How Structure limits Scale: Case Study on Rain Industries
Disclaimer: I am not invested in Rain Industries. I am not an investment advisor. I love thinking about investing and businesses, and this blog is just an expression of that love.
Few people have influenced me as much as Charlie Munger. Like many others, I do not think I can properly express my gratitude for his generosity to the world. I have always loved reading and he helped me figure out a career that primarily involves reading.
I attempt to apply the multi-disciplinary approach in investing in ways I can, and this post is one such attempt. This post is also in some ways a follow-up to my previous post on Rain Industries. There are some businesses that are fascinating and a fountain of learning. Rain is one such business- I continue to ponder on and learn from the various facets of company.
Over the last couple of years, I perceive some risks to scale and thus, possibility of material value creation in Rain Industries.
A couple of years back, I read the book ‘Scale’, an impressive book written by Geoffrey West (the erstwhile President of the Santa Fe Institute) with a lot of Big Ideas relevant for the investment field. In the book, he focuses on how things - both living and non-living- scale, and on the properties and limits of scaling. It is a fascinating book with important applications for investing.
I thought it would be fun to use some of the ideas from the book to explain my hypothesis on why I think Rain might find it difficult to Scale.
Let us begin with a discussion on Godzilla.
Godzilla cannot exist. Why?
In the book, Mr. West shares a story of when a journalist reached out to him for an interview. It was around the time Hollywood was going to release Godzilla, the Japanese classic. For readers who are unaware, Godzilla is this cool, gigantic monster that comes from the sea and mostly roams around cities (Tokyo, in the original 1954 version) causing destruction while terrorizing the populace.
The journalist wanted to do a fun interview on what the hypothetical characteristics (how fast it would walk, its metabolic rate, etc) of such a creature would be, and if such a creature were to actually exist on the planet.
And here is the surprising answer that Mr. West gave: Almost any scientist she contacted would tell her that no such beast as Godzilla could actually exist because, if it were made of pretty much the same basic stuff as we are (meaning all of life), it could not function because it would collapse under its own weight.
The basis of this conclusion was based on Galileo’s scientific argument on what would happen when you indefinitely scale up an animal, a tree or a building. The answer is that it collapses due to a fundamental constraint. Here is an excerpt from Galileo’s book - Discourses and Mathematical Demonstrations Relating to Two New Sciences.
You can plainly see the impossibility of increasing the size of structures to vast dimensions either in art or in nature; likewise the impossibility of building ships, palaces, or temples of enormous size in such a way that their oars, yards, beams, iron-bolts, and, in short, all their other parts will hold together; nor can nature produce trees of extraordinary size because the branches would break down under their own weight; so also it would be impossible to build up the bony structures of men, horses, or other animals so as to hold together and perform their normal functions if these animals were to be increased enormously in height . . . for if his height be increased inordinately he will fall and be crushed under his own weight.
When an object is scaled up in size, its volume (which is cubed) increases at rate much faster than that of the surface area (which is squared). Let’s say there is a cube with side of 2m - in this case, its volume is 8 cubic metre and surface area is 4 square meter. If the cube is scaled larger to 3m, then, the volume is 27 cubic metre and surface area is 9 square metre.
And why does this matter? This matters because the weight of an object is directly proportional to its volume, while its strength is dependent on its cross-section, which in turn is dependent on the surface area.
With this point in mind, let’s imagine what happens when a tree is scaled up 10x from its original height; its height increases 1000x while its strength increases 100x. Thus, it collapses under its own weight.
Now, there are only two ways around the fundamental limitation above - either the material with which the object is made has to change (steel is better than wood and has better strength per unit area, and thus can support larger weights); or the structure of the object itself (think of the difference a tree trunk functioning as a bridge and the Golden Gate bridge). A more efficient structure can support a larger scale of the same object or organism.
In effect, if you want to achieve gigantic scale it is important the right material and have the most efficient structure.
How does this all connect to Rain Industries?
My tentative hypothesis is this - given a large enough market opportunity, in order to achieve inordinate scale a company needs to be made of the right material and have the right structure, in its context, for that industry. The material and the structure of the company can be either due to internal or external factors, and these factors impose a limit on the scaling potential. This conclusion is tentative and hazy.
For example, I think a company selling atoms (valuable physical goods) with an inefficient structure can scale only to a certain level as compared to a company where value is driven by electrons and has an efficient structure. In the first case, think of a company that sells physical goods via a complex supply chain versus a software product company solving an important problem.
It is my hypothesis that Rain is nearing its limits in value creation due to inherent constraints in its structure, which would limit scaling.
Scaling in intrinsic value per share of a business occurs broadly in two ways - scaling in high quality earnings or buyback of stock at attractive prices. In this context, I think Rain’s structure seems inefficient on three separate counts:
Business structure
Holding company structure
Balance sheet structure
Business Structure:
As discussed in the previous post on Rain, the company has a complex value chain. Rain manufactures CPC and CTP. Its facilities are located across the US and Europe primarily. The manufacturing process for CPC and CTP are both polluting and thus, no more plants for their manufacture are allowed to be set up in US and Europe.
CPC is made from GPC, which in turn is obtained when high-quality (low sulphur) crude oil is refined in a refinery. High quality crude is not that easily available today.
Refineries are also considered dirty and no more refineries are being built in the US or Europe.
Due to adverse value-weight ratio, GPC and CPC cannot travel from one end of the world to the other; it is restricted regionally.
CTP is made from coal tar, which is obtained as a residue when steel is manufactured using the blast furnace process. Blast furnace process is considered polluting as well, and in addition, due to high cost structure, it is unviable for new such steel plants to be built in Europe and Western World.
Both the above products are used in aluminium manufacturing, an energy intensive process, which too is growing more in Asia and emerging markets than in US and Western Europe due to cost reasons. Rain’s major customers in those regions are in the developed markets of the west and the emerging regions in Europe and Latin America.
In effect, scaling of the core business (in terms of volumes) is difficult due to limited raw material availability, regulatory constraints to expansion and limited demand in core regions of operations.
If volume growth is difficult, then high quality earnings growth can happen only through value added products or buybacks. But even there, there are limitations to structure, availability of core raw materials and being present in a high cost geography.
Holding company structure:
As discussed above, another route to growth in intrinsic value is opportunistic buyback of shares. In this aspect, it is interesting that the Rain management understands the logic behind the same but has indicated its inability to execute the strategy due to the holding company structure.
Majority of Rain’s value resides in Rain Carbon (a wholly-owned subsidiary of Rain Industries), which in turn is the holding company for Rain CII and Rutgers.
As per the management, for a buyback to happen, cash has to be upstreamed from the operating entities up to the parent level, and when such cash is upstreamed, there is tax leakage. In India, buybacks are taxed as well. Thus, this results in double taxation, which the management wishes to avoid.
This is an evident example of structural disadvantage in value creation.
Balance sheet structure:
In my previous note on Rain, I wrote about the efficient nature of Rain’s balance sheet - where it raised long term debt at attractive rates to fund its high return generating assets.
The mistake I made in my assessment was in assuming the interest rates of the debt will remain acceptable in future as well. I fell for the extrapolation bias. I also believed the company’s operations would allow it to raise debt at attractive levels even in a world that changes. This assumption was proven wrong with the recent interest rate hikes.
Rain has debt in two currencies - in Euros and in Dollars. When Rain refinanced its debt last year, its interest rates shot up dramatically. Its 7-8% interest rate was dramatically hiked to 12.25% (dollar debt) and Euribor + 5% (vs Euribor +3%). This dramatic hike in interest rates has severely impacted the profitability. What I assumed to be an efficient balance sheet structure, and thus a source of strength, has now become a source of weakness for the company.
Maintenance energy
I believe the idea of ‘maintenance energy’ to be an extremely important one for investing.
Here is an excerpt from the book ‘Scale’ which is relevant to understand the concept and then we figure out how to apply it to investing:
All of us are familiar with growth. We’ve all experienced it at a very personal level and recognize it as an essential and ubiquitous feature of nature.
Growth cannot happen without a continuous supply of energy and resources. You eat, you metabolize, you transport metabolic energy through networks to your cells, where some is allocated to the repair and maintenance of existing cells, some to replace those that have died, and some to create new ones that add to your overall biomass. This sequence of events is the template for how all growth occurs, whether for an organism, a city, a company, or even an economy. Roughly speaking, incoming energy and resources are apportioned to general maintenance and repair, on the one hand, and on the other to the creation of new entities, whether cells, people, or infrastructure.
One of the curiosities of our growth pattern that might well have intrigued you at various times in your life is why it is that we eventually stop growing, even though we continue to eat and metabolize throughout life. Why is it that we reach a relatively stable size and don’t continue to grow by adding more and more tissue the way some organisms do?
Because the supply of metabolic energy is apportioned between the maintenance of existing cells and the creation of new ones, the rate at which energy is used to create new tissue is just the difference between metabolic rate and what is needed for maintenance of existing cells. And due to some fundamental reasons, the rate at which energy is needed for maintenance increases faster than the rate at which metabolic energy can be supplied, forcing the amount of energy available for growth to systematically decrease and eventually go to zero, resulting in the cessation of growth. In other words, you stop growing because of the mismatch between the way maintenance and supply scale as size increases.
As investors, we are familiar with the concept of maintenance capital expenditure. It is the capital expended to sustain the business at the current level of operations and profitability.
Similar to that concept, I think it helps to think in terms of maintenance energy or maintenance mental capital. It is the energy or resources or bandwidth expended by a company and its management to sustain / maintain the current set of operations.
In the context of this idea, it is my hypothesis that Rain Industries seems sort of saturated. As discussed above, there are structural constraints in Rain’s business model. In addition to the above constraints, there are other complexities in the Rain business like - hurricanes affect their plants periodically in USA, regulatory issues in India which limit the amount of raw material available for operations, JV operations with Russian steel maker Severstal among others.
Simply put, Rain has a complex business with many moving parts and it is the nature of the universe that high complexity requires high energy to maintain. It is a tentative hypothesis that when there is a complex structure with dependencies that cannot be clearly figured out, the maintenance energy expended by the company and management to sustain the current operations is high.
Almost every year, Rain has some element of exceptional occurrences that impact its business. It is so frequent that one can almost be sure it is recurring.
Incentives, Feedback Loops,Business Ecosystems- The Big Picture Risk (?)
It is interesting to think how a majority of the things that we see today and that dominate are the result of positive feedback loops or virtuous cycles over a long period of time. The domination of our species, the rise of agriculture, the prevalence of capitalism, the rise and domination of science – all are a result of positive feedback loops. A positive feedback loop or mechanism is where the output enhances the original stimulus, which further enhances output, which further enhances stimulus and so on.
The power of positive feedback loops explains the strength of the business model of some dominant businesses today, including Amazon. Here is a famous pictorial representation of Amazon’s flywheel.
Only when a chink arises in any of the elements of the loop can the cycle be broken. Walmart had a great virtuous cycle going for it till Amazon came up with a better one. An important characteristic that determines the durability of the loop is the power of incentives in the system. In case of Amazon, customers would always want larger selection, shorter delivery times and lower prices.
What does all this have to do with Rain?
Ever since the rise of capitalism, a majority of the world’s systems have been driven by the profit motive. This, to a great deal, explains the rise of the oil economy. The benefits of oil far outshone the harmful effects of it over a span of a century and a half, and further tailwinds were provided by businessmen who’s interests aligned with increasing use of oil. The birth of the internal combustion engine provided a major boost. All these together led to a virtuous cycle in favor of use of oil. However, over the last couple of decades, with increasing proliferation of cars, it is the harmful effects that have come to the fore.
An example serves to explain this best – Glencore, one of world’s largest commodity miners, has decided to cap thermal coal production due to pressure from investors worried about climate change. It is extremely interesting to note that driven by pressures from investors (who by definition seek higher profits) from the birthplace of capitalism (the Western World), one of the world’s largest companies has decided to cap production of one of the most profitable commodities today.
There are whole ecosystems where the incentive to become eco-friendly is becoming stronger. Elon Musk has, for example, changed the direction of the automobile industry.
Coming back to Rain Industries, it is probably the most efficient player globally in providing carbon products to the Aluminum industry. It provides high quality products to its customers on time at competitive prices and generates good profits for its shareholders at the same time. It has strong access to raw materials as it has a long history of being reliable to its suppliers. It has also taken considerable efforts in reducing its carbon footprint by investing heavily in pollution reduction. In the old world, this would probably have been enough.
Aluminum production is increasing over the long term due to its inherent advantages that include light weight and durability. But it cannot be denied that the current method of Aluminum production using carbon materials supplied by Rain and other players pollutes the atmosphere. The incentives in the current system are changing. Last year, Apple, Alcoa and Rio Tinto came together to form a JV called Elsysis which intends to commercialize a technology of Aluminum production that would totally remove greenhouse gas emission.
There are of course deterrents to this new technology. It seems that this has been in the works for decades now but so far has been commercially unviable. Also, global aluminum production today is more than 60 million tons, and to retrofit all the smelters with the new technology (IF it becomes viable) might take a long time (probably much more than a decade). But still, it pays to never underestimate technological progress (ask Kodak).
Additionally, another major issue with certain of Rain’s products is the toxicity. Coal tar pitch, benzene, creosote, etcetera are known to cause various human ailments including cancer. There are litigations going on in North America against Rain and many of its peers, the outcome of which is not known and cannot be known at this point. Also, the reducing availability of quality coal tar and GPC at a time of increasing popularity of Aluminum implies over the really long-term the incentives are to come out with newer technology.
In the long-term, it is the nature of the world we live in that zero-sum relationships (in this case with the environment) are bound to become a problem eventually. On average, it is the best win-win relationships that survive. For example, Amazon provided a better win-win to the customer which allowed it to overtake Walmart as the pre-eminent retailer. In case of Rain, if a better win-win is created in the ecosystem there is reasonable probability that it will impact them enormously.
It is key to remember that any technological breakthrough that is bad for Rain’s business model (particular with respect to the Aluminum business) would be beneficial to the earth we live in. And that is a pretty powerful incentive.
It is my perception of these risks above which makes me skeptical of Rain’s long term investment prospects.
But having said all the above, it is possible that I might be entirely off the mark. The framework I use might be wrong and Rain might turn out to be a great investment from this point on. There might be other mental models out there which can help us better understand Rain’s position. This is just how I think about Rain today.
While I enjoy thinking about various mental models as taught by the great teacher Charlie Munger, I must acknowledge that I am very much a novice and thus prone to making a hell of a lot of mistakes. It is quite possible that this is one of them.