The Fertile Grounds of Decay

“Optimism isn't funny unless you are laughing at the person, whereas extreme pessimism is extremely funny. It's exaggeration.” - Steve Toltz

There is always some big new idea, luring people in and placing dollar signs square in their eyes. New markets grow as everyone gets eager to charge headfirst to capture the opportunity. Naturally, that pace usually forces heavy spending, and with mounting competition, it doesn’t take long until those dollar signs fade. Prospects for excess returns dwindle, as do the valuations of any related companies. Counterintuitively, numerous industries have generated substantial excess returns despite having qualities that are the inverse. These are old and mature and sport consistent volume declines in what they sell. Headlines declare these industries as close to taking their last gasp of air, yet profits keep rolling in.

An assortment of factors explain this phenomenon. While some mature industries have existing brands and regulations that make it difficult for new entry, industries with declining volumes further disincentivize new competition. It is difficult to rationalize the elevated costs of breaking in when you have no established advantage. This provides incumbents the luxury of consolidating amongst themselves and taking over the pockets of the market from others who exit, creating an optimal pool of scaled rational actors—optimal industry structure matters. Further, declining volumes force incumbents to address their own mortality while also limiting avenues to redeploy capital. Efficiency comes to the forefront and cost rationalization becomes paramount. Discipline shines, and the small group supplying things of critical natures is afforded pricing power. Most people are hardwired to avoid anything with negative volumes, fixating on that variable, creating forward expectations far under what can be achieved. In such an environment, limited reinvestment needs result in excess cash being returned to shareholders, and share repurchases shine brightest when associated equity multiples remain depressed.

I have written extensively on the legacy tobacco operations of Altria, Philip Morris International, British American Tobacco, Imperial Brands, and Scandinavian Tobacco Group. Cigarette volumes have declined for decades, yet regulation, brand equity, and trade relationships have bestowed manufacturers with a pricing power formula that has generated substantial and growing profits over the period.

What about the convenience stores that sell tobacco products? Nikhil Daftary of NK Capital pitched Alimentation Couche-Tard at Sohn 2024, highlighting the company’s unique position. It was an exceptional pitch, well-distilled down into ~10 minutes, in which he correctly addressed criticisms of the industry head-on. EVs won’t kill the industry—fuel volumes in the U.S. peaked nearly 20 years ago. The industry continues to consolidate, capacity rationalizes, and fuel/basket mix and continued scale provide a solid formula for margin expansion.

Regarding cars, what about auto parts retailers? Canuck Analyst’s Blog offered thoughts on Autozone last year, again highlighting an industry with negative volumes:

One of the less well understood factors about auto parts retail is that it is a zero / slightly negative unit growth industry. Technology gets better, cars are more durable. The offset is that cars are designed to fit consumer budgets and consumers trade up for cars with better tech.

Comments by AutoZone management:

2023 - “Basically, for the 28 years that I've been in this business, there has been transaction count declines”

2022 - “You've heard me say many times that the dirty little secret of our industry is that there's downward pressure on units and have been for decades…You used to buy spark plugs and they were copper spark plugs and they would last for 30,000 miles. Now you buy Iridium spark plugs and they last 100,000 miles. Now the old copper spark plugs used to cost $0.59. Now Iridium's are often times over $10. So there's an upward pressure on cost or price per piece and a downward pressure on units.”

In a similar vein are oil change providers. Jared Duda, Joe Ferguson, and Garrett Wallis pitched Valvoline in the Spring 2024 Pershing Square Challenge. Seven years ago the company was a neglected subsidiary of Ashland, which was spun out, followed by its products business being sold to Aramco in 2023, leaving a focused, pure-play services business. The comprehensive pitch deck includes all kinds of incredible data and thrusts a spear through the narrative that both synthetic lubricants and EVs will destroy the business. The reality is that EVs will not substantially derail the ICE Car Parc, and while synthetic oils allow for cars to be driven further between oil changes, consumers largely maintain their service frequency habits, and even with a degree of decreasing frequency, premium synthetic products drive higher tickets, thus driving same-store sales growth.

Industrial lubricants share similar dynamics. Earlier in the year, on the Preferred Shares Podcast, we interviewed our friend Warwick, a chemical process engineer by training who has extensive industrial knowledge. Warwick offered a first-hand perspective (emphasis added):

So I tend to think of them as kind of industrial staples. It's a stuff that you're always buying it, you always need to buy it. And usually, there's small ticket items that don't get a lot of scrutiny, just because people don't, people in plants who do the purchasing don't have time. So In most large companies, if I'm going to buy something large, like I'm going to sign a contract to buy natural gas for a year or a couple of years, or I'm going to buy electricity or a whole new factory, there's going to be a lot of scrutiny. There's going to be people from the purchasing department getting involved, and there's going to be a lot of price pressure on whoever's supplying that. Below that level, there's a whole bunch of other things that are smaller purchases where there's not so much scrutiny. And there's not as many resources to get over the switching costs of changing suppliers or putting things out to bid to different suppliers. So some examples of that, you've mentioned FUCHS, which is a lubricant oil supplier. About something like 45% of that business is industrial lubricant as opposed to auto. And industrial lubricants are something that maintenance managers will tend to buy from the same supplier through convenience. But, if they have a particular bit of equipment that needs a certain type of oil, special type of oil, and often that oil is certified by the manufacturer, then they'll just stick to that type of oil, even if the price goes up year after year. So it's more easy for those types of suppliers to maintain pricing power.

So for example, we've got a decanter centrifuge that comes from a company called GEA. It's a big German company. The lubricant oil that goes in that, if you get it from GEA, I want to say they're going to charge you something like a thousand bucks a litre, something like that. But if you don't buy that oil from them and you try something else, you're running the risk that you damage a bit of equipment that's worth about half a million bucks. So it's a high speed centrifuge, runs at very high speeds. If the lubrication is not right, it will destroy itself in seconds. So it's super important in that sort of situation.

In that case, there's another supplier called Kluba. They’re a privately-owned German company that makes the lubricant that GEA rebadge and sell to their customers. So you can buy it direct from Kluba, they’ll provide some evidence that the oil is certified by GEA and you can use that one with confidence. But we don’t use the local supplier of that oil for anything else. I could go to our other supplier and ask for an equivilant oil but I’m not going to do it because the cost of it, which direct from Kluba it’s more like a hundred bucks a litre instead of a thousand bucks, it’s just not worth ruining a machine that’s worth half a million bucks, and which if I put it out of action it will cost probably forty thousand to get repaired, plus lost production in the meantime.

…If you look at FUCHs as a company, their sales have increased gradually over time. If you look at their actual volumes, the whole lubricant market has been slowly shrinking over time. So they've got some decent pricing power.

When switching suppliers could shave 90% off the cost of a critical input, but it still doesn’t make sense to switch; that’s something to take note of. If you’re intrigued, I encourage you to listen to the entire interview with Warwick:

Inside the Factory: The Industrial Processes That Feed the World

There is little doubt that the future will continue to provide new, similar opportunities. The avoidance of negative volume growth industries is ingrained into the masses. But, time and time again, we will be shown that less is more—selling less of something for much more can be quite a good business.

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Ownership Disclaimer

I own positions in tobacco companies such as Altria, Philip Morris International, British American Tobacco, Scandinavian Tobacco Group, and Imperial Brands. I also own positions in Haypp Group, a major online retailer of reduced-risk nicotine products. I also own positions in Alimentation Couche-Tard and Casey’s General Stores.

Disclaimer

This publication’s content is for entertainment and educational purposes only. I am not a licensed investment professional. Nothing produced under the Invariant brand should be thought of as investment advice. Do your own research. All content is subject to interpretation.