The WHY of the Business Model

A business can start out to solve a problem, offer a product / service, address a need,
facilitate exchange of products / services or have any other objective. But to do it
sustainably requires having to deploy capital to its best use. To earn returns over & above
the cost of capital. Businesses those excel at capital allocation command premium
valuations.

Financial Statement analysis (FSA) is a forward looking exercise. The output of FSA is input
to Valuation. Hence, the orientation while analyzing financial statements should be to
comprehend a businesss ability to create value.

How do we define value? Value is a function of the below three factors

The higher the Return on Invested Capital (ROIC) over the Cost of Capital (COC).

The longer (time-wise) the ROIC is sustained.

The lesser the RISK taken to generate ROIC.

The better a business performs on the above three factors, the higher the value. In our
endeavor of analyzing businesses, the critical part of financial statement analysis is to ask
the right questions. What makes a question right and what wont? Any question that
enhances our ability to understand or appraise a business of its ability to create value is an
appropriate & a necessary question (to dig for).

The act of analyzing financial statements in isolation, without a proper understanding of

1. Business Environment (competitive dynamics & macro-economic factors).

2. Size of the Opportunity the business is facing.

3. Managements Strategy to exploit the opportunity.

would lead us to wrong conclusions. Ponder over below ones by looking at financials alone,
without what-so-ever idea of the business environment, size of the opportunity & strategy.

We will in all cases reach wrong conclusions.

Selling bikes, what explains significant difference in operating margins of two

leading 2W companies (Hero & Bajaj)?

Working capital ratios of a basmati rice manufacturer (KRBL) have been improving
off late. Is this temporary or sustainable?
 A printing & document solutions company (RICOH India) is growing its sales at
scorching pace without profitability. Can we look forward to profits at some point in
time in the future or will it continue to remain in losses?

Gross margins & turnover ratios of a synthetic leather manufacturer (Mayur

Uniquoters) have been steadily improving year after year leading to better return
ratios. What explains this improvement & are these new margins and returns
sustainable?

TTK Prestige & Hawkins have different EBITDA margins on their cooker sales. Why?

A twenty year old IT payment solution provider (RS Software) is struggling to grow
its sales. Industry slowdown or Company specific issue?

WHY of financials is more important than WHAT? We arent trying to see what the
numbers are, but what they say & how they might look like going forward.

The first step towards understanding a business is to create its business model.

Business model:

A Business model describes the rationale of how an organization creates, delivers

and captures value.

How a business intends to make money? Business model can be best described through
nine building blocks that show the logic of how a company intends to make money.

1. Customer Segments:

Defines different groups of people or organizations an enterprise aims to reach &

serve. Customer groups represent separate segments if:

a. Their needs require & justify different offer.

b. They are reached through different distribution channels.
c. They require different types of relationships.
d. They have substantially different profitabilitys.
e. They are willing to pay for different aspects of the offer.

For whom are we creating value? Who are our most important customers?
2. Value Propositions:

The bundle of products & services that create value for specific customer segment.
Value proposition is the reason why customers turn to one company over another. It
solves a customer problem or satisfies a customer need. Each value proposition
consists of a selected bundle of products and/or services that caters to the
requirements of a specific customer segment.

What do we deliver to the customer? Which one of our customers problem are we
helping to solve? Which customer needs are we satisfying? What bundles of products
and services are we offering to each Customer segment?

3. Channels:

How a company communicates with & reaches its customer segments to deliver
value proposition.

Channels serve several functions

a. Raising awareness among customers about a companys products & services.

b. Helping customers evaluate a companys value proposition.
c. Allowing customers to purchase specific products & services.
d. Delivering a value proposition to customers.
e. Providing post-purchase customer support.

Through which channels do our customer segments want to be reached? How are we
reaching them now? How are our channels integrated? Which ones work best? Which
ones are the most cost-efficient? How are we integrating with customer routines?

4. Customer Relationships:

The types of relationships a company establishes with a specific customer segments.

Customer relationships may be driven by the following motivations:

a. Customer satisfaction.
b. Customer retention.
c. Boosting Sales (upselling)
 What type of relationship does each of our Customer Segments expect us to establish
and maintain with them? Which ones have we established? How costly they are? How
are they integrated with the rest of the business model?

5. Revenue Streams:

Represents the cash a company generates from each customer segment. A business
model can involve two types of revenue streams

a. Transaction Revenues resulting from one time customer payments.

b. Recurring Revenues resulting from ongoing payments to either deliver a value
proposition to customers or provide post-purchase customer support.

For what value are our customers really willing to pay? For what do they currently
pay? How are they currently paying? How would they prefer to pay? How much does
each Revenue Stream contribute to overall revenues?

6. Key Resources:

Describes the most important assets required to make a business model work. Key
resources can be physical, financial, intellectual or human. Resources allow an
enterprise to create and offer a value proposition, reach markets, maintain
relationships with customer segments and earn revenues.

What Key Resources do our Value Proposition requires? Our Distribution Channels?
Customer Relationships? Revenue Streams?

7. Key Activities:

Describes the most important things a company must do to make its business model
work. These are the most important actions a company must take to operate
successfully. It can be R&D, product or service design, production, marketing,
distribution, etc

What Key Activities do our Value Propositions require? Our Distribution Channels?
Customer Relationships? Revenue Streams?
8. Key Partnerships:

Describes the network of suppliers and partners that make the business model
work. Companies create alliances to optimize their business models, reduce risk or
acquire resources.

Four different types of partnerships:

a. Strategic alliances between non-competitors.

b. Coopetition: Strategic partnerships between competitors.
c. Joint ventures to develop new businesses.
d. Buyer-supplier relationships to assure reliable supplies.

Who are our Key Partners? Who are our Key Suppliers? Which Key Resources are we
acquiring from our partners? Which Key Activities do our partners perform?

9. Cost Structure:

Describes all costs incurred to operate a business model. Creating & delivering
value, maintaining customer relationships & generating revenue all incur costs. Cost
structure is what defines if a business is asset-light or capital intensive.

What are the most important costs inherent in our business model? Which Key
resources are most expensive? Which Key Activities are most expensive?
 Example: Apple iPod / iTunes Business Model

In 2001, Apple launched its iconic iPod brand of portable media player. The device works in
conjunction with iTunes software that enables users to transfer music and other content
from iPod to a computer. The software also provides a seamless connection to Apples
online store so users can purchase and download content.

The potent combination of device, software, and online store quickly disrupted the music
industry and gave Apple a dominant market position. Yet Apple was not the first company
to bring portable media player to the market. Competitors such as Diamond Multimedia
with its Rio brand of portable media players were successful until they were outpaced by
Apple.

How did Apple achieve such dominance? Because it competed with a better business
model. On the one hand, it offered users a seamless music experience by combining its
distinctively designed iPod devices with iTunes software and the online iTunes store.
Apples Value Proposition is to allow customers to easily search, buy and enjoy digital
music. On the other hand to make this Value Proposition possible, Apple had to negotiate
deals with all the major record companies to create the worlds largest online music
library.

The twist? Apple earns most of its music related revenues from selling iPods, while using
integration with online music store to protect itself from competitors.
Create the business model of Bajaj Auto as an exercise.