Physical assets & leverage windows

Ownership of physical assets has historically been a dirty word in tech. The Valley has been spoilt by years of asset-light growth from companies such as Google, Facebook, and recently, Uber. The valuations of these companies have amazed even the most optimistic observers. Most of these business arguably have “network effects” that create winner-takes-all markets.

However, as customer usage patterns evolve and the opportunities to create large asset-light businesses diminish, there is a newfound interest around full-stack businesses. While full-stack business is a broader term that encompasses a range of operationally intensive businesses, my goal here is to talk about a subset of tech businesses that hold physical assets for the long term (a year or more) as a core part of their business + have a direct consumer touchpoint.

This classification includes businesses such as Amazon, WeWork, Sonder, b8ta, etc., and excludes businesses such as Opendoor which hold physical assets for the short term as part of a transaction. These businesses have built (or are building) demand on top of physical assets that sit at the core of their day to day. While a lot of businesses have physical assets, some of these businesses are special in that the physical assets are a significant point of leverage, resulting in high multiples.

I believe that as long as the 3 conditions below are met, holding physical assets for the long term provides a huge point of leverage.

Let’s look at a few examples to develop an understanding of the framework above. It’s important to note that physical assets that provided leverage yesterday might not be leverage points if investing in them today.

When they were set up, Amazon warehouses offered as high a leverage as one could imagine. With the promise of fast shipping, they triggered the demand that brought more suppliers to Amazon at cheaper prices. However, if a business was to set up warehouses today, Conditions 1 and 2 would both not be met.

That is the reason Walmart is getting cold feet on future investments in its warehouse network. Today, the bar for creating network effects (Condition 2) on the back of warehouses is much higher; one has to promise one-day or faster shipping. What’s worse, a network of sophisticated third-party warehouses has already emerged, making warehouse aggregation a more realistic strategy (i.e. Condition 1 is not met).

Food delivery is a hard business, with a constant need to provide consumers with the specific food item/cuisine they might want, faster. Cloud kitchens have emerged as a physical asset that meet all the 3 conditions. They trigger network effects (Condition 2) by generating demand within a food delivery ecosystem (say Uber Eats) that makes more such kitchens feasible, enabling the food delivery company to provide cheaper and tastier food, faster.

While there are already some third-party cloud kitchens (largest being Rebel Foods), there are very likely gaps in food types and density (location) that justifies companies such as Deliveroo holding cloud kitchens themselves. Over time, a more elaborate network of third-party cloud kitchens will undoubtedly emerge but there isn’t time to wait for that in the bloody food delivery wars; cloud kitchens would play their part in crowning the winner.

The need for co-working spaces came about as it became easier to start companies and gig economy took off. Co-working spaces met all the 3 conditions at the time WeWork pioneered the concept. The network effects mentioned in Condition 2 were around the relationships and partnerships one could build by being in a WeWork as opposed to being a different space. Going forward, WeWork’s focus on membership benefits through the creation of a software stack would further extend the network effects beyond local network effects.

If one was to start a co-working business today, meeting Conditions 1 and 2 would require the co-working spaces to cater to a very different taste/community or use case. That is exactly what The Wing has done by promising deeper relationships and partnerships among women. Many other undifferentiated co-working spaces are unlikely to have any leverage, they will just be average businesses.

Airbnb exposed consumers to the wonderful world of alternate accommodation, and now consumers have an increasing preference for such accommodation over hotels. While there are many Airbnb accommodations, there is a dearth of reliable stays for professionals. That is where the new crop of startups (Sonder, Lyric, Domio), holding an inventory of service apartments, comes in. At this moment, they satisfy all the 3 conditions. Condition 2 is satisfied in the same way Condition 2 is satisfied for Hilton — more members means more certainty that one would find a Hilton on their next stay and the more the value of the loyalty membership.

Building new hospitality brands is the stated goal for all these startups. A few years later, building a business around holding these kind of assets would become much harder.

Most retail stores, though in-vogue, aren’t the point of leverage. They don’t trigger network effects (Condition 2). This includes stores for Warby Parkers and Caspers of the world. These stores are definitely good for business, but don’t drive network effects. However, the retail stores of the kind b8ta is building meet all the 3 conditions.

They meet Condition 1 because online discovery for cutting-edge products is hard and there isn’t any way to try these products out without buying them. They drive network effects (Condition 2) similar to how Walmart stores drove them in their time — more stores meant better (and more) suppliers at better prices.

After a couple of decades of returns from asset-light businesses, it is time to appreciate how the physical and digital together can drive huge business outcomes.