Scale Economies Shared (a Business Breakdowns Follow-Up)

One thread to pull on from our Business Breakdowns podcast interview about Wise (formerly Transferwise) is the concept of 'Scale Economies Shared’.

Understanding the nuances of this topic is critical to anyone seeking further insight into Wise’s competitive advantage.

Listen to James Revell’s breakdown:

The concept of Scale Economies Shared (SES), coined by Nick Sleep and Qais Zakaria of Nomad Partners, describes a business model that shares the benefits of ‘economies of scale’ with customers, typically by offering lower prices to gain long-term market share. It is a model that lends itself to long-term investing, almost by definition. As Sleep suggests in Nomad’s 2004 letter, referencing Costco:

‘Most companies pursue scale efficiencies, but few share them. It’s the sharing that makes the model so powerful. But in the center of the model is a paradox: the company grows through giving more back. We often ask companies what they would do with windfall profits, and most spend it on something or other, or return the cash to shareholders. Almost no one replies give it back to customers – how would that go down with Wall Street? That is why competing with Costco is so hard to do. The firm is not interested in today’s static assessment of performance. It is managing the business as if to raise the probability of long-term success.’

Amazon is another example of this business model in action. Nomad’s letters refer to one of Amazon’s own shareholder letters which describes an Amazon employee removing the light bulbs from the vending machines to save the firm US$20,000 per annum! 

Wise, a cross-border payments business we recently broke down on a podcast, adheres to the same principle as Costco and is equally hard to compete against.

It too has equally eye-opening examples – actively offboarding partners who were marking-up FX or not being transparent with pricing to customers; a refusal to cross-subsidise routes or customers from more profitable parts of the business; and Kristo (co-founder and CEO) apparently only ever flying economy despite his wealth.  

This exemplifies an inherent tension in SES businesses – counter-intuitive actions whereby profit or growth is seemingly unnecessarily sacrificed in pursuit of the mission

As the founder of Fed-Mart, the predecessor firm to Costco, Sol Price, once said: 

‘Although we are all interested in margin, it must never be done at the expense of our philosophy. Margin must be obtained by better buying, emphasis on selling the kind of goods we want to sell, operating efficiencies, lower markdowns, greater turnover, etc. Increasing the retail prices and justifying it on the basis that we are still “competitive” could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there.’

The knowledge that you could raise prices and generate more profits, with little to no harmful short-term effects is so tempting. This is the very reason why two things must be in place for these businesses to succeed (and why so many get a ‘rude awakening’): 

The first is an ability to disengage from today’s short-termism and recognise that the most powerful ‘scale economies shared’ models are the consequence of the accumulation of many small (counter-intuitive) decisions over a very long period of time.

This example from John D. Rockefeller, one of the most powerful businessmen and scale economies (not necessarily shared, however) businesses of modern times, highlights the level of devotion required to win over the long term in a scale economies business:

‘In the early 1870s, Rockefeller inspected a Standard plant in New York City that filled and sealed five-gallon tin cans of kerosene for export. After watching a machine solder caps to the cans, he asked the resident expert:

“How many drops of solder do you use on each can?”

“Forty,” the man replied.

“Have you ever tried thirty-eight?” Rockefeller asked.

“No? Would you mind having some sealed with thirty-eight and let me know?”

When thirty-eight drops were applied, a small percentage of cans leaked—but none at thirty-nine. Hence, thirty-nine drops of solder became the new standard instituted at all Standard Oil refineries. “That one drop of solder,” said Rockefeller, still smiling in retirement, “saved $2,500 the first year; but the export business kept on increasing after that and doubled, quadrupled—became immensely greater than it was then; and the saving has gone steadily along, one drop on each can, and has amounted since to many hundreds of thousands of dollars.”

The second is a zealous, steadfast and almost pedantic cultural pursuit of a sacred mission, refusing to waver in its desire to return operational efficiencies to the customer.

Typically, this means that these types of organisations have: 

Vocal and vociferous founders at the helm. Whilst not a founder, Michael O’Leary at Ryanair is probably an extreme example of this. The counter-intuitive nature of some of the decisions required to build a ‘scale economies shared’ moat over a 10-year period necessitates the ability to pushback against the more obvious short-term path.  

Cultures that obsess over the customer. The bigger the company gets, the more decision making tends to drift away from the customer ‘coal face’. This reduces mental and emotional friction to making the ‘easy’ business decision to raise prices or forego cost reductions that are neither obvious nor straightforward i.e. ignoring the customer in the room rather than the elephant. This breaks the implicit sacred contract you have with the customer that incentives reciprocity (“you pass on cost savings in the form of lower prices, I’ll buy more things from you”), a phenomenon Nomad calls a ‘super-factor in business performance’. Built From Scratch, Bernie Marcus and Arthur Blank’s description of their journey in founding The Home Depot, is centred around the customer, particularly the belief that they only ‘lease’ the customer – they will leave if they aren’t treated right. This anecdote exemplifies the depth of their customer obsession:

‘One day, a man came into one of our Atlanta stores with a set of automobile tires, demanding a refund. The Home Depot doesn’t sell tires – never did, even when we sold some other automotive supplies – so the person running the service desk called Mercer [VP of Operations & Group President] for help.

“Sir,” Mercer said, “if you bought them here, what did you pay for them?”

The man named a figure. Mercer reached into the cash register and handed the man the exact amount without another word. Then Mercer hung the tires over the service desk to remind everybody: the customer is always right.’

Businesses that have these two things in place are able to establish a flywheel that picks up unstoppable momentum over many, many years. The Amazon (diagram 1) and Wise (diagram 2) flywheels might look a bit different, but are ultimately the same: 

As with any momentum, what takes time to accumulate can be undone in a moment, often through ill-considered poking and prodding (the customer is leased, not owned). In most businesses, this manifests in supposedly ‘once-off’ price increases. However, time and again the sweet nectar of short-term performance improvement has management returning to the well. The detriment to the long-term competitive advantage is only apparent on a timescale often not within the sights of a management team. 

Without an omnipotent and omnipresent despot keeping management’s hands off the tiller, how does a company scale whilst maintaining this discipline? 

We believe that organisations should orient around a sustainable competitive advantage and find people that value it. At Wise, the following examples lend weight to this hypothesis: 

  • The mission is at the centre of everything they do and every decision they make: Money without borders – instant, convenient, transparent and eventually free.
  • The customer is never forgotten – everyone in the company takes customer support calls, including the founder and CEO.
  • The product roadmap is published on the website for customers to ‘up-vote’ or ‘down-vote’ suggested features.
  • Over 100 small cross-functional and autonomous mini businesses within the business are empowered to solve problems and deliver features. They orient their missions around the bigger mission and key goals of cross-border volume, price, transparency and convenience.

In relation to Wise’s business model, two intriguing lines of commentary have emerged: 

The first is an observer’s potential conflation of their Scale Economies Shared business model with it being a commodity business. One being a deliberate business model producing an intergenerational competitive advantage that chooses to strategically compete on price. The other reflects quite the opposite – an indistinct business operating in an industry defined by lower barriers to entry that can only compete on price. Where you stand on this issue depends entirely on whether you see their customer valuing more from Wise other than simply price. To put it another way – at the same price or even at a slightly better price, would the customer be the one to break their unspoken oath of reciprocity and choose another provider? 

The second, is whether Wise’s business is inherently tied to being a better version of a bad system – the status quo of correspondent banking. This therefore leaves it exposed to the inevitability of progression to a better system – a paradigm shift in how cross-border transfers work. How long did producers of faster horses last once the internal combustion engine appeared?

One way to tackle both of these, without getting caught up in the details, is to apply one of Jeff Bezos’s mental models: solve what won’t change on a 10-year basis, rather than what will. In this case, I think we’re treading on fairly thick ice when we state: 

  1. Customers will want the lowest cost 
  1. Customers will want speed 
  1. Customers will want transparency 
  1. Customers will want the best all-round user experience

With a mission fanatically centred on these four pillars, one can take comfort from the fact that even if there is a paradigm shift to a faster, cheaper, better way of transferring money across borders – Wise will be doing their utmost to be at the forefront of that change. 

About the author

James is a member of the TDM Investment Team. Alongside his day-to-day investment duties, he supports Block and advises other portfolio companies on growth strategy.

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