Updated: Apr 25, 2019
If you're curious and want to read more, here are the business model posts so far:
Adding onto last week's dive into What Makes a Good Business, this week, we'll cover how to think through business models.
Before jumping right in, a business model is just: how a company makes money.
When you sell lemonade or shoes or a carpet-cleaning service, those business models are pretty straight-forward. Sell a product or service and get paid.
However, there are many different types of business models and sometimes the industry dictates how you sell something.
Let's break it down.
Take the pharmaceutical industry for example (this post is not a commentary on ethics, just business models). It's basically a lottery system, but replace the ignorant with PhDs and the cost of lotto tickets with billions of dollars in research and development.
On average, it takes about $2 billion and 10 years of research and testing to create a new drug.
So why would thousands of companies compete in this industry?
Well, it's just like the lottery. Why would millions of people buy tickets with such low odds?
One word: hope.
Hope of winning the jackpot that is. For drug companies, the jackpot is called a blockbuster. No, not the video store that was destroyed by Netflix, the other kind of blockbuster.
A blockbuster drug makes over $1 billion in revenue, and all drug companies are vying to create the next one.
Another reason the industry is so appealing is because of the patents. After a drug is approved by the FDA (Federal Drug Administration), patents last for 20 years. During that time, knock-off drugs can't be sold. This lack of competition is why some drugs are so expensive.
As soon as that 20-year window is over though, blockbuster drugs are copied, and cheap generics become substitutes.
But how do these drug companies actually make money?
Do they set up a drug stand on your street corner and ask if anyone has heart burn or maybe erectile dysfunction? (*pan to two people in separate bath tubs.*)
Do they set up an account on Amazon Marketplace and try to sell them online?
So even though we can wrap our heads around the value drug companies are creating, it is sometimes difficult to nail down the specifics of a business model.
Most drug companies are simply manufacturers that sell to wholesalers which then sell to pharmacies and hospitals.
It's just like clothing manufacturers. When you buy a T-shirt from Costco, Costco doesn't actually make the shirt. Kirkland, the wholesaler, doesn't even make the shirt. The manufacturer might be Fruit of the Loom or Gildan.
But why don't manufacturers just sell products straight to consumers? What is the point of these wholesalers acting as middlemen?
Well, it's pretty complicated.
Wholesalers provide scale and know-how to take the burden off of manufacturers. It's all about specialization.
Think about it this way.
You're a cavewo(man) trying to develop a civilization (bear with me).
You need food, water, and shelter.
Theoretically you could do all of this on your own and make it work. But it helps to specialize. If your friend gathers the nuts and berries, you can focus on creating a well to draw water. By specializing, each of you will get better and more efficient at your respective tasks. Like they say, "Teamwork makes the dream work."
But specialization doesn't always work out perfectly. Your friend could mess up the hunting and gathering and poison you. In short, you have less control over the outcomes.
So there are trade-offs. On one hand, you can get more done by specializing but, on the other hand, you have less control.
It's the same in business. Most of the time, it doesn't make economic sense for a manufacturer to do marketing, logistics, credit, storefronts, online operations, and whatever else retailing involves.
When a company can manage to do everything, from making the products to selling them to consumers, that is called vertical integration. It's much more expensive, labor intensive, and complicated, but it gives the company more control over the end products.
So let's go back to our drug manufacturing example. Even after a drug company hits the lottery and makes a blockbuster, they still have to sell it to wholesalers and negotiate price points. It might be smooth sailing for the 20 years without competition. But as soon as that window closes, those drug companies have a decision to make. Either start over and try to make another blockbuster or continue to market the older drug.
Most companies choose a combination of the two by creating new "pipeline" drugs while also marketing older ones.
If you've ever seen a drug commercial on TV with friendly faces while a voiceover reads 3 minutes of side effects that may include death, stroke, or depression, you're likely seeing the marketing of old drugs. Simultaneously, these drug companies persuade doctors and hospitals to continue buying their drugs rather than cheaper generics. So doctors are getting pressured from patients who watch TV and drug salespeople. It's no wonder drug companies can continue selling old drugs even after they have fallen off the patent cliff.
But there are trade-offs. The time and money spent on marketing old drugs could be used for developing new ones. Those are the decisions that pharmaceutical executives have to make and the ones that investors are interested in.
So when we think about the lifecycle of a drug, from testing it in a lab to picking it up at CVS, it's really not that simple. There are all sorts of nuances and layers. It's not as simple as a company making a drug and then selling it. There are wholesalers, PBMs (pharmacy benefit managers, don't get me started here), health insurers, pharmacies, and even more. Though it may make our heads spin, it is important to understand each piece of the puzzle.
This is the key to deciphering business models: really understanding a business and the industry it operates in and then figuring out how it makes money. For instance, the chart below does a great job of breaking down the pharmaceutical industry.
Source: Follow the Pill
It may look confusing because it is! However, drilling down and understanding the competitive dynamics allows us, as investors, to have a strategic advantage. This is why investing in your circle of competence is so important.
It could be any industry, but the point is that deciphering a business model is crucial to investing.
Understand how the company makes money and then stay curious. Just keep asking, "Why does it work like that?"
After some digging, you'll figure it out, while adding a key tool to your investing tool belt.