When Products Drive Profits

Some of the most inspiring entrepreneurial stories are written when professionals venture out on their own. Building on their education and/or experience, these professionals usually strive to build product-centered businesses, forever changing the utility of the product in the eyes of the consumer. The key challenge in building pathbreaking products is balancing the economics of making a business out of them with the perfection/ aesthetics related to the product. In this piece, we delve into why some founders are able to strike this balance whilst others flounder.

“I never went into business to make money. I went into business so that I could do interesting things that hadn’t been done before.” – Dr. Amar Bose

“Entrepreneurship is all about courage, it’s all about thinking about a powerful idea and then converting it into wealth” – NR Narayana Murthy

“The idea was never merely to make money. The compulsion was to think big, always to offer the best” – Rai Bahadur Mohan Singh Oberoi

One of the great joys of being an equity investor is studying and learning about the history of businesses and companies. The origin story of a company gives fascinating insights into the motivation of the founder/promoter in getting into business. The ‘Why’ of a venture often tells you about the foundational principles of a company, an insight that is immensely valuable in understanding what makes a business tick.

While businesses are born out of many different reasons, entrepreneurs usually come down from broadly two different paths. One path starts with just the basic desire to do business. Such entrepreneurs are not as much motivated by what they make or sell as they are by the fact that are making or selling something – or anything. Think of Dhirubhai Ambani. He did not seem to have any particular liking or understanding of spices, in which he first began trading after returning to India from Aden. And neither was he endowed with any technical knowledge of polyester, his next big trading venture on which sits the foundation of the Reliance Group. For such entrepreneurs, the product is in a way, just a means to an end – the end being a business.

The other path entrepreneurs take, starts with them knowing what they want to make or sell or having already made it, and the business comes much later, usually as a natural extension or an unavoidable necessity. The awareness of what to do comes either from their education, training, their experience as professionals in the field or just as an idea, a eureka moment so to say. Dr. SK Burman was already preparing natural cures for different diseases before going on to set up Dabur. Karsanbhai Patel developed a detergent powder, started making it in his backyard and selling it door-to-door, eventually setting up Nirma, the largest selling detergent in India at a point in time. The founders of Uber hit upon the idea of a phone-based cab hailing service after being unable to find a taxi one night in Paris.

The business for such founders is the means to an end – the end being their product or service. Such individuals bring the best of two worlds, by adding a professional touch to entrepreneurial zeal. And these are some of the most inspiring journeys to learn about.

One of the most interesting aspects of professionals turning entrepreneurs is the primacy of the product in the business. They see an opportunity in building a product that does a far better job of serving a customer’s needs than what the prevailing norm is. And since the product is the foundation, it remains central through the life of the business.

Kochouseph Chittilappilly in his early career worked with firms that made electrical goods, including one that made voltage stabilisers. Power fluctuations were frequent back then and having seen up close the quality of stabilisers available, he saw an opportunity to solve a common problem by venturing out on his own to make better voltage stabilisers. He practically made it his mission to make a far superior product – a product that not just performed better but was also aesthetically pleasing and had a long life. This set V-Guard on the path to creating a niche for itself in a market with large well-known incumbents. V-Guard went on to build a strong name in other electrical goods too and is a ~Rs25bn revenues and Rs73bn market cap company today.

Rai Bahadur Mohan Singh Oberoi, the founder of the hotel chain that bears his name, started his career as a clerk at a hotel in Shimla. When opportunity presented itself, he decided to use his early training and experience in hospitality to take the entrepreneurial plunge and went on to acquire the very hotel where he started out as a clerk. His passion with superior hospitality has led to the creation of one of the finest luxury hotel chains in the world. Multiple Oberoi properties find themselves ranked amongst the best hotels in the world year after year. You will struggle to find a traveller who would not aspire to spend their holidays staying at an Oberoi property – that is the power of the product created by MS Oberoi.

The founders of Infosys, from the very beginning, extended their mission beyond just building a great product, to also building a great company. When the founders, led by N R Narayana Murthy came together for the first time to chalk out the vision of the company, they did not restrict themselves to just delivering best-in-class software or technology, but in employing best-in-class professionals, earning the respect of clients and the trust of all stakeholders. In fact, we can credit Infosys with building not just Infosys, but inspiring a whole generation of professionals to turn in to first-generation entrepreneurs and build their own versions of Infosys.

The other facet that stands out for product-centered businesses is the near obsession with continuous improvement. James Dyson spent 15 years perfecting his now iconic cyclonic vacuum cleaner. His first prototype was made of cardboard! With each prototype, he improved on the previous one until he got it right on the 5,127th one. Dyson continues to set the standard in vacuum cleaners till today. James Dyson describes his company as “We’re all about invention and improvement.”

Dr. Amar Bose already had multiple patents to his credit while teaching at MIT and decided to take his technical expertise in electrical engineering and acoustics down the entrepreneurial path. His relentless pursuit of replicating concert-quality sound inside homes and elsewhere has revolutionised the design of speakers, and has led to multiple innovations, including the now ubiquitous noise-cancelling headphones. Dr. Bose first thought of noise-cancelling headphones on a flight in 1978, made a working prototype in 1986 and launched them for airline pilots in 1989. Consumer headphones came much later – in 2000. That is 22 years of continuous innovation and improvement to take a product from concept to commercial day-to-day usage for consumers.

While an obsession with building a great product and keeping on improving it is commendable, the tricky part is balancing it with business economics. After all, spending 15 or 22 years in developing or perfecting a product comes at a price. The problem compounds when you are a public company and are answerable to shareholders for profits and return on capital.

To keep his company’s focus relentlessly on R&D (which could also mean many failures before a successful product) Dr. Bose kept his company private, so that pesky analysts or investors would not pressurise the management on short term goals. Like Bose, Dyson has also kept his company private, and for the same reasons. Dyson says “I love the independence of owning 100 percent of the shares, of having to think only about the products and not to worry about shareholders. In that sense, we’re completely free.”

Companies like Infosys, V-Guard and many others have balanced the competing pulls of the product and the shareholders quite well. On the other hand, Tesla Motors, another product-obsessed company, reported its first ever annual profit only in 2019, 16 years after inception. Shareholders have had their patience tested while the management perfected the electric car, but the rewards have been sweet. However, that is not always the case. EIH Ltd., the company that runs the Oberoi hotels, has struggled to make a return on capital that is consistently above its cost of capital for years. While the hotels business is high fixed-cost and cyclical in nature, the variance between the quality of EIH’s product and the quality of their earnings remains wide.

We have observed four key factors that enable product-focused companies to also deliver on profitability.

High degree of differentiation – Companies that put the product at the centre of the business need to make sure that their product is not just a minor improvement over incumbents. The key to profitability is developing a highly differentiated product that serves as an entry barrier to competition. This differentiation could result in a product that can either command a price premium (eg. the iPhone, which was a pathbreaking product when launched) or is a low-cost radically discounted offering (eg. DMart, which changed the supermarket shopping experience for Indians). Successful founders avoid developing a product which is a me-too version of one that is already available. The history of airlines and non-banking finance companies (NBFCs) in India however shows us that founders often fall into this trap and then struggle to compete in a crowded market.
Costs are equally important – V-Guard outsources a large part of its manufacturing to multiple smaller units. This not only help de-risk procurement, but also makes the company capital-light, enabling it to generate returns in excess of its cost of capital. Dyson started with a manufacturing plant in the UK, but later moved production to Malaysia in order to bring down costs of production and improve profitability.
Expanding the scope of product-market fit – Dr. Bose first developed the noise-cancelling headphones for the use of airline pilots. Having an early market for the product allowed them to sustain development of the consumer version of the product, which came much later. Tesla was not the first company to start work on an electric car, but they expanded the scope of the product by deciding to tackle the one key concern potential buyers had – that is acceleration. Their positioning was not as much a ‘green’ car, but a ‘sports’ car that was also electric. Effectively, every car buyer was now a potential customer.
High levels of reinvestment of cash flows – Product-centric companies seldom let their guard down on innovation. The barriers to entry created with the flagship product needs continuous fortification in order to sustain their advantage over a long period of time. To this end, they reinvest a large part of free cash flows back in the business to grow not just the existing product but also to expand into adjacent products/markets that drive the next level of growth. This is not easy as the founder must postpone monetary rewards in the short term to keep the product engine revving for a much longer time horizon. Bose Corporation famously reinvests almost all of its profits back into the business towards research – and the results are visible in its continued dominance in its product categories for over 50 years. Dyson spends 40-50% of EBITDA on R&D on a recurring basis and has developed trailblazing products in newer categories too, from washing machines to hand dryers. Almost all the companies in our Consistent Compounders and Little Champs portfolios re-invest over 60% of their cashflows back into their business.
A welcome relief for product-focused entrepreneurs has been the growing pool of patient capital available to them. Venture capital and private equity firms today not just fund large amounts, but also have sufficiently long-term investment horizons to wait for the product to be perfected. It would be interesting to see the future of such companies when they navigate the world of public markets and need to commit time and capital for continuous R&D.

Each entrepreneurial story is different in its origin, its journey and in some unfortunate cases, its end. At Marcellus, we as a team continue to take inspiration from stories of other professional entrepreneurs, as we go down our own path of building a business with the product (or specifically, a philosophy) at its core.

Salil Desai is a Portfolio Counsellor with Marcellus Investment Managers

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