Clay Finck (02:03):

Thank you. I really appreciate that. Now, in preparation for our conversation, I took a look at some of your writings and noticed that your team puts a big emphasis on pricing power in a company. With inflation on the rise recently, many companies are seeing rising input costs. Could you talk to our audience about the importance of the businesses we are invested in having adequate pricing power?

Arif Karim (02:28):

Yeah, of course. Over time, prices increase. There’s inflation embedded in the financial systems in many parts of the world, including ours, and credit to Warren Buffet who popularized the term “pricing power” in what he looks for in a competitively differentiated business. At Ensemble, our number one criterion is how differentiated competitively advantaged our business is when we’re evaluating any business for inclusion in our portfolio. Of course, one aspect of that, or one benefit of being competitively differentiated is the ability to raise prices as your own prices go up. But oftentimes, that also manifests itself with being able to raise prices beyond the cost of your own inputs. Of course, those are the best kinds of businesses because you need to see leverage on the operating margin line, so over time, you’re adding more and more value for shareholders.

Arif Karim (03:17):

Of course, you don’t want to abuse pricing power, which is sometimes something that we see, and we think that’s a very negative thing. Where in essence, you’re taking advantage of your customer’s need or desire for your product’s services. So there’s a balance that comes into play between to create a mutually beneficial relationship instead of transactions with your customer where the value of what you’re providing them in terms of product and services leaves quite a bit of what we’d call consumer surplus for them. So they feel like even though they’re paying you a fair price, they also feel like they’re getting a good deal in return, and so that’s the balance, but ultimately, the ability to be able to have pricing power is what allows you to grow beyond the rate inflation up with your revenues and your profits over time. That’s one of the critical aspects of a wonderful business, in our opinion.

Clay Finck (04:06):

Now, this idea sounds great and makes a ton of sense to me. My question is, how can one determine whether a business has adequate pricing power or not in their business?

Arif Karim (04:18):

Yeah, there’s two ways. So one is, you look at the top line, which is the revenue, and see how fast that’s growing. If possible this is not always disclosed or discoverable, you want to look at price per unit, the ASP, the average sales price per unit that a company sells a product or a service for, and to the extent that they can grow that at a rate at or faster than inflation, that’s one an indication. However, I think the more important indication is to look at the operating profit line or gross margin line and the operating profit line, so you’re looking at different elements that comprise profits. So gross margin is basically the profit that you have after you pay for the direct costs of the product and service that you sell, and what that tells you is that, so let’s say it’s a car. If you have a car that you’re selling at a gross profit margin that’s stable to rising, it’s telling you that your ability to price that unit is at, or above the cost of your inputs to build that one car.

Arif Karim (05:16):

So that’s a good indication of your pricing power because what’ll happen is if you don’t, then you also want to compare it to the industry as we, well if you don’t have pricing power, you’ll have an average gross profit gross margin that’s in line with maybe your competitors. That tells you this is a commodity business, and there’s times when it gets competitive where there’ll be volatility in that gross profit line, but one indication that you got pricing power and get pricing power by being differentiated is by being able to control that gross margin line. So it’s stable to growing and you’ll find it’s disconnected from what you’d consider to be the rest of the industry for other competitors for that one particular company that you’re looking at. So I think that’s one of the signs that I look for. Then on the operating profit line, of course, is the rest of your costs that have to feed into the direct cost for your products down to the corporate level. So there too, we like to see stability to increasing, of course, operating margins, again, indicating to you how much-differentiated value your company’s actually provided to customers.

Clay Finck (06:11):

Yeah. This is an interesting concept. I think of the business landscape, there are companies that have these higher input costs and have a lot of raw materials that go into their products. Those companies, in general, I think might not have as much pricing power because if their input costs increased by, say, 10% on average, then it’s going to be very hard for them to pass that onto their customers just that year-over-year 10% increase, whereas, say, a technology company that doesn’t have a lot of those raw materials, they’re able to absorb increased costs because they might not have raw materials. So that’s some of the things I like to consider as well is how easy are they able to pass that on?

Arif Karim (06:54):

That’s a great point. I think technology companies is actually a really good and interesting case that’s very different than a car company, like I was talking about. In technology, there’s this deflationary pressure. It’s not even a pressure it’s an advantage, I would say, or a characteristic in the sense that there’s lots of companies within the technology space, whereas they grow, what happens is their actual unit cost decline over time per unit basis. So they could potentially even sell the product cheaper to you every year, and the PC’s a classic example of this, where they can keep selling it cheaper and cheaper to you as some of the important aspects of the cost of building a PC actually declined in price. So in that way, consumers win. The nice thing about declining price per unit in which you’re offering the consumer is that it’s the right kind of product. The consumption of that product actually builds up.

Arif Karim (07:40):

So overall, your revenue actually grows because the consumption of units actually grows faster than the price declines. Technology’s very unique that way. Traditionally, you didn’t have that issue with most industries. You always had the opposite issue, which was prices rising, and then can you incorporate those rising prices in how you price your product to your consumers. You bring up an interesting point, though, and I think this exactly goes to the heart of the question about pricing power, which is that companies that are able to raise pricing to offset the pressure on their own costs, especially in an environment like today, that’s the most fundamental definition of pricing power. If you mentioned that some companies have the ability to absorb some of those increases in costs, like not have to pass it on to customers, but at the heart, and if you can do that via productivity, that’s great.

Arif Karim (08:26):

But if you’re absorbing that pricing pressure of your inputs and not able to pass on that rising cost to your customers, that signals there’s a temporal aspect to it as well. You don’t have to do it right away necessarily, but over some reasonable period, if you can’t pass on those increases in costs that signals that maybe there’s not quite pricing power there, because if you are competitive to differentiate, your customers really can’t go anywhere else for what you offer. So the presumption is that the value you’re offering is actually an important part of their consumption, and it’s valuable to the customer relative to their basket of goods they’re buying from elsewhere. So there’s this relativistic model to it too, but to the extent that you offer a differentiated product, it’s valuable to the customer, then you should be able to pass on the bulk, not all of the increases in cost that you’re seeing in your input level.

Clay Finck (09:15):

So essentially, to summarize your points, you’re looking at the top-line revenue and the gross margins and how those look over time, and if they’re growing at a rate equal to, or greater than inflation. I really like how you made the point that customers feel like they are getting much more value than they’re paying for, is management taking that into consideration, putting the customer first?

Arif Karim (09:38):

Mm-hmm (affirmative). Mm-hmm (affirmative).

Clay Finck (09:39):

I can’t help, but think that companies with low margins will be in a bind with inflationary pressures. One company that came to my mind, that’s very popular in the value investing community is Costco who, as everyone knows, their margins are very low, yet the stock has performed very well in the past couple of years. What do you make of Costco’s very good performance?

Arif Karim (10:02):

Yeah. Costco’s a really interesting example in the context of the discussion, in the sense that they do optically have a low margin. However, it’s a very differentiated business in the sense that they bring a huge amount of scale as that middle man that sits between suppliers of goods that consumers want to buy and consumers. So what they’re trying to do is they’re trying to get consumers to spend most of their consumption basket, dollars, or wallet at Costco. The value proposition they offer to the consumers that by being a Costco member, you’re going to get the lowest price per serving, let’s say. Typically, the size of the basket they’re selling to the consumer is larger at Costco than it would be at a grocery store, for example. So you’ll get whatever, 30 granola bars instead of a pack of 12 when you’re buying.

Arif Karim (10:46):

So that way they get consumers to come shop at Costco, spend a lot of their consumption wallet at Costco, then they go to the suppliers and they say, “Look, we have all these consumers shopping with us. We have all these dollars they’re spending. We have a limited number of products we’ll carry on our shelves,” and each product usually has a UPC code and that’s called a SKU. That’s what it’s referred to. So they carry something like 3000 SKUs compared to an average grocery store that’ll have roughly 30, 40,000 and Walmart could have over 100,000. So every SKU on the shelf of Costco sells huge volumes. So they go back to the supplier and say, “Look, you have to give us the best pricing per serving that we can then offer to our customers if you want to be on our shelf.”

Arif Karim (11:25):

Also, Costco will vet quality of the stuff they’re actually putting on their shelves. So to get a spot on Costco’s shelves by suppliers is a very desirable thing, because you can sell at a lower margin to Costco, but in exchange, you get much higher volumes than your typical grocer. So what ends up happening in this relationship is that customers feel confident they’re getting the best price per serving at Costco in exchange for buying in bulk. So then, when you look at Costco in the middle, they basically take a certain gross margin on everything in the store. So they’re not trying to maximize dollars of profit; they’re trying to get enough dollars of profit to cover their overhead. The bulk of their profits actually comes to the membership that customers pay. So every year, to be a customer and to go to Costco, you have to be a member and you have to pay $60 a month to be a member.

Arif Karim (12:10):

Then they have an executive-level member, which is 120, maybe. Of course, that membership fee is 100% margin. If you compare that 100% margin membership fee revenue to the operating profit dollars that they actually come out at the end with, it’s something like 80% of profit dollars are basically membership fees. So for Costco, they just need enough margin on the products they sell to cover their overhead; whereas, the profits at the bottom line end up coming out of the membership fees. So it’s a really cool model, because then the store is incentivized to work for the customer because the way they make most of the profits is by adding customers over time, rather than charging them as much as they can in terms of margin.

Clay Finck (12:44):

Yeah. It’s funny that people know they’re getting the best deal at Costco, yet, it seems like every time we go there, everyone’s spending at least 200 bucks each time-

Arif Karim (12:53):

Yeah. Yeah.

Clay Finck (12:54):

But like you’ve mentioned they’re going for the bulk purchases. Another piece I noticed with Costco when I visited their store is their Kirkland-branded products, it’s their own brand, that’s often priced lower than the other brand sitting right next to it. Say for toilet paper, the Kirkland toilet paper is price slower and gives you a better deal than the Charmin sitting right next to it, I find that dynamic pretty interesting. You see the same thing at Sam’s Club as well.

Arif Karim (13:24):

Yeah. What’s funny about Kirkland is that oftentimes, the Kirkland brand, which is a Costco brand is actually a rebranded Charmin, or rebranded Starbucks, or rebranded Tide, whatever it is. I don’t know exactly what the match is, but it’s actually, they’ll go back sometimes to some of their suppliers and say, “Look, we want you to provide even lower price under our brand name,” and they’ll be like, “Well, why would you do that? Why would Planters Peanuts do that and make a Kirkland Peanuts?” Because A, you’re leaving margin on the table and you’re diluting your own brand to some degree. Most of the time you don’t actually know who made that Kirkland brand, so that way they create this veil so you don’t actually know that, “Oh, Planters made these peanuts for Kirkland, and on the shelf there’s Planters and there’s Kirkland, Kirkland’s cheaper, I should just go with the Kirkland,” but suppliers will do this. One of the exceptions is Starbucks, actually. You’ll see the Kirkland coffee’s actually made by Starbucks.

Arif Karim (14:12):

Starbucks has its logo there, which is really interesting because that’s another branded product that wants its own brand to be first on display and they want you to buy Starbucks, not Kirkland necessarily. But what these name brands will do this is because again, it’s just trying to get more shelf space with Costco and more incremental dollars, because it’s very profitable dollars based on the volumes that they get from Costco, so it’s amazing. There’s two parts that are amazing. So one is that Costco has built so much trust with its customers, that customers are like, “Oh, I trust the Kirkland brand by Costco, it should be actually as good as Starbucks. Well, with Starbucks, it’s made by Starbucks. Let’s say my peanuts from Kirkland will be as good as Planters, but secondly, it tells you a lot about the power they have in that value chain, between the manufacturer and the supplier, the middle man is Costco and the customer.

Arif Karim (14:59):

Costco has so much distribution power, they’re actually able to get even more leverage against suppliers in favor of the customers, which is amazing. Tying that back to that pricing PowerPoint that you made, generally speaking, the rule of thumb, when you see low margins, you think, “Oh, this is a commodity business,” but Costco stands out as being this exception in the sense that it actually has pricing power in that it can actually push all of the cost increases to the customer. On the other hand, it also has pricing power against suppliers in that if a supplier says, “I need to raise pricing by 10%,” Costco could say, “Well, you’re raising to 10 for everybody else, how about you raise it seven for me to stay on my shelf?” There, the supplier will absorb the added cost, not Costco. Costco almost as a rule has a standard gross margin they’ll take on any price. If the cost goes up, their price is going to go up, but yet what you pay Costco is going to be a better deal than pretty much anywhere else. So it’s a relative game as well, obviously.

Clay Finck (15:52):

Let’s transition to talk about another company. A very interesting and potentially underrated company I wanted to discuss with you is Ferrari, which is a holding of yours at Ensemble Capital. When I look up this company in our TIP finance tool, I see a price to free cash flow ratio of roughly 45. While the company’s growing at a relatively steady rate with the exception of 2021, we saw a huge boost in revenues. I’m really curious what your investment thesis is on Ferrari.

Arif Karim (16:26):

Yeah, sure. Ferrari is a really interesting company, but we all know they make cars, very high-end sports cars. It’s been around for, I think it’s about 70, 75 years now, and its heritage comes from racing. Originally, the founder of Ferrari, Enzo Ferrari ran the racing team at Alpha Romeo. Then I think there’s some falling out. I don’t know exactly what the details of it are, but he ended up going out on his own and starting his own racing team under his own name Ferrari. It turned out racing is an expensive business, and so he designed and built racing cars that did really well early in the history of it, and he was one of the founding car companies for Formula 1, So they were racing and of course his car ended up winning multiple years and it turned out that people actually wanted to buy one of these winning racing cars.

Arif Karim (17:10):

What he would do is sell them the old car, because every year you’d have to build a new, faster, better handling, et cetera, et cetera. So the old car would be off sleep, but people would pay dearly for those old cars. So of course, it clicked that, “Well, it’s expensive to race. It’s expensive to build these cars, why not build a few extra cars to sell to some people and use that to fund the racing team?” That’s exactly what he did, but he wouldn’t build very many of these cars to sell. So when he would build these cars, the demand would be higher than the supply of cars and he would select his customers. So you would have to go a long ways to be somebody that he would select to be able to buy his car, which is an incredible thought, because these were not cheap. These were expensive cars that you basically had to get into his good graces to buy.

Arif Karim (17:56):

So that ethos, that culture, that legacy of the relationship between the car and the customers still exists today in the sense that Ferrari doesn’t build enough cars to meet the demand for those cars. We all know that you don’t use a Ferrari to go from point a to point B, you use your Honda Civic or your Toyota or BMW, whatever it is. The Ferrari is your weekend car, it’s your showpiece, it’s your collector car. So it’s a highly coveted object from an emotional perspective. There’s no utility to it, but it’s all emotional. So when you put those pieces together, you to create this beautiful business model in Ferrari where they build these beautiful sports cars that are highly coveted and they don’t make enough for everybody that wants one. So that creates this pricing power under the car. Then it also supports the used car market as well, because every year they come out with a new car every year, but they have a model range and there’s always new cars in each part of the model range that comes out in any particular year.

Arif Karim (18:52):

So they’re in this business of basically selling these highly coveted cars to people with means who really, really want them. You could want them because you’re a car nut like I am. I just like fast cars, and the driving experience is very differentiated. It’s loud. It’s that racing feel, and it makes you feel like a race car driver, or you can sell them to people that want to show that they’re wealthy, so it’s a status piece, a place to that. It’s also a mechanical art, so there’s people that like to collect these things as show pieces or collectibles over time as investments that rise in value. Historically, we’ve seen certain limited models rising in value faster than the stock market has. So if you’re picking the right cars to invest in, it’s a way to actually accrue more wealth over time than you would invest in the same amount of money in the stock market, for example.

Clay Finck (19:41):

It’s funny, their limited edition cars are only available to those who currently own Ferrari, so there’s definitely this club field. Plus they get these other special benefits say can go to events and such. One statistic that was in your writings was two thirds of new Ferrari buyers are repeat buyers, and the prices of those Ferrari are anywhere between 250,000 to a million plus. These are the types of wealthy individuals who really aren’t even looking at the price tags. So if that doesn’t screen pricing power, I don’t know what does

Arif Karim (20:14):

Yeah. Yeah. That’s a great point. So that’s a point that I make, which is that when you are a Ferrari owner, you’re part of a club. The analogy I like to make is that those people that want to be part of a club can pick different kinds of clubs. But I think the analogy for most listeners will be that if you have a country club in your town, you pay to be a part of it. As a result, you get to hang out with people in that network, basically. Ferrari, in many ways, is a club that’s a global network. It’s a global network of the wealthiest and many successful people. And Ferrari actually goes a great length to make their customers and Ferrari owners feel special. They’ll arrange events, both in your country, but also bring people to special events in Italy or elsewhere in Europe, for example, or other parts of the world where they’ll invite their most elite customers from all around the world that come to those events.

Arif Karim (21:05):

Those events could be a track day in Barcelona at a real race track, and a real live one race track, and you can bring your Ferrari or Ferrari can actually arrange transportation for your Ferrari. There are people that have these track only Ferrari that they have Ferrari stored for them in Europe, and then when these events happen, Ferrari will bring their cars for them to actually race at these track meets. Of course, part of it is that you’re actually is going there to have fun with your Ferrari, but you’re really going there to also meet other very successful people from around the world that you’re building relationships with. So that alone can be much more valuable than the value of that million dollar Ferrari that you bought to be part of the club. But as you say, it takes work to become part of the club, so those million dollar Ferrari, 2 million, 3 million, but those high-end Ferrari are very limited models.

Arif Karim (21:52):

Usually it’s on the order of 500 units that are sold with that particular model, and so they’re very desirable. In order to get on that list, you don’t say, “Oh, Hey, I would like to buy a LaFerrari.” No, no, no, no. You get invited to buy a LaFerrari. There’s no way otherwise you get to buy one. So Ferrari, actually we has this different tier of customer list, depending on how loyal a customer you are, aka how many Ferraris you own, or how many you bought, how often you’d come in and repeat by from Ferrari that moves you up the echelon of these tiers. So the most exclusive, most limited models are reserved for their best customers, and these are the ones that get access to actually be able to buy a million or 2 million Ferrari. The crazy thing is that if you get invitation, you don’t say no, because once you get delivery of this Ferrari on your driveway, once it gets to your driveway, it’s immediately worth much more than what you paid for it because of that big difference in supply and demand.

Arif Karim (22:46):

In fact, one of the things that Ferrari does is it actually contracts you to limits you from reselling that Ferrari for a year-and-a-half, two years. You don’t go back and just flip it. It’s an interesting relationship Ferrari has with its customers from that perspective. So yeah, the better the customer you are you’ll get the newest models first, you’ll get the limited models. You’ll be amongst this small list of people that get a limited model. So it could be a very profitable enterprise for you as a customer as well. Again, it’s just building these relationships, creating this network and creating this incredible cycle. One other thing I’ll add is that a topic of pricing power, which of course is very relevant today in these days when we see high inflation rate, is that when you think about managing a limited supply model business, without frustrating too many customers, and I think this is an incredible part of business, you need the price of the product to actually increase roughly in line with the rate at which the wealth of your customers increases, because over time there are more and more people that get nominally wealthier and wealthier, but you want to create this exclusivity in your product.

Arif Karim (23:54):

Ferrari only sells 11, 12,000, at least sold about 11,000 cars last year, they’re going to sell like 12 to 13,000 this year, so it’s not many units. This is nothing compared to most auto companies will make millions of units. Porsche makes 300,000 units. Ferrari makes 11, 12, 13. It’s nothing, it’s tiny. We estimate that the number of high net worth individuals in the world who could potentially buy a Ferrari, could be a customer, is on the order of it’s a rough guess, but it’s in the ballpark, like something like 5 million people can afford to buy Ferrari. They have liquidity, the net worth outside of their main home to be able to spend anywhere from 250,000 to a million bucks on a car. So A, you want it so that you don’t have, I don’t know, 100,000 people wanting to buy 500 cars. That’s a really frustrating experience for all those people.

Arif Karim (24:39):

You want to manage it, and the way you manage it is by basically pricing the car high enough that there’s a certain number that can afford it and want it, but it’s not an overwhelming number that’ll get frustrated. That certain number also have an incentive to work their way to try to get up into that top tier list. There’s a really interesting pricing model built into the company. I’ll just end it with just saying that what it really translates to is that Ferrari has to raise prices to stay exclusive, and the thing is, customers want a Ferrari to be exclusive, because that supports the value of their cars they’re buying from Ferrari. So customers are happy for Ferrari to raise prices. Where do you ever see that?

Clay Finck (25:18):

Yeah, it’s funny Ferrari most definitely benefited from this asset boom over the last 10, 20 years, obviously wealthy people own assets. They own stocks in real estate that have massively appreciated and value over the years. And I just looked it up. You mentioned these numbers, but Ferrari, they sold just north of 11,000 cars in 2021. In comparison to Ford, they sold 1.7 million vehicles. So they’re obviously in a very different business then. For example, I’m curious, do they have any actual competitors in the business that they are in where this community business, this exclusivity and scarcity around their business?

Arif Karim (25:59):

So Ferrari is very unique. I think of them as having built this business model. I don’t know if that’s actually true, but I haven’t come across anybody else that’s has all these different aspects to it. Now, having said that, when I first started looking at Ferrari, I’m a car nut, so I read car magazines. Growing up, I was always reading car magazines. So we all know these brands like Ferrari, Lamborghini, Astin Martin, Porsche, and when they went public in 2015, they were spun out of Fiat, which was the majority owner of Ferrari. Initially, this is really interesting, just from a research perspective and investor perspective, normally a brand name like Ferrari, everybody knows Ferrari. You’d think this be a hot IPO. It’s probably going to be grossly mispriced, it’s going to be so expensive.

Arif Karim (26:42):

That’s the prejudice I had, I guess I would say, until I came across a report from an analyst. I was just looking at it out of curiosity and I noticed certain aspects of the business. So one was just that in that great recession in 2008, 2009, I would’ve thought Ferrari would’ve lost, I don’t know, 10 or 20% of the business or something like that, some big number. They only sold like 4% less units roughly or 9%. It was between four and 9%. When was the revenue? When was the units? Right? I can’t remember now, which one was it? I might be flipping it, but it was either revenue was down 4% or 9% when the rest of the car companies were down 20, 30, a big number, Ferrari was very sticky. So that was really surprising to me. When I started digging into it is when I understood the power they had with their customers, this relationship that they had. I’m not sure if anybody else has that relationship because when you look at historically the cars that have grown in value, if you look at the most valuable cars, in history, again, I’m sorry, my number is a little rusty, but I want to say something like three out of the top five most expensive cars sold at auction are Ferrari.

Arif Karim (27:53):

I think it’s seven out of 10, and it goes on. You can go up to the top 100 it’s like Ferrari has a predominant presence, in those lists. That says something about the legacy, the brand, the value that you’ll associate with Ferrari. So I don’t think there’s another brand that’s quite like that. You’ll see every now and then there’ll be some special model from a brand that comes up as a one-off that’s highly coveted, but they don’t have the consistency that Ferrari has in having so many models that end up being so desirable amongst collectors. In many ways, it’s really funny. I went to Ferrari, Ferrari hosted an investor day at a customer event back in 2018. So they were probably in 2015, and I suspect they felt like people didn’t really understand Ferrari. Initially, it was me too, until I dug into it.

Arif Karim (28:41):

In 2016 is when I dug into it and then really came away impressed with the business model, started to understand the scarcity of the model, exclusivity, the relationship with the customers, two-thirds are repeat buyers, what? Why? Then you come to realize people own 20 Ferraris. They’re collectors. But part of the reason they’re collectors is also because they have to keep purchasing to be invited to buy the next high-end limited model. They’ll buy like the entry level $250,000, but with some perks and maybe 350,000, because they’re going to personalize it to make it special to them. But this is the thing, like people really get this emotional, thrill or emotional high from purchasing Ferraris and driving their Ferraris, and it’s very unique in that way. But having said that, I’m sure people that get their Porsche 911 are also thrilled and those with Lamborghinis are also thrilled, but it’s just that over time they can consistency of the brand and the legacy has been such that it also, for certain models will make for good investments.

Arif Karim (29:32):

The persistence is a key part of this, as well as that network part like I talked about. So in 2016, I started to understand the specialness of the business and how the business worked. Although optically, it looked expensive compared to if you looked at the auto industry, really, it wasn’t the auto industry, you were really comparing to, you were comparing it to the luxury industry. So I like to think of the analogy being Hermes, the handbag company, the high-end European handbag company. I remember reading that, “Oh, their Birkin bag has this exclusivity thing to it as well, just like Ferrari does where you don’t stroll into an Hermes store and go, “Oh, I want to buy an $80,000 Birkin bag.” No, you have to like work your way up

Arif Karim (30:10):

I don’t know the details of it, but there too, it’s very exclusive. You have to earn your way to being able to purchase a Birkin bag. So when we realized that this was more of a luxury business, then it was a utilitarian car business, and we knew it wasn’t that, it was definitely luxury businesses. Not many people would buy 250,000 car or a million dollar car to commute to work. But there was a lot of confusion in the market about how to value this thing. So that was more the right analogy. A part of that, our evaluation technique revolves around being able to understand how for castable and durable and predictable future earning streams to our company, and then the normal financial model you discount that back to then you have some price. There’s some assumptions and of course there’s sensitivity now and stuff. But if there’s not the duration in the product, the service, or the brand, it’s really hard to know what it’ll look like in 10 years. The thing is most stocks, the value they embed for a company, the majority of the value comes from the future, beyond 10 years.

Arif Karim (31:08):

So the persistence of that, the durability of sales, the durability of the brand, the durability of the relevance to customers, those are all really, really important qualitative pieces to build a confident 10-year plus model kind of thing. Even if you’re not explicitly modeling, but to have confidence that in your 10, 15, 20, that this will still be the kind of business that I think it is today kind of thing. In general, you want to buy something that you think will have that persistence, if not improve. It’s a very hard thing to do. Very, very few companies fall into that category of having that visibility. So with Ferrari, what was really interesting is they put up this event where they unveiled their Monza SP1, SP2 limited production models. This was the first in this umbrella, what they call econoline, which is a design first type of line of collectibles. These are really cars that are taking some of their most famous designs, most desired designs from the past, and basically creating a modern version off of some of the key aspects of those designs.

Arif Karim (32:10):

So they had this customer event and they wanted investors to come and meet customers and talk to customers. It was really incredible because I remember they had the whole big premiere for the car and had a reception. In the reception, they had two of those cars out for you to look at, to sit in. I remember being behind this older gentleman and he was taller and bigger than I was, and I was just talking to him. I said, “Oh, what a beautiful car? What do you think?” He was like, “Oh, I love this. This is a great car.” I was like, “Oh, so you’re a customer? Obviously, you’ve been invited. So what do you think? Do you think you’re going to put in a bid? Are you going to try to buy one of these cars?” He goes, “Oh, I’ve already done it. I’ve signed on the bottom one already.” The thing was, he didn’t actually know what the price was. They hadn’t disclosed pricing, like there might have been a range, but at the end of the day, it turned out this car was sold at roughly $2 million a piece.

Arif Karim (32:57):

But whether it was one-of-a-half million dollars, $2 million, @3 million didn’t matter a whole lot, I don’t think, to this type of customer, because at the end of the day, like I said, it’s limited product. You get it. Once it lands on your driveway, it’ll be worth more. Honestly, okay, so that’s like the rational financial sense piece to it, but this guy, I didn’t delve too deeply into his personals, but he obviously carried himself as he’s some executive, he’s probably running a company with many, many employee. He’s the kind of guy that could, pretty much buy whatever he wants, but he wants to buy his Ferrari. The thing is, in his tone, in his eyes, he was like a kid at Disneyland. Like what else is going to bring that kind of a feeling to someone like that? He’s got big responsibilities. He could buy whatever he wants, but at the end of the day, this thing brought so much giddiness and excitement to him, that’s really the magic of Ferrari.

Clay Finck (33:46):

Yeah. It’s funny. I did notice that they have these product releases where they showcase all of their new products, their limited editions and such, and all these true fans come in. They have these huge events where all these people from everywhere all around the world are coming in for these events. It really reminded me a lot of Apple and Tesla where they just developed this community of true fans, and they just take it to a whole new level on their own.

Arif Karim (34:08):

Yeah, no, exactly. It’s funny. We used to own Apple. One of the things that we always thought was fascinating was that I don’t think it happens anymore, but, but this is back in the first 10 years of the iPhones, people would line up I out the door, they would line up at stores around the world. They would camp for a night or two, and it’s like, “Oh, my gosh, what is this product?” They would line up, just be at the door and be like, “Here, Apple, take my $1,000.” What an incredible business model to have, and that’s exactly it. Ferrari is the same thing, only at a different scale. We’re talking about hundreds of thousands of dollars or millions as opposed to a thousand dollars. That’s the thing, it’s like when you think about the demographics of those that buy Ferraris and how enthusiastic they are about it, it’s like this universal human feeling that we all want, the excitement, the passion that makes life fun.

Clay Finck (34:58):

In one of your articles you described Ferrari as an idiosyncratic business, which is a term I hadn’t read too much about before. Could you describe what this term means and how it applies to Ferrari specifically?

Arif Karim (35:12):

Yeah, sure, sure. So the word idiosyncratic means it’s something that is different than the rest, roughly speaking. So we’ll think of, like what I saying, cars. You think of cars as transportation, and of course, many people like their cars, they get excited about their cars and stuff. But at the end of the day for most people, the car is a transportation piece and it’ll depreciate over time, and at some point you’ll have to replace it. But when you think of a Ferrari, it’s idiosyncratic in the sense that it’s not really a car that you’re buying, you’re buying anything but a car. You’re buying experience, you’re buying emotion, you’re buying into the network, you’re buying into the status, whatever your motivation is. Like art, it’s a collectible, so you’re not buying the car for actually transportation.

Arif Karim (35:50):

That’s one way to think about it. It’s idiosyncratic, Apple is also an idiosyncratic business in the sense that, they sell a device that you actually use. Prior to the iPhone, the model in the U.S. at least was you’d get your dumb phone for free or for 50 bucks, and it was like when they first introduced the iPhone, I think they priced it at, I want to say 499 or 699 or something like that, and it exclusively sold through AT&T here in the U.S. They had these distribution partnerships around the world where it was one main Telco carrier sold the iPhone and became the differentiation for that carrier, and so that was an interesting model to go by. So again, it’s a little bit of an exclusivity thing. If I wanted an iPhone, I had to go to AT&T. I couldn’t go to Verizon anywhere else. But at the same time we were coming from a model where people were used to free phones or a $50 phone, or a $100 phone, not a $500 phone.

Arif Karim (36:40):

Not just that, but you also have to pay an extra $40 a month for a data plan, on top of your voice service plan. So it was like, “Wow, this is really expensive,” The common perception was that this was going to be a very niche product, just like the Mac, very niche, like not many people use this thing. “Oh, there goes Apple again with their funky model,” but it turned out that it was such a useful device that it actually became very desirable for many, many people. Over time, they brought the price of that down. Not because the iPhone got cheaper, but because carriers subsidized it with more money. The carriers actually paid for a lot of this, which ultimately ended up with the consumers, because we paid for data plants and things like that were more expensive than whatever our voice plan was. But over to time, Android phones caught up in terms of technology like the raw capabilities, utilitarian capabilities of the iPhone.

Arif Karim (37:25):

It was always like, “Okay, well, the iPhone’s going to have to get cheaper at some point because why would you pay $1,000 for this iPhone when you could buy this Android phone for $250?” The point was iPhone users didn’t switch for the most part. They stuck to this $1,000 phone that had this same technology as the $250 phone, and the difference was emotional. It’s emotional, it’s the user interface. Apple is the cool brand. In someplace like China, Apple became the luxury brand. Like you showed up that you actually were well off by owning an Apple phone as opposed to any generic smartphone. So that’s another inflationary business that when you looked at the PC business, it always became the lowest common denominator. Prices always fell, it was very competitive. The analogy was being made that in the smartphone business, the same thing that happened, this is basically a PC in your pocket, and yet Apple defied that by all these different emotional things that are brought in into the experience that other manufacturers were not able to do. So that again makes it idiosyncratic, it’s very different than the rest of the competitors.

Clay Finck (38:22):

Very interesting idea. Shifting back to Ferrari, I mentioned earlier that its valuation seems to be on the higher end at a surface level, but it also seems like this is a business that is likely to be around and bring in more revenue over the years to come because they’ve built this moat, and the fact that they’ve been around for more than 75 years, they have a pretty good track record. I’m curious, what do you think of their valuation given its trading at a multiple much higher than the overall market?

Arif Karim (38:51):

Yeah, sure. So just high level, when Ferrari in public, they were selling on the order of seven to 8,000 cars a year and they hadn’t grown their units very much in prior years. Since they’ve gone public, they have had a little bit of a change in the way they’ve approached the market. I think it’s been the right thing, and there were a lot of questions as to whether it was smart to do this or not, because the exclusivity part of their business. So a specific idea about exclusivity is limiting the number of units that are out there, which then props up their price supports their price, but it doesn’t necessarily mean that you can’t grow the number of units. Now, if you grow too much, then you lose exclusivity, then you don’t have that coveted, unmet desire, which supports pricing. So you see the pricing come down and that starts to unwind the traditional way that the business model works, which is that you buy Ferrari, you buy the next one, you can sell your previous one for it, it hasn’t depreciated like 50% kind of thing.

Arif Karim (39:44):

If it’s like a 250,000 entry model, maybe it’ll be down 10 or 20%, but not 50, like most cars would be. Then it’ll be stable actually for a long time. If you have a limited model, it’ll actually appreciate, and so that results in this repeat business they get from existing Ferrari owners who understand this dynamic and are willing to buy the next Ferrari. In exchange, Ferrari gets great visibility. So the question was, could they actually increase the number of units in total that they sell without diluting that exclusivity aspect of the business? The answer so far turns out to be yes, because now they’re shipping 11,000 units and they’re still seeing, good pricing power and good pricing stability in the used market, and so the other aspect of it is pricing power.

Arif Karim (40:23):

So over time when they come out with a refreshed model or a new model, so sometimes it’s a brand new model, sometimes a refreshed existing model, they’ll usually raise pricing on the car. So just as an example, the average selling price on a Ferrari back in 2015 around the time they went public, I’ll just give that number real quick, because it’s really illustrative of that pricing power. So it’s not that they necessarily take the same unit and increase its price dramatically, it’s more like every X number of years, they refresh every three years and they come out with a revamped product. But their average selling price in 2015 was $271,000 per unit, and they were selling, it looks like 7,664 units is what they sold. Last year, their average selling price was $320,000, and they had over 11,000 units they sold. So they grew both pricing and the number of units. Of course, that resulted at double-digit top line growth in over time. I think that model continues to work for a number of years.

Arif Karim (41:24):

It’s unclear how far, in many ways the dynamic model Ferrari’s watching how many customers are asking for a certain model, how many are they selling? What are the wait lists like? Currently, their wait lists, it’s not unusual to see a 18-month wait list, now which is on the high-end of what’s desirable. They wanted to keep it a year. When it gets much beyond a year, then they worry about potentially customers going to Aston Martin or Lamborghini or somewhere else. I don’t want to wait two years for a car. I want this car now, so if I can’t get in a reasonable amount of time. I’m just going to go somewhere else. But I would really like a Ferrari if I and get it. So when you think about valuation, like I said, there’s elements to it that play into it for a given amount of capital invested in the company that can create more profit dollars off that capital is worth more than one that creates less profit dollars, so in other words, return on capital. The higher, the return on capital, the more valuable the business. So that’ll impact the multiple.

Arif Karim (42:10):

Secondly, a company that can grow faster is going to be more valuable than a company that grows less fast and in a durable way. So in the stock market, we often see companies that grow, 50%, 25%, 15, 5 kind of thing, but a company that can grow 10, 12% a year, 8%, 10% a year for 20 years, let’s say, it’s going to be worth a lot more in the company that basically does 100%, 50% of 25%, 15, 10, 5, because they don’t have the duration of growth in there. So from our perspective, Ferrari is very profitable, very high return on capital business. We think it has a number of years of double digit near double digit growth. It’s really based on this assumption that they can probably grow their units by mid single digit to high single digits, so call it 5 to 7, 8% a year for a number of years and that they can grow pricing by maybe single digit percent, so can roughly half the growth of call it 10% a year from units and half the growth from pricing.

Arif Karim (43:08):

On that unit growth, one smart thing Ferrari has done, this is the amazing thing. When you think about a company, we you think about investing, you think of stocks; the stock price goes up, price goes down. We get happy when it goes up and we’re sad when it goes down, that sort of thing. But when you are a long term investor, the thing you really want to do is really understand the business, and that’s where it gets really, really interesting because when you study enough businesses and follow them over time, you really start to see how a business is like an organism. It’s always adapting. It has to adapt, and part of adaptation, just like you and me, is trying some new things, learning from mistakes, something works right, then you do more of that. So it’s this perpetual evolution towards optimizing for, in this case, revenue and profits, but that’s a derivative of optimizing for creating things that your customers will love that adds value to their life. Ultimately, all businesses are like that.

Arif Karim (44:00):

It’s about creating things that customers will love by being able to recruit and retain employees that are wonderful, that are an essential piece of providing that value to the customers and then having enough value created for the customers, for them to be happy and have the consumer surplus for the money that of paying, have enough to pay your employees well and provide them the benefits and treat them well and then have enough leftover after that for shareholders to also benefit and for profits. So the wonderful thing about a company like Ferrari is that you can see, we’ve seen how management over time has whole different levers experimented. So in terms of challenge of how you stay exclusive while also growing the number of unity you sell. But one of the things they did is they actually created more types of models. So I don’t remember specific numbers, but I’ll just throw it out there. Let’s say they had 10 models at 2015, I don’t think it’s that. They didn’t do that many, but they created some new category. So one is the SF90 Stradale, which was introduced, I think, last year, which was their first production hybrid.

Clay Finck (44:59):

I would think one really good opportunity for them would be to expand into EVs as a new revenue generator as well, which they look to be releasing over the coming years too.

Arif Karim (45:10):

Exactly. Yeah. Yeah. So we’re seeing Ferrari evolve into the EV front. It’s something that’s necessary because of regulatory reasons over the next decade where countries around the world are mandating either lower emissions or just all out EV-only sales. They’re actually bating fossil fuel sales. So that of course is a push for Ferrari to head towards that route, when traditionally it had cars that had V12s and V8 engines that consumed a lot of gasoline, but one of the things that Ferrari has done opportunistically, again, going back to this creativity and adaptation by companies is they’ve actually started to release models that hybridize the Ferrari and electric powertrain that compliments the fossil fuel today to actually just improve the fuel consumption, the CO2 emissions, but also improve the performance of the car.

Arif Karim (45:59):

In the process, at the end of day, if you’re improving performance of the car, you’re adding more value to the customers and process being able to charge more. So a good example is the SF90 Stradale, which was introduced, I think it was last year. It was priced at roughly 500,000 Euro, which is a price point they didn’t actually have for a non-limited production model, So they’ve got those very elite limited models, and those are like in the 800,000 and higher, and then they had their production models, which are the ones that aren’t limited. They’re still limited, but not exclusive models, let’s say. Those are that 250, 350 $400,000 range. The Stradale actually came in a tier above that below the limited in 500,000 effectively after you put in all the options that you want, it’ll be a 650,000 car.

Arif Karim (46:42):

So that’s a new price point that they brought this car into that leverages the higher performance. It’s like 1,000 horsepower, right between the electric power plant and the V8 that it has, but you basically are creating this new price point for this new car that incorporates what the hybrid powertrain, which Ferrari had to do anyway, but they found a way to make it value additive for the customer, therefore themselves and us, in the process. So that’s one of the things that’s really interesting. People are talking about it as an SUV Ferrari and Ferrari insists they’re not making SUVs. So some kind of a more utilitarian car that’s going to be a four-door car, probably, it’s called a Purosangue. They talked about this being in development back in 2018 and it’s supposed to be released late this year. But that car too, it’s a totally different address of market we’re looking at.

Arif Karim (47:30):

You used to have a Porsche 911, the two-door sports car, and then Porsche came out with a Cayenne SUV. At the time, the purists were like, “Oh, my God, this is terrible. Porsche’s selling out, this is going to be terrible.” But then there were other people are like, “Oh, well I love my 911. I have this Ford Explorer that they really don’t like driving, because it doesn’t handle very well and it’s not fast. I’m going to get me a Porsche Cayenne and try that out.” It turns out that’s been a great product. It’s been such a huge success, so successful that Porsche now sells more SUVs than they sell sports cars, which is incredible. But Porsche might argue and say, “Ah, ah, ah, you’re actually wrong. We’re still selling sports cars. They look like an SUV.”

Arif Karim (48:10):

That’s what many people would say, when you drive a Cayenne or Macan, it handles like a sports car. It has the utilitarian function of what you need an SUV to have. So Ferrari is coming out with a more utilitarian vehicle very late to the game, but that’s okay because it’s exclusive, there’s still going to be demand for it. Recently, actually we’ve seen other very more luxury exclusive companies like Bentley and Lamborghini come out with SUVs that are priced in the $200,000 plus range. They’ve been very, very successful. It’s hard to see Ferrari’s utilitarian vehicle, I won’t call an SUV, come out and not be success too in particular, in the China market where wealthy individuals actually get driven rather than drive.

Arif Karim (48:51):

So to the extent that you are a Ferrari enthusiast, you like F1, you want to own a Ferrari, but probably have one, two or more Ferraris in your garage that you drive now and then when you want to, maybe when you’re driving to work or going for a long drive to your holiday home and you’re being driven, you might want to get a Ferrari that can get you driven as well, so things like that. So they’ve added new models to their range. Over time, the majority of them are going to become electrified. The majority units sold that are going to be either hybrid and eventually EV as well, but Ferrari has a roadmap towards getting to EV. I think they got it to about 2025 when they were going to show us their first EV, basically.

Clay Finck (49:31):

Very cool, definitely a compelling, long-term investment from my perspective. Arif, thank you so much for coming onto the show. This is a really fun conversation, and I’m excited to look a little bit deeper on this company. Before we close out the episode and I let you go, where can the audience go to connect with you and Ensemble Capital?

Arif Karim (49:51):

Sure. Yeah. So we have a website ensemblecapital.com where all of our contact info’s there. I’m also on LinkedIn, just look up my name, Arif Karim, I’ll be there. We also have the intrinsicinvesting.com website where we publish our research and thoughts over time. We post on their regularly talking about our thoughts and we’ll do profiles of our companies too, sometimes on there. Then finally on Twitter, we’re @IntrinsicINV that’s our Twitter handle. We regularly, post stuff there and interact with anyone that wants to interact with us on Twitter. So happy to be here on your show, Clay. I enjoyed this conversation and I look forward to having it again.

Clay Finck (50:29):

Yeah. We’ll love to have you back. I’d love to have you back on. Thank you so much, Arif.

Arif Karim (50:32):

All right. Great. Thanks, bye.

Clay Finck (50:35):

All right. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app, so you can get these episodes delivered automatically. If you’ve been enjoying the podcast, we would really appreciate it if you left us rating or review on the podcast app you’re on. This will really help us in the search algorithm so others can discover the show as well. If you haven’t already done so, be sure to check out our website, theinvestorspodcast.com. There you’ll find all of our episodes, some educational resources, as well as our TIP finance tool that Robert and I use to manage our own stock portfolios. With that, we’ll see you again next time.

Outro (51:11):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.