Over the years, we have written extensively about what we call “the three-legged stool” approach we use to identify the compounding machines in which we have concentrated our capital. The three legs are the business model, the people running the business, and the reinvestment acumen and opportunities. The combination of an exceptional business run by intelligent and rational people with the skill and opportunity to reinvest most of the free cash back into the business at high rates of return creates the flywheel we call a compounding machine. I would like to briefly elaborate on the business model leg of the stool by describing a concept we refer to internally as a “bottleneck business” and how it applies to several holdings.
We think of a bottleneck business as one that a) sits atop large, global, secular growth opportunities fed by multiple industries and geographies, b) has those opportunities funneled (hence the bottleneck visual) disproportionately to it because of sustainable competitive advantages, and c) enjoys exceptional economics, often superior to the industries and customers the business serves. An electric utility, for example, would typically fail to qualify as a bottleneck business—despite often having a local monopoly in its service area—because of its limited geographic scope and generally unexceptional, regulated economics.
Qualified examples of bottleneck businesses abound, however, in our portfolios, including American Tower, Moody’s, and MasterCard which in aggregate represent a significant portion of our investable assets. How do these companies fit this notion of a bottleneck business?
Sit atop large, global, secular growth opportunities fed by multiple industries and geographies.
- American Tower’s cellular tower assets across 12 countries represent the bottleneck in the secular growth of mobile communications and data. The business spans across countries, wireless carriers, handset manufacturers and connected devices.
- Moody’s opportunities center around the growth and development of public debt capital markets around the world, again cutting across countries, industry sectors, debt issuers and debt types.
- In MasterCard, we own a business with secularly improving odds of being involved and so profiting from the growing share of electronic payments worldwide, a business that cuts across countries, retailers, online, offline, and mobile commerce.
Opportunities funneled disproportionately because of sustainable competitive advantages.
- American Tower’s business is advantaged by the physics of radio frequency (including the physics of spectrum re-use and signal propagation) and the deployment and service efficiencies of carrier co-location on macro towers.
- Moody’s status as one of two de-facto “toll bridges” to the public debt capital markets is the result of over 100 years of market forces, in our view, and this status has, if anything, been fortified in the wake of the financial crisis.
- MasterCard’s leading global payment network is the result of powerful network effects having solved the two-sided dilemma of merchant acceptance and consumer usage, as well as the need for standards and innovation in payment systems.
Exceptional economics, often superior to the industries and customers the business serves.
- American Tower’s free cash flow margin (as measured by adjusted funds from operations) exceeds 40%, revenues are in the form of hell-or-high-water multi-year leases with annual escalators, and maintenance capital requirements are a low single digit percentage of revenue.
- MasterCard’s free cash flow margins are just under 40%, its unlevered free cash flow return on assets is around 25%, and over half of its revenue is tied to purchasing volumes and so has built-in inflation protection.
- Moody’s free cash flow margin is just under 30%, pricing power alone is expected to generate ~4% annual topline growth, free cash flow return on assets is well above 20%, and free cash flow returns on invested capital above 100%.
By no means are “bottlenecks” the only business models we own. Other holdings owe their place in our portfolios due more to the equally important people and/or reinvestment legs of our three-legged stool. But my hope is that this bottleneck discussion puts some more meat on the bone in describing what, to us, a great business model looks like.