance Sheets
Like retail, exemplified by companies such as Inditex, H&M and Ikea, Financial Services is one area where Europe has a chance to create singularity sized companies, via fintech firms that sit at the center of the digital era financial ecosystem.
It is very important that Europe produces technology companies that dominate this sector to claw back some of the ground lost to American Internet platforms. These will be true technology companies and will involve large balance sheet businesses directly or in partnership, because unlike retail, money is all about information and unlike Internet platforms, banking is all about large balance sheets.
This is the sector we look at exclusively at the anthemis foundry and the relationship between new routes to customers and the required balance sheet size is one of the primary lenses to view it through.
Financial Services innovation is in a transitional phase. As banking is unbundled, lower balance sheet businesses are chipping away at its core, however at some point a focus on building large balance sheet businesses is necessary.
For retail banking the big disruptor is obviously the smartphone. With a secure, network enabled computer in everyone’s hand, a smartphone is both bank and wallet. The idea of a physical building with classical marble columns as a display of conservative wealth and therefore trust, for a product that is ones and zeros is clearly absurd, but delaminating and replacing the rest of the banking stack, will take time.
For corporate banking the big disruptor is SaaS accounting. With realtime updates from multiple banks reconciled directly to a business’ balance sheet, an individual bank account itself becomes a largely irrelevant and incomplete financial picture. SaaS accounting may not replace large enterprise ERP systems that combine this picture with a supply chain, but it is possible that they could evolve into something very powerful, moving from SMEs to bigger businesses.
For banking consortia and back end rails, the disruptor could be blockchains and smart contracts, or whatever they morph into, as they allow for services that traditionally have had to be run by third parties such as SWIFT or Visa to be implemented in software only. With all parties being treated equally anyone can take the lead in trying to form them.
For insurance, more data from sensors and improved analytics on that data, will allow smaller pools of calculable risk. This means that insurance will become more granular and the market of products will increase, however the portion which allows punishing bad luck (risk of a disease) vs bad behaviour (reckless driving) will be legislated (hopefully) to be outside the scope of insurers. The roles of re-insurers and underwriters may overlap differently.
Underlying all of the banking examples is their core activity — lending.
Loans are the assets that sit on a bank’s own balance sheet, and it is very important that it takes risk by lending more than it has in deposits (and putting its own capital at risk), as this means there is a belief in the future value created by the people it lends to.
Contrary to what conspiracy theorists think, without the kind of leverage that fractional reserve banking allows, money will not be spread out and capital will concentrate further in the hands of those who already have it. Because of this, it’s important that banking isn’t replaced by distributed peer-to-peer platforms with no money creating capability, but is either re-bundled as large corporations or run as a utility, with associated infrastructure. Both the corporate bundling and infrastructure propositions are large balance sheet ones that are not like Internet platforms.
Banking is intrinsically a leveraged business and it is important that large balance sheet operations appear somewhere in the new digital era ecosystem.
