McCaw Cellular Communications sold to AT&T for $12.6 billion in September 1994. And yet the business did not show an accounting profit on its income statement until the second quarter of that year (after the deal was announced on August 17, 1993). The McCaw Cellular example shows that you can create a tremendous amount of value for shareholders without showing any profit on an income statement. Or not. Here below is a picture of a real letter from Craig McCaw sent in July of 1994 which documents what I said above.
Amazon and Netflix are examples of the same value creation phenomenon as are many businesses that John Malone has created over the years. This post will try to help people understand why this is true.
The drumbeat of people (especially reporters) saying a that a business is “losing money” and is therefore doomed is constant. People with a political axe to grind on a platform company like Uber to make this sort of statement. What these people are usually claiming is that they learned from sources that the current income statement of a business reflects a loss. The reality is that a loss on the income statement can reflect bad news or good news, depending on other variables, as I noted in my post on CAC. Weirdly, these people will also say that a business is great because they are “making money” when all they know is that revenue is rising.
Working through some examples usually helps people understand these issues. Every business on Earth, from a huge company to a hot dog stand, can be analyzed in this same way. No matter what your business may be, this unit economics method of analysis is relevant to you!
Assume you have a business that sells a streamed film collection. Looking at comparable movie streaming (OTT) services like Netflix (there are over 110 businesses doing this), the key inputs into the unit economics of the business might look like this:
Monthly Churn 4%
Monthly ARPU $10
Gross Margin 30%
Cost Per Gross Addition (CPGA sometimes called SAC or CAC) $30
A screen shot of the unit economics calculation might look like this:
Note what happens up front: $30 immediately is spent to acquire the customer (see the red number). But in month one the net cash flow coming in is only $3. That means $27 in cash has been consumed in the first month ($30 out and $3 in). If the customer stays a customer for a long enough time and keeps generate $3 in net cash flow, shareholder value can be created. Without knowing churn you don’t know if the business is sound. You do know that the business is “losing money” in the aggregate, but that is not enough.
In this screen shot above I cut off the picture at 10 months to make it fit the page. The reality of the screen shot below is that at 4% churn the implied user life is 25 months (i.e., cash will be coming in for that long on average).
Value is being created in my first example but it is deferred value. Why does anyone defer consumption to create or invest in a business? They do so if they believe delaying gratification will allow them to consume more in the future. In deciding whether to defer consumption people know that a dollar delivered tomorrow is worth less than a dollar today and therefore the dollar delivered tomorrow must be discounted to a lower value in order to determine its value today (10% annually is chosen at the discount rate in the example).
The cost per gross addition (CPGA) is assumed to be relatively low in my first example because customer value is high versus alternatives and customers are able to terminate service with 30 days’ notice (which lowers sales resistance). But the absence of an annual or longer contract means higher churn is possible.
Gross margins are assisted in this case because the business only pays the credit card merchant fees one time per month versus many credit card charges for à la carte movie buying services.
The important point to understand about the unit economics in this example above is that the variables are assumptions, they feed back on each other and inevitably change with an evolving business climate. If the business asks customers to commit for a year of service in a contract instead of paying month to month, CPGA would rise. Let’s assume CPGA would rise to $70 with that change to a yearly contract. If CPGA is now $70, the unit economics of this business look like this (red is not good):
In this business a $70 CPGA kills shareholder value. But in an alternative scenario that shareholder value killing input could have instead been higher churn or lower gross margin.
As another example, if the business encountered 10% churn the unit economics also get uglier than the first example:
Making all of this work financially for the business is tricky and some people spend their entire careers working on just one aspect of lifetime value problems like this. There is a lot of art rather than science in this work since these people are dealing with human behavior, which fluctuates and is unpredictable.
Investors often need to make guesses about these numbers since business do not real the data. For example, many businesses do not like reporting CPGA or whatever the customer acquisition cost metric is called in their industry (e.g., CAC or SAC). As an example, Netflix no longer reports SAC, but when it did:
Reports in 2016 indicate the Netflix has substantially reduced CPGA/SAC and churn since 2008 through changes like original first party content (which can increase COGs, but at an acceptable cost say many people), but that is a topic for another post. Your business can also die because it runs out of cash and that is another post too.
The most important “take away” from this blog post is that looking at an income statement alone is not enough to determine whether a business is creating value. You must also understand the unit economics of the business.
When someone says a business is “making money” or “losing money” be skeptical about either claim until you get enough data to apply math like I explain above.
Think for yourself. Be a learning machine.