How Small Beats Large

How does a smaller company beat a large company with seemingly unlimited resources?

This is a problem I have been struggling with, and here are some thoughts (basically a synthesis of Porter and Christensen).

The problem has to be looked at from both sides, let's call them SmallCo and BigCo. The SmallCo's strengths alone are not going to be enough, nor the BigCo's weaknesses. It's only when the former's strengths match the latter's weaknesses that you have a David beats Goliath situation.

So let's look at it from both sides, starting with BigCo.

Just because a company has the resources to fight and win on any given single front, does not mean it can do so on all fronts, simultaneously. At some point every empire overextends itself. Where's the weak link?

A large company can have weak points where it lacks a) willingness/motivation, or b) ability to compete.

• Lacking willingness/motivation to compete. Perhaps because
• a) under the radar situation. The market in question is unattractive at the surface, or too small to move the needle for BigCo. 
• b) requires trade-offs. Examples would be if the market takes away resource from BigCo's favored customers, doesn’t match corporate value, or leads to cannibalization of opportunities. In his book "Seeing What's Next", Clay Christensen cited example of a firm that counts on post sale service agreement not being interested in an off-the-shelf /self-service product.
• Lacking ability.
• Perhaps because BigCo's activities and processes are not tailored to the value proposition offered by SmallCo.
• BigCo may have difficulty replicating SmallCo's value chain.

Moving on SmallCo's side. How does SmallCo take advantage of BigCo's weaknesses while avoiding its strengths?  

• Distinct customer segment and value proposition that does not match BigCo's. 
• SmallCo would target over-served customers, under-served customers, non-customers (creating new market)
• Tailored value chain supporting that value proposition. The value chain should show 1) uniqueness, 2) internal fit, 3) independence from BigCo.
• Uniqueness. It has to be different from BigCo's. Otherwise you will just be overwhelmed by brute force.
• Internal Fit (interdependency). The value chain should fit together in a way that’s hard to replicate. Ideally the parts are interdependent on each other. This way your competitive moat compounds and is hard to replicate.
• Independence. Separate value chain. If parts of the value chain overlap, then SmallCo could be forced to play by BigCo's rules.

Basically if your David, make sure you can afford to NOT play by Goliath's rules.

A Short Example with Elastic N.V and Chewy

These are two companies that compete with Amazon in two completely different industries. The differences provide them different strengths and weaknesses relative to Amazon.

Elastic ("ESTC"), which I have written about here, provides search functionalities that Amazon effectively copied. Chewy ("CHWY", as discussed here) is an online pet food/supplies provider. 

Which has a better chance against Amazon?

Amazon's Motivations

I would say Amazon is much more motivated to go after Elastic's search market, which competes with Amazon's AWS segment. This segment of Amazon not only provides more profitability than its e-commerce segment, but it is also growing much faster. A quick look at Amazon's earning releases shows tremendous focus on developing AWS's capabilities. Overall, Elastic's search/indexing market looks strategic to Amazon.

On the other hand, pet e-commerce is seen as a fairly steady, slower growth market. Pets are hardly ever mentioned in Amazon's earning calls. 

Verdict: Amazon is much more motivated to attack Elastic than Chewy.

SmallCo's Value Chain

Chewy has its own distribution facilities, call center, and service reps. These fit together in a way that reinforces Chewy's niche strategy (as discussed here). In terms of pet products, its suppliers does overlap with that of Amazon's, and that could be a problem.

Elastic though, actually deploys its hosted service on AWS! Talk about NOT having an independent value chain! Elastic belated realized Amazon meant harm and started diversifying to Microsoft Azure in addition to Google (GCP), but the damage has been done.

Verdict: Chewy's has a more distinct value chain from Amazon.

We can go further, but this is enough to show that Chewy will have much stronger defense against Amazon's invasion.

Chewy's Competitive Advantages

In my 10/15/2019 post I mentioned that I passed on Chewy and Uber. Over the past few weeks I ended up buying into both.

Here’s a thread I recently tweeted out on Chewy (CHWY). It's a hypothesis of Chewy's "flywheels". I am definitely not wedded to the idea so this is an attempt to crowd-source my thinking process.

1/n. Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft)$CHWY pic.twitter.com/FgzJLcD46L

— mspacey (@mspacey4415) December 12, 2019

For your convenience, here is the expanded thread (lightly edited and reformatted for blog).

Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft):

To fend off Amazon, we have to answer how the value chain is different and how those pieces fit together in a way that competitors: a) can't copy, b) not willing to copy.

I think the answer is Chewy's vertical Focus strategy.

Start with right hand side of diagram:

• Niche focus allows Chewy to optimize supply chain (e.g less product variation means easier arrangement/picking at fulfillment centers .. saves space/time/cost..etc)
• Chewy can invest cost savings into customer service (focus strategy reinforces this. e.g knowledgeable reps)
• Good service drives growth/retention. More Autoship customers enhances predictability -> more efficiency. (See original tweet for screenshot of management comments on this topic)
• Reinvest that saving into service = closes the loop on right side of diagram

Move on to left side of diagram:

• CHWY has built up a lot of fixed costs (fulfillment centers..etc). 
• Customer experience drives growth. 
• Growth + fixed cost = operating leverage & economy of scale. 
• Reinvest cost savings into customer service closes the loop

We are already seeing this reflected in CHWY's financials:  more active customers, higher % of Autoship customers, higher gross margins..etc. 

Again, I think it's all enabled by focus strategy, which won't be matched by Amazon.

Feedbacks and Conclusion

Overall reactions to the thread suggest that people are quiet negative about Chewy (even after the stock's recent run up). This makes me uncomfortable as I don't consider myself a contrarian.

The most notable response is from @CharlieZvible. He argues that CHWY's limited TAM means its margin needs to be more than low/mid single digits to justify valuation. He questions if that can be achieved.

"...The TAM is pretty well defined. $65bn if I remember correctly. Remaining share split mostly between wmt, cost, tgt, Amzn, pets. Didn’t look at Q3 but guessing $ sales added still flattening out. Think you need HSD margins to be good stock-high for consumables"

This is definitely a good point that needs to be considered. I'm inclined to disagree after doing some basic calculations. Here's how I think about it.

• At the time of this writing, CHWY trades at about $29/share. This represents <$12bn enterprise value. 
• CHWY is on track for $5bn of revenue a year and growing ~37% for the year ending 1/31/2020.
• They can easily reach $10bn revenue in a few years. A 5% EBIT margin on that is $500mm. CHWY would be trading at 24x EV/EBIT. 
• I would not be surprised that in 5 years it's more like $15bn revenue. At the same 5% EBIT margin, the current price implies ~16x EV/EBIT.
• Well known consumer stocks usually trade at high multiples so these are not far fetched.  

Going back to the TAM limitation. A $15bn revenue would imply 25% of the $60bn TAM cited. That sounds like a lot. Too much? I'm not sure. The whole point of the "flywheel" discussion above is to assert that Chewy's competitive advantages reinforce themselves overtime, so that the company gets stronger relative to competitors, and thus can grab a disproportionately large market share.

It's also possible that the $60bn TAM is not fixed, but in fact expanding due to secular trends ("humanization of pets"). It also seems logical to me that the convenience of e-commerce should expand TAM by converting previous non-consumers. New product innovations is another factor that can increase market size. Along that line of reasoning, I would note that the above is not counting the pet healthcare business.

So I'll leave off here. I bought Chewy under $26/share, as soon as I saw it pop above MA50 on huge volume. The discussion above was to decided whether I should add, hold, or exit. My decision, at least so far, is to hold.