Archives For Network Effects

Exceptional Business Pic

I’m testing a theory here, the driving question of which is What are the cardinal traits of exceptional software and technology businesses?

The term “exceptional” is as qualitative as it gets. Perhaps we’ll give it more definition as we proceed, but for the time let’s be comfortable with former U.S. Supreme Court Justice Potter Stewart’s threshold test for obscenity: I know it when I see it.

I’m suggesting four criteria and using them as a framework for evaluating various businesses in different stages of development, as early as start-ups and as late as technology that has been retired from companies that have long since moved on. The application for what we learn will resonate most, I think, with young businesses either in their fledgling stages or otherwise still able to mold their cultures and their values.

My early thesis is that the exceptional software and technology companies share some combination of the following traits summarized below in very rough form:

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MadMen MBA

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, (“for really understanding companies”) outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it’s a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today’s ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960’s).  In episode five, At the Codfish BallJack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper’s young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent.

Doug sets up the case study in a recent email:

Heinz’s big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.

That was the 1960’s, let’s bring it back to the Heinz of today using our four-part framework for understanding businesses.

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MadMen MBA

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we’re the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I’ve expanded with a barrage of verbosity. I’ve agreed to his proposal (and we’ll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I’ve dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn’t send him running for an escape, perhaps we’ll feature one or two of the case studies in a Mad Men MBA series here on pauldryden.co. 

Ok, Doug, let’s up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what’s good or bad about a company, but unless you have some way to organize all the information you’re taking in…it tends to float around in disconnected ways. That’s how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on.

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom.

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men…

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Sometimes it makes sense to deny the profitability bias, the investor’s case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market.

For the sake of simplicity, let’s say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale.

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term “gestalt.” The whole is much greater than the sum of its parts.

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs’ crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user’s experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple’s connection with customers.

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot.

But let’s remind ourselves, those profits were the result of investments that lowered Pfizer’s overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents.

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month’s time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill.

For captive demand, “sticky” has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor’s offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank’s website? And for what? A free toaster with your new checking account? No thanks.

Finally, we have economies of scale, or just “scale” for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it’s foolhardy to even attempt to compete with you and the fanatical ones – those that make an irrational decision to compete anyway – would run out of money before you.

We’ll dig more later on the benefits of scale…

Next on the impact of expense investments on Amazon’s earnings, we consider this…

C. Content to encourage more customer loyalty via Amazon Prime membership.

I joined Amazon Prime last month for $79 a year. I promptly dropped my Netflix membership in favor of Prime streaming videos, found a book I wanted to “check out” for free on my Kindle this month, and went looking for items I could put on “subscribe and save” status. Oh yes, I’ve ordered several more things this month than I ordinarily would as a test to see how extensively I could use Amazon Prime as a replacement for my family’s weekly (or more) trips to Target and to revel in the close-enough-to-instant gratification provided by its two-day shipping at no additional cost.

We’re hooked, and I have no doubt we’ll spend a lot more money at Amazon as a result…which will translate into less money at Target and even fewer reasons to visit other web retailers at all.

Growth At Too High a Cost?

A site called firstadopter.com singled out Amazon last month as its “secular short of 2012.” It makes a reasonable comparison to dot.com bubble company Kozmo when considering the cost of cheap delivery:

Back in the dot.com bubble there was a company called Kozmo.com that offered free 1 hour shipping of array of small goods like books, videos, magazines, etc. To my amazement, I tried the service and ordered a pack of gum. Within an hour someone was at my door to deliver it. The company reported amazing revenue growth. Obviously investors should have discounted that sales growth as it was an “uneconomic” business model.

Amazon is doing a similar thing by subsidizing free shipping. Anecdotally I am hearing customers who have Amazon Prime feel compelled to order small items to take advantage of the free 2-day shipping benefit. They are ordering batteries, Listerine, toilet paper, water bottles, etc. all with free 2-day shipping, which is goosing Amazon’s revenue without helping their bottom line.

If you sell $1.00 of value for 99c, you will show amazing revenue growth. It’s all fine and dandy until your free shipping offering hits critical mass with take-up accelerating and the losses start ballooning.

The author makes good points, and it’s hard to disagree that Amazon shouldn’t put itself on a slippery slope of economic destruction via cheap delivery. We must, of course, consider Amazon’s rationale for embarking on this program and its capacity to continue it without overwhelming the business economics.

First, the Prime program is several years old at this point. If I recall correctly, it started at $99/year before Amazon started dropping the price (as it has a habit of doing). Management has had time to review the data and look at its impact on the business. Unless we have reason to believe that Bezos et al. are irrational or such brinks-men that they would double-down on a value-destroying initiative, I think it’s fair to give them the benefit of the doubt and assume they’re seeing some positive things coming from the effort.

In 2008 Bezos did this interview with Businessweek in which he commented on the benefit of being big when you want to try innovative things:

One of the nice things now is that we have enough scale that we can do quite large experiments without it having significant impact on our short-term financials. Over the last three years the company has done very well financially at the same time we’ve been investing in Kindle and Web services – and all that was sort of beneath the covers.

Remember, Prime is part of a marketing tactic for Amazon that presumably fits within the context of a much larger strategy. Inexpensive (or free) shipping is not a business model for them as it was for Kozmo.com.

Second, I’m reminded of a story from Built From Scratch, the autobiographical book from Home Depot’s founders. Early in the company’s history they began offering no-question refunds to their customers. Anyone could bring in any item purchased from Home Depot and get a full refund without any flack from the store. It should be no surprise that this practice invited abuse and fraud which really irked some employees. They couldn’t stand the idea of being fleeced by freeloaders and fraudsters. When they complained to Bernie Marcus and Arthur Blank, the founders told them to suck it up. Despite the handful of jerks eager to take advantage of them, the lenient returns policy was driving more business to their stores and away from competitors who would wrestle with customers over each return. In context of the big picture, the losses were tiny compared to the gains from all the additional business.

The Amazon Prime Impact

Last December, Ben Schachter of Macquarie Research put together a piece of homespun research called The Amazon Prime Impact: A Self-Portrait Case Study. (Hat tip to amazonstrategies.com for that link.) He looked at his own buying habits pre- and post-Amazon Prime membership. His data demonstrated these points:

  1. Increasing Order Activity: His annual number of orders was up 7x and dollar spend up 500 percent.
  2. Declining Order Size: His cost per order dropped from $70 to $54.
  3. Gross Profit Benefit: Overall gross profit dollars to Amazon were up though percentage margin was down.
  4. Loss Leaders: 33 percent of his orders lost money for Amazon.

The key points are that he increased his orders and dollar spend with Amazon, AND while its margins were lower, Amazon likely netted higher overall gross profit dollars from Schachter using Prime membership so extensively. He says his margin percent dropped from 25 to 18 but because he did so much more volume, the overall gross profit generated went from  $322 before he joined Prime to $816 in 2011.

It’s critical to understand that absolute gross margin dollars generated by sales trumps the gross profit percentage in Amazon’s business model. Why? I wrote this last year when evaluating Overstock.com (here):

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin. Percentages be damned! That’s cold, hard cash.

Back To My Own Experience

I considered myself an Amazon consumer fan for years, and yet I didn’t join Prime. As Amazon expanded the Prime experience, however, it became a no brainer to do it. (Indeed, it paid for itself twice over when I canceled my Netflix subscription.)

Amazon is creating another virtuous cycle by plowing hundreds of millions into content for Prime members. But it’s not going to show short-term earnings benefits. Over the long haul, however, I expect my experience will mirror the overall increased adoption rate. At some point the value becomes so high, many more Amazon customers will do it because it’s just dumb not to.

Amazon found my tipping point, and now I’m a Prime member who spends more money with them and has even paid to rent a few videos for my daughter to enjoy on the Kindle Fire during long car rides (something I would not have done if i weren’t already enjoying the “free” streaming videos courtesy of Prime).

Moreover, I’ve canceled my Netflix subscription and am actively looking for more ways to spend my shopping dollars with Amazon instead of making trips to Target.

Conclusion: If Amazon is not locking itself into a Kozmo.com uneconomic business model and is, as Schachter’s self-analysis suggests, building in higher overall gross dollars to cover its expense nut…AND…it’s building customer habits and loyalty…AND…it’s taking business away competitors. Well, i think this counts as an offensive move.

I’ve been thinking about the role of competitive advantage in evaluating investment opportunities after watching this interview with Clayton Homes CEO, Kevin Clayton (here is the YouTube video). As a subsidiary of Berkshire Hathaway, Clayton benefits from such horse’s-mouth management wisdom from Warren Buffett as…”Deepen and widen your moat – that competitive advantage that keeps your opponents at bay – everyday.”

It occurs to me that “generate loads of profits” is neither an inspiring rally cry for the troops nor an enduring moat. Herein lies a flaw with so much focus on concepts like Economic Value Add (EVA) or Total Shareholder Return (TSR). While noble – and I believe accurate – in principle, these ideas are often bastardized by management in their execution at the business level. Oftentimes managers become enamored of sending so much cash back to shareholders that they stop protecting their moats, opening themselves to attacks by capable foes.

Dun & Bradstreet (DNB) comes to mind. I spent some time looking at the business last November when it was trading around 61 per share, its 52-week low, while sporting a respectable ROIC, nice dividend payment, low capital requirements and demonstrating a willingness to throw plenty of cash (even in the form of new debt) at buying back its shares.

On face value alone, it was a compelling investment candidate…The DUNS Right number is supposedly the ubiquitous mechanism for businesses to evaluate the credit worthiness of trading partners. DNB has honed its process for a century, and – according to them – created a proprietary database of such size and sophistication as to be impossible for a competitor to replicate. In a previous life, I remember my CFO turning to DNB immediately if he had questions about a partner, competitor, or new customer.

That sounds like a good moat, right?

Well, I believe it really was at one time. But over the years DNB has allowed this resource to wither. They have starved the golden goose in the name of total shareholder returns.

Assuming that the DUNS Right process was the dominant way to evaluate your potential trading partners at one time, what should DNB have done to deepen and widen that moat everyday?

1. DNB should have continued investing behind the data and its uses, employing the best engineers and marketing minds available to make it better and expand its uses.

2. DNB should have priced it out reasonably and looked for opportunities to reduce its price to make it impossible for new entrants to even attempt a competitive offering.

What did DNB do instead?

They handed all the golden eggs back to investors (and management) and stopped feeding the goose. They turned a powerful tool with long-term earnings prospects into a dwindling asset. They sought to return cash to shareholders first – reducing capital investment, cutting expenses to the bone, and increasing prices on customers – and ignored their competitive advantage.

In the process they alienated customers with an arrogance that suggested a belief in “where else will they go?” They chopped away research and development, choosing to squeeze existing assets instead. (Not coincidentally for a company no longer investing in itself, a quick dig through the scuttlebutt demonstrates that DNB is not considered a good place to work.) They preyed upon their sources of data, calling small business and extorting them for $500 to monitor and update their Paydex scores so other companies saw them as credit worthy. (This makes the input for DUNS Right data suspect, destroying the air of impartial data needed for customers to really trust DNB as trustworthy source of credit info.)

DNB has returned a lot of cash to shareholders, no question. Not investing sufficiently to protect the competitive advantages of the business can feel really good to short-term investors. Since I considered the investment, the stock price has soared over 30 percent! But for those holding on for the long haul, they must consider the damage done by management. They have taken what should have been an impenetrable fortress surrounding their competitive advantage, neglected it in the name of TSR, and weakened the defenses to a point where competition is entering the market. (Equifax is treating business credit as an adjacent expansion of its consumer credit offerings, Cortera is a start-up exploiting the distrust of DNB and its high cost to crowd-source an alternative at a much cheaper price, and trade associations are pooling information on creditworthiness for their members.)

I passed on DNB despite its apparently cheap price tag. It started with such a strong position in the market, but in neglecting its moat has lost its advantage. While I can’t say the competition will prevail, I can say that DNB’s neglect has increased their odds considerably.