Capital Intensive Inputs, Capital Light Outputs

 

For more than 10 years, we have focused our investments towards companies that become increasingly profitable as they grow. These businesses are often called “capital light,” since their reinvestment needs are relatively modest compared to their revenue opportunities. The market increasingly appreciates the value of companies that can grow without a lot of additional spending.  

As an example of a capital light business, consider Microsoft Excel. As the company sells copies of Excel to customers, there is essentially no incremental cost for Microsoft to produce those sales; each successive sale is increasingly profitable. Contrast that with running a successful airline. If the airline sells every seat for every flight, they will need to buy another plane to make another dollar of sales. That’s a capital heavy business model.

So when some of the largest tech companies started spending hundreds of billions of dollars each on hardware for artificial intelligence, Wall Street analysts and the market looked suspiciously at this costly infrastructure that these companies were building. 

Astute investors have asked us how we feel about the heavy capital investment involved in building more data centers, since we’ve been extolling the virtues of capital light business models for years. 

Are these companies transitioning to a worse business model? Our answer has been that we’re looking for profitable growth, not just capital light businesses. 

As Warren Buffett once said, “The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns.” High capital requirements are actually a moat, a barrier to entry. Not everyone can afford to build a multibillion-dollar data center. If you can grow and there are barriers to entry, that’s an excellent business. 

The large cloud service providers (Amazon, Google, Microsoft) have that kind of structure right now. At first glance, it may look like they’re becoming more like Exxon and Chevron: slow-growing industrial giants with heavy spending on physical infrastructure. But the large tech companies are experiencing faster revenue growth and better profit margins, exactly what Buffett described as desirable. And they’re not just growing faster than traditional capital intensive businesses, it’s also that their products and services are different in kind.

These businesses are becoming an interesting combination of capital intensive and capital light at the same time. 

The inputs are capital intensive with hundreds of billions of dollars of data centers, GPUs, power and cooling. But the outputs are capital light because they’re digital. Increasingly, this heavy physical capital produces software which can be sold over and over at high profit margins. It’s as if Delta buys a plane and a year later the same plane can seat twice as many people – because the output here is digital, like Excel, not physical like seats. The capital is deployed once, but its productivity grows over time. Impossible in aviation, but routine in software. 

These businesses actually may have the best of both worlds: the accelerating economics of the capital light business model, with the moat of the capital intensive business model. Should these companies be spending hundreds of billions to build this infrastructure? We think the answer is a resounding yes.

 

Best regards,

Evan McGoff

Disclosure: Dock Street Asset Management, Inc. and/or our clients may own Amazon (AMZN), Google (GOOG), and Microsoft (MSFT). This article is not intended to be used as investment advice.