Is bigger better? The Innscor case study

In the universe of economics and investments, there is a widely accepted theory of economies of scale. This entails that the overhead cost per unit of production decreases as total production increases, and this subsequently results in stronger profit figures and margins.

Tafara Mtutu
INvestment analyst

As an example, if overhead costs of $100 are used to produce 10 units of product X, then the cost per unit is (=100/10) $10. However, if the same cash outlay of $100 is used to produce 20 units. Then the cost per unit falls to $5. Given a constant selling price, additional production translates to higher profits per unit.

Economies of scale have been a significant motivating factor behind businesses that engage in growth, whether acquisitive or organic. In fact, almost all the brands in your home can be identified with 11 companies who have become giants in their industries shown in the infographic below.

These 11 companies are aggressive in acquisitive growth because of economies of scale and, to some extent, a need to maintain market leadership through acquisition of competition. However, the level of growth that translates to better performance has its limits, which are aptly explained by the concept of marginal benefits.

At a certain level of growth, the cost of producing an additional unit outweighs the benefits associated with the associated unit. For example, there is a certain number of labour that a manufacturer can employ in a plant before it becomes unfeasible. At that point, it is no longer economical to increase your staff complement. As the old adage goes, “too many cooks spoil the broth”.

This is also observed in investment banking, where small to medium hedge funds outperform the largest funds on return metrics. Coined the Hedge Fund Paradox, this phenomenon affirms that funds with less assets under management (AUMs), tend to perform better than funds that manage considerably more assets under their belt.

Research on the Hedge Fund Paradox has been done in different economies and over different time periods, with conclusive evidence to the statement that bigger is not necessarily better. More specifically, funds managed by firms with US$50 million to $500 million in AUMs have outperformed those run by larger peers over almost any period, by as much as 231%.

A major reason cited by the various reports is the mismatch between the cost structure and opportunity set of investments that tends to favour smaller funds. In layman’s terms, as the fund grows, the number of profitable investments available to the fund shrinks and this is pronounced by the rising costs incurred in managing the fund.

This theory extends to traditional markets. In Zimbabwe, the decline in economic activity has shrunk the opportunity set for many entities who have now become too big for the current operating environment. There are now less opportunities to grow and sustain operations given shrinking consumer wallets and a regionally uncompetitive operating environment in most sectors which limits exports.

For example, the decline in economic activity since the beginning of 2019 has seen cement manufacturers servicing a market that requires 1,4 million tonnes of cement with an industrial capacity of 2,6 million tonnes, resulted in declining returns on invested capital.

In real estate, demand for CBD office space has drastically fallen over the last 3 years with occupancy levels struggling to break the 60% mark over evolving tenant preferences and the pandemic. This is the result of high supply of CBD office space that has overwhelmed demand and lowered the “opportunity set” for real estate entities such as Masholdings and First Mutual Properties.

Meikles Limited’s disposal of its iconic Meikles Hotel can be thought of as a response to the declining economic feasibility of incurring demanding hotel expenditure amid declining demand for hotel rooms. This begs the question, “How can businesses maintain growth without becoming too big for their opportunity set?”, which can be answered by studying the journey of Innscor Africa Limited. The business has managed to balance between growth and size through a perpetual cycle of nurturing good businesses and unbundling them when they reach critical mass.

Innscor is currently a light manufacturing fast-moving consumer goods (FMCGs) business that evolved from a quick service restaurant business. The reason I say “currently” is because Innscor is a dynamic business. The business took off as a quick service restaurant business in 1987 before venturing into crocodile ranching, tourism, distribution, and FMCG manufacturing.

Innscor’s competent management has shown a track record in nurturing its businesses from the start-up phase of their life cycle to the maturity stage where they can unbundle them. The proceeds are then reinvested into newer and smaller operations with high growth potential and a perpetual cycle of growth continues. Innscor, however, retains some shareholding in the unbundled entities which allows it to continue enjoying the benefits that accrue from the unbundled units.

In 1993, Innscor acquired Astra Crocodile Ranching which it nurtured until 2010 and unbundled from the group through a listing on the Zimbabwe Stock Exchange (ZSE) under the name Padenga Holdings Limited. The transaction allowed Innscor to focus on its remaining operations, which it also funded with the proceeds of the initial public offering (IPO). The transaction also unlocked value for both Innscor and Padenga, as Padenga’s share price increased from US5c per share in 2010 to US9c per share in 2014.

A similar restructuring was done with its quick service restaurant operations, which it unbundled under the name Simbisa Brands in 2015. Innscor listed Simbisa Brands at a price of US15c per share and so much was the success of the unbundled business that its share price sky-rocketed to US68c per share in a space of two years. Axia Corporation, whose operations were nurtured since 1993, was unbundled from Innscor at an opening price of US3c per share on ZSE. Within a year later, the business was trading at US30c per share.

There are many other instances that the business unbundled some of its operations in order to keep Innscor light and on a continuous growth strategy, which include the disposal of Spar Zambia and the tour operator Shearwater.

The group is currently focusing on other operations which could be ripe for a listing once fundamentals in Zimbabwe improve. Potential transactions include unbundling Irvine’s Zimbabwe, Probrands and Associated Meat Packers Limited. In addition, the group stands to indirectly benefit from further unbundling of operations that it unbundled in the long term.

TV Sales & Home (a subsidiary of Axia Corporation) and Dial-a-Delivery (a subsidiary of Simbisa Brands) are some potential opportunities that spring to mind. The stellar management of these businesses and the well-timed execution of these transactions have been a key driver in the consistently impressive performance by the group over the years.

Perhaps the success of Innscor since inception pivots on a business model whose philosophy closely mimics a venture capital firm. Venture capitalists are private equity investors that provide capital to companies exhibiting high growth potential in exchange for an equity stake.

Innscor’s ability to create and unlock value in the way that it does can spark a debate on whether the group is a venture capitalist clothed as a FMCGs entity or not.

I personally think this is a coin toss, but whichever side wins, I am convinced that Innscor Africa Limited is a well-oiled machine that investors should keep an eye on.

Tafara Mtutu is an investment analyst with Morgan & Co. He writes in his personal capacity.

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