Archives For July 2012

I couldn’t find a way to link to this Google+ posting from the resources page, so I decided to cut and paste it here. Steve Yegge is a programmer at Google and a former Amazonian. I’m sure I’m breaching all sorts of etiquette by doing this, but I rationalize it by saying I want to make sure this piece – with all its pearls about Amazon’s transition to service oriented architecture and Jeff Bezos’ mercurial ways – is preserved for posterity.

Steve Yegge originally shared this post:

Stevey’s Google Platforms Rant

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Productivity LoopThis is the fourth post in a series about Amazon’s Feedback Loop, the mechanism most responsible for the company’s success. See also the previous posts, The Growth Levers in Retail: Price, Selection, ConvenienceUnlocking the Broad Middle (Hint: Price Is the Key); and Sam Walton, Panties and Power Laws.

After three hours of high-energy corporate pep rally, Walmart’s CEO – Mike Duke – strides onto stage to bat clean up. The setting is the company’s 2011 annual shareholders’ meeting, emceed by Will Smith and featuring a cavalcade of senior executive speeches and heart-warming vignettes on the dedication of Walmart associates.

Whether from Doug McMillon of Walmart International, Brian Cornell of Sam’s Club (now departed), or Eduardo Castro-Wright (now departed) of walmart.com, each manager preceding the CEO has used his stage time to extol the virtues of what they call the Productivity Loop: Operate for less through every day low costs (EDLC), which leads to…Buy for less from suppliers, which leads to…Sell for less to customers with every day low price (EDLP), which leads to…GROWTH! And the loop circles around the unifying theme of “Saving people money so they can live better.”

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Sam Walton Made in AmericaThis is the third post in a series about Amazon’s Feedback Loop, the mechanism most responsible for the company’s success. See also the previous posts, The Growth Levers in Retail: Price, Selection, Convenience and Unlocking the Broad Middle (Hint: Price Is the Key).

Sam Walton understood the power of price better than anybody. From the earliest days of Walmart, he decided price would be the lever he pressed the hardest. He pressed it with a fanatic’s zeal.

In those early days, even before it was called Walmart, Walton unearthed a truism about low prices. He found that in lowering prices, sales didn’t just bump up a little bit. The bump was dramatic. It was disproportionate to the discount, as if the relationship between price reduction and volume of sales followed some sort of power law. Cutting your price 30 percent didn’t increase sales by a corresponding 30 percent…it might triple them. Walton saw that deep price cuts at his first five-and-dime store had the effect of not only drawing customers from the competitors across the way, but it also opened the purses of shoppers who might not otherwise buy his product. They couldn’t pass up the bargain. It was as if he uncovered a secret of human nature.

Which brings us to an important discussion of panties from Sam Walton: Made in America:

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Broad MiddleThis is the second post in a series about Amazon’s Feedback Loop, the mechanism most responsible for the company’s success. See also the previous post, The Growth Levers in Retail: Price, Selection, Convenience.

In the previous post in this series we discussed the growth levers for retail, that retailers must decide how to allocate their resources among price, selection, and convenience (the levers) in the unending competition for customers.

In a retailer’s utopia, it would have enough resources to push simultaneously on all the levers. For the retailer that offers the lowest price, the widest selection, and the best convenience will win the most customers. When you win the most customers, you get the most growth.

But traditional storefront retail just won’t allow that perfect combination. It’s held back, for one reason among many, by real estate constraints. Convenience is driven primarily by location, location, location. Every retailer wants to be as close as possible to the most customers, so those shopping locations that provide that access carry steep rents. But if you’re forced to pay too much for rent, you can’t afford to lower your prices or expand your selection. You’ll still win some less price-sensitive shoppers who prize convenience most of all, but others will drive past your store on the way to your competitor in the suburb that offers cheaper prices. So we’re back to the trade-offs.

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Crabby Twitter 1

 

After tweeting about my post The Growth Levers in Retail: Price, Selection, Convenience, I received the following reply:

 

Crabby Twitter 2

 

Marketing Experts Like New Marketing Ideas

I’m pretty sure Mike is referring to the CNBC special, The Costco Craze (it originally aired in late-April) in which a marketing expert explains to host Carl Quintanilla the concept of “paradox of choice.” It was popularized several years ago by psychologist Barry Schwartz who authored a book with the same name. The idea is this: while people tend to believe that options are great (and the more you have the better), the reality is that we tend to be overwhelmed by too many. It creates stress. In many cases we would prefer not to have a choice; that our decisions be made for us. In the shopping environment, that stress can lead to indecision and consumers walking away from a purchase altogether. Mike is absolutely right about that.

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Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon’s current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market’s reaction…let’s just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo’s always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching – ever so briefly – its own 52-week high.

One of those important Wall Street metrics is eBay’s Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market’s logic…

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Feedback Loop No Outside Cash

If we were forced to reduce the secret of Amazon’s success to one simple concept, this would be it: Amazon churning hard on the Feedback Loop featured above.

This is absolutely critical to understanding Amazon. And not just retail. I mean every business line it’s in. So I’ll dedicate several posts to breaking it down, and then building it back up again.

Stick with me on this. It will be worth it.

The Growth Levers in Retail: Price, Selection, Convenience

In the world of retailing three variables are responsible for driving the lion’s share of growth. Price, Selection, and Convenience. Price is self-evident. When comparing apples to apples, customers want the lower-priced apple. Selection means the retailer offers the products the customer wants. And convenience means the shopping experience is streamlined, not confusing, not complex, and requires as little exertion from the customer as is humanly possible.

A couple weeks ago Greg Bensinger wrote a worthwhile read in the Wall Street JournalCompeting With Amazon on Amazon. The gist is this: Amazon has a nasty habit of poaching the highest volume products from its third party sellers, opting to compete with them by selling the same thing in its marketplace rather than just sitting back and collecting the fees it gets from letting the partner make the sell.

It’s a solid story from Greg. What it misses, but something I’m certain Greg is thinking about, is why would Amazon be simultaneously pushing its third party seller program while poaching best selling products from those partners? That’s befuddling.

First, let me take a stab at the simple answer: Follow the money.

In the fourth quarter of 2011, Amazon did $10 billion in sales from third-party merchants. Against this it charged somewhere in the ballpark of 13 percent fees. (That’s an average of all fees charged, though it ranges pretty dramatically from category to category and can go up or down depending on which of Amazon’s services sellers take advantage of.) It gets 80 percent gross margin for that business, so the whole thing netted Amazon about $1 billion in gross profits. That’s cold hard cash it extracts from sellers in exchange for using the Amazon platform to get access to their customers.

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We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.]

Uh-oh, a threat to Amazon’s AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I’m not. It’s more because the challenges keeps me honest.

It reminds me of the verse from Rudyard Kipling’s “If“:

 

…If you can trust yourself when all men doubt you,

But make allowance for their doubting, too…

It’s the only way to keep a kernel of intellectual integrity in his game of investing…look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It’s possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

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In this my third reading of Taleb’s Fooled By Randomness in the past five years, my attention is drawn to a section he calls The Earnings Season: Fooled by the Results. Its description (below) is reminiscent of (or prescient of) the Shleifer Effect. It creates interesting questions about the model and how/whether it’s tied to randomness.

First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I’ve already conceded (here) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb’s book, I would assume his thoughts have influenced the Shleifer Effect as well.

From pages 164-5:

Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting – stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. 

Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 “star” companies showing an increase in profits (assuming no inflation), and 5,000 “dogs.” After three years, we will have 1,250 “stars.” The stock review committee at the investment house will give your broker their names as “strong buys.” He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.

Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book Inefficient Markets, Andrei Shleifer’s assumption seems to be that chance determines whether a company’s earnings go up or down. He does not concern himself with competitive advantages protecting profits. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter.  So it is chance.

I don’t think that’s his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.)  The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.

That’s Taleb’s point here, too. I think. He constructs his cohort of 10,000 companies that “engage in all forms of volatile business.” Perhaps I’m reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage.

Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer’s predicted overreaction. And it happens on the upside and the downside.

For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside…BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.

I’m re-reading Nassim Taleb’s Fooled By Randomness. There are a handful of books I think worth revisiting every year or two to see how your refined understanding of the world – those things you’ve learned since reading it the last time – influence how you interpret it. It can become a measure of how you’ve matured in your learning quest. Taleb’s book(s) belongs in that rarefied air.

I’m not sure what it means about my own intelligence or reading comprehension level, but it just seems fresh with each new pass. Like I’m reading it for the first time though this is my third time flipping through its well-worn pages.

This will not be a book report. I wanted to highlight a quote that appears before the first chapter and relate it back to a previous post here.

Solon’s Warning

Taleb retells an apocryphal story from ancient Greece in which King Croesus (the richest man) is making a futile attempt to get Solon (the wisest man) to agree that the former’s wealth and success mean he must be the happiest.

Solon responded:

The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyments, or to admire a man’s happiness that may yet, in the course of time, suffer change. For the uncertain future has yet to come, with all variety of future; and him only to whom the divinity has [guaranteed] continued happiness until the end we may call happy.

These are the thoughts it inspires (mostly self-plagiarized from a previous post):

Thoughts on Success and Failure

What is success? Is it really an outcome? Too often we think of it as a destination as if it were a platform we land on and upon which we reside forever more. I think we would find that most people we consider successful don’t think of it as such a static thing. It’s very dynamic. And it’s not accurate to use the term in such a general way. I would argue it’s just not a precise use of the term.

Perhaps you accomplished a specific thing successfully. You employed strong thinking in an investment decision process that produced an outcome with high returns. That was an example of being successful, but does it define you as a “success.” Or say you produced a string of these good outcomes with high returns. Again, those are multiple instances of success, but are you now a “success?”

You can have a thousand such “successes” followed by a single “failure.” How are you then labeled? Or you have a thousand failures followed by a single success.

Such labels are meaningless. I’m reminded of Malcolm Gladwell’s New Yorker profile of Nassim Taleb  [ah, this is why these thoughts reconnect for me a few months later…neural synapses, funny things] several years ago. (Click here to read Blowing Up: How Nassim Taleb Turned the Inevitability of Disaster Into an Investment Strategy.) Taleb revered Victor Niederhoffer as one of the world’s best traders and a brilliant thinker. Niederhoffer had a respected fund with investors desperate to include their capital in his investments. He had more wealth than most people could hope for.

Niederhoffer had it all. Until he didn’t. He “blew up”, as traders put it, when the strategy he had used with such success for a decade suddenly didn’t work. He lost everything. One day he was a “success” and the next he was a “failure.” Well, that would be the description if you chose to think of it in such “destination” terms.

It all brings to mind the story of the Taoist farmer. I had a vague recollection of the tale, and googling it produced this version (from this source):

This farmer had only one horse, and one day the horse ran away. The neighbors came to condole over his terrible loss. The farmer said, “What makes you think it is so terrible?”

A month later, the horse came home–this time bringing with her two beautiful wild horses. The neighbors became excited at the farmer’s good fortune. Such lovely strong horses! The farmer said, “What makes you think this is good fortune?”

The farmer’s son was thrown from one of the wild horses and broke his leg. All the neighbors were very distressed. Such bad luck! The farmer said, “What makes you think it is bad?”

A war came, and every able-bodied man was conscripted and sent into battle. Only the farmer’s son, because he had a broken leg, remained. The neighbors congratulated the farmer. “What makes you think this is good?” said the farmer.

Luck is fleeting. It is a point-in-time result. What we perceive as luck today, we may view as the root of great misfortune tomorrow. The same reasons we might have used to consider a person lucky today we might use to pity him tomorrow.

So goes success, and so the path is circuitous and the arrow points forever further.

Henry Blodget

I’m hesitant to admit such a fascination with him, but after several posts quoting or featuring him, I must now confess a bit of an obsession with Henry Blodget. To refresh on his story, you may turn to Wikipedia here.

It helps to know the back story to understand the context of why he posted this image on his business news aggregator Business Insider back in April:

 

The grit required to stage a comeback (it’s in process) after being laid so low is a much better story – a Greek tragedy reversed – than a straight line success story.

Bloomberg reported this morning that Amazon has its own smartphone in development, that the company is working with Foxconn in China for production, and that it has actively been acquiring wireless technology-related patents in advance of the launch. See the story here.

Even more so than its decision to challenge Apple’s dominance of the tablet market by introducing the Kindle Fire, this move into smartphones is likely to leave a lot of consumers and investors scratching their heads. What business does Amazon – a web retailer – have getting into the phone market?

Let me take a stab at that…

Convergence of the Tech Giants

Though Jeff Bezos will deny it until he’s blue in the face, this is a classic move of defense by playing offense.

There’s a convergence going on in technology.  Apple, Google, Facebook, and Amazon are quickly converging on the same base of customers. To be sure, there is a growth imperative at play, too. Each of these companies has become accustomed to growing at a rapid clip, and each has the ambition (and gall) to believe it should continue growing. And as each runs out of room to expand in its core markets, it will seek new growth by introducing services that poach customers from the other tech giants. The spheres in which they operate, once so placidly independent of each other, are beginning to overlap. If you put a Venn diagram of their markets on time-lapse video, the shaded areas of market overlap would grow darker and darker with each passing year. Convergence is happening.

And in a converging marketplace, if you don’t play offense by actively growing into your competitors’ markets, you run the risk that they will grow into yours in the near future. Offense becomes the best form of defense. It compels you to grow, thus the growth “imperative.”

(To put this in the appropriate context, you should take a look at Farhad Manjoo’s The Great Tech War of 2012, published in Fast Company back in October 2012.)

An Aside on Google

Google has been the most interesting case study for both the growth imperative and how a company reacts to convergence. For the time being, Google is spinning like a dervish. It seems to believe it must compete with each of these giants…and NOW. Its rivalry with Facebook has been well-documented with Google+. (See James Whittaker’s Why I Left Google blog entry.) That’s a competition for the future of advertising dominance, and I think it makes sense.

What makes far less sense to me is Google’s foray into retail with its “Prime” one-day delivery deal with bricks-and-mortar shops (see this WSJ blog description and the best overview from amazonstrategies.com here). Google benefits from competition among lots of retailers selling the same products and bidding up adword search prices to get premier listing on the search engine. But with Amazon becoming the ubiquitous web retailer, more consumers are skipping Google altogether and just going straight to Amazon for searches. This is costly for the search engine. And so it goes on the offensive, putting its considerable clout (and resources) behind an attempt at a competitive retail offering.

According to a Walter Isaacson (the Steve Jobs biographer) HBR.org essay back in April, Larry Page visited Jobs in his dying days looking for advice. Jobs asked him…”What are the five products you want to focus on? Get rid of the rest, because they’re dragging you down. They’re turning you into Microsoft. They’re causing you to turn out products that are adequate but not great.”…FOCUS! Isaacson credits Page with taking the advice to heart. I think there’s plenty of evidence to the contrary.

Amazon Devices to Prevent Apple iTunes Dominance

But back to Amazon and the smartphones. Amazon dips its toes in the water a lot. It’s renown for its constant A/B testing and its devotion to running with winning concepts while ditching the losers. So once it decides on a strategy, Bezos brings the company all-in.

In that regard, the smartphones can viewed as an extension of the reasons Amazon developed the Kindle Fire. A sizable chunk of its business is electronic media (songs, games, apps, movies, and books), and that media is being consumed more and more on mobile platforms. Apple gained an early lead in the market for those platforms with iPod, iPhone and iPad, creating a close-looped ecosystem of content to boot. Jobs and company might let others sell their content on iTunes, but they extracted a pound of flesh in return. This was problematic for Bezos and Amazon. To prevent total dominance by iOS, he had to present an alternative.

So we received the first iteration of Kindle Fire. But we know that electronic media is consumed on other devices as well, so it’s only logical that Amazon continues its all-in philosophy to ensure it gets a piece of that action, too. I would expect more (and better) tablets in the future. I would expect better links into television sets (Amazon branded set-top boxes). I would expect music players. And I’m not surprised by the smartphones.

So What Should We Anticipate from the Amazon Move?

First, lots of hiccups. We saw this with the early Kindles and with the Kindle Fire. It’s unavoidable when entering a sophisticated new market with complicated electronic technology. Amazon was not a device manufacturer a few years ago, but it is nothing if not a learning organization. Expect it to build on its experience, constantly improve, and ruthlessly eliminate defects. So, hiccups at first, but Amazon will only get better.

Second, a low price. Amazon is committed to the low-margin/high-volume business model. It has the capacity to suffer, a willingness to take losses on the early batches of inventory while it grabs market share and improves its cost structure.

Third, potential volatility in its stock price. Going all-in on phones – while juggling lots of other growth initiatives simultaneously – has the potential to move Amazon from profits to losses. And Bezos is not afraid of letting his company lose money for a while if he believes it will pay off in the long-term. The market, however, will not take kindly to this. It’s reasonable to anticipate bad financial press and a hit to its stock price if the company sports losses over multiple quarterly earnings reports.

Return of the Land Rush Metaphor

In 2001 Bezos told Charlie Rose (here) that Amazon understood the early days of web retailing (especially 1998 through 2000) through the heuristic of a land rush metaphor. That era was also dominated by a growth imperative. If Amazon didn’t move at an almost reckless pace to establish scaled operations, expand its product selection, and improve its technology, it risked another retailer – fueled by a steady stream of venture capital cash – converging on its markets and earning the trust (and the habits) of customers.

Bezos recognized the risk of being outflanked, so he engaged in the land rush. He bought into every niche retailer that sold a product that he thought Amazon might want to sell someday, better to bring your enemies close than let them flourish outside your control. He invested heavily in technology and distribution infrastructure. He priced his selection as aggressively as he could to attract customers. He bled cash, almost recklessly, because it kept Amazon in front of the pack and reduced the risk that another retailer could gain a toehold in its market.

That land rush mentality came from Bezos’ survey of the landscape at the time telling him that a convergence was afoot then, too. We see what he did to ensure he came out of the convergence as the dominant power.  Indeed, he came out of the dot-com bubble burst as the sole hegemonic power of web retailing. Despite the Amazon stock price falling from $106 to $6, despite losing countless hundreds of millions in equity investments in competing web retailers, and despite losing upwards of $500 million in personal fortune as the stock plummeted…the bursting of that bubble took all the outside cash out of the web retail industry. Everyone had to fend for themselves, and Amazon was the only one that could. Bezos did alright through it all.

If he’s reading the current technology situation with a mind to his experience in the early days of web retailing, I think we can expect him to turn to a page from his old playbook. He will compete ferociously, bordering on recklessness. He will lean heavily into his investments. He will play to dominate the markets.

 

I’m catching up on some of my screens from last week, and I notice that Nike (NKE) took a big hit on news that it missed consensus earnings estimates by about 15 percent. The price dropped over nine percent on the news.

MarketWatch provides a news write-up here. Revenue was up 12 percent for last quarter, but earnings dropped about eight percent. Costs went up, the company increased marketing spending in preparation for the London Olympics, orders from China dropped quite a bit, and it reduced it earnings growth guidance for the year.

Here are some of the analyst quotes pulled from  MarketWatch article (mainly for entertainment purposes):

It’s “a rare miss for Nike,” said UBS analyst Michael Binetti, who added he’s “disheartened to hear” that the company’s gross-margin recovery will be pushed out again after three straight quarters of missing its own targets.

 

“Nike becomes a much trickier stock from here,” according to ISI Group analyst Omar Saad. Sales “may no longer be enough for investors to overlook the company’s perplexing ongoing margin pressure.” Saad also said the margin miss makes him “a little concerned that this highly sophisticated, dominant, global consumer company does not have as good a handle on its costs as one would hope.”

 

Nike is an incredible brand. An icon really. It’s down about 20 percent from its 52-week high, but that $115 price was being fueled by a lot of optimism. It’s now trading around 20x earnings trailing twelve month earnings. That’s not cheap unless we think those earnings are depressed for some reason. A quick view of Morningstar data shows that Nike is actually near an all time earnings  peak.

For now it’s on the watchlist, but I would want to see some more healthy pessimism behind this before saying it’s a prime Shleifer Opportunity.

Profits are good. And our profitability bias – that preference to own, to cover, to work for, to partner with companies that turn a profit – is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition.

It’s not as if they don’t recognize that everyone prefers they were profitable. It’s that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage – strong brand, legal protection, captive demand, and scale – the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position.

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke’s most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars.

Pepsi wasn’t so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it’s nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola’s competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst.

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary’s shop.

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990’s with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn’t even get most grocery stores in his native UK to give his drinks a shot. When you can’t gain entry through basic distribution channels, you must know your future is grim. Price doesn’t even matter.

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke’s scale. As a last resort of scale, Coke could always fall back to its balance sheet – it has plenty of cash – and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola’s most valuable secrets. In reality, Coke’s competitive advantages are hidden in plain sight.  A big piece resides with its brand…but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.