A widely under-followed blogger, Lyall Taylor, lately wrote up Capital One Financial’s most recent quarterly results. You will find the blog post here. The glinting center of his essay is the importance of understanding GAAP accounting’s effect on value creation for asset-light businesses. Equity investors in the 21st century would do well to heed his lessons. Here we follow the thread from COF’s Q4 results, through one of history’s greatest applied microeconomic meditations, onto John Malone.
Capital One Financial is a credit card company. Their business depends on developing a portfolio of consumer loans which offer positive net present value and attractive returns on invested capital. In this way COF sounds like a traditional business.
LT’s point is that accounting rules mask this economic reality. In order to generate future earnings streams COF must spend money to acquire customers. They do not build factories. They do not purchase equipment (for their primary business). Their cost of customer acquisition is the sum of the variable costs required to acquire the customer (primarily marketing) plus some fixed costs allocated across the customer base (rent, salary, etc.). As LT describes, these customer acquisition costs show up on COF’s income statement which makes them appear different from a capitalized expense. But they are not.
Just as with tangible assets, prudent management teams “invest” in these customer acquisition costs because they expect to earn a strong return over the customer’s lifetime with the product/service. Overestimating the customer’s life or spending too much to acquire a customer is not different in principle from purchasing quickly obsolete capital equipment (e.g. buying VCR producing machines when DVDs emerged) or spending too much on a fancy robotized machine. Kudos to COF for recognizing a good quarter to push market share.
Of course, Capital One and Mr. Taylor are far from the first to apply themselves to understanding these dynamics. The authority on the subject, in your humble author’s view, is Information Rules: A Strategic Guide to the Network Economy by Hal Varian and Carl Shapiro. In fact, the authors make explicit reference to consumer credit providers in the book. Readers should consult this book for fabulous reference material.
A line in LT3000’s post also caused me to reflect on an insight harvested as much by Capital One and Amazon as by John Malone. LT writes:
Amazon has understood this for years, and taken advantage of many companies’ lack of ‘capacity to suffer’ earnings hits in the near term. This aversion creates exploitable business opportunities for companies that are willing to take a longer term view.
John Malone once quipped of the 1980s TV landscape: “A number of our eastern competitors early on were still large industrial companies — Westinghouse, GE, — and they were on an earnings metric. It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings.” He worked through the same math which has enriched shareholders of AMZN, COF, NFLX, and many more. Those unable or unwilling to read Cable Cowboy or Outsiders can harvest a full crop of Malone lessons from this Tren Griffin post.
Investors and entrepreneurs today would do well to search out business’s whose investors are addicted to dividends and whose management team’s optimize for GAAP earnings. They should search them out as, in the words of LT3000, “exploitable business opportunities.” Those focused on misguided metrics will lose over time as a result of ill-advised capital allocation.
BONUS LINK The recent podcast publicized in the tweet below flirts with some of the themes mentioned here. Specifically, Eugene Wei and Patrick O’Shaughnessy compare ideas about the relative importance and cost of various forms of public content in the pursuit of potential consumers.
I had a blast talking with Patrick O’Shaughnessy on his podcast. We really did go broad; he kept surprising me with new topics.
— Eugene Wei (@eugenewei) January 22, 2019
I dropped my newest idea which is from a piece I keep reworking on how new social networks are like ICO’s.
(Bonus: Patrick is a soothing baritone) https://t.co/pq3uLFE9WL
Your author has no position in any security mentioned.