Happy Customers

One of the most important factors we look for in our Builder Companies is a vibrant, exciting, and lucrative relationship with customers.  We don’t tend to invest in companies with poor customer satisfaction scores, poor customer service, and/or price gouging characteristics – even if they exhibit some interesting expressions of market power.  Most great companies delight their customers which keeps those customers coming back for more.  When that relationship sours, it can be catastrophic. 

I was doing some research on Sonos (NASDAQ: SONO) recently.  It piqued my interest because it has market leadership in what it does and relatively low penetration in home audio, but it flubbed a software update this summer which has upset customers and which forced the company to delay new product launches.  The user community and news outlets have had a field day with it.  However, I suspect such an event will blow over and will be remembered similar to Chipotle’s E. Coli issues about a decade ago.  That exploration inspired this post. Why would Chipotle “get away” with making people sick?  Why do cruise companies “get away” with outbreaks of norovirus every so often, and Covid in 2020?  And why should Sonos “get away” (or not) with this bad software release?

The answer is simple: if customers love a company’s products or service, they are forgiving.  If they are reluctant users, they will leave and never come back. 

How To Identify Companies with Happy Customers

Something magical happens when companies deliver their products and/or services so well that they make their customers happy - not just satisfied.  Those companies tend to grow nicely and gain market share for a long time.  Their growth is more than just a fad – it is the product of generating a surplus of tangible and intangible value for their customers across multiple dimensions.  They tend to be disruptive to the competitors in their markets.  A further level of analysis is needed to ensure that customers aren’t simply happy because of an obvious economic value transfer from the companies to customers (like selling $1,000 iPhones for $500 indefinitely).  That said, companies with strong business models and happy customers enjoy above-average margins and generate great shareholder returns. 

The most obvious areas to look for “happy customer” metrics in company financials are in growth rates (i.e. is it above their peers and sector’s growth rates) and in customer acquisition costs and/or advertising intensity.  It may show in other areas as well, but these are the first places I look. 

I like to look at advertising intensity relative to growth and implied payback periods to get a sense for the “happiness” factor in companies.  For instance, company A could spend 20% of revenue on advertising, while company B could spend 2%.  Depending on the growth and contribution margins of each company, either could be better or worse.   

Let’s walk through a simple example to illustrate.

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In the above example, Companies A and B start with the same revenue, gross margins, and incremental gross margins, but Company B spends twice the advertising budget in Year 1 (as a % of revenue) to drive 3x the growth.  It has more efficient advertising spend, delivering shorter paybacks (~6 months payback on its advertising vs. ~8.5 months for Company A).  This is a very simple example that is very intuitive – companies with shorter paybacks on advertising should spend more – and that’s a good thing. 

Of course, in reality it’s rarely this simple.  There are numerous differences in business models and other nuances to consider.  But this is what we’re looking for – companies that generate so much value and happiness for customers that their advertising efficiency is superior to their competitors’.

Examples

An easy example of what we are looking for is Tesla.  The company doesn’t spend on traditional advertising.  Its total SG&A expenses are 5% of revenues ($4.5B in 2023), but it doesn’t break out advertising expenses explicitly.  GM spent $3.6B alone on advertising.  Ford spent $2.5B.  Tesla tripled revenue from 2020 to 2023, while GM grew revenue +45% and Ford grew +42% over the same period.  Both Ford and GM are big spenders across media channels (TV, print, search, etc.).  For Tesla to grow that much faster without wildly outspending the others in advertising is a testament to the power of the brand, to customer satisfaction, and to it being a disruptive force in the auto market.

What about an example of something we’d like to avoid?  Verizon spent $3.85 billion on advertising in 2023 to drive a -2% decline in revenue and a $1.4 billion increase in gross profit (primarily due to cost cutting, not growth).  Generally speaking, Verizon’s advertising expenses do not generate any growth for the business.  Verizon must spend to acquire gross new subscribers to help offset existing subscriber churn.  This is the consequence of competing in a commodity-like industry with little differentiation against other well-funded national competitors. Carriers offer promotions to entice their competitors’ customers away in a mature wireless industry.  There’s little to no value surplus flowing to customers across multiple dimensions which keeps them happy and loyal. Low churn is a product of customer inertia, lack of an obvious “best” service provider, and a horrible disconnection experience. Competing in retail telecom services these days is like fighting in a gladiator arena – all participants get bloodied and beaten up even if they do stay alive. 

There is another class of companies that have high repeat and retention rates, but do not have happy customers.  Their customers would eagerly switch if viable alternatives were available.  These tend to be financially efficient and appear to have attractive business models, but we tend not to like them as much.  I call these “Valeant” types of investments, in honor of Mike Pearson’s strategy of price gouging customers and cutting all R&D investments for newly acquired companies.  Companies that get away with exploitation strategies clearly have enormous market power, but we’d rather partner with those that push innovation and disruption in their sectors and use “more for more” go-to-market strategies.

In the past we wrote how Charter Communications is an anti-model for what we seek, and it’s a good example of what happens when the exploitation strategy meets new alternatives - like 5G fixed wireless internet and YouTubeTV. The moment cable-hating customers had other options for video and home internet connectivity, cable companies suffered competitive losses in subscribers.

We strongly prefer to own companies that are innovative, disruptive, and constantly driving their enterprises generate more value and happiness for customers. We prefer to find the small handful of companies that we believe will keep innovating and winning incremental share, rather than own a portfolio of companies in their exploitation phases.

Conclusion

There’s no silver bullet analysis that allows us to quickly and easily screen for companies that have happy customers.  Business model nuances and differences make it challenging to standardize across different companies and industries.  Nonetheless, this is an important angle of attack in our research efforts.

We get excited when we find companies generating so much value for their customers that those customers will keep coming back for more, repeatedly, and without needing much enticement.  The core products and services speak for themselves and drive repeat behavior.  Their brands have strong intangible value in the market and allow for greater optionality around new product launches and category expansions.  Such companies have inherent pricing power, great advertising efficiency ratios, and tend to generate superior equity value over long periods of time.