Enterprise Attributes that Build Value: Quality of Earnings
March 29, 2009
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A corporation can only be as sound as its customers are financially. Also, a corporation can only be as strong as the necessity for their product or service offered.
A classic example of a company that achieves both attributes on our quality of earnings checklist is Warren Buffett’s GEICO property. For a little background the Government Employees Insurance Company was founded in 1936 on the assumption that government employees would not only be more responsible drivers (reducing claims) but would also be more credit worthy (increasing revenue predictability). A strong majority of drivers avoid accidents on a yearly basis but still put a significant amount of funds towards the float (which is the premium minus the claims) that can be invested and grown by the company’s management. If you want to study a fantastic business GEICO is a one-stop shop. The premiums are paid on a regular, predictable schedule and are a legal imperative if you want to drive. As Warren Buffett said in his 2008 Annual Report “No one likes to buy auto insurance. But virtually everyone likes to drive.” Combine that necessity with a rock solid customer and you have a business built for long-term success.
GEICO also doesn’t rely on a small set of customers and doesn’t fall into what many call the 80/20 earnings rule. That is if 80% of your revenues come from 20% of your customers your earnings could be very vulnerable if those customers lost their ability to pay or you lost their loyalty to your product. Companies that have government contracts (Raytheon) or who work on large construction projects (Perini Corp.) can be very susceptible to these dangers. Reaching a wide range of customers therefore is very important. Essentially you’d like customers with steady income streams from stable industries and that function well in a majority of economic climates. The 80/20 rule could also be applied to short-term currency situations as you might not want to be overexposed to a volatile monetary situation which will impair earnings. It’s somewhat safe to say though that currency fluctuations even out over the long-term though.
One way to achieve this broad based consistent earnings approach is to make a product that is required on a regular basis. We all can probably name some household products or regular services that we receive that could be categorized as necessities. Personal care items, telecommunications, maybe your cable sports programming, prescription drugs, etc. are all solid examples. Any product or service that is bought/paid for on at least a quarterly basis should fall into this prime category for selection.
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