When pouring through Company 10-Ks is your idea of a good time like it is for me, you develop a certain type of familiarity with different business models and you start categorizing them in your mind. And while there are a lot of different types of business models across various industries, the strategies that they employ aren't all that different. We'll get to this but let's take just one step back to something a bit more fundamental. A term that is often used by Warren Buffett to describe the type of businesses he invests in is "moat". He describes many of the businesses that he invests in as benefitting from an economic moat and often a wide economic moat. In other words, these businesses benefit from important competitive advantages that protect its business from competitors whether that be a wonderful brand like Coca-Cola or network effects like American Express. I'm not quite sure if Buffett coined the term but he has popularized it over the years. At the recent 2017 Berkshire Hathaway Annual Meeting, he reinforced the point:
“If you got a wonderful business - even if it’s a small one like See’s Candy-you basically have an economic castle. In capitalism, people are going to try to take away that castle from you so you want a moat around it protecting it in various ways and you want a knight in the castle who is pretty darn good at warding off marauders. But there are going to be marauders and they’ll never go away”
So this got me thinking more about the different types of businesses model strategies and what I call Empire Theory. I also thought it would be a great way to drive traffic to the site with the new season of Game of Thrones out! The crux of Empire Theory is that many businesses fall into one of two major buckets. There are Castle Protectors and there are Kingdom Builders.
Castle Protectors
There are some companies out there that have a core high margin business or cash cow that they are trying to protect - what I would refer to as the castle. These castles are like printing presses and churn out vast sums of money so the company is highly motivated to do everything it can to protect this castle. Often, the companies will build innovations around this core business (moats) that don't necessarily generate revenue on their own but that rather seek to reinforce the core business in some meaningful way. The list of companies fall into this camp of castle protectors is long. Google (GOOG) is a pretty good example of a castle protector. Google's core business of search ads generates the lion share of its revenue and profits and are much higher margin than YouTube ads for example. Sure, other businesses like self driving cars and internet balloons get a lot media attention but let that not distract you from the economic castle that is search ads. Google gets a lot of credit for being an innovative company (and I don't disagree) but many of these innovations are essentially different layers of moats that seek to protect the castle (search ads) that pays everyone's salaries and keeps the lights on in Mountain View.
When Google realized that Microsoft could leverage its share leading Internet Explorer browser to push consumer usage of its own search engine over Google, Google quickly developed the Chrome browser as a defensive maneuver. Not only did Chrome quickly overtake the other browsers as the dominant internet browser, but it helped further cement Google search as the de-facto search engine by reinforcing search behaviors in several critical ways (i.e. the address bar doubles as a search prompt for Google Search).
When Apple introduced the iPhone way back in 2007, Google had already been working on a mobile operating system and smartphone. But once they saw the revolutionary capabilities and UX of the iPhone, they knew they had to go back to the drawing board lest they be beholden to Apple for getting their products seamlessly to the end consumer. Sure they would be fine as long as there was a negotiated agreement with Apple to embed Google as the default search engine on the device, but relying on Apple to be a gatekeeper to the cash cow is no way to protect the monopoly. Thus Google developed Android- an alternative mobile operating system - with none other than Google search embedded at its core.
Chrome Browser, Android OS, Maps, Gmail, Chrome OS, News, the list goes on and on. Yes, these are all wonderful consumer products on their own, but they also serve another important purpose - to put wider and wider moats around the castle (as shown in the pic above) or in other words, to protect and extend Google's cash cow of search ads. If you're searching for anything, anywhere, Google wants to be the one to monetize it and even if they don't monetize it (as with many of these products), they want to make sure that their direct linkage to the end consumer isn't abstracted by competitor products or devices. Not to mention a secondary benefit of serving up more relevant ads by tracking behavior across their various products.
This notion of protecting Google's castle becomes very interesting in the world of voice dictation. Amazon is the current market leader for smart speakers with the Amazon Echo, but if Amazon controls a future where consumers search for everything through voice commands, that leaves Google's castle of search ads vulnerable. Cue the music...introducing Google Home - Google's smart speaker released last year and the outermost rung of the moat protecting the castle in the image above. And have no doubt, Google will continue to create new products and services that reinforce its dominant position in internet search ads anytime that position is threatened in any way. This is what Castle Protectors are expected to do.
You can't knock a company for being a castle protector. As an investor, we should expect a company to vigorously protect outsized margins and returns. But recognizing that a company falls in this camp is important as there are some key implications of being a castle protector. For castle protectors everything is interconnected so it can lead to slower decision making and in some cases, poor decision making. Every Google product that is launched is likely vetted by someone that works on what I would expect is the very politically powerful search or search ads team. And if it doesn't reinforce search or have some future path to do that, you can bet that it's a more difficult and lengthy internal sell. Castle protectors can often struggle with providing their senior managers and leaders with autonomy - since many of the ancillary businesses are so interconnected to the cash cow, a lot of decisions quickly become about the cash cow and are deferred to the leadership of the cash cow or the most senior leaders in the company, like the CEO rather than the manager of the business unit. This can become a problem. If you've read The Outsiders (a wonderful book about successful CEOs), one of the recipes of success that is threaded across most of the eight CEO stories that generated incredible shareholder returns over many years, is this notion of decentralization and pushing down authority and providing autonomy to the general managers of business units. This level of autonomy and decentralization is often not possible with castle builders and so the persons most knowledgable about something aren't making the decision. I've talked about this problem before in The Travails of a Businessman.
A second critical implication of being a castle protector is that they can become so fixated on protecting the core with "innovation" that they might miss some important shift or a new competitor that comes from left field. More often than not, it's a shift that they might have known about, but were unwilling to acknowledge or respond to because it would cannibalize the cash cow. Kodak is a classic example. Rochester was once the Silicon Valley of its day with both Kodak and Xerox thriving in its midst. Kodak had a very lucrative, high margin business model of selling "razor blades" (film) to service both its own "razors" (cameras) and other companies' razors. But Kodak actually invented and patented the technology for digital photography well before anyone had even thought of the idea in the 1970s, but they buried it in some closet because of the threat it posed to the cash cow. There's a wonderful Marketplace podcast about it.
Understanding and analyzing a company's orientation as a castle protector is helpful in analyzing the business' strategic decisions and overall prospects. Google is just one example but there are a lot of other companies that could also be classified as a castle protector. Costco's (COST) castle is memberships and over the years, they have put a ton of benefits (rungs of the moat) around the membership like gas stations, optical, car buying, etc. I would argue that Amazon's castle is also memberships - memberships of Amazon Prime and similarly they have put a lot of benefits around it to protect it from marauders.
Kingdom Builders
Kingdom Builders are another species in the classification of company business model strategies. Kingdom builders don't rely on one cash cow but rather many different cash cow businesses that can all exist independently of each other. These individual cash cows (kingdoms) generate their own cash flow that is fed back up to the parent organization that can then decide if they want to use the cash to extend or shore up the moats of existing castles, acquire new castles or build new castles.
There were a lot of examples that came to mind with Kingdom Builders but one that is near and dear to my heart is consumer packaged goods companies. A company like Procter & Gamble (PG) is a perfect example of a Kingdom Builder. P&G owns many wonderful businesses or brands as they would refer to them that could very well be independent companies and in some cases were independent companies. P&G owns an entire kingdom of castles like Pampers, Gillette, Tide, and Crest to name a few. Each of these businesses has their own moat around it - in the case of P&G this is often a combination of a strong brand and strong R&D that leads to a product advantage. In some cases, P&G goes right out and builds massive new castles like Febreeze, which launched in 1996 and went on to become a billion dollar brand.
In addition to the moats around each castle, P&G also has a moat or a massive ocean around its kingdom protecting its borders. Even though many of these brands are fundamentally different, operating under the umbrella of P&G brings unique competitive advantages like scale in sourcing and dealing with customers, capital, logistics expertise, etc.
There are some inherent implications of being a Kingdom Builder as well. In contrast to Castle Protectors, Kingdom Builders can push down a fair bit of decision making and autonomy to the general managers of the businesses. While the business units are loosely connected under the parent, the decisions that are made within one business unit don't often impact other business units. All things being equal, this can lead to better decisions - the person most knowledgable about the business unit is making the key decisions. Company and investment risk can often be significantly lower in Kingdom Builders as it is spread out over several different businesses versus Castle Protectors where the risk is concentrated into one business or profit center. If a business like Crest toothpaste for examples loses its competitive edge and suffers financially, P&G can cut off the tentacles without impacting the core. In the case of a Castle Protector though, if a competitor manages to traverse the deep moats surrounding the castle or profit center, there is not much that can be done to stem the loss and keep the company intact - it can't be severed because the core is everything- it's the cash cow and many of the other business units are dependent on it.
Kingdom Builders isn't all unicorns and rainbows though. The very thing that makes Kingdom Builders less risky and more decentralized/autonomous also makes them less efficient. Marketing dollars and other investments (e.g. manufacturing lines) have to be doled out individually to each castle and other castles don't typically benefit from the investment in one castle. These competing priorities can become difficult to manage and challenge the capital allocation process. Kingdom builders can also often find themselves down the path of building businesses that are outside of their core competencies or circle of competence as Warren likes to say. This can be a destruction of value - when companies venture out from what they are good at and fail.
Many companies in the consumer packaged goods space like Hershey, Nestle, Kraft Heinz fit the definition of Kingdom Builders but there are also others. Disney (DIS) is also a Kingdom Builder in some ways. They build what I like to call creative franchises like Toy Story, Cars, The Avengers. While they are monetized in similar ways through films, TV, merchandizing, live shows, etc., these creative franchises can stand on their own two feet.
Starbucks is an interesting example of a company that thought it probably could be a Kingdom Builder only to realize that it is a Castle Protector. Over the years, it has purchased many other QSR type retailers like Evolution Fresh, Teavana, La Boulange and it has gone on to close all the stores under these alternative banners. They just announced the closure of Teavana in the last day. While they still carry these alternative brands in Starbucks stores, it's clear that Starbucks is a Castle Protector very good at protecting the core Starbucks brand and concept but not so good at allocating capital and having the patience to see through the growth of some high potential alternative concepts.
The reality is that not all businesses fall cleanly into the buckets of Castle Protectors or Kingdom Builders. There are definitely companies that are hybrids and others where the framework doesn't provide much value. However, for many companies I believe it does provide a good framework and starting point for analysis. Next time you're analyzing a company's investment prospects, I would encourage you to think about what bucket they might fall in and the inherent implications of such. Heck, maybe take out your colored pencils and draw it out like I did!