‘Scale’ is a Two-edged Blade

I have heard many people cite ‘scale’ as a business’s barrier to entry or even its competitive advantage.

Normally, the argument goes along these lines: ABC Company is XXX big, thus they can afford numerous overheads/compliance/regulatory costs and/or certain capex and/or certain assets and/or certain purchasing power that individually or collectively generate returns to scale.

Thus, any newcomer would need to XXX capital to effectively compete with them. And/or their smaller peers are at a disadvantage because they do not have ABC Company’s size.

Hence, their scale is a barrier to entry for newcomers and a competitive advantage over competitors.

While this may be true in many cases, it is (1) not always true, and (2) can create its own problems.

Let me deal with each of these things individually:

 

(1) Size Does Not Perfectly Correlate to Profitability

Just because ABC Company is bigger than XYZ Company, it does not necessarily mean that it is more profitable. If it was that simple, then CEOs would only focus on building size and all investors had to do was find the biggest companies out there to invest in. We all know that things are not that simple, thus neither is true.

While size and profitability may have a softly positive correlation (i.e. bigger tends to mean more profitable), this correlation is very weak (i.e. the relationship is not strong enough to demand much attention or action).

For example, over the last decade, the Return on Capital (ROC) on the JSE has been negatively correlated to size. In other words, the smaller the listed business, the more profitable it tends to be.

Below is a graph showing the 10 year average ROC on the JSE per size-based index (click on the image to expand it):

I’ll acknowledge that if you did the same study on a Return on Equity (ROE) basis, the results less clear. This is probably because bigger businesses can both borrow at lower interest rates and they tend to more geared than smaller ones. Thus, they can financially-leverage their lower returns to generate a higher ROE (albeit, a potentially riskier one too…). Interestingly, though, the above ROC average indicates that the marginal extra debt bigger businesses borrows are invested into projects with marginal diminishing returns…

Anyway, academics aside, consider the following other examples where smaller businesses are more profitable than their large peers:

  • Capitec versus the rest of the banking sector: Yes, Capitec (CPI) is not all that small anymore, but go back in history and compare its ROE and ROC against the other banks over the last decade or two. Capitec has been comfortably more profitable than the large banks for decades now.
  • Retailers: Notice how Massmart’s (MSM) debt keeps rising, but its ROC keeps dropping? Massmart is a case study in how size (and complexity) can kill a business if not carefully managed. Likewise, go check how profitable Dis-Chem (DCP) and Clicks (CLS) are relative to other larger retailers? Not perfect comparisons, but useful to my point here.
  • CSG Holdings (CSG) versus ADCorp (ADR): The former has multiples of the latter’s returns and margins. See here for some background.
  • Pan Africa Resources versus other gold miners: Consider Pan Africa Resources (PAN). It is pretty much always profitable, no matter the gold price and generates a long-term ROE above its Cost of Equity (COE). This in materially better than almost all of its much-large, multinational gold mining peers.
  • Rolfes versus other Chemical Peers: This example may be convoluted by Rolfes’ (RLF) recent account restatements (see here), but Rolfes is more profitable than its larger peers, Omnia (OMN) and AECI (AFE) on most metrics, yet Rolfes is a fraction of either of their sizes (interestingly, also a fraction of their valuation).

I’m sure I could find other examples, but for sake of brevity, I will move along with my point.

Why does expected relationship between scale and profitability break down? What goes wrong?

Well, it is simple: complexity has a cost. The larger a business, the more complex it is. That complexity literally has a cost that absorbs returns. So, on the one side, returns to scale help a company scale upwards, but at some point along the way, it becomes too big and too complex to be efficiently run (managers of managers employing other managers start to pop up…) and its returns actually start to fall.

Personally, I call this my ‘optimal size’ theory (my workings find that this “optimal size” in South Africa tends to be around R15bn to R30bn market cap, depending on the industry). While bigger can mean better, it does not always translate into this.

 

(2) Scale Needs Volume

After the 2010 World Cup, the domestic construction industry margins collapsed. Sure, part of this was the protracted Competition Commission inquiry in collusion, but another aspect was excess capacity.

What? How can excess capacity be a problem?

It was simple: construction firms were too big. They had hired too many permanent people, built up too many overheads and were too big. Downsizing is painful, thus, they began tendering for work at lower and lower margins just to ensure that they had sufficient volume of work going through their business to keep the lights on.

Unfortunately, all of them were doing this.

Thus, well over a half decade later, and construction margins in South Africa are still rubbish.

What is the moral here?

Really big businesses can actually end up with little wiggle room and a desperate need to fill up their capacity. If they don’t, they have (because of their size) massive overheads that will hurt them. Scale, after all, is synonymous with operating leverage.

Thus, scale comes with an obligation to fill it and very rarely substitutes fixed costs for variables ones. That means that in tough times, bigger businesses can sometimes find themselves as price takers purely to fill up their enlarged scale’s capacity. Smaller businesses often balance their capex with variables costs (sometimes out of choice, like Calgro M3, and sometimes just because they do not have the capital).

Due to these differing cost structures, bigger businesses can sometimes be more cyclical than the smaller ones. Not always, but it is worth bearing in mind when comparing businesses.

 

In conclusion, scale may be a barrier to entry, but it is not a great one. Likewise, scale may offer a competitive advantage, but it is not a strong one. In many instances, scale comes with the added cost of complexity and the obligation to fill its capacity and, in some instances, these two negative variables can outweigh benefits that the scale offers.

Any day of the week, I would rather choose profitability over size. So beware the next time you hear someone quoting ‘scale’ as either a barrier to entry or a competitive advantage. It may not be as good as it sounds.

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