How to Find Companies Profiting From the “Asset Lite” Model

All too often, investors focus simply on raw growth. Growth is rarely free.

Boosting earnings by 10% is counterproductive if the investment capital needed to obtain it costs 11%. In fact, value has been destroyed rather than created.

Aswath Damodaran, finance professor and dean of equity valuation at New York University, sums it up like this:

To generate cash flow, firms have to raise and invest capital and this capital is not costless. In fact, it is only to the extent that these cash flows exceed the cost of raising capital from both debt and equity that they create value. In effect, the value of a business can be simply stated as a function of the excess returns that it generates from both existing assets and new investments.

I’ll spare you the calculations.

This explains why I place a premium on businesses that generate lofty returns on invested capital (ROIC). Ultimately, it’s the difference between return on capital and weighted average cost of capital (WACC) that matters most.

But all things equal, I’d rather own a company that can earn 14% on every dollar invested than a rival that only manages 8%.

The textbook definition looks like this:

ROIC = Net Operating Profits after Taxes (NOPAT)/Invested Capital

The Secret of the Most Successful Businesses

Unfortunately, there’s no magic formula to increase the numerator in this little equation (although a wide economic moat goes a long way). But some companies have found a clever way to decrease the denominator, which can be just as effective. They maintain (or possibly even increase) operating profits using less capital.

In other words, less input for the same level of output.

The most successful businesses are highly efficient and can often match the per-dollar profit of their competitors with only $0.70 or $0.80 at work.

Let’s multiply that a few hundred million times over. Two similar companies might deliver identical annual operating earnings of $50 million, but one requires $500 million in capital to do so (10.0% ROIC) while the other achieves it with just $400 million (12.5%).

Capital requirements can vary widely from industry to industry. So it’s hard to compare, say, a midstream energy company with a fabless software developer.

But in general, heavier businesses that can’t meet their needs internally must tap the bond markets and/or make dilutive share offerings more often to raise cash to feed their growth engine.

That’s yet another reason why so many finance czars these days have advocated for a so-called “asset light” model.

In the simplest terms, that involves shifting physical assets off the balance sheet into the hands of third-party owners.

This strategy naturally requires less upfront investment to purchase property, plants and equipment — and reduces maintenance and upkeep expenses in future years.

Some “new economy” businesses were simply born this way.

Airbnb (NSDQ: ABNB) is a textbook example. The home-sharing platform hosts nearly 8 million active listings in 100,000 cities. Travelers booked 133 million nightly lodging accommodations on the site last quarter.

Yet the company doesn’t actually own a single property. You can imagine the cost savings.

This ultra-lean organization converts $10 billion in annual sales into $4 billion-plus in pure free cash flow (FCF) — a sky-high margin above 40%. That’s more profit than some businesses three to four times larger. In turn, it commands a premium valuation approaching $100 billion.

Legacy lodging companies learned this trick long ago. Take Hilton Worldwide Holdings (NYSE: HLT). There are two dozen brands under the umbrella, from the namesake Hilton to popular mid-priced chains like DoubleTree to the luxurious Waldorf Astoria. Combined, these brands encompass 7,600 properties containing 1.2 million rooms across 126 countries.

Yet Hilton owns only 51 (less than 1%) of these hotels and mostly lets somebody else handle all the reservations and housekeeping and other day-to-day operating responsibilities. It passively lets partners use the valuable Hilton brand name, so 95% of its cash flows come from licensing, management and franchise fees.

While shedding most of its brick-and-mortar portfolio since 2009, the firm’s fee-based income has soared from $814 million to $3.1 billion. As we speak, it has a massive development pipeline of 472,000 additional rooms. Hilton plans to invest a miniscule $0.3 billion in these new rooms — while third-party owners contribute $50 billion.

Hotels don’t come cheap. So this approach keeps the balance sheet far more nimble and flexible. The market appreciates de-leveraging, particularly in high-rate environments like this. And cash that used to go toward mortgage notes has been freed up for other uses: marketing, dividends, share repurchases and acquisitions.

Removing the burden of ownership also smooths out the inherent cyclicality in this industry.

Even in economic slumps when occupancy tumbles and room rates dive, Hilton still pockets steady management and franchise fees every quarter. That aligns with management’s clearly-stated goal of “generating substantial returns on minimal capital investment.”

Of course, this is just one example. Many other companies have embraced this model… to one degree or another.

  • eBay (NSDQ: EBAY) rakes in cash for every transaction conducted on its site, yet spends nothing on inventory (or warehouse fulfillment centers).
  • Uber (NYSE: UBER) connects millions of riders with nearby drivers and gets paid to move people without owning a single vehicle. Logistics providers do the same thing with freight by arranging transportation with third-party trucking companies.
  • Casual dining chains like Red Robin (NSDQ: RRGB) have sold off most of their real estate assets and then leased the stores back.
  • Global container and dry bulk shippers have sold off vessels and found it more advantageous to lease or charter ships from fleet owners such as Star Bulk Carriers (NSDQ: SBLK).

The Other Side of the Coin

Of course, these kinds of partnerships wouldn’t work if it wasn’t a symbiotic win-win relationship that allowed each party to leverage their own expertise.

Remember all those resorts that Hilton sold? Many of them were bought by Park Hotels & Resorts (NYSE: PK), whose portfolio stretches from Ontario to Waikiki. Including food and beverage, the company’s hotels are now generating $290 in revenues per room per night — supporting a strong dividend yield of nearly 7%.

And while casino operators like Bally’s (NYSE: BALY) and Caesars Entertainment (NSDQ: CZR) have shed a few pounds by unloading land and buildings, that decision has benefited their landlord.

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