One of the things that are permanently on my to-do list is to constantly look for companies with a durable competitive advantage (aka “moat”) to add to my watch-list or even better to my portfolio if I’m lucky and find one on the cheap.
“We operate leading online auction marketplaces for surplus and salvage assets. We enable buyers and sellers to transact in an efficient, online auction environment offering over 500 product categories. Our marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with customer focused information including digital images and other relevant product information along with services to efficiently complete the transaction. Additionally, we enable our corporate and government sellers to enhance their financial return on excess assets by providing liquid marketplaces and value-added services that integrate sales and marketing, logistics and transaction settlement into a single offering. We organize our products into categories across major industry verticals such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware, energy equipment, industrial capital assets, fleet and transportation equipment, and specialty equipment. Our online auction marketplaces are http://www.liquidation.com, http://www.govliquidation.com, http://www.govdeals.com, http://www.networkintl.com, http://www.truckcenter.com, http://www.secondipity.com, and http://www.go-dove.com.”
What essentially LQDT does is being a “market maker” in the surplus & salvage assets market. It makes it easy for big companies that neither have nor want to operate a reverse supply chain for their surplus & salvage assets. LQDT does it for them. It picks up the goods, stores them and makes sure to find a willing buyer to sell them to.
At first glance LQDT seems to benefit from a classic network-type moat. The more asset sellers it serves the more asset buyers it attracts and the more asset buyers it attracts the more asset sellers are attracted to its services. And the virtual cycle goes on and on..
Furthermore this qualitative analysis seems to be backed by the company’s extraordinary performance. It has compounded its revenue at 24% for the last decade and its net income at 31%. It has no debt and has negative working capital (excluding cash) that suggest the existence of float, and thus a competitive advantage.
However, the image of a big sturdy moat around LQDT’s business collapsed when I reached the Management discussion segment, where the company clarifies how it makes its money. LQDT generates income from three transaction models. Asset sellers are free to choose which one they want:
- The profit-sharing model: Under this model LQDT buys inventory from the asset sellers and sells it, sharing a portion of the profit with the original seller. This model accounts for 13.5% of the company’s revenue and 7% of its gross merchandise volume or GMV.
- The consignment model (fee revenue): Under this model LQDT receives a commission fee for matching asset sellers with the buyers of the surplus & salvage goods. The fee is a percentage of the price the assets are sold. This model accounts for just 20.1% of the company’s revenue despite the fact it covers 59.1% of the company’s GMV.
- The purchase model: Under this model LQDT offers asset sellers a fixed amount for their assets or the option to share a portion of the revenue generated by the assets’ sale. This model accounts for 66.5% of the company’s revenue although it covers only 33.9% of its GMV.
The only part of LQDT’s business that has a network-type moat is the consignment segment where LQDT is the facilitator of the transactions in a model similar to eBay’s. However under the other two models, LQDT is nothing more than a wholesaler/reseller of surplus and salvage assets. It may have some cost advantages due to its scale but nothing more.
The way I arrived at this conclusion was by trying to answer the following question:
“What would happen if Amazon and/or eBay (which are the eventual selling places of many surplus and salvage goods) decide that they want a piece of LQDT’s business?”
Well they would probably try to steal asset sellers from LQDT by offering a bigger portion of sales profits/revenue or by buying their assets for a higher price. And thus they would target LQDT’s most profitable models. Would they succeed? Probably yes, because they both have the necessary distribution networks to sell the surplus/salvage assets and they can afford to do it with smaller profit margins compared to LQDT. And they would satisfy both asset sellers (with greater profit/revenue returns) and asset buyers (with lower selling prices).
“Would LQDT’s customers have any trouble or hesitation to abandon LQDT or to split their business between LQDT and LQDT’s competitors?”
And the answer here is… no. LQDT’s clients on both sides of the transaction are mostly businesses who are targeting consumers one way or another and that constantly working on razor-thin margins. They wouldn’t miss an opportunity to be the low-cost seller or increase their margins for a tiny-bit even if it’s temporary.
So it seems perfectly clear that LQDT faces a big catastrophe risk down the road. Competition from the likes of Amazon or eBay has the potential to wipe out 80% of the company’s revenue and thus putting it in existential risk.
HOWEVER, what I’m not saying above is that if LQDT continues to operate competitor-free as it has so far, I believe that it will continue to grow at a breakneck pace and would probably be a multi-bagger for the next decade or so.
Nevertheless, I’m a hard-core Buffett fan and cloner and I can’t bring myself to violate the first step in Buffett’s investment process. And the first step is (as it was artfully demonstrated by Alice Schroeder in the video below) to always check every potential investment for catastrophe risk, which is the possibility of the investment going to zero. If the investment has even a small chance of catastrophe risk the investor should stop thinking and just reject the idea.
And (at least in my eyes) LQDT certainly seems to face some degree of catastrophe risk…
Disclosure: I have no position in LQDT and as of this writing I don’t plan to initiate any long or short position on the company.