Thursday, April 26, 2012

Pricing Power Part II: Lowering Price As Competitive Advantage

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them.


It's easy to understand the model of charging high prices for your products and services when you're able. We grasp the concept as an elementary principle of business, and its logic flows naturally: if you can charge a higher price, you gather a higher margin. More gross margin dollars give you the walking around money you need to pay competitive salaries for the best talent, to hire the best sales force, to build the most recognizable brand, and to plow money back into research and development. Then you should have plenty left over to pay the tax man, and whatever remains either goes back to shareholders or is plowed back into the business in a way that increases its value over time.

It's far less intuitive to grasp how charging a lower price is another form of pricing power that belies competitive advantage. Our first impulse is to think that lower prices lead to lower margins, leaving less to cover operating expenses and even less to drop to the bottom line.

That's all true. But not always. Certain complicating factors can arise: like customer price sensitivity affecting demand...and increased demand driving greater market share...and greater market share producing higher sales volume...and high sales volume creating scale advantages.

As we stated in regards to businesses that can charge high prices for their offerings (this post):

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.


I'm no business historian, but my survey-level reading leads me to this abbreviated chronology of the "low price as advantage" strategy.

Begin With The Great A&P 

First, notwithstanding the travails of their business in the current generation, A&P stumbled first upon the idea of using low prices to generate high volume. In the book The Great A&P and the Struggle for Small Business in America, author Mark Levison attributes this simplest of quotes to co-founder John A. Hartford:
We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit.
A&P's founders uncovered the basic tendency of grocery shoppers to buy a lot more when prices are lower. As long as the grocery store could afford to charge less it would steal market share from the traditional mom-and-pop grocers. A&P used that philosophy as the cornerstone of its expansion and grew into the largest and most powerful retailer the world had know up to that point. 

Lesson learned: Grocery shoppers are price sensitive, preferring to pay less when offered the choice.

A New Level With Walmart

Second, Sam Walton applied the exact idea to the discount general store with results that have forever altered the retailing industry. From his book, Sam Walton: Made in America:

Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume.
The amazing thing to Walton was that this idea was nothing novel. It should have been just as apparent to Kmart and Target (which were founded the same year as Walmart) and other discounters that should have had advantages over the Bentonville upstart. Again, from his book, Walton provides this explanation of why he got the pricing edge: 

What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking.
The fact that they did not (or could not) adopt the idea even while witnessing Walmart's mind-boggling growth is testimony to how difficult it is for a business to adapt itself to a low-margin model. It seems you must start with the philosophy or you'll just never get it. 

Lesson learned: I don't believe I need to rattle off statistics on Walmart's success using low price as a competitive advantage. Discount shoppers are price sensitive, preferring to pay less when offered the choice. A business that can institutionalize the practices of EDLC-EDLP (see more here) has a competitive advantage over those that cling to high margins when selling the same or similar products. Indeed, the former will move into town eventually and steal market from the latter. History has provided ample evidence of that.

Refined For Home Depot and Costco

Third, unlike all the time that past between A&P demonstrating the earliest success story of the model and Walmart taking it to new heights, contemporaries of Sam Walton gleaned lessons from the concept as they launched their own retail operations. Most notable are Home Depot and Costco. Each has its own twist on the model...

Home Depot does it in categories where Walmart never could compete effectively. It decimated local hardware stores and various home improvement wholesalers in every market it built stores. (You can read the Home Depot story in the founders' book, Built From Scratch. For anyone studying the low price retail model, this book is as important as Sam Walton's.)

And Costco took the idea to its absurd logical extension by somehow intuiting that shoppers would be so enamored of lower prices that they would buy in huge bulk quantities from a much smaller overall selection of goods. Its gross margins are only 11 percent, and its operating expenses are only eight percent of revenue. Contrast that to Walmart's 24 percent and 19 percent performance respective metrics!

(Speaking of Costco, CNBC will be airing its documentary The Costco Craze tonight. If you can't tear yourself away from the NFL Draft, you can click here to see clips and excerpts.) 

Lesson learned: Shoppers are price sensitive in more categories than grocery and discount. They will give their business to the low price seller across a variety of retail lines.

Bringing It To the Web:

Fourth, enters the retail fray with its web only offering in 1994, declaring early that it would stand apart with its selection of goods and its commitment to selling them for less. More about Amazon in the next post.


In my truncated chronology of retailers using low prices as their form of pricing power as competitive advantage, each iteration built on the lessons provided by its predecessors, tweaking them to fit its particular circumstance and incorporating its own wrinkles for improvement. Amazon is no exception.

The premise is this...

There is an abundance of products and services whose customers possess some degree of price sensitivity. All other variables being equal (or close enough), they will give their business to the low price provider. This price sensitivity creates the potential for shifts in market share.

The companies that commit themselves to being the low price providers in these categories will win additional customers, and often at the direct expense of competitors (though also through increased overall purchasing habits and the general expansion of their market size). They will generate higher sales volume. They will turn inventory more quickly (sales velocity). 

To use terminology from CEO Jeff Bezos, being able to afford selling products and services at low prices means having a lower rate of operating expense. The higher your operating expense, the more you must mark-up your products to generate the gross profits you'll need to cover that overhead. Conversely, when you run a lean operation that squeezes out expenses, you don't require as much gross profit. You can afford to lower your prices.

With lower prices (and each time you lower them further), you initiate a virtuous cycle: lower prices mean high sales volume; higher sales volume means better bargaining power with your suppliers; better bargaining power means lower sourcing costs; and lower sourcing costs means you can afford to lower your prices even further. 


And the virtuous cycle works for equity investors in the businesses. While your net profitability appears low (as a percent of revenue anyway, e.g. Walmart at five percent, Amazon at five percent and Costco at three percent), your return on invested capital is quite high. This is a superior measure of profitability anyway. It means you can generate high earnings against your asset base. It might cost you $10 million to build, equip, and stock a new store, but each store does $50 million in revenue, generates a $12 million in gross profit, has allocated expenses of $9.5 million and so generates $2.5 million of earnings contribution...or 25 percent ROIC on that $10 million initial investment. 

Your sales velocity hits a critical mass in which you're able to sell your inventory more quickly than you pay for it or have to pay your employees for their labor. You obviously pay the bills and paychecks eventually, but as you get a bigger gap between receiving cash and paying it out, it becomes a free source of capital. As long as you keep selling high volumes at high velocities you can use this pile of cash  to invest in your business, make strategic acquisitions, or pay out to shareholders in the form of dividends or share repurchases. 

You could also use it to lower prices even further.

You've created expectations among all your stakeholders that you abide to a low-cost-low-price model. (Indeed, expectations and habits are hard to change. This is probably why so few businesses have ever successfully transitioned from the high-cost-high-price model to low-cost-low-price.) Employees recognize what this means for perks and as a workplace culture. Suppliers know to bring their lowest prices and work with you to make them lower. Customers expect you to have the lowest price and feel less need to comparison shop. And investors come to understand what your model means for them and so gear their expectations accordingly. (Well, theoretically at least.)


There is a high degree of fanatical devotion to being the low-cost-low-price provider. It has to be this way because there's just a natural tendency to make life easier on the people running the business by raising prices when you're able. For the true devotees, this is heresy. As soon as you look for excuses to raise prices - to cover those growing expenses - you find yourself on a slippery slope.

Walmart protects against it by talking incessantly about the need to keep costs low since the company's founding. From Charles Fishman's bestseller The Wal-Mart Effect:

'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'

Costco talks about being the lowest price provider for every good it sales as a matter of life or death for the business. It's fanatical about maintaining the ability to mark items up only 15 percent, and if it can't sell something for less than the other warehouse clubs or Walmart, it has been known to drop the product altogether...even Coke in this highly publicized price showdown a few years ago.

Amazon is said to leave one empty chair at each meeting as a powerful symbol that the customer is represented in all decisions...always.

These forms of devotion can come across as corny at best and cultish at the extreme. But the madness has a purpose. It reinforces the ideal, creating a culture committed to the idea of low-cost-low-price, spurring workers to pursue it with vigor day-in day-out.

Why? Because it is a competitive advantage. A huge one.


This essay is meant to weigh the two approaches to pricing power as a competitive business advantage. The first - the ability to raise prices or charge a premium - is not the advantage in and of itself but rather a reflection of an advantage. In the example of Apple, the root advantage is some combination of brand cachet, innovative products, sleek designs, and content that confines purchasing to the iTunes ecosystem. The company has done a remarkable job with this. But I ask the question of what they must continue doing to maintain the advantage. The economics of the business, where revenue is primarily tied to selling more and more products each year, suggest they must stay on the crest of the innovation wave. Constantly. With little to no interruption. If they disappoint their customers with new releases, they risk losing the advantage very quickly to a pack of hungry competitors just a step or two behind.

(Yes, this point - that what Apple does is VERY difficult to sustain - remains just as true today as it was last week when I posted about matter the intervening news about Apple's profit rising 94 percent. I'm not calling an end to Apple's streak of success. I'm remarking how difficult it is to sustain and that one must consider whether it can continue the streak indefinitely and what might happen when the streak does end. Consumer electronics is a TOUGH business.)

The second approach to pricing power - having the ability to lower prices - really is an advantage on its own. Yes, it reflects efficient operations, strong procurement practices, and cultural devotion. But you don't have to provide customers with many reasons to accept your lower prices. If you can do it, a large subset will come to you. 

If you raise prices or continue charging a premium? You must justify it - always - with some benefit that your competition can't match. 

H&R Block (HRB): Entering Shleifer Effect Watchlist

H&R Block (HRB) was slammed this morning after announcing a strategic realignment, using the same press release (here) to announce it also expects fiscal 2012 revenue and earnings to be in line with analyst estimates. The news was a tacit admission that its current approach of offering its services with storefronts and software is far from optimized. With a 13 percent price drop, HRB now sports a P/E around 12 and a dividend yield over five percent.  The dividend looks sustainable from current levels of operating cash flow.

My quick impressions of HRB is that it is a much despised stock with a relatively new management team attempting to escape the reputation established by their predecessors. The business also has a sullied reputation given its long association with tax refund anticipation loans (a practice akin to issuing usurious payday advance loans). Without question, it is in turnaround mode. Its business peaked in 2004 when it generated over $1 billion in operating income, but it was not able to sustain that level of earnings. Earnings have been pretty bumpy ever since. 

This appears to be the first piece of first-order bad news in some time.

Well, we're adding HRB to the Shleifer Watchlist. The next big piece of news seems to be Q4 and FY 2012 earnings announcement that is scheduled for June 26 (see the calendar here). We'll watch with anticipation and try to spend some more time with the business beforehand in case it an overreaction opportunity presents itself.

Wednesday, April 25, 2012

Walmart (WMT): More Thoughts on NY Times Allegations

As considered here, the allegations of Walmart violating the US Foreign Corrupt Practices Act (FCPA) presents an interesting opportunity to watch the Shleifer Effect in play. 

It's about three days since the news broke. The market reaction has remained pretty tame with Walmart down about 6.5 percent (to about $58) from its Friday close. True, that's $15 or so billion in value disappeared, but that's for a company sporting a $200+ billion market cap. And while it puts WMT near its lows for this calendar year, let's remember that Mr. Market was pretty down on the business just several months ago when it traded below $50 per share. A 6.5 percent drop is big for a single day, but it's not beyond the sort of fluctuating price range most fundamental investors might expect from Mr. Market's typical fickleness.  Per the Shleifer Effect, it doesn't seem to indicate a wholesale change in the way most investors view the business. In other words, it would be hard to argue that the news has stoked an overreaction bias.

When considering the Shleifer Effect, not all news is created equal. Let's say there are two categories of news. You have first order news, the kind that suggests to owners that their thesis for investing might be wrong and a new (negative) trend might be taking hold. This information might say that sales are slipping or expenses increasing or the market is not as strong as hoped or competition has an edge...basically, anything that gives the investor reason to believe the earnings trend points down instead of up. 

First order news is more likely to generate a change in "conservativeness bias", creating a belief in a new trend taking hold, and instigating an overreaction.

I would suggest that first order news is either a.) a story or piece of information that gives the market sufficient reason to believe that earnings will be affected or,  b.) earnings themselves coming in below expectations.

Then there is second order news. While this might be salacious or disturbing, it's ambiguous about how or whether it affects the actual prospects of the business. Investors take notice of it, but they don't necessarily change their views on the prospects of the business itself.

The NY Times story seems to be second order news when it comes to the Shleifer Effect. It has certainly grabbed people's attention, but the market response (so far) suggests investors are willing to wait to see whether the alleged FCPA violations actually affect Walmart's business fundamentals in a meaningful way.


As a current investor, my initial thoughts on the potential impact of the news are as follows (in order of magnitude):

1. Walmart's International Growth Suffers

Not only will corporate management become entangled in the legal and PR aspects of managing this crisis, but the in-the-trenches guys will be considering their own practices in a different light.

As suggested in this Business Week article (here), Walmart has relied heavily on its international division to produce earnings growth while US performance has been sluggish for a few years. I can easily see a scenario in which international managers go into CYA mode, becoming so conservative in their business practices that they sacrifice growth opportunities. 

Let's hope that the Mexico thing represents the extreme version of international managers pushing the envelope in the name of growth. But I have no doubt that plenty of other managers are aggressive, stepping deep into the gray zone of ethics as they attempt to hit ambitious expansion targets. 

I think it's reasonable to expect that executives throughout the corporation perform a quick review and start slashing practices that might attract any attention from investigators that start poking around, no matter if they're illegal...if it's in the gray zone, it's out. This could affect the number of new store openings, a critical driver of growth.

I don't think we would know anything more about this until we read Walmart's announcements on the performance of its various divisions. So, we wait and see...

2. Walmart's Senior Management Goes Through Widespread Shake-Up

The NY Times article claims that many of Walmart's senior executives were made aware of the activities in Mexico and elected to cover up the problem rather than self-report to the Department of Justice.  It implies CEO Mike Duke, who had management responsibilities over Mexico operations in his role at the time, was briefed on the violations. 

(Somehow Doug MacMillon, current CEO of Walmart International, escaped mention in the article. That's a little baffling especially given his rising star within the company.)

If true, it's hard to see the current regime of executives surviving the investigation. Walmart is under the firm control of the Walton children (who have nearly 50 percent ownership and much more say than all other investors), and I don't see them allowing a wide assault on the reputation of their business without going to the bench to promote a new group of managers.

Expect a shake-up with ensuing disruption. While I'm inclined to want continuity in operations and management (give their strategies a chance to develop), I suspect the Waltons and other investors would not be heart-broken to see the current regime leave. Their performance has not exactly been stellar, most notably when it comes to U.S. same store sales growth, a division that Eduardo Castro-Wright attempted to overhaul after he was promoted from Mexico to run the U.S. (Castro-Wright failed in this attempt and was demoted in 2010 in favor of Bill Simon.) 

The shake-up would likely create optimism for the stock provided Walmart has the right managers in waiting that are both immunized from the scandal and capable up stepping-up.  

3. Walmart Is Punished and Subjected to Historic FCPA Violation Fines

Here is the area where we can expect the greatest speculation. Business Insider has already put together a scenario (here) in which Walmart would have to pay out a fine in excess of $13 billion. 

I have no relevant experience here to make even an educated guess at how this plays out with the DOJ. But I'll try anyway. 

I think it's fair to assume that politics will get nasty and regulators will look for their pound of flesh, hoping to make an example out of Walmart. That being said, it's worth noting that the biggest penalty to date under FCPA has come from Siemen's AG at $1.6 billion. Perhaps Walmart would end up paying higher fines, but I would suspect the DOJ would get what it could and not risk trying to extract such a high penalty that it risks Walmart goes nuclear in fighting back. Would DOJ risk going for something too high and watching Walmart choose litigation over settlement? I would assume they are reasonable and get the guaranteed money for the US Treasury.

Still, what's the effect? First, the process is likely to take a long time (as noted below by Mike Koehler of FCPA Professor in his thoughts here on what we might expect for Walmart's near future as a result of these allegations): 

...the information revealed in the Times article is likely to be a long and costly exercise for Wal-Mart and certain of its executives. Wal-Mart’s statement over the weekend indicated that it already is conducting a world-wide review of its operations and such “where else” investigations frequently uncover additional problematic conduct...This world-wide review will take time and for this reason FCPA scrutiny of the type that Wal-Mart is currently under is likely to last 2-4 years. 
Second, the fine will be a one-time thing. With Walmart losing $15 billion in market value, one could easily argue that investors have already accounted for its penalty (and then some). That's wishful thinking, of course. But with $24 billion in net cash provided by operations last year, we can feel safe that even a large penalty doesn't threaten the ongoing health of Walmart.

It's hard to imagine that a one-time event that might happen two or more years in the future can be properly discounted now. However, when expectations about its price tag get more settled, it is the sort of thing that could create a short-term hit to Walmart's price. We'll watch it then.


And so we call the NY Times story second order news. It puts everyone on alert, and it probably means most investors will be paying a lot more attention to Walmart's earnings announcement over the next several months to see how/if the Mexico scandal is bleeding into operations in a broader way. 

We will continue thinking about our own investment in WMT, watching those earnings carefully to see if they produce a Shleifer Effect overreaction and create another buying opportunity for long-term investors.

Tuesday, April 24, 2012

Thoughts On Success and Failure

Business Insider posted this today (here).

Not only is the path circuitous, but there is no point to suggest an end to the line. The arrow keeps pointing further (infinitely?) into the future. 

Two things comes to mind. 

First, people interested in developing deep skills in which ever vocation(s) they dedicate their time should spend some serious time with Cal Newport and his "career craftsman" philosophy. We do not stumble into our life's true love, unearthing hidden talent we never knew existed, and make a happy-ever-after career success story. Cal has built a strong case against the do-what-you-love-and-you'll-be-a-success fairy tale, eschewing it for guiding people (as a side gig only, he's a computer science professor) in how to work hard - very hard - to develop deep and narrow skills. 

According to Cal, we make a decision to get good at something. We work hard at it. We work smart at getting better. We carve niches for ourselves. Over years and years of hard work, we develop expertise. And this expertise, along with the hard work itself, can provide deep and abiding satisfaction. And if we're lucky, it provides a means for supporting oneself and the freedom to pursue one's interests as one sees fit.

A reasonable person might call that outcome success.

But, second, 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 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.

Monday, April 23, 2012

Walmart (WMT): Shleifer Effect Watchlist

Yesterday's NY Times reported here that Walmart employees have spent years bribing Mexican government officials to speed approvals to build new stores. If true, this would be in violation of the US Foreign Corrupt Practices Act (FCPA). Worse yet, the article claims senior Walmart executives (up to, and including, then CEO - and current board member - Lee Scott and then CEO of Walmart International - and current head honcho - Mike Duke and then CEO of Walmart de Mexico - and current, albeit outgoing, corporate Vice-Chairman Eduardo Castro-Wright) had been made aware of the practice and elected to treat it as an internal matter for its Mexican subsidiary to manage. In effect, they covered it up.

It's fair to assume that Walmart is in for a tumultuous months and potentially years of news reports. 

I own shares of Walmart, beginning my position in March 2011 and building it at an average price around $50. Be assured that I'm watching these events unfold with much anticipation both as an investor in the company and also as an observer fascinated by the dynamics this news will likely instigate. It's a fascinating test for the Shleifer Effect as a construct. 

Though I own it now, the current news warrants looking at it anew. Does it create price movement that overreacts to reasonably considered estimates of what happens to Walmart's fundamental business in the near future? Therefore, I'm adding it to the Shleifer Watchlist.


Let's start with the immediate market reaction to the news. The chart below shows a fairly muted response. WMT started trading about five percent down at today's opening. 

I wouldn't read too much into the first blush. Walmart has not exactly been the Wall Street darling over the past ten years. The stock has moved sideways for a decade, and over the past two years it has repeatedly reported earnings and growth below consensus estimates. Comparable US store sales have been a particular thorny point.  (See Sideways Action Deflates the Value Balloon.) To be blunt, expectations for Walmart have not been particularly high. While it traded as high as 40x its owner earnings in 2003, my last estimate had the current price sporting a 10x 2011 owner earnings. So, despite its 20+ percent rise since I purchased it, Walmart did not enter this PR crisis burdened with lofty expectations of its future.

So what we didn't see this morning was an absolute panic. I suspect that's because current owners might be the type that pay a bit more attention to the fundamental business of an investment. They didn't buy Walmart as a hot stock idea. They bought into the idea of the dominant retailer growing its earnings at an acceptable pace and using its tremendous cash flows to repurchase a lot of shares and continue paying a big dividend. 

If I'm correct, these investors will be assessing whether or not this news has impaired Walmart's ability to continue doing those things. They are, perhaps, spending some time trying to understand the ramifications of the news...specifically, what it means for Walmart's ability to keep generating cash to use for investor benefit.


Let's count this as a quick few thoughts to initiate Walmart on the Shleifer Effect watchlist. I'll spend some more time with it soon thinking through what it means to own shares of the company now and how that affects my decision whether to invest further if the price drops below the level where I've purchased WMT over the past year.

Stay tuned...

Saturday, April 21, 2012

Pricing Power Part I: Apple (AAPL) Demands a Premium

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. The following is the first of a (two part? three part) series on pricing power as a competitive business advantage. 


The ability to raise prices for your offerings, or demanding a premium over competitive products based on some perceived superiority of your offering, is an excellent indication that your business offers some form of competitive advantage. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must address some consumer want. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.


I can't stop thinking about Apple (AAPL) as an example. It is the clear leader in consumer electronics. It has created beautiful products with elegant simplicity and the content ecosystem that gives users reason to keep on using. It is a beloved brand. Iconic even. So it is no surprise that Apple charges a tremendous premium for its products and does so unflinchingly.

Apple rolls out innovation after innovation. One can easily be lulled into believing that this string of successes portends a trend that will go far into the future, that each new cycle of the iPhone and iPad will demonstrate another "wow!" and send consumers running to Apple stores to secure their upgrade.

But what happens if Apple disappoints? Sustained innovation - staying at the lead of this pack - is very, VERY difficult. Expectations are incredibly high (Shleifer Effect anyone?). Competitors are emulating the technology and it would seem they're narrowing Apple's lead with each product cycle.

And the competitors are eager to charge a lower price. Think Amazon. Think about selling Kindle Fire at a loss. Think of Kindle Fire getting just a little bit closer to the iPad with each new generation. Think how Amazon offers an equivalent content ecosystem to keep users using...but often at a cheaper price. Think how difficult it will be to get price sensitive consumers to justify paying that premium as Kindle Fire gets better and better. 

Apple will just lower its price, you might argue. Or it will offer a scaled back set of devices to compete with Amazon. They have plenty of margin to give and still be plenty profitable. Right?

Perhaps. but what does Apple lose in the process? Certainly the high ground of being a premium-only device provider; one that refuses to sacrifice quality; one that seeks the sublime in its designs. That is the sacrosanct brand of Apple, that which Steve Jobs dedicated a life to creating.  Changing it would be a substantial change to the culture of the company.  Indeed, a big change to its image of itself.

Were it to accept lower margins for its products, it also presents a revised economic model to its investors. Can we imagine investors reacting well to a product line with lower margins that likely cannibalizes its much more profitable existing product line? That certainly changes the earnings profile of the business.  One might easily argue that such a move would create additional new unit sales for Apple, generating more revenue by bringing in the price sensitive buyers who want iPods and iPads and iPhones but cannot afford them today. Perhaps. That is a plausible scenario. But I suspect that Apple will have a hard time dumbing down its products enough to make them price competitive with Kindles. This just goes against the DNA passed down from Jobs. And if Amazon is willing to sell Kindles at break-even or lower...


I suspect that Apple has painted itself into a corner. In no way is that comment meant to denigrate the company...its achievements are extraordinary; its products are remarkable. But from a competitive perspective and an investor perspective, I think it has a tough trail in front of it. I mean...

Customers have sky high expectations that each new release will make strides over the last. Apple must continue its track record of innovation (which is probably unmatched in the annals of consumer electronics) in perpetuity (or at the very least, only allow minor setbacks) to satisfy those high expectations.

This while carrying the banner of lead innovator, holding it high and proud for all the competition to see. This is hard! It's like holding the lead at the Tour de France. You cut into the wind for everyone behind you. They get the benefit of drafting. They can watch your every design move, tear apart each new release to learn how you did it, study your supply chain tactics...emulate your every move and pull closer to you with each cycle. 

That banner of innovation, and that grinding into the wind, gets harder and harder the longer you do it! The peloton drags you back in.

Finally, whether it comes from a lapse in innovation for a new product release or the decision to cut margins by moving downstream with a "value" product, earnings will suffer. And investors DO NOT suffer declining earnings happily. 

In light of how the market rewards Apples long string of record-breaking earnings - by giving it a multiple around 16 times its trailing results at a time when they should be at the height of their optimism - one must ask how investors react if these earnings slow down or shrink. (Actually, for the sake of the Shleifer Effect, it could present a good investing opportunity!)


So Apple is my example of a firm able to raise prices and/or charge a big premium. At the outset I suggest that we must inquire whether the advantage(s) that gives the company the ability to charge a premium is defensible and enduring. We must understand this in assessing the strength of its competitive advantage. 

I believe Apple's is based on continuous superior innovation leading to excellent products and brand cachet. If the innovation slips, its reputation becomes scarred and competitors will step in on short notice to fill any breech. And innovation is hard. What Apple has done to date is extraordinary. But at some point do the pressures cause them to revert to a mean? At some point, do they tire and stumble? Perhaps not. But I wouldn't bet on it.

Friday, April 20, 2012

Intuit (INTU): Entering Shleifer Effect Watchlist

Intuit, developer of Quickbooks, TurboTax and, announced today that its revenue might meet or fall below Wall Street expectations. Shares fell nearly five percent. (See a brief write-up from Bloomberg here and Intuit's release here.)

The chart below shows that the drop is big as a one-day event, but investors have demonstrated a lot of optimism about the company's prospects over the past year as the price has appreciated about 50 percent. As I posted yesterday, it's a dangerous thing to buy in on optimism.

I'll hold off on any analysis now and wait for the actual earnings announcement due in about a month. If we get more news that the investment community interprets as bad, perhaps we'll have a live one to pursue. For now, it's on the watchlist.

Thursday, April 19, 2012

No Extra Credit for Being a Contrarian

I'll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham's bi-polar Mr. Market, Sir John Templeton's suggestion to buy when there's blood in the streets, and even from Joel Greenblatt's magic formula for spotting strong businesses that are out of favor. 

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It's a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It's an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn't mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you'll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news. 

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We're looking for companies operating good businesses that happen to be misunderstood or unpopular.  

There is no extra credit for being contrarian. You must be right! 

“The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

Tuesday, April 17, 2012

Mattel (MAT): Entering Shleifer Effect Watchlist

The NY Times headline sums it up...In Season of Slow Toy Sales, Mattel’s Profit Plunges 53%. From that article...

Mattel said Monday that its first-quarter profit dropped 53 percent, pulled down by costs tied to an acquisition and lower sales for Barbie and Hot Wheels.
Results were below expectations and its shares fell more than 9 percent. But the disappointing results came in what is typically a slow time for toy sales, so Mattel executives said they remained optimistic.
This is the first real earnings miss or piece of bad news that has the potential for making a big impact on the way investors view the business. It's only a notice to pay attention, not a call to action. 

What are the potential outcomes? 

One, the business improves its results next quarter (or with some interim reporting period), investors cling to their previous view of the business (conservativeness heuristic), and the price stabilizes.

Two, the business reports another one or two periods of earnings trouble, investors change their view of the businesses future (a new representativeness heuristic) deciding that it's now in a down trend, and they overreact by selling off its shares...creating an opportunity to buy the business at a price below a reasonable estimate of its intrinsic value.

And the chart below shows the sell-off yesterday. The nine percent drop is significant as a one day decline on high volume. But the price investors are willing to pay for the stock has been heading up for several months now. There has been a sense of optimism about Mattel's future.

Some Thoughts On the Toy Business Model - Dependence on Blockbusters

I spent some time with Mattel and Hasbro in a few posts in January 2012 (here). I never completed the valuation of Hasbro (sorry), but the research highlighted some key characteristic of the toy industry. 

Toy sales are pretty volatile. Mattel and Hasbro have several brands they own outright. Mattel has Barbie, American Girl dolls, Hot Wheels, etc. Sales from these brands tend to be somewhat stable, smoothing out the ups and downs from the huge chunk of their business that depends on licensing entertainment-based brands. 

Here are a few big things to keep in mind about the entertainment brands...

One, there are not very many big ones out there. The biggies are Sesame Street, Star Wars, Marvel Comics, etc. They are very valuable to the intellectual property owners who want licensing partners that will generate a lot of revenue for them, obviously. 

Two, Hasbro and Mattel must bid against each other for the rights to make and sell toys based on the big brands. They pay guaranteed money and a portion of each revenue dollar to the brand owners. Their eagerness to win rights to the big brands creates an epidemic of the winner's curse in which there is a tendency to overpay in order to beat out your rival. Hasbro had a big problem with this several years ago after winning the Star Wars contract. Lucas Ltd. demanded major dollars upfront. Hasbro paid and then saw the popularity of Star Wars toys go on the decline as movie after movie saturated demand. They took a hit. 

Three, and this is the most important trait of the toy business to understand, the blockbuster element of toy sales creates peaks and valleys in sales and earnings. Sales and earnings don't creep onwards and upwards to a steady drumbeat. When a big movie hits, toys associated with that movie spike. Kids are fickle and tend to buy (rather, their parents and grandparents buy for them) the most popular items that all the other kids are buying. The toy companies must anticipate demand, design the right toys, and get them into retail channels in tight coordination with the movie release. So, when Transformers movies come out, Hasbro tends to kill it (especially since, in this case, they own that brand outright and don't have to pay licensing royalties). They'll sell a hundred million in a year. But then the brand popularity wanes when the movie goes away, and if Hasbro can't find something to replace it...sales and earnings tank the following year. 

The Shleifer Opportunity

And so here we are with Mattel showing a 50 percent drop on earnings over last year as Barbie (its own brand) shows weakness. This is not the first won't be the last time. It creates a trailing P/E of 14 after the nine percent drop in the stock price yesterday. Is that cheap? 


I'll add this to the Shleifer Effect watchlist, but given the volatility of the toy business I'll require two things to take Mattel seriously as in investment. 

First, it must drop significantly below its current price. Therefore, it's going to need more bad earnings reports to create the overreaction bias necessary to get investors selling.

Second, based on a price driven down by overreaction, I must see a clear and conservative path for Mattel earning profits that would easily exceed depressed expectations over the next few years. 

To be very clear, Mattel would not be a long-term holding for my portfolio. If the right confluence of events happen to justify an investment, it would be based on a tremendously cheap price that bakes in low expectations for future performance that Mattel would have little trouble exceeding based on conservative assumptions. I would sell after a new optimistic representativeness heuristic set in, causing overreaction to the upside. 

The Shleifer Effect Watchlist

Over the past few weeks I've begun working on some screens to help identify businesses experiencing some element of what I've come to call the "Shleifer Effect." In short, these are companies that have produced a string of results below investor and/or market expectations. The impact is a shift in current owners' expectations for future results (i.e., the trend will continue and the future will look like a worse version of the present) which produces an OVERREACTION in the form of a heavy sell-off and price drop. 

I'm really looking for two things. 

First, if I can uncover opportunities where the Shleifer Effect is already in play, that's the best. This is where the bad news is out in the open and the price has already been hammered over successive earnings reports. The overreaction had already set in and current investors have either stuck with it despite all the bad news (true long-term owners), or they've purchased their shares with the bad news in the open which potentially moderates their expectations of upcoming results.

Second, I'm trying to identify opportunities with developing Shleifer Effects. In other words, there is initial bad news/results but not yet enough to change investors' perception of the business and create an overreaction. I'll watch these to see how the market reacts as one earnings miss turns into two...three...four.

An important note: though these descriptions, and the use of charts, makes this seem like technical analysis, this is not really about timing a bottom. I'm still looking for good or great businesses whose models I understand (or can learn quickly) and whose economics are usually relatively stable...just not at the moment.  My ideal is to find an excellent business (a la, Costco, etc.) with clear competitive advantages and buy them as long-term holdings when the market punishes them for short-term outcomes. But I'm also open to investing in decent businesses (see Aeropostale) as medium-term (up to five years) when investors have overreacted in such a way that I can see a clear and conservative path to 15 percent annual returns with very little risk.

As discussed in this previous post about Thomson Reuters, using the Shleifer Effect as an investment screening strategy is about, as much as anything, interpretation arbitrage opportunities that can lead to time arbitrage opportunities.*

So, with that, I'll begin tracking existing and developing Shleifer Effect investment opportunities here. There is also a link on the blog homepage to see the spreadsheet.


*From the Thomson Reuters post referenced above:

Interpretation Arbitrage: Investors have interpreted declining earnings - and the resulting earnings misses - as bad news and reacted accordingly by changing their opinions on the firm's future and selling off shares. They've misinterpreted the financial information or news, creating an "interpretation arbitrage" opportunity.

Sometimes the EPS miss does not represent a change in the company's prospects. It can be random. It can be part of the grittiness of operating a business where you're just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow.

Time Arbitrage: Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings.

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.

Friday, April 13, 2012

Amazon (AMZN): Playing Offense or Defense? Part I. Kiva Robots

In the interest of writing time, I'm skipping over Parts G (Technical talent to extend market dominance over the burgeoning field of cloud computing) and H (More server hardware infrastructure to attract more cloud computing customers). So, we'll hit "I" below and then sum things up in a later post. 

I. Little (expensive!) orange robots that will drastically reduce the company's dependence on (expensive!) manpower (and air conditioning) over time?

When compared to companies like Walmart - frequently skewered by press critics and interest groups for all sorts of sins, fairly at times and overstated at others - Amazon has benefited from little critique of its business practices. But its growth and success has opened the gates to critics of all shapes and sizes, and much of what they hurl at Amazon is fair.

The big story from last summer came from a small newspaper in Pennsylvania that caught whiff of Amazon's stingy, almost Dickensian treatment of its warehouse workers in Allentown. As reported here, Amazon worked its people hard and in miserable conditions with little regard to their well-being. The story took the glean off the Amazon halo, bringing out more criticism. The title of this Mother Jones expose published in February 2012, I Was a Warehouse Wage Slave, says it all. And more recently, Amazon's backyard paper, the Seattle Times, has been running a series of articles called Behind the  Smile

I'm going to suspend any desire to rage against the Amazon machine here, looking at this instead through the dispassionate lens of a business owner. Put simply: Amazon has a labor problem that could cause grievous injury to its otherwise sublime brand perception with customers. 

In light of this, what would you do as Jeff Bezos et al. if presented with the opportunity to 1. introduce tremendous efficiencies into fulfillment center operations; 2. simultaneously reduce long-term costs; and 3. get rid of this pesky labor-cum-PR problem?

Enter Kiva Systems with its little orange robots.

Once again, I turn to for its insights. Scot Wingo, CEO of Amazon partner ChannelAdvisor, has working knowledge of both businesses and imagined the following dialog among logistics gurus at Amazon, Zappos and Quidsi (both Amazon subsidiaries uses Kiva robots) in a recent blog entry (link):

Amazon super-star DC operation manager: I heard you guys had a pretty efficient warehouse - we have been building and operating warehouses for 10yrs and we think we've got about every bit of juice squeezed out. Let me see your numbers.
Zappos super-star DC guy: Do you guys use robots? We do... Here are our numbers.
Amazon super DC guy: (long pause)....... This can't be right, you must have a different way of measuring everything. These numbers are more than double ours.

Quidsi super-star DC guy: weird, we have the same numbers as the zappos guys, but we are on version 4.2 of Kiva so ours are a bit better.
Amazon super DC guy: Ok, ok, but your labor has got to be twice ours or more, you guys running four shifts?
Zappos and Quidsi guys: Well, if you look at our cost/order it's X and our number of employees are actually 20% of yours.
Amazon super DC guy: (sheepishly) ummmm so tell me more about this Kiva robotic system again...
<10 days later>
Amazon super DC guy: (on phone with Kiva) Yes, how much would it cost to deploy this system in 50 domestic DCs and say 20-30 internationally? Ok, $5m/warehouse, ok.
Amazon super-DC guy: Mr. Bezos. You know every year we've been able to get 10% improvement on our DC metrics. Well, I figured out how we can double the productivity of our warehouses and significantly reduce our costs, but it's going to cost us $600m. I know that's a big number sir, but what if we don't have to build 20 more warehouses this year because of it? My calculations have the payback on this as less than 18 months.

Bezos: (after picking apart the numbers, touring Zappos/Quidsi and falling in love with some orange 'bots) Instead of licensing this, we should just buy the whole dang company, do you realize what a huge strategic advantage this would give us over everyone? Plus we can make our customers happier with fewer error rates and even deliver products faster than we do today. Think of it - one day delivery around the country powered by robots at a cost that is less than what our competitors pay for 3 day delivery!
(Insert Bezos laugh)

So Amazon ponies up $750 million to buy Kiva systems. Assuming the technology works as advertised by Scot Wingo, there are tremendous efficiency benefits that will ultimately improve order-to-delivery time for customers, decrease costs, get more throughput from each fulfillment center, and...

...Potentially allow Amazon to get rid of a lot of full-time and seasonal warehouse wage earners. If Wingo is correct, up to 80 percent of the workers will become redundant to the robots. These workers, while earning maybe $10-$15 an hour, are both an expense and a liability to the company. The expense side is obvious, but the longer term liability is the clincher. It's doubtful Amazon can continue paying low wages, contracting out for labor to avoid paying market rates and providing benefits, and being creative to prevent unionizing efforts from taking hold. To date, they've built warehouses in locations offering tax incentives, cheap rents, and cheap labor because the areas are desperate to create jobs for low-skill workers. It won't be like that forever. Eventually labor figures out how to organize, and that will complicate Amazon's operations and its goal to be low-cost, low-price.

The price tag is huge, but Amazon sees those little orange robots as game-changing. And based on my cursory analysis, I tend to agree.

Conclusion: Definitely a matter of leaning into investments in itself. This is Amazon playing offense with a bold, expensive bet.

Amazon (AMZN): Playing Offense or Defense? Part F. Kindle Fire

F. Devices like Kindles which encourage consumption of higher margin digital media as well as increased shopping on

Much has been written about the likelihood that Amazon is losing money on each individual Kindle Fire it sells. Estimates range from a few bucks to over $50 per unit.

The former assumption (from iSuppli and reported here at
According to iSuppli, a market research firm, the cost of the components required to build a Kindle Fire tablet – from the battery to the memory to the plastic shell – totals approximately $185. Add in manufacturing and assembly fees, and that figure rises to $201.70. That's $2.70 more than the $199 price tag on the Fire.

The latter - bigger loss - assumption (here) lead to fears such as this:
Assuming Amazon is able to sell 2.5 million tablets in the fourth quarter, Munster says the loss on each Kindle Fire could affect earnings by 10 percent to 20 percent.
Allow me to go heavy on the links in this edition of Playing Offense or Defense.  Forbes writer Eric Savitz wrote in January 2012 about an RBC analyst survey of 200 or so Kindle Fire users (link). What were their purchase patterns from Amazon once the Fire was in their palms?

“Our assumption is that AMZN could sell 3-4 million Kindle Fire units in Q4, and that those units are accretive to company-average operating margin within the first six months of ownership. Our analysis assigns a cumulative lifetime operating income per unit of $136, with a cumulative operating margin of over 20%. We believe these insights could ease some investor concerns around operating margin compression per Kindle Fire unit in 2012, which bodes well for Amazon shares.”
Other key findings were these:
Over 80% of Fire owners have purchased an e-book, and 58% had purchased more than three e-books within 15-60 days of buying the Fire. He estimates that customers will by 5 e-books per quarter. At a $10 ASP for the books, he says, that would mean $15 in e-book revenue per quarter.
66% of the survey group had purchased at least one app; 41% have purchased three or more. He assumes 3 apps per purchase per quarter, suggesting $9 in paid app revenue per Kindle Fire unit per quarter at above-company average operating margin.
72% of the sample had not used the Fire to buy physical goods on Of the 26% who had, a third said the purchases were incremental to what they would have purchased on the site otherwise. 51% increased their physical purchases on Amazon “slightly to significantly” because of owning the Kindle Fire.
In the name of conducting my own market research, I purchased a Kindle Fire for myself in March and combined the device with a Prime membership subscription (which I wrote about here). Here are some of my observations...

  • I quickly purchased a $20 Kindle Fire cover. Amazon puts tight controls over Kindle accessories, allowing others to manufacture and sell them, but the mothership gets a higher percentage of each of these transactions. I'll assume 25 percent. So, at $5 gross profit, Amazon already recouped the $2.70 loss estimate, but has a way to go if the true price to cost discrepancy is $50. No worries, Amazon. I'm still buying...
  • I've consumed a fair amount of paid digital content, including...two videos for my daughter to watch on a long car ride ($3.98), several MP3 songs for cloudplayer ($10.96), and one app ($1.99). At 20 a percent gross margin assumption (probably WAY underestimated for digital content), Amazon made another $3.40 off me.
  • I've accumulated $120 in "convenience" purchases that would have otherwise gone to Target (diapers and other such baby paraphernalia). Let's say they get 15 percent on those, there's another $18 in gross profit. (Though this is arguably more of a Prime Membership thing...I did order it using the Amazon app on the Kindle Fire.)
So, there we have $157 in incremental Amazon purchases that represents somewhere in the ballpark of $25 of gross profit for the company. Best case scenario, Bezos et al. made a profit off me within days of selling the Kindle Fire at a small loss. Worst case, they're about half way to breaking even while getting some very sticky fingers on my wallet. 

Conclusion: While none of this is scientific, I think it's fair to assume Amazon is accomplishing a major offensive victory by (potentially) taking a loss on the sell of each Kindle Fire by getting people like me more interested in exploring what else Amazon has to offer me. I continue to look for excuses to buy every day stuff from Amazon to avoid family trips to Target. Bad news for wife seems to concur!  

If Amazon is losing $50 per Kindle Fire, and these losses are multiplied across millions of Fires sold each quarter, I (as a potential investor) welcome the hit to earnings and the dissonance (a la the Shleifer Effect) it will create for short-term shareholders. While hopeful, I'm also skeptical of the big losses.

Amazon (AMZN): Playing Offense or Defense? Part E. Investing in Software

E. Software that makes buying easier, faster and more secure.

Excuse me for this, but I'm going to gloss over "E" and assume it's almost a given that Amazon benefits from and keeps its opponents on the defensive by investing in software that makes its services easier, faster, and more secure. 

Most of this expense falls under "Technology & Content" on the income statement, and it's clear the company sees it as an important to keep plowing cash into the category. From 2010 to 2011, its investment jumped 68 percent, going from $1.7 to $2.9 billion. It now gobbles up 6.1 percent of revenue compared to 5.1 percent the previous year and 4.3 percent the year before. I assume much of this comes from growing the cloud computing offering but that a good chunk is attributable to R&D efforts into the Kindle line of devices.

In the Overview portion of its 2011 10-K, Amazon says this about its Technology and Content expenses:
We expect spending in technology and content will increase over time as we add computer scientists, software engineers, and merchandising employees. We seek to efficiently invest in several areas of technology and content, including seller platforms, digital initiatives, and expansion of new and existing physical and digital product categories, as well as in technology infrastructure to enhance the customer experience, improve our process efficiencies, and support AWS.
We believe that advances in technology, specifically the speed and reduced cost of processing power, the improved consumer experience of the Internet outside of the workplace through lower-cost broadband service to the home, and the advances of wireless connectivity, will continue to improve the consumer experience on the Internet and increase its ubiquity in people’s lives. To best take advantage of these continued advances in technology, we are investing in initiatives to build and deploy innovative and efficient software and devices.
We are also investing in AWS, which provides technology services that give developers and enterprises of all sizes access to technology infrastructure that enables virtually any type of business.
Conclusion: It's critical that Amazon not rest on its laurels here, something that would be quite easy to do. It's lead over most other web retailing sites is's an advantage...and it's an offensive move to continue investing behind it.

Thursday, April 12, 2012

Thomson Reuters (TRI): Shleifer Effect & Interpretation Arbitrage (?)

Part of my screening process is seeking out companies whose investors have become captive to the Shleifer Effect, overreacting to ostensibly bad news to drive the stock price down. I use "ostensibly" because I'm looking for instances in which:  

A.) Interpretation Arbitrage

(Forgive my feeble attempts at coining a new phrase. I won't promise it will stick. I'll probably forget about it myself.)

Investors have interpreted declining earnings - and the resulting earnings misses - as bad news and reacted accordingly by changing their opinions on the firm's future and selling off shares. They've misinterpreted the financial information or news, creating an "interpretation arbitrage" opportunity. 

Sometimes the EPS miss does not represent a change in the company's prospects. It can be random. It can be part of the grittiness of operating a business where you're just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow. 


B.) Time Arbitrage

Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings. 

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.


Enter Thomson Reuters (TRI), the information and business news giant. By way of background, Thomson acquired Reuters in 2007 for a whopping $16 billion. This for $600 million in operating income, indicating this wasn't a merger made primarily for earnings considerations. This was a strategic move to combine content offerings in an attempt to create a more perfect set of products. It was designed for synergy, and it was intended to create a viable competitor for Bloomberg, L.P. in the lucrative markets for trading desk data and information. 

Investors greeted the strategy warmly despite the price tag. Thomson traded in a $40 to $50 range for some time. It collapsed to $20 per share in late-2008, and understandably so given the uncertainty surrounding financial institutions, a group that represented the lion's share of its customer base. It recovered back to the low-40s by early-2011, but has since been on a long slide to mid-20s. 

At this writing TRI trades at 28.50, creating a market cap of $23.6 billion on trailing earnings (excluding a huge non-cash write-off of $3 billion) of about $2.3 billion. That's 10x semi-normalized net earnings, which looks pretty cheap. Of course the company has been reinvesting upwards of $1 billion each year in capex, suggesting (in the roughest of calculations) that owner earnings are probably more like $1.3 billion.

Despite plenty of ups and downs, the stock price has not generated wealth for its investors since the acquisition. Indeed, long-term owners (in particular, the Thomson family which owns about 55 percent of the business) are suffering.

The stagnant price, in and of itself, could be enough to indicate an investment opportunity. The Thomson Reuter combination story is clearly out of favor with Wall Street. But more interesting to me is the heavy investment the company has been plowing into a product it calls Eikon.

Eikon is meant to be the culmination of the synergies between Thomson and Reuters...the ultimate justification for the expensive merger. (Take a look at the terminal/service here.) 

Joanna Pachner of Canadian Business put together an excellent overview of TRI's great hopes for Eikon in a February 2012 piece here. She writes:

The Eikon platform, which cost a billion dollars and took more than two years to build, gave users access to the two companies’ combined intelligence on one desktop—hundreds of news sources, research reports and analytical and trading tools that brokers, bankers and analysts rely on to weigh investments, assess risk and conduct transactions.
There's no question that TRI has leaned heavily into this investment. Both sales and earnings have suffered as a result. This has all the hallmarks of a Shleifer Effect opportunity. While revenue has grown year over year, reported earnings have declined each year since 2008. This creates a narrative for Wall Street of a business in a holding pattern (at best) or whose offerings are in decline (at worst).  As the Shleifer Effect describes, investors tend to see patterns in the earnings. Unless they have strong reason to believe otherwise, they interpret a down-sloped trend line to keep the same trajectory in the future. Owners sell. New buyers are loathe to come in. The long-suffering of shareholders tends to chase away all but the most entrenched interests. 

The great hopes for Eikon and the stability of the Thomson family 55 percent stake in the business have probably mitigated the effect somewhat. 

Eikon holds out a double-sided promise to expand operating margins from 18 percent to mid-20s. On the revenue side, it is meant to drive TRI into new markets with new clients. It's supposed to be so cutting edge and so easy to use, it will cast a halo on the company and the rest of its products, easing the growth path into new geographic markets and adjacent line expansions. 

On the expense side, it allows TRI to cut 200 expensive legacy systems with their equipment costs, maintenance, and separate silos for sales, customer service, etc. In its 2011 investor day presentation, TRI anticipates Eikon allowing it to consolidate from 172 data centers to six, from 19 delivery infrastructures to one, and from 1,600 developers to only 1,000. 

The ambitions are large. Each percentage improvement in operating margin is $130 million-plus increase in earnings. If TRI can accomplish its goals - successfully launch Eikon, realize the strategy behind the Reuters acquisition five years ago - the business should be much more valuable than Mr. Market gives it credit today.

Eikon creates a binary decision-making process on TRI as an investment. If Eikon succeeds, TRI will look cheap a few years out. But if Eikon fails, the Mr. Market has probably been too generous with his 18x market cap to owner earnings multiple.


Strategies that look so good in investor presentations, and whose numbers hold such great promise for enriching shareholders, are not implemented in a vacuum. No, companies must execute them in the live-fire world of resource constraints, operational hurdles, and constant competitive challenges.

In a previous life I was part of a software company that sat on a cash-cow of legacy products used by a couple hundred hospitals nationwide. The products were solid, but the limitations of the old technology meant there was little we could do to expand their functionality. And (even worse) the legacy platform was becoming passe. No one was buying the operating system anymore. We had a decision to make...milk the cow until it ran dry, or try to reinvent the business.

Given the ambitious management team, we chose the latter path. (The ambitious are prone to action even in the face of difficulty and often despite odds stacked wildly against them.) We transitioned to a new platform. First we called it ASP, then SaaS, now cloud-computing. Using the legacy features as our blueprint, we built several new products from scratch. They were a thing to behold! The latest. The greatest. We expected the market to beat a path to our door, demanding the products immediately and waving crisp dollar bills under our noses.

That didn't happen.

Well, at least we had our fallback. We would offer our existing legacy customers the opportunity to transition to the new products, revel in their benefits, and spout the benefits to the rest of the world. Well, they didn't want to change.

We were stuck. We went through a couple rounds of lay-offs. And then the president went for the hail-mary. He sunset the legacy products, announcing to the customers that they had 18 months to transition to the new platform before we stopped supporting the old. The gamble paid-off. Mostly. With much grumbling and gnashing of teeth (we heard the term "extortion" over and over again), we managed to swap over a little better than half of existing customers. We survived the loss of clients because we forced them to pay a premium for the new products.

What happened to the others? This is the most informative part of the story when thinking about introducing new technology products...while they would have continued paying us for years on the legacy products (inertia is a powerful force when dealing with IT buyers), when we forced them to make a decision they decided to open up their process to our competitors. And our competitors got fat and happy off the defections.

Lesson for all...heavy investments in technology upgrades are painful for everyone involved. Even if you think you're loved by your customers, pushing an upgrade (that requires new equipment, new training...just change in general, even if there is no additional cost) creates opportunity for your competition. In the enterprise software business, the long knives come out when a foe is pushing an upgrade or transitioning to new platforms. From a sales and marketing perspective, you know you can ramp up your prospecting when there is an opportunity to drive a wedge between a previously unbreakable bond between client and vendor.

Such is the reality that Thomson Reuters has faced with attempting to funnel hundreds of legacy applications into a single platform. One, there is the normal intransigence from existing clients around IT changes. And two, change gives those clients an opportunity to get cozy with the competition.


As measured by nearly all significant metrics, the Eikon launch has been a dud. This despite a two-year development effort, involving the work of some 2,000 programmers, a reported 1,000 client beta test, and a heavy marketing push through major financial media. 

The results? According to the Canadian Business article, nine months into the launch only 25,000 of TRI's 400,000 financial product users have transitioned to the new platform. Worst yet, only 3,500 new users have signed up. The CEO of the Eikon division left the company with several of his lieutenants. The company CEO, Tom Glocer, took over. Soon enough, he was shown the door. 

According to this article from July 2011...

...deployment of the platform has been marred by poor product integration, cumbersome technology, and a fragmented sales effort. One industry executive familiar with the company said that where co-operation over the implementation of Eikon had been required, there had instead been “territoriality”.

The Economist supplies this graph, comparing the market share of Thomson Reuters financial offerings versus those of Bloomberg. At the merger, TRI had a distinct advantage. But Bloomberg has closed that share at an astonishing rate. Indeed, Bloomberg defines the competitive environment into which Eikon is attempting its launch.

What has Bloomberg done during the Eikon launch? A lot. This is, I think, the most damning evidence against the long-term potential of Eikon competing against Bloomberg.

Computer World UK reported in February 2012 that Bloomberg dived into its own platform redesign...Bloomberg NEXT. The results versus TRI's attempt could hardly diverge more. Bloomberg spent a reported $100 million versus TRI's $1 billion. It programmers worked extensively with end-users, making sure to track their acceptance of changes and new features. It was an Apple-like design approach. Bloomberg moved some 100,000 of its 300,000 customers in the first few month and said it expected to move the rest by end of 2012. 

And Bloomberg isn't stopping there. Sensing a weakened opponent, it's pushing its advantage by going even deeper into markets that TRI has traditionally dominated. From the Canadian Business article: 

This month, Bloomberg launched another salvo across TR’s bow by unveiling a new tool that will let clients freely access information for which TR charges fees. The private company has said it expects its fiscal 2011 revenue to rise 11%, to $7.6 billion—a much steeper growth curve than the 2% Burton-Taylor projects for the industry. The two companies’ market-share trajectories sum up the momentum: both now have around 31%, but for Bloomberg, that’s up from 25% in 2005; TR is down from 37%.

I'll use two more quotes and then end this comparison between rivals. First, Bloomberg executives are displaying thinly veiled schadenfreude at TRI's troubles. Regarding NEXT, Tom Secunda (Bloomberg co-founder) states

Simplicity has tremendous value. A function that's brilliant and never used is worth zero...Our business model is that we keep our price fixed but we dramatically increase the value of our product. 
Second, the Candadian Business article winds up using this conclusion (apt, I think):

TR executives may be confronting a disheartening realization: that even a huge investment in state-of-the-art technology, which is in many ways superior to its main competition, may not be enough to reverse its slide and Bloomberg’s gains—“which goes to the core of how entrenched Bloomberg is,” says Aspesi. TR admitted last year, he says, that it doesn’t expect to regain the market share it’s lost any time soon. In what promises to be a very tough year in the financial markets, amid economic weakness and European instability, Thomson Reuters may have to significantly change its game plan. “The merger could not have made more sense,” sums up Taylor. “The strategy is still sound. But the tactical implementation just hasn’t worked.”

Using screens to identify investment candidates, Thomson Reuters showed some early promise. While somewhat cheap on a reported earnings basis, the company was clearly investing heavily in what it saw as a future franchise...Eikon. It just might be a Shleifer Effect interpretation arbitrage opportunity. For purpose of our assessment, the success or failure of Eikon really is the driver, creating a decision based on a very simplified question...

Do we have good reason to believe that Eikon will succeed, creating stronger earnings in the future, and protecting the business with a competitive advantage against the likes of Bloomberg?

From the evidence we collected, it seems the answer is "no." Reality might very well play out differently. Perhaps there's something going on behind the scenes that we just don't understand. Perhaps TRI is worth considerably more after another year or two of getting Eikon (and its other businesses) right. I'll accept that possibility while understanding that I don't see a clear, conservative path to it. The shallow competence I possess calls TRI a pass.