tag:blogger.com,1999:blog-46391182226549802292024-03-14T01:11:16.204-04:00Adjacent ProgressionEssays On Investing, Thinking & Continuous LearningUnknownnoreply@blogger.comBlogger89125tag:blogger.com,1999:blog-4639118222654980229.post-56942762486156973792012-09-19T14:31:00.002-04:002012-09-19T14:31:39.214-04:00We've Moved to PAULDRYDEN.CODear Readers, <div>
<br /></div>
<div>
I've been writing in too many different places, so I decided to consolidate everything into one website organized by a variety of topics that satisfy my far flung interests. <div>
<br /></div>
<div>
This morning I launched the eponymous <a href="http://pauldryden.co/">pauldryden.co</a>. (Why not ".com" you may ask. Because the "m" cost too damn much.) I've moved most of my content over there and it will henceforth be the gathering spot for all future posts. </div>
<div>
<br /></div>
<div>
I hope you choose to continue following my meandering thoughts there.</div>
</div>
<div>
<br /></div>
<div>
Many thanks, </div>
<div>
<br /></div>
<div>
Paul</div>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-65566612872273823902012-08-26T17:02:00.000-04:002012-08-27T11:30:04.286-04:00An Exchange on ROIC...the Key Measure of Profitability<blockquote class="tr_bq">
<i style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px;">Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.</i></blockquote>
<div style="text-align: justify;">
</div>
<div style="background-color: white; color: #444444; font-family: Arial, Tahoma, Helvetica, FreeSans, sans-serif; font-size: 13px; line-height: 18px; text-align: right;">
- Charlie Munger</div>
<div style="background-color: white; color: #444444; font-family: Arial, Tahoma, Helvetica, FreeSans, sans-serif; font-size: 13px; line-height: 18px; text-align: right;">
(as quoted on p.233 of <a href="http://www.amazon.com/Seeking-Wisdom-Darwin-Munger-Edition/dp/1578644283" style="color: #4d469c; text-decoration: none;">Seeking Wisdom: From Darwin to Munger</a> by Peter Bevelin)</div>
<div style="background-color: white; color: #444444; font-family: Arial, Tahoma, Helvetica, FreeSans, sans-serif; font-size: 13px; line-height: 18px; text-align: right;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="http://1.bp.blogspot.com/-o3uJ-AYphhc/T7ZSr7fyeII/AAAAAAAADVw/vpHJEm863u4/s1600/seeking+wisdom.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://1.bp.blogspot.com/-o3uJ-AYphhc/T7ZSr7fyeII/AAAAAAAADVw/vpHJEm863u4/s1600/seeking+wisdom.jpg" /></a></div>
<div style="background-color: white; color: #444444; font-family: Arial, Tahoma, Helvetica, FreeSans, sans-serif; font-size: 13px; line-height: 18px; text-align: right;">
<br /></div>
<br />
<div style="text-align: justify;">
<i style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px;"><br /></i></div>
<div style="text-align: justify;">
<span style="color: #222222; font-family: arial, sans-serif; font-size: x-small;">A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go...</span></div>
<div style="text-align: justify;">
<span style="color: #222222; font-family: arial, sans-serif; font-size: x-small;"><br /></span></div>
<br />
<div style="text-align: justify;">
<span style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px;">Hi Derek, </span></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
It's a Charlie Munger quote, and it's among the most important constructs for any long-term investor to understand. It goes to the heart of the return on invested capital (ROIC) portion of the economic model of a business. (See 3(d) of, "Does the economic model work?" from the<a href="http://adjacentprogression.blogspot.com/2012/08/the-mad-men-mba-4-part-framework-for.html" style="color: #1155cc;" target="_blank">Mad Men MBA 4-Part Framework for Really Understanding Companies</a>.) </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Consider this...a company has $1M of invested capital (equipment, buildings, accounts receivable, etc.) supporting its business. It earns $60K on that each year, meaning it sports a six percent ROIC. Tell yourself that $1M is cash in a savings account and the $60K is your interest on your principle. The concepts are the same. You can grow your overall interest earned (earnings) by putting more cash into that account (increasing its capital), but the rate of return remains the same...a lousy six percent.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
For the company, the earnings can go one of three ways in the future: 1. They decline; 2. They stagnate; or 3. They grow. What happens to those earnings is important, but it's most important in the context of what happens to that base of invested capital at the same time. Let's consider number three, where the earnings grow. (That tends to be the happiest scenario.)</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Say the earnings grow ten percent a year, going from $60K to $66K to $73K to $80K, etc. Ten percent growth seems pretty good, but we have to ask how much capital had to be invested in the business to generate that earnings growth. We must always look at earnings in the context of invested capital.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
If the invested capital stayed steady at $1M, you're looking at a rosy scenario in which a business doesn't have to add to its capital base to grow. That means it can probably pay out those earnings to shareholders without fear of losing its competitive position in the market and continue to compound its value. It started off earning 6% ROIC, but that number grows with each passing year (6.6%, 7.3%, 8%, etc.). </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
You won't find a lot of business like this. The vast, vast majority must plow back capital in order to increase earnings.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
How much is this business worth? That's up to the judgment of individual investors, each of whom must attempt to predict the future in terms of whether this growth rate continues. (Are the earnings protected by competitive advantage? That's number two on the <a href="http://adjacentprogression.blogspot.com/2012/08/the-mad-men-mba-4-part-framework-for.html" style="color: #1155cc;" target="_blank">Mad Men MBA framework</a>.) My threshold for an investment is a 15 percent yield. That means with earnings of $60K, I want to pay no more than $420K ($60K x about 7). But if I'm confident those earnings will continue growing at 10 percent, I might be willing to look, say, three years into the future, take that $80K in earnings and pay 7x that number (about $560K). But only if I'm confident that ten percent earnings growth (plus little additional capital reinvestment needs) continues deep into the future. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
That exercise is nothing more than an abbreviated form of discounted cash flow. Of course it's unlikely you'll find too many businesses with $1M invested in capital, earning only six percent ROIC, trading for a fraction of its capital. Someone would likely buy the whole company, liquidate it, and take the cash for a fast, hefty, and low-risk return.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
But what if earnings are growing at ten percent while invested capital is growing at 15 percent? Now the economic value of the business is being destroyed with each passing year. What would you pay for a business like this? Nothing! Unless you have the power to shut it down and cash it out. As a shareholder, you'll never get the benefit of those earnings because the business has to plow all of it back into property, equipment, accounts receivable, etc. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Munger's quote is really highlighting the famous dictum from Ben Graham's, "in the short run the market is a voting machine, but in the long run it is a weighing machine." In the short run, investors will have different opinions of the prospect for this business. The different views can lead to wildly different prices each is willing to pay, and that can lead to a lot of volatility in the stock price. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
But over the long run, the economic viability of a business (its ability to compound earnings at a rate AT LEAST equal to its need to reinvest capital) will define its price. That's the weighing machine. If it returns six percent ROIC, even if you buy it at a cheap price, you won't get much better than six percent returns over extended periods of time. If it returns 20 percent (and you think it might be able to keep that up for a while), you can buy it at almost any price and you'll do fine. 20 percent is a powerful rate for compounding any number if you give it enough years to do its compounding work! </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
To get a mathematical proof, create an spreadsheet. Start with $1M on the row A. This is invested capital. To its right, multiply it by whatever ROIC you expect the company to earn. Say 1.1 (10 percent) and push that out 19 more rows compounding at the same rate each year. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
On row B, start with $60K for earnings. To its right assign whatever multiple you want for its growth, and push that out 20 years. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
On row C, divide B by A and show it as a percentage. This is your ROIC.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Now, if you select variables in which the growth of the invested capital outpaces the growth of the earnings, you'll see the ROIC creep closer and closer to zero the more years you extend the simulation. The company is eating itself. It has no economic value.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
If you select variables in which the growth of earnings outpaces invested capital, you'll see those ROIC and earnings grow the further you push out the model. The business is creating economic value, and it's worth a lot more. </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
But it's far less about creating a mathematical proof, and much more about understanding the concept of return on invested capital. A proof might lead you down the path of seeking false precision; searching for that perfect screen that unearths all the best ROIC companies. I think of it more as a way of looking at the world of investment opportunities while thinking in terms of compounded earnings. The more a business can grow its earnings without reinvesting them (as capital) back into itself, the better its ROIC...the more it pays out to its investors (dividends or share repurchases) while continuing to compound.</div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Kind regards, </div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #222222; font-family: arial, sans-serif; font-size: 13px; text-align: justify;">
Paul</div>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-84017818790029957492012-08-23T08:54:00.003-04:002012-08-23T08:54:41.049-04:00Mad Men MBA - Heinz (HNZ) Case Study in Competitive Advantage<div class="separator" style="clear: both; text-align: center;">
<a href="http://4.bp.blogspot.com/-BcHEE8lMgNk/UC5jWrj9gsI/AAAAAAAAD-k/TaS2-ZeU2qk/s1600/Mad-men-title-card.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="http://4.bp.blogspot.com/-BcHEE8lMgNk/UC5jWrj9gsI/AAAAAAAAD-k/TaS2-ZeU2qk/s1600/Mad-men-title-card.jpg" /></a></div>
<div style="text-align: justify;">
<i>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 <a href="http://adjacentprogression.blogspot.com/2012/08/the-mad-men-mba-4-part-framework-for.html" target="_blank">here</a>. 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.</i></div>
<div style="text-align: justify;">
<i><br /></i></div>
<div style="text-align: justify;">
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, <i><a href="http://www.amctv.com/mad-men/videos/inside-episode-507-mad-men-at-the-codfish-ball" target="_blank">At the Codfish Ball</a>, </i>Jack 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.<br />
<br />
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. </div>
<br />
Doug sets up the case study in a recent email:<br />
<blockquote class="tr_bq" style="text-align: justify;">
<i>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.</i></blockquote>
<div style="text-align: justify;">
That was the 1960's, let's bring it back to the Heinz of today using our four-part framework for understanding businesses. </div>
<br />
<b><i>Competitive Advantages: </i></b><b style="text-align: justify;"><i>The Heinz Ketchup X-Factor</i></b><br />
<br />
<div style="text-align: justify;">
Competitive advantages serve to protect a company's earnings from attack by other businesses eager to steal their customers and their profits. The best companies are protected by advantages that intertwine around each other, creating greater protection in combination than any one of them could individually. Heinz is a clear beneficiary of the intertwining gestalt effect, distancing it from much cheaper catsup alternatives offered by Hunt's, Del Monte, and countless private labels offered by grocery stores. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We should start out with what we can only describe as an "X"-factor that protects Heinz's ketchup empire. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In his excellent 2004 <i>The New Yorker</i> article, "The Ketchup Conundrum"*, Malcolm Gladwell sits down with food-tasting specialists who describe how the human palate possesses some intrinsic attraction to flavors with a specific balance among salty, sweet, sour, bitter, and umami. If a particular food or drink strikes the right harmony - the specialists call it "high amplitude" - it keeps drawing consumers back for more. From Gladwell's article:</div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>When something is high in amplitude, all its constituent elements converge into a single gestalt. You can't isolate the elements of an iconic, high-amplitude flavor like Coca-Cola or Pepsi. But you can with one of those private label colas that you get in the supermarket...Some of the cheaper ketchups are the same way. Ketchup aficionados say that there's a disquieting unevenness to the tomato notes in Del Monte ketchup.</i></blockquote>
<div style="text-align: justify;">
Products with high amplitude resonate so much with consumers that they can eat more and more without ever seeming to grow tired of it. So businesses that somehow stumble upon the right formulation for achieving high amplitude - Coke, Pepsi, Heinz - have some sort of built-in advantage rooted deep in the physiology of the human taste buds. </div>
<br />
<div style="text-align: justify;">
This creates such consumer demand for Heinz ketchup that they pick it over the alternatives, pay more for it, and even favor restaurants that allow them to slather their burgers and fries with this particular Heinz condiment. The high amplitude has created a strong consumer preference, giving Heinz an opportunity to combine the flavor preference with an emotional attachment by investing heavily in creating a <b>brand</b>. Heinz has wisely exploited this opportunity, and it's effects are undeniable. It has created a preference so powerful that we can recount multiple experiences of sitting in a restaurant and watching as a waitress picks up one of those iconic glass Heinz bottles (surely a Don Draper recommendation) to refill it with a cheaper alternative like Hunt's. Ketchup counterfeits! The restaurant would only bother to do this if they knew customers had a strong preference for Heinz. It doesn't want to pay extra for carrying the premium brand, but it sure loves the benefits of the Heinz halo effect. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This high amplitude "X"-factor sounds like a pretty compelling competitive advantage. But it doesn't operate in a vacuum. As we explored in a previous article, <a href="http://adjacentprogression.blogspot.com/2012/07/scale-advantage-and-great-coke-scandal.html" target="_blank">Scale Advantage and the Great Coke Scandal</a> (where a secretary at the cola company tried to sell Coke's secrets to Pepsi), the success of even the most delectable of food and drink products are not born solely of taste. It creates demand, but the companies must work tirelessly to build additional advantages to fortify this consumer preference and brand. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Like Coke, Heinz has developed deep relationships with grocery stores and restaurants to get its ketchup on shelves and tables. That's distribution, a component of customer captivity or the <b>network effect</b>. If Heinz can tie up enough shelf-space with its ketchup, it doesn't leave much room for fresh alternatives to establish a toehold to compete. Heinz invests in this distribution network and guards it jealously. Any new entrant that Heinz deems viable that tries to get into the grocery stores will meet a ferocious counterattack to box it out. It's very, very hard to break through.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Finally, there's the <b>scale advantage </b>that allows Heinz to practice selective low-cost, low-price tactics. While it charges a premium over other ketchups, Heinz produces such an enormous amount of ketchup that it has all sorts of scale benefits. From buying tomatoes in massive volume, to running more throughput in its manufacturing facilities, to spreading its advertising budget over a much wider base of sales...each of these reduce Heinz's cost per unit of ketchup bottle produced. If push comes to shove and a competitive product tapped into its own "X"-factor (thereby threatening Heinz's market dominance), Heinz could - by virtue of its low-cost scale advantages - undercut the emerging threat. It could push them into a price war, and Heinz's scale advantages would provide it the ability to price its products lower for extended periods of time without threatening the survival of the company.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So we see that Heinz has intertwining advantages to protect those earnings from encroachment by competitors.</div>
<br />
<br />
Information sources:<br />
<br />
* Malcolm Gladwell's excellent 2004 article for the New Yorker, <i>The Ketchup Conundrum, </i>is available on his website: <a href="http://www.gladwell.com/2004/2004_09_06_a_ketchup.html">www.gladwell.com/2004/2004_09_06_a_ketchup.html</a>.<br />
<br />
** Information about Heinz business performance and history is pulled largely from the company websites, <a href="http://www.heinzketchup.com/">www.heinzketchup.com</a> and <a href="http://www.heinz.com/our-company/investor-relations/presentationswebcasts.aspx">www.heinz.com/our-company/investor-relations/presentationswebcasts.aspx</a>. We pulled from the company's strategic overview slides from a 5/24/2012 presentation available on the investor relations website.<br />
<br />Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-54635526666699384432012-08-17T11:51:00.001-04:002012-08-17T12:03:28.184-04:00The Mad Men MBA: A 4-Part Framework for Really Understanding Companies <a href="http://4.bp.blogspot.com/-BcHEE8lMgNk/UC5jWrj9gsI/AAAAAAAAD-k/TaS2-ZeU2qk/s1600/Mad-men-title-card.jpg" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="http://4.bp.blogspot.com/-BcHEE8lMgNk/UC5jWrj9gsI/AAAAAAAAD-k/TaS2-ZeU2qk/s1600/Mad-men-title-card.jpg" /></a><br />
<i><div style="text-align: justify;">
<i>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. </i></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>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. </i></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>For these purposes, I've dubbed it the Mad Men MBA, and below is the framework I proposed via email.</i></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>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 the Adjacent Progression. </i></div>
</i><br /><div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men...</div>
<div style="text-align: justify;">
<br /></div>
<b><div style="text-align: justify;">
<b>1. What is the nature of the company's earnings?</b></div>
</b><div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This question forces you to go to the heart of a company's prospects, asking hard questions about the demand for its products or services and the potential for growth. It also forces you to consider whether your starting point (the financial results of a given year) are an aberration from the norm or a signal that a new trend is taking effect. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Some businesses have <b>cyclical earnings</b> demonstrated by high peaks and low troughs of demand. This makes their earnings really high some years and really low others. Auto companies (the Jaguar discussion from Mad Men) tend to have cyclical ties to the economy. When it's good, they kill it. When it's bad, they have a hard time scaling back operations to meet the decline in demand...they hemorrhage money.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Some business depend on <b>blockbuster success</b>. Think movies, music, video games, even toys. They will have huge earnings in a year when they have a blockbuster seller, but then drop off precipitously if they can't produce another blockbuster. For movies, you have a lot of production companies working on the next hit, but a disproportionate amount of the money goes to only a handful of successes. Economist (and fitness guru) Art DeVany did some <a href="http://www.arthurdevany.com/articles/20100225">research</a> that demonstrated that it's virtually impossible to predict what movies will be huge successes and which will be bombs...even for the studios themselves. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
You have businesses whose earnings are <b>declining over time</b> because technology or habits have just passed them by. (Think GameStop...at some point even the most graphic intensive video games will be played via the internet - and probably on iPhones - rather than on consoles.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
You have businesses whose earnings <b>just stay the same</b>. They're neither growing or shrinking. They have their niche, they make a set profit from it, and they just keep plugging along.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And you have businesses whose earnings are <b>growing</b> over time. The growth companies. Either demand is increasing for their products/services, or they're expanding into adjacent markets, or they're raising prices to generate more profits, or they're reducing costs to generate more profits. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
(Also, see <a href="http://adjacentprogression.blogspot.com/2012/03/contemplation-on-owner-earnings.html">here for a discussion of Owner Earnings</a>, an incredibly important concept to understand as part of the framework.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>2. What competitive advantages exist to protect those earnings against foes trying to steal the company's customers?</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is the most important piece of the framework. In a free market, there is vicious competition for profit. And when a business pops up, demonstrating an ability to make tidy profits, it's only a matter of time before bigger, faster, smarter competitors start gunning for them. They will build similar products, they will undercut pricing, they will exclude them from distribution networks...anything to steal their customers and take those profits for themselves.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So, what <a href="http://adjacentprogression.blogspot.com/2012/06/competitive-advantages-umbrella.html">competitive advantage</a> (or "advantages" plural...the more it has, the better) does the business have that makes it difficult for bigger, faster, smarter competitors to steal customers? The four main categories are these:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>a. <a href="http://understandingamazon.blogspot.com/2012/08/why-is-price-ultimate-competitive.html">Low-Cost, Low-Price</a></b>. Think Southwest Airlines (or Amazon, or Costco). Customers prefer paying less instead of more. (So if you're charging a higher price than your competitor, you better give them a really good reason to pay more.) Companies possessing this competitive advantage usually have some sort of scale benefit from being large. They've passed that tipping point where they can produce more of a product and thereby do it for less on a per unit basis. The best of these are fanatical about keeping costs down and equally fanatical about passing the cost savings on to customers in the form of lowest prices (think <a href="http://adjacentprogression.blogspot.com/2011/09/walmart-wmt-part-three-benefits-of.html">Sam Walton</a>).</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>b. Network Effects/Customer Captivity</b>. It's a matter of making your product or service "sticky" so customers either can't or don't want to leave you. Facebook is the textbook example of this right now, and the case is made when you compare it to what Google is trying to accomplish with Google+. It's arguably a better service, but not enough people use it to get other people using it. Google can't pull people from Facebook because that's where all their friends are. And all their friends are there because all their friends are there. They're stuck! That makes it really hard for Google to make inroads.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
My favorite example, however, is online banking with their billpay features. I have stuck it out for way too long with a bank whose other services I can't stand because I didn't want to go through the hassle of switching my bills over. That's a sticky feature.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>c. Brand</b>. This is the hardest to define, but you tend to know it when you see it. The hallmark of a great brand is that have such an emotional connection to it that they'll pay a premium to buy the product over a competitor's offering that costs much less. Coke and Apple come to mind for consumer brands. IBM has a powerful brand in corporate IT. A great test of a brand is how well its products do when it gets serious competition from a lower priced competitor. There's a <a href="http://adjacentprogression.blogspot.com/2012/07/scale-advantage-and-great-coke-scandal.html">great case study</a> of Richard Branson trying to make Virgin Cola a legitimate contender against Coke and Pepsi. As we know, he failed. It's hard to take on established brands. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>d. Legal Protections</b>. It's always a nice advantage when the government tells your competitors they aren't allowed to go after your customers (legalized monopolies like local cable providers), or you have airtight patent protection for your product (pharma), or you have exclusive rights to an asset like FCC-managed bandwidth (local tv franchises). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The big debate about competitive advantage is how and whether innovation fits on here. It is, unquestionably, a competitive advantage. Apple is the best example. (See my previous write-ups <a href="http://understandingamazon.blogspot.com/2012/04/pricing-power-part-i-apple-aapl-demands.html">here</a>, <a href="http://understandingamazon.blogspot.com/2012/04/pricing-power-part-ii-lowering-price-as.html">here</a>, and <a href="http://understandingamazon.blogspot.com/2012/05/pricing-power-part-iii-amazoncom-as.html">here</a>.) They have a long string of innovation successes that have differentiated their products from the competition, allowed them to charge a premium, and made them amazingly profitable. But how durable is that advantage? Innovation is very, very hard to sustain over long periods of time. Competition will study your success, and they will eventually figure out how to do it. If your earnings depend on constant innovation (as tends to be the case in consumer electronics) - and you don't have other forms of competitive advantage protecting you - I don't call that a durable advantage. You'll stumble at some point. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>3. Does the economic model of the business work?</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is where you get more into the finance and accounting stuff. Basically, you want to know if the basic economics of the business make sense. The questions seem almost too elementary, but you have to ask them. If you're considering an investment in the business, you have to go through them like a check-list. They're critical. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>a. Gross Margin Model</b>. Does the company cover the costs of making the goods by the price it charges for them? i.e., Does its business allow it to create a gross profit? Again, elementary, right? Sure, but there are so many things you can learn by watching a company's gross margin. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For some early-stage and growing companies, sometimes they won't produce a gross margin despite having demand for their products. Their costs for acquiring and transporting materials might be too high, but it will go down as they hit scale and can procure raw materials in high volumes. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
A declining gross margin can show that a business is being attacked by the competition and must therefore reduce prices so it doesn't lose customers. It makes you ask the important questions about competitive advantage.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
An increasing gross margin might suggest that the company has some form of pricing power where it can raise prices without losing market share. Maybe its brand is just that good. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Gross margin is the highest line-item of profit on the income statement, and it's the one that can be least manipulated by accounting tricks. It's the pure one that can tell you a lot about what's happening with a business, so it's worth paying attention to.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>b. Operating Margin Model</b>. From the gross profit (above), a company will subtract its operating expenses (overhead, marketing, selling, etc.) to come up with an operating profit. What I'm looking for here is that the business can cover its operating expenses with the amount of gross profit it generates. For a mature business, this is the true sign of control over expenses. Discipline. It also gives you the first hint of what the company might have left over to reinvest in itself or to payout stakeholders (the government, owners of its debt, and then owners of its equity).</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>c. Net Margin Model</b>. This is the bottom line number. Though it should tell us what the business should have left over the payout to shareholders, accounting standards actually force us to spend time with the statement of cash flows and balance sheet to really figure out that number. Consider it a discussion for another long, boring email. Suffice it to say, the net margin model is really forcing us to look at required debt payments to see if it leaves anything over to pay equity owners. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>d. Return on Invested Capital Model</b>. I've left the most important - and least understood - one for last. It, too, would require its own lengthy discussion. While everyone spends their time frittering away on a-c above, they forget (or just don't know) that the true sign of economic viability is a company's ability to produce earnings in excess of the amount of capital that is invested in the business...and the amount of money that must be reinvested in the business over time so it can maintain its competitive position. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back to Mad Men and the Jaguar example...The nature of earnings for automobile companies tends to be cyclical, high in good economies and low in bad. When the economy is especially bad, car companies have a very hard time scaling back their operations (reducing costs) so they don't bleed out all the profits they accumulated in the good times. Scaling back, unfortunately, tends to mean laying off a lot of employees. That's why you have governments stepping in for bail-outs. They're far less interested in whether GM, Chrysler (or Jaguar in the 70s) survive as viable businesses and much more interested that 1. important union constituents aren't out of jobs and 2. that the unemployment of massive workforces won't lead to a ripple effect in the economy, making a vicious downward spiral. Those are important points to understand in terms of the nature of Jaguar's earnings.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For its return on invested capital model, the auto companies engage in high-stakes combat with each other that involves putting obscene amounts of capital to work in building and maintaining production lines in their factories. The constant competition led them to create new models for nearly all their cars every year, and to introduce brand new models every few years. Each time they do that, they must invest capital to change or completely overhaul their production lines. And these are HUGE investments that don't always create the most reliable returns. (Some car lines succeed, others are black holes.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That additional invested capital they plow back into the business would otherwise go to shareholders in the form of dividends or share buybacks or acquisitions that generate more earnings in the future. Instead, they must put all that money back in the business in a way that doesn't necessarily even create more earnings in the future. It's the worst kind of heavy capital reinvestment...the kind you must make just keep running in place, to stop competitors from taking market share from you.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Even while those car companies might produce a tidy profit in any given year, the brutal truth is that shareholders will probably see very little of it. The car companies must hold onto it (retained earnings) and reinvest it back into the business even though it won't necessarily make for bigger earnings in the future.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That's the nature of a capital intensive business. Over periods of several years, its return on invested capital model will demonstrate that it's not a very good place to invest money. Because you just don't get much of it back... </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
If a company can invest capital in itself and produce higher earnings as a result (and I mean higher than you think a reasonable investor could get by putting the cash into a safe investment somewhere else), than you're onto something good. That means it passes this measure of profitability. It can grow and create value in doing so. It will be worth more further down the line than it is now.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
If it invests money in itself while the earnings stay the same or shrink, it fails this test. It's probably not worth investing in. Hell, it's likely to be out of business before too long.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>4. (For investment purposes)...Does the price make sense?</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The three questions above help you establish whether or not the company is a high quality business. This last one tells you whether or not the business is worthy of your investment. Even the highest quality businesses (those with growing earnings, durable competitive advantages, and economic models that make sense) can be priced so high that they don't make sense as an investment. That happens all the time.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The price question forces you to combine elements of what you discovered answering all the questions above. In the end, the value of a company is roughly what cash you can expect to get out of it over the long-term. Once you estimate the value (and since it involves predicting the future using very complex variables, it's NEVER a precise number), you see if the market is offering the company to you at a price that's comfortably below that value.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>a. Flat Earnings</b>. If the framework questions demonstrate that the nature of the company's earnings are flat (neither growing nor shrinking), plus protected by some combination of competitive advantages, plus they don't have to reinvest tons of their earnings into keeping the company going (i.e., their economic models make sense)...then you've learned a lot and can probably make a good guess about its value and therefore what you should be willing to pay for it. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In the above scenario (flat but protected earnings), I would generally pay something around 7x earnings. These tend to be cash cow companies, and since the markets recognize them as steady and true producers of cash, they don't tend to have much fluctuation in the stock price. But because they're so predictable, they tend to fetch premiums above that 7x mark. You have to be patient and prepared to catch them trading for what you want.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>b. Shrinking Earnings</b>. If the framework demonstrates shrinking earnings, be very careful. All you know for sure is that the value of the company is in decline, but rarely will you know how quickly the decline happens. Think GameStop again. I'm an investor even though the business will necessarily shrink over time. How can that possibly make sense? Because the price of owning it is low when compared to what the company is paying me while it shrinks. It's market share is currently a bit over $2 billion. As of yesterday, it offers a 5.5% dividend and has committed essentially all the earnings/cash it generates over the next two years to paying dividends and buying back stock. It estimates that amount to be $2 billion, meaning if the stock price stays where it is...GameStop management says it will essentially buy back the whole company using its cash flow.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Except in situations like these, I shy away from shrinking earnings. Unless you REALLY know the company and its market, it's like trying to catch a falling knife...chances are good you'll cut yourself up when you grab it.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>c. Cyclicals and Blockbusters</b>. I tend to shy away from these unless I really understand the business, the industry, and the cycles in which they operate. The trick here is to have the discipline to only buy at a low point in the cycle or in a non-blockbuster year (but you anticipate - with good reason - that the company will produce more block busters in the future). Never, ever, ever buy at the high point of earnings. You'll overpay and get burned when the earnings drop.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>d. Growing Earnings</b>. A business with growing earnings, protected by durable competitive advantages, and with profitable economic models (especially when it comes to returns on invested capital) is the holy grail. These are the <a href="http://adjacentprogression.blogspot.com/2011/05/return-on-invested-capital-part-one.html">compounding machines</a> that take capital in, apply the eighth wonder of the world, and make that capital really grow. Most investors, naturally, want their money with these companies, and so they tend to be overpriced. Sometimes to ridiculous levels.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Take Amazon.com for a moment. Today the market values it at 240 per share. That's about 300 times its reported earnings over the previous 12 months. Ludicrous, right? Probably. I mean, you know I'm fascinated by this business. Its earnings will undoubtedly grow over time. (They're currently depressed because of all of Amazon's investments in growth.) It has low-cost, low-price, network, and brand competitive advantages protecting its earnings. It's hard to see someone being able to take those away. And its economic model is profitable, especially for returns on invested capital (despite the depressed earnings, it invests very little capital to create higher earnings). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But to pay 300 times earnings is a tough pill to swallow. It requires that you assume the current earnings will grow at a rate (and for an extended period of time) that very few large companies have ever accomplished. Not an impossible feat, mind you. But tough. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So here's my investing prime directive, a sub-heading of the "price question" in this framework... </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b><i>Never, EVER buy anything when the market is optimistic about its future prospects. Only buy in pessimism, and preferably in dark pessimism. </i></b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
(See the Buffett quote at the end of this <a href="http://adjacentprogression.blogspot.com/2012/04/no-extra-credit-for-being-contrarian.html">article</a>.) </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I still want high quality companies, but I want to buy them when the price is depressed. This creates a margin of safety for your investment. For <a href="http://www.understandingamazon.com/">Amazon</a>, people are very heady on that business right now. They understand its dominant position in web retailing, and they see how it's expanding its competitive advantages. But Amazon's earnings are bumpy. Not in a bad way, but in a way that's just natural for a fast-growth business. The market HATES bumpy earnings, and if it sees a couple of quarters of falling earnings it may decide that a downward trend is in play and quickly change from optimism from dark pessimism about its fortunes. When that happens, the stock tanks. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I'm on the sidelines of Amazon, knowing that <a href="http://understandingamazon.blogspot.com/2012/07/ebay-mr-market-and-amazons-q2-results.html">it will likely show a loss in next quarter's earnings report</a>, just waiting for the optimism to turn dark. When/if that happens, that current 300x earnings valuation will likely drop in breath-taking fashion. Which will create an buying opportunity for anyone that has studied the business and understands it according to the framework above...anyone who recognizes that its earnings will grow substantially over time, be protected from competitors, and show a nice return on invested capital. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But it takes a strong stomach to buy even the highest quality companies when the market says they're junk.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The best way to use the framework questions is to lay it on top of any company that you want to understand better, practice using it, and make sure to consider the questions in an intertwining (as opposed to "siloed") way. In other words, the answers to one question will help you better understand the answers to another question. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So, what's the next Mad Men case study?</div>
Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-11720871752478141342012-08-02T11:19:00.001-04:002012-08-02T11:19:27.390-04:00Why Is Price the Ultimate Competitive Advantage? (Playing Games)<br />
<div style="text-align: justify;">
<i style="background-color: white;">This is a shared post with understandingamazon.com (<a href="http://understandingamazon.blogspot.com/2012/08/why-is-price-ultimate-competitive.html" target="_blank">here</a>). Forgive the self-plagiarism, but I think you'll see how the idea is tied tightly with many of the investment ideas (especially the string of what actually makes for a competitive business advantage) discussed on Adjacent Progression.</i><br />
<i style="background-color: white;"><br /></i></div>
<div style="text-align: justify;">
<span style="background-color: white;">There are two forms of pricing power: the ability to raise prices and the ability to lower prices. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">The ability to raise prices for your offerings - demanding a premium over competitors’ products based on something you do better than they do - is an excellent indication that your business offers some form of competitive advantage. Otherwise you probably couldn’t charge a higher price. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must satisfy some consumer desire for functionality, novelty, or style. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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. And, of course, most advantages do go away with time. New fashion designs get mimicked, and the public’s taste for a particular style is fickle. Innovation in technology may provide a lead over the peloton of competitors for a while, but it has a tendency to figure out your tricks, duplicate your product features, and draw you back into the pack over time. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Most competitive advantages are decidedly NOT enduring. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">But when a company dedicates itself to offering the lowest prices (and maintaining a low cost structure to boot), it has a durable advantage that is very, very difficult to compete against. It is the ultimate competitive advantage, better than those that allow a business the ability to charge higher prices. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Why? </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Consider this statement attributed to David Glass, the former Walmart CEO: </span></div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white;"><i>We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will. *</i></span></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">To understand Glass’s point, we have to dabble a bit here in a rough (very rough) game theory scenario. (My apologies in advance to actual game theorists.) Let’s reduce the totality of competitive capitalism - that unrelenting tug-o-war among firms to gain the slightest of edge over rivals - to the following matrix (the Price-Cost Matrix) and assume that a company must fit into one of the squares. We’ll further assume that no company possesses an insurmountable competitive advantage over another. Any one company might stumble upon a popular fad that drives sales, or its engineers might cobble together a product whose innovation wows customers. But competitors will eventually figure out the advantage and replicate it. Again, the peloton sucks everyone back in. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">So, in this game, the only true differentiation, over the long-term, is price. Who can offer the lowest price?</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<br /></div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td><a href="http://2.bp.blogspot.com/-sxJBGONzT4g/UAg1jeYVIiI/AAAAAAAADw8/UzW85ur8iG4/s1600/Price+Matrix+C.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="192" src="http://2.bp.blogspot.com/-sxJBGONzT4g/UAg1jeYVIiI/AAAAAAAADw8/UzW85ur8iG4/s320/Price+Matrix+C.jpg" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="font-size: 13px;">Price-Cost Matrix</td></tr>
</tbody></table>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Your prices can either be high relative to competitors, or low. Same with your costs. So we get four possible combinations to define the companies: High Price, High Cost; Low Price, High Cost; High Price, Low Cost; and Low Price, Low Cost. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Conventional wisdom says you want to be in the top left hand quadrant (High Price, Low Cost) with the power to raise prices. That’s where the fat profit margins reside, that exalted place where you have low costs to acquire or produce your products yet can sell them with a big markup. Everyone loves profits. In fact I’d go so far as to say most people are blinded in their business decisions by an overwhelming <a href="http://adjacentprogression.blogspot.com/2012/06/profitability-bias.html" target="_blank">profitability bias</a>. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">The problem with profits is that competitors notice them. Nothing grabs more attention than high profits. And they’ll want a piece of the action. They’ll enter your market and go after your customers. And in this game scenario of ours, they’ll woo your customers with the offer of a better price. You get sucked into a price war. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">The game theory part of this exercise (and this is ultimately David Glass’ point) is this: you must extend any business competition to its furthest – and even most absurd – logical conclusion. If it’s a price war, you must imagine which player can engage in battle the longest and prevail. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">So let’s imagine it from the perspective of the game’s predator: Low Price, Low Cost. He will source his merchandise at the lowest possible cost, he will maintain the lowest possible overhead, and he will work with evangelical zeal to uncover inventive ways to make both even lower. Then, he will turn around and put a frighteningly slim markup on his items. He offers everything at the lowest price he can muster, and he keeps his costs below those of everyone else. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">He is a fanatic, and he has an insatiable appetite for growth. How do players in the other quadrants fare in a price war against Low Price, Low Cost?</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<br /></div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td><a href="http://4.bp.blogspot.com/-4iUbk7VKkOc/UAg2OOwOO0I/AAAAAAAADxE/_EHzHgIcc7E/s1600/PriceWar.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="192" src="http://4.bp.blogspot.com/-4iUbk7VKkOc/UAg2OOwOO0I/AAAAAAAADxE/_EHzHgIcc7E/s320/PriceWar.jpg" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="font-size: 13px;">Low Price, Low Cost Starts a Price War</td></tr>
</tbody></table>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">In our game, Low Price, Low Cost goes on the offensive. First, he attacks Low Price, High Cost. This skirmish is easy. Low Price, High Cost is a terrible business that’s stuck, for some reason, in the unenviable position of having to sell its products at a low price yet incapable of revising its cost structure. It’s limping along on tiny margins. All the predator must do is make his prices just a bit lower (enough that a price match would get rid of any remaining profits from Low Price, High Cost), and then wait it out as the wounded competitor goes out of business. It cannot afford to lower prices enough to compete, and so Low Price, Low Cost wins these customers. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Next is High Price, High Costs. This battle would be easier than the first, expect that High Price, High Costs has some cash on its balance sheet (from earning decent margins over the years) and is foolhardy enough to spend it on the fight. The predator makes his price dramatically lower, the prey tries to match, but in the end it must relent. Its high cost structure means it cannot afford to offer low prices for long. Low Price, Low Cost wins these customers. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Finally we have High Price, Low Cost. This is a long, drawn-out battle. High Price, Low Cost has plenty of cash to fight, having built deep reserves over the years from its fat profit margins. It price matches the predator, even ups the ante by lowering its own prices further and challenging the predator to match. It can afford this because its costs are so low. But over time its resolve is tested. It had grown used to that big margin (more importantly, its investors had grown accustomed to the profit). It tries to reinvent its culture to dedicate itself to low prices, too. Alas, cultures are very hard things to change. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">The competitors go back and forth on price, creating a war of attrition with both sides taking deep losses. But in the end, the predator remains fanatical about his cost structure. He lowers it more and more, and High Price, Low Cost just can’t keep up. It goes broke, perhaps just five percent before the predator would have. But that doesn’t matter in the end. At the end of the game, Low Price, Low Cost is the only player still standing. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">You may argue that this game is unrealistic. And, of course, it is. The practice of competition is much more nuanced than a hypothetical game. But history shows that, over time, the competitive advantages that protect businesses and allow them to earn high margins…well, they grow weaker as competition learns the secrets. In the long run, everything is commoditized. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">And in the light of this extreme game – one taken to its absurd logical conclusion - we can reconsider David Glass’ words: </span></div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white;"><i>We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will.</i> </span></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">The companies that want the most enduring competitive advantage commit themselves to staying in the bottom left quadrant in the Price-Cost Matrix, as far below and to the left of the competition as they can. To do it, they muster a fanatical devotion to staying low price and low cost. More on that next…</span><br />
<span style="background-color: white;"><br /></span><br />
<span style="background-color: white;"></span><br />
<div>
<span style="background-color: white;"><i>This is the fifth post in a series about Amazon's Feedback Loop, the mechanism most responsible for the company's success. See also the previous posts, <a href="http://understandingamazon.blogspot.com/2012/07/the-growth-levers-in-retail-price.html" target="_blank">The Growth Levers in Retail: Price, Selection, Convenience</a>; </i><span style="background-color: white;"><i><a href="http://understandingamazon.blogspot.com/2012/07/unlocking-broad-middle-hint-price-is-key.html" target="_blank">Unlocking the Broad Middle (Hint: Price Is the Key)</a>; </i></span><span style="background-color: white; text-align: -webkit-auto;"><i><a href="http://understandingamazon.blogspot.com/2012/07/sam-walton-panties-and-power-laws.html" target="_blank">Sam Walton, Panties and Power Laws</a>; and <a href="http://understandingamazon.blogspot.com/2012/07/the-productivity-loop-walmarts-feedback.html" target="_blank">The Productivity Loop (Walmart's Feedback Loop)</a>.</i></span></span></div>
<div>
<span style="background-color: white;"><br class="Apple-interchange-newline" /></span></div>
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="font-size: x-small;">* Quote from Charles Fishman's excellent <i><a href="http://www.walmarteffectbook.com/" target="_blank">The Wal-mart Effect</a></i>. </span></div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-76177793207916199732012-07-19T17:06:00.001-04:002012-07-20T07:02:46.522-04:00EBay, Mr. Market, and Amazon's Q2 Results<i>This is a shared post with <a href="http://understandingamazon.com/">understandingamazon.com</a></i><i style="background-color: white;">, re-posted here because of its obvious ties to the <a href="http://adjacentprogression.blogspot.com/2012/02/aeropostale-aro-part-three-behavioral.html" target="_blank">Shleifer Effect</a>, Mr. Market, <a href="http://adjacentprogression.blogspot.com/2012/06/profitability-bias.html" target="_blank">profitability bias</a>, and other investing concepts we discuss. </i><br />
<i style="background-color: white;"><br /></i><br />
<br />
<div style="text-align: justify;">
<br />
<div>
Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.<br />
<br />
Well, eBay plus lofty expectations that Amazon's current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market's reaction...let's just say it shows an interesting dynamic.<br />
<br />
<b>The eBay Angle</b><br />
<br />
eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo's always well-informed discussion of the results at eBay Strategies <a href="http://ebaystrategies.blogs.com/ebay_strategies/2012/07/deep-dive-into-ebays-strong-q2-2012-results.html" target="_blank">here</a>.) Mr. Market has pushed its price up over 10 percent on the day, touching - ever so briefly - its own 52-week high.<br />
<br />
One of those important Wall Street metrics is eBay's Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.<br />
<br />
So here comes Mr. Market's logic...<br />
<br />
Since Amazon has been crushing the e-commerce growth rate, outpacing it 2:1 with Q1 results in April when Amazon increased revenue 34 percent. And...with eBay showing it can match industry growth in the most recent quarter, then there must be some good tailwinds for e-commerce right now. Ergo...Amazon is going to kill it with Q2 results next Thursday! So let's bet on Amazon! </div>
<div>
<br />
Well, Mr. Market, you may be right. I'll grant that Amazon will probably outpace industry growth yet again. But what happens if earnings - once again - don't follow revenue growth? Moreover, what if earnings (gasp!) disappear altogether for Q2 as Amazon has suggested is a distinct possibility?<br />
<br />
<b>Going Back in Time (But Just a Little)</b><br />
<br />
Let's go back in time to look at Mr. Market's previous reactions to Amazon's earnings. We'll use some charts based on Wall Street analyst estimates of Amazon's performance (provided <a href="http://investing.businessweek.com/research/stocks/earnings/earnings.asp?ticker=AMZN:US" style="background-color: white;" target="_blank">here</a> <span style="background-color: white;">by Businessweek) and go backwards from most recent.</span><br />
<br />
Last quarter, Q1 results, Amazon surprised Mr. Market by earning .28 cents per share. This after his consensus estimate was .07. The stock shot up about 15 percent in the two trading sessions immediately following the news. It was the second such positive report, which leads us to...<br />
<br />
Q4 of 2011 Amazon reported .38 cents per share. Mr. Market has expected .18. A 110 percent upside surprise. The stock actually fell seven percent on the news. Maybe that's because Mr. Market still had not recuperated from the hangover caused by the previous quarter's different kind of surprise...<br />
<br />
In Q3 of 2011 Mr. Market had high hopes for Amazon. He was expecting .25 per share after Amazon had posted a hefty .41 cents per share in the previous period. He was hoping for the trend to continue, and in anticipation of it he had run up the stock price by about ten percent since the last earnings announcement. <span style="background-color: white;">Amazon only earned .14 cents per share. Mr. Market's great hopes were dashed, and he punished Amazon, sending its stock price plummeting from about $225 to about $200 within a couple days. It went as low as $173 before starting to climb back up again.</span><br />
<br />
Over this past year, Amazon has been nothing if not volatile. Google Finance is quick to highlight its 52-week range as 166.97 - 246.71. That's a wide spread, indicative of Mr. Market and this game of expectations he likes to play...and the bi-polar extremes that take over depending on whether Amazon has lived up to his expectations.<br />
<br />
<b style="background-color: white;">Q2 2012 and the Profitability Bias</b><br />
<br />
Well Mr. Market's expectations for next week's results are not too lofty. At least as conveyed by the consensus estimates. It's at .03 cents per share (though the range is quite wide: .17 cents on the high side and .23 LOSS on the low side).<br />
<br />
But the reaction today to eBay's results suggest to me that there exists loftier expectations than he's letting on to with the estimates. I think he secretly expects HUGE revenue numbers that will wow investors into paying even more for the privilege of owning shares.<br />
<br />
I wouldn't bet against that happening. But even if the big revenue numbers come in and earnings disappoint, this faith in Amazon's upward performance trend is going to be dashed. And Amazon losing money in Q2 is a very real possibility. (Its guidance from the <a href="http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-newsArticle&ID=1688177&highlight=" target="_blank">Q1 press release</a> said this: "Operating income (loss) is expected to be between $(260) million and $40 million, or between 229% decline and 80% decline compared with second quarter 2011.") <span style="background-color: white;">We know how heavily the company is investing in growth, and how willing it is to let those growth costs eat up profits. (See <i><a href="http://understandingamazon.blogspot.com/2012/06/amazons-rapid-sales-growthbuying-new.html" target="_blank">Amazon's Rapid Sales Growth...Buying the New Business</a>?</i>)</span><br />
<br />
So, even if revenue growth blows us away, losses tend to shake investors' faith. <span style="background-color: white;">Why? The <a href="http://www.blogger.com/goog_1454028459">p</a></span><span style="background-color: white;"><a href="http://adjacentprogression.blogspot.com/2012/06/profitability-bias.html" target="_blank">rofitability bias</a></span><span style="background-color: white;">. It's almost as if we have an instinctive visceral reaction to seeing losses in a business that was previously showing earnings. We just can't help but think more losses are coming, that there's something wrong with the company, and that the losses will extend into future quarters. We have very weak stomachs for these things. Even if we know the business has staying power, is investing heavily in initiatives to make even better profits in the future, or is just going through a temporary funk. We just get spooked. We overreact and send the price down.</span><br />
<span style="background-color: white;"><br /></span><br />
<span style="background-color: white;">That's the basis for the <a href="http://adjacentprogression.blogspot.com/2012/02/aeropostale-aro-part-three-behavioral.html" target="_blank">Shleifer Effect</a>. </span><br />
<br />
Note that I'm making no predictions for Amazon's results next week. I am, however, highlighting the appearance of high expectations combined with the POSSIBILITY (nothing more than that) of Amazon not satisfying those expectations. Plus, we've seen what happens to the stock price when Mr. Market's expectations are dashed.<br />
<br />
I'll end with this incredibly inappropriate teaser...<br />
<br />
Amazon finished today at 226.17. That's almost exactly where it was immediately prior to the Q3 2011 update when it disappointed and proceeded to fall to its year lows over the next three months.</div>
</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-36573470373372407352012-07-19T11:53:00.000-04:002012-07-19T11:53:00.979-04:00What Would You Buy If Price Didn't Matter? (Take Two)<br />
<div class="separator" style="clear: both; text-align: justify;">
Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you! Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. </div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
So, for anyone new or interested, I wanted to re-issue my thought challenge. </div>
<div class="separator" style="clear: both; text-align: left;">
<b style="text-align: justify;"><br /></b></div>
<div class="separator" style="clear: both; text-align: left;">
<b style="text-align: justify;">A Thought Challenge For Value Investors</b></div>
<div>
<div style="text-align: justify;">
<br />
Dear Fellow Value Investors:<br />
<br />
I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.<br />
<br />
This will all take place in a mythical market where there are <b>no prices</b>. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!<br />
<br />
Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.<br />
<br />
So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?<br />
<br />
<br />
The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...<br />
<br />
<br />
<b>1. Market Size</b>. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;<br />
<br />
<b>2. Competitive Advantage</b>. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);<br />
<br />
While putting the following control in place:<br />
<br />
<b>3. Economic Profitability</b>. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)<br />
<br />
<br />
<br />
What are your five companies and why do you think they can compound their earnings at such a high rate?<br />
<br />
Let me know your thoughts, and I'll keep a running update on the blog.<br />
<br />
Sincerely,<br />
<br />
Paul<br />
<br />
You can email me at pauldryden (at) gmail.<br />
<br /></div>
<div style="text-align: center;">
***</div>
<div style="text-align: justify;">
</div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
<i>Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.</i></div>
<div style="text-align: justify;">
</div>
</blockquote>
<blockquote class="tr_bq">
<div style="text-align: justify;">
- Charlie Munger</div>
<div style="text-align: justify;">
(as quoted on p.233 of <a href="http://www.amazon.com/Seeking-Wisdom-Darwin-Munger-Edition/dp/1578644283">Seeking Wisdom: From Darwin to Munger</a> by Peter Bevelin)</div>
</blockquote>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="http://1.bp.blogspot.com/-o3uJ-AYphhc/T7ZSr7fyeII/AAAAAAAADVw/vpHJEm863u4/s1600/seeking+wisdom.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://1.bp.blogspot.com/-o3uJ-AYphhc/T7ZSr7fyeII/AAAAAAAADVw/vpHJEm863u4/s1600/seeking+wisdom.jpg" /></a></div>
<div style="text-align: justify;">
<br class="Apple-interchange-newline" /></div>
</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-10071944090419693742012-07-16T10:20:00.001-04:002012-07-16T10:23:50.945-04:00Understanding Amazon...A Spin Off<div style="text-align: justify;">
First, a housekeeping note. I've been experimenting with the mysterious world of twitter. I'll confess it baffles me, but it also intrigues. If you're interested in my occasional twitter musings, feel free to connect with me at this handle: <a href="http://twitter.com/pauldryden" target="_blank">@pauldryden</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I've also put a box of tweet updates on the blog. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is a brave new world for me, folks. Be patient!</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Now, as many of you have noticed, my interest in the business of Amazon.com has turned into an obsession. But it's a healthy one. I think. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I don't want that to suck all the oxygen out of my other ideas and research exercises here on Adjacent Progression. Amazon-related posts now account for about a quarter of the content of this blog, and - for better or worse - there's a lot more coming. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So it's time for a spin off. New musings about Amazon will appear at this site, <a href="http://www.understandingamazon.com/">www.understandingamazon.com</a>. I've also put a link to it at the top right hand corner of the side navigation bar. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
My goal is to continue posting at Adjacent Progression two or three times a week on average. There remains plenty of material to wrap my brain around. And while the cardinal purpose of the blog continues to be about helping me develop my own thoughts (especially around investments), I hope the readers who have stumbled upon it will still find it useful, entertaining, frustrating, confounding...whatever those reasons are that keep you reading.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Why all the thinking about Amazon? In brief, it's a remarkable business (which I mean less in the adoring fan sense and more from the perspective of a - somewhat - neutral researcher willing to be impressed by the performance of his specimen). It's poised to do some transformational things in its various spheres of influence. I see it taking those models refined in its web retailing ventures, and applying them to a long string of new initiatives. And I think its likelihood of success in the new businesses is unusually high. I'll explore those concepts more on the new blog.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
From an investment perspective, I remain on the sidelines. The price is not right. Though I suspect it will be in the not so distant future. What is the right price? I have no idea the amount. The opportunity to buy will come less from a precise price and more from Mr. Market's attitude about the company. Today he is optimistic and excited. But because Amazon is investing so heavily in its growth opportunities - to a point where it could very well post a loss at some point in the next few quarters - and because those growth opportunities are hard to understand, I anticipate the current attitude will give way to overreaction on the downside. The sort of pessimism that, when attached to an outstanding business, gets my heart pumping.</div>
<br />
I'll revert back to this Warren Buffett quote previously posted under <a href="http://adjacentprogression.blogspot.com/2012/04/no-extra-credit-for-being-contrarian.html">No Extra Credit for Being a Contrarian</a>:<br />
<br />
<blockquote class="tr_bq">
<i>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.</i></blockquote>
I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait. <br />
<br />
<div style="text-align: justify;">
I hope you'll continue indulging my obsession by following the series at <a href="http://understandingamazon.com/" target="_blank">Understanding Amazon</a>.</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-42679745139054765492012-07-12T10:44:00.000-04:002012-07-12T10:44:00.264-04:00Re: Google vs. Your Boys (but really about amazon)<div style="text-align: justify;">
<span style="background-color: white;">We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later: <a href="http://online.wsj.com/article/SB10001424052702304058404577494952616126434.html?mod=dist_smartbrief">Google is coming</a>! [Links to WSJ article.] </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">Uh-oh, a threat to Amazon's AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I'm not. It's more because the challenges keeps me honest. </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">It reminds me of the verse from <a href="http://www.poemhunter.com/poem/if/">Rudyard Kipling's "If</a>": </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<blockquote class="tr_bq">
<span style="background-color: white;"><i>...If you can trust yourself when all men doubt you,</i></span></blockquote>
<blockquote class="tr_bq">
<i>But make allowance for their doubting, too...</i></blockquote>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">It's the only way to keep a kernel of intellectual integrity in his game of investing...look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It's possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a <a href="http://adjacentprogression.blogspot.com/2012/05/confirmation-marketplaces-and.html">confirmation marketplace</a>.</span></div>
<br />
Below is my reply to my good lunch friend:<br />
<div>
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">Thanks for passing this on, T. I'm fascinated by this impending convergence of the major tech giants. They're all sitting on these enormous and valuable assets, mainly large customer bases and some combination of tech gear, tech infrastructure, and customer captivity. As a sort of manifest destiny, they are all compelled to extend and expand the use of their infrastructure...those assets. It's inevitable, as if the combination of management ego and economic drive for higher profits, creates a siren's song for the businesses to expand. I've started calling it the <b>growth imperative</b>, a set of behaviors I've noted in other industries, too.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">So it becomes interesting with Amazon, Apple, Facebook, and Google. [See <a href="http://www.fastcompany.com/magazine/160/tech-wars-2012-amazon-apple-google-facebook">The Great Tech War of 2012</a> by Farhad Manjoo in Fast Company back in October 2012.] Their markets, as they expand, are overlapping more and more. They must compete, not only to grow, but also to make sure one of the competitors doesn't gain some advantage that allows them to attack their core markets....sort of like offense is the best defense.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">A theory I've considering works something like this: cloud computing is a huge market that Amazon entered early and has pretty much controlled. Amazon is taking great pains to commoditize the industry - making the services non-branded - so it will be defined by who can offer computing at the cheapest price to customers. Amazon has demonstrated its willingness to make AWS (its cloud computing) cheaper and cheaper, having lowered prices 20 times since launching. Jeff Bezos has thrown down a gauntlet and dared others - IBM, Microsoft, a slew of tiny players, and now Google - to follow. Amazon has said it will make it all about price.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">That creates a fascinating dynamic, and this is where the theory part kicks in. What company can afford to offer cloud computing the cheapest? Both Amazon and Google have deep cash reserves, so they can duke it out on low price there while subsidizing any losses with their own cash. That could be a painful war, and we must ask who would win.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">My bet would be with Amazon, and for a simple reason...Amazon has demonstrated both an indifference to how the stock market perceives it as it pursues long-term dominance of an industry, and it has demonstrated a capacity to suffer while its stock price is getting killed because it is losing money in pursuit of dominance. Jeff Bezos frequently says he's comfortable being misunderstood for long periods of time.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">So let's consider this like a game theory scenario...you have two giants pressing on the gas, hurling their dragsters at each other in a business that one of them (amazon) is willing to define by price. They will both take losses. The more they fight, the deeper those losses will be, and the more likely their stocks will tank as long as the war persists.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Jeff Bezos is fond of saying something to the effect of ..we want to sell the same thing as everyone else, but because we run more efficiently than they do, we can sell it cheaper. So if they want to have a price war, they'll go broke 5 percent before we do.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">He's signaled to the world his intentions and his willingness to be a fanatic in pursuit of them. Now, how crazy is google willing to be as it enters the cloud computing market? How deep is its capacity to suffer? And remember, there's a lot of catching up to do since Amazon has been in the market since 2006.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">In this game theory game of chicken, my vote is with crazy Jeff Bezos. That dude's a fanatic!</span></div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-36546332375039023192012-07-10T09:36:00.000-04:002012-07-10T09:36:56.201-04:00Fooled By Randomness and Shleifer Effect<div style="text-align: justify;">
In this my third reading of Taleb's Fooled By Randomness in the past five years, my attention is drawn to a section he calls <i>The Earnings Season: Fooled by the Results</i>. Its description (below) is reminiscent of (or prescient of) the <a href="http://adjacentprogression.blogspot.com/2012/02/aeropostale-aro-part-three-behavioral.html">Shleifer Effect</a>. It creates interesting questions about the model and how/whether it's tied to randomness.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I've already conceded (<a href="http://adjacentprogression.blogspot.com/2012/04/no-extra-credit-for-being-contrarian.html">here</a>) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb's book, I would assume his thoughts have influenced the Shleifer Effect as well.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
From pages 164-5:</div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting - stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. </i></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i>Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 "star" companies showing an increase in profits (assuming no inflation), and 5,000 "dogs." After three years, we will have 1,250 "stars." The stock review committee at the investment house will give your broker their names as "strong buys." He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.</i></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book <i>Inefficient Markets</i>, Andrei Shleifer's assumption seems to be that chance determines whether a company's earnings go up or down. He does not concern himself with <a href="http://adjacentprogression.blogspot.com/2012/06/competitive-advantages-umbrella.html">competitive advantages protecting profits</a>. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter. So it is chance. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I don't think that's his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.) The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That's Taleb's point here, too. I think. He constructs his cohort of 10,000 companies that "engage in all forms of volatile business." Perhaps I'm reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer's predicted overreaction. And it happens on the upside and the downside. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside...BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-38932253154439589752012-07-06T13:40:00.000-04:002012-07-06T13:40:59.707-04:00Amazon Entering Smartphone Game...Why?<div style="text-align: justify;">
Bloomberg reported this morning that Amazon has its own smartphone in development, that the company is working with Foxconn in China for production, and that it has actively been acquiring wireless technology-related patents in advance of the launch. See the story <a href="http://www.bloomberg.com/news/2012-07-06/amazon-said-to-plan-smartphone-to-vie-with-apple.html">here</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Even more so than its decision to challenge Apple's dominance of the tablet market by introducing the Kindle Fire, this move into smartphones is likely to leave a lot of consumers and investors scratching their heads. What business does Amazon - a web retailer - have getting into the phone market? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Let me take a stab at that...</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Convergence of the Tech Giants</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Though Jeff Bezos will deny it until he's blue in the face, this is a classic move of defense by playing offense. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There's a convergence going on in technology. Apple, Google, Facebook, and Amazon are quickly converging on the same base of customers. <span style="background-color: white;">To be sure, there is a growth imperative at play, too. Each of these companies has become accustomed to growing at a rapid clip, and each has the ambition (and gall) to believe it should continue growing. </span><span style="background-color: white;">And as each runs out of room to expand in its core markets, it will seek new growth by introducing services that poach customers from the other tech giants. The spheres in which they operate, once so placidly independent of each other, are beginning to overlap. If you put a Venn diagram of their markets on time-lapse video, the shaded areas of market overlap would grow darker and darker with each passing year. Convergence is happening.</span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">And in a converging marketplace, if you don't play offense by actively growing into your competitors' markets, you run the risk that they will grow into yours in the near future. Offense becomes the best form of defense. It compels you to grow, thus the growth "imperative."</span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">(To put this in the appropriate context, you should take a look at Farhad Manjoo's </span><a href="http://www.fastcompany.com/magazine/160/tech-wars-2012-amazon-apple-google-facebook" style="background-color: white;"><i>The Great Tech War of 2012</i></a><span style="background-color: white;">, published in Fast Company back in October 2012.)</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>An Aside on Google</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Google has been the most interesting case study for both the growth imperative and how a company reacts to convergence. <span style="background-color: white;">For the time being, Google is spinning like a dervish. It seems to believe it must compete with each of these giants...and NOW. Its rivalry with Facebook has been well-documented with Google+. (See James Whittaker's</span><span style="background-color: white;"> </span><i style="background-color: white;"><a href="http://blogs.msdn.com/b/jw_on_tech/archive/2012/03/13/why-i-left-google.aspx" target="_blank">Why I Left Google</a></i><span style="background-color: white;"> </span><span style="background-color: white;">blog entry.) That's a competition for the future of advertising dominance, and I think it makes sense.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What makes far less sense to me is Google's foray into retail with its "Prime" one-day delivery deal with bricks-and-mortar shops (see this <a href="http://blogs.wsj.com/digits/2011/12/01/delivery-plan-makes-google-more-foe-less-friend-to-amazon/" target="_blank">WSJ blog description</a> and the best overview from amazonstrategies.com <a href="http://www.amazonstrategies.com/2011/12/announcing-google-prime.html" target="_blank">here</a>). Google benefits from competition among lots of retailers selling the same products and bidding up adword search prices to get premier listing on the search engine. But with Amazon becoming the ubiquitous web retailer, more consumers are skipping Google altogether and just going straight to Amazon for searches. This is costly for the search engine. And so it goes on the offensive, putting its considerable clout (and resources) behind an attempt at a competitive retail offering.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
According to a Walter Isaacson (the Steve Jobs biographer) <a href="http://hbr.org/2012/04/the-real-leadership-lessons-of-steve-jobs/ar/1" target="_blank">HBR.org essay</a> back in April, Larry Page visited Jobs in his dying days looking for advice. Jobs asked him..."What are the five products you want to focus on? Get rid of the rest, because they’re dragging you down. They’re turning you into Microsoft. They’re causing you to turn out products that are adequate but not great.”...FOCUS! Isaacson credits Page with taking the advice to heart. I think there's plenty of evidence to the contrary.
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Amazon Devices to Prevent Apple iTunes Dominance</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But back to Amazon and the smartphones. Amazon dips its toes in the water a lot. It's <a href="http://www.wired.com/business/2012/04/ff_abtesting/">renown for its constant A/B testing</a> and its devotion to running with winning concepts while ditching the losers. So once it decides on a strategy, Bezos brings the company all-in. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In that regard, the smartphones can viewed as an extension of the reasons Amazon developed the Kindle Fire. A sizable chunk of its business is electronic media (songs, games, apps, movies, and books), and that media is being consumed more and more on mobile platforms. Apple gained an early lead in the market for those platforms with iPod, iPhone and iPad, creating a close-looped ecosystem of content to boot. Jobs and company might let others sell their content on iTunes, but they extracted a pound of flesh in return. This was problematic for Bezos and Amazon. To prevent total dominance by iOS, he had to present an alternative.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So we received the first iteration of Kindle Fire. But we know that electronic media is consumed on other devices as well, so it's only logical that Amazon continues its all-in philosophy to ensure it gets a piece of that action, too. I would expect more (and better) tablets in the future. I would expect better links into television sets (Amazon branded set-top boxes). I would expect music players. And I'm not surprised by the smartphones.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>So What Should We Anticipate from the Amazon Move?</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
First, lots of hiccups. We saw this with the early Kindles and with the Kindle Fire. It's unavoidable when entering a sophisticated new market with complicated electronic technology. Amazon was not a device manufacturer a few years ago, but it is nothing if not a learning organization. Expect it to build on its experience, constantly improve, and ruthlessly eliminate defects. So, hiccups at first, but Amazon will only get better. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Second, a low price. Amazon is committed to the low-margin/high-volume business model. It has the capacity to suffer, a willingness to take losses on the early batches of inventory while it grabs market share and improves its cost structure. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Third, potential volatility in its stock price. Going all-in on phones - while juggling lots of other growth initiatives simultaneously - has the potential to move Amazon from profits to losses. And Bezos is not afraid of letting his company lose money for a while if he believes it will pay off in the long-term. The market, however, will not take kindly to this. It's reasonable to anticipate bad financial press and a hit to its stock price if the company sports losses over multiple quarterly earnings reports. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Return of the Land Rush Metaphor</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In 2001 Bezos told Charlie Rose (<a href="http://adjacentprogression.blogspot.com/2012/05/everything-you-need-to-know-about.html">here</a>) that Amazon understood the early days of web retailing (especially 1998 through 2000) through the heuristic of a land rush metaphor. That era was also dominated by a growth imperative. If Amazon didn't move at an almost reckless pace to establish scaled operations, expand its product selection, and improve its technology, it risked another retailer - fueled by a steady stream of venture capital cash - converging on its markets and earning the trust (and the habits) of customers. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Bezos recognized the risk of being outflanked, so he engaged in the land rush. He bought into every niche retailer that sold a product that he thought Amazon might want to sell someday, better to bring your enemies close than let them flourish outside your control. He invested heavily in technology and distribution infrastructure. He priced his selection as aggressively as he could to attract customers. He bled cash, almost recklessly, because it kept Amazon in front of the pack and reduced the risk that another retailer could gain a toehold in its market. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That land rush mentality came from Bezos' survey of the landscape at the time telling him that a convergence was afoot then, too. We see what he did to ensure he came out of the convergence as the dominant power. Indeed, he came out of the dot-com bubble burst as the sole hegemonic power of web retailing. Despite the Amazon stock price falling from $106 to $6, despite losing countless hundreds of millions in equity investments in competing web retailers, and despite losing upwards of $500 million in personal fortune as the stock plummeted...the bursting of that bubble took all the outside cash out of the web retail industry. Everyone had to fend for themselves, and Amazon was the only one that could. Bezos did alright through it all.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
If he's reading the current technology situation with a mind to his experience in the early days of web retailing, I think we can expect him to turn to a page from his old playbook. He will compete ferociously, bordering on recklessness. He will lean heavily into his investments. He will play to dominate the markets. </div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-13761301127246507502012-07-06T11:24:00.000-04:002012-07-06T11:24:07.960-04:00Solon's Warning...More Thoughts On Success and Failure<div class="separator" style="clear: both; text-align: center;">
<a href="http://3.bp.blogspot.com/-Rgg3kdWytJg/T-sjL66SkRI/AAAAAAAADp0/j-An9Yd-KMU/s1600/fooled+by+randomness.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" src="http://3.bp.blogspot.com/-Rgg3kdWytJg/T-sjL66SkRI/AAAAAAAADp0/j-An9Yd-KMU/s1600/fooled+by+randomness.jpg" /></a></div>
<div style="text-align: justify;">
I'm re-reading Nassim Taleb's Fooled By Randomness. There are a handful of books I think worth revisiting every year or two to see how your refined understanding of the world - those things you've learned since reading it the last time - influence how you interpret it. It can become a measure of how you've matured in your learning quest. Taleb's book(s) belongs in that rarefied air.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I'm not sure what it means about my own intelligence or reading comprehension level, but it just seems fresh with each new pass. Like I'm reading it for the first time though this is my third time flipping through its well-worn pages.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This will not be a book report. I wanted to highlight a quote that appears before the first chapter and relate it back to a previous post here.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Solon's Warning</b></div>
<div>
<br /></div>
Taleb retells an apocryphal story from ancient Greece in which King Croesus (the richest man) is making a futile attempt to get Solon (the wisest man) to agree that the former's wealth and success mean he must be the happiest.<br />
<div>
<br /></div>
<div>
Solon responded:<br />
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white;"><i>The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyments, or to admire a man's happiness that may yet, in the course of time, suffer change. For the uncertain future has yet to come, with all variety of future; and him only to whom the divinity has [guaranteed] continued happiness until the end we may call happy.</i></span></blockquote>
<br />
These are the thoughts it inspires (mostly self-plagiarized from a <a href="http://adjacentprogression.blogspot.com/2012/04/thoughts-on-success-and-failure.html" target="_blank">previous post</a>):<br />
<br />
<div style="text-align: justify;">
<b>Thoughts on Success and Failure</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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?" </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">Such labels are meaningless. I'm reminded of Malcolm Gladwell's New Yorker profile of Nassim Taleb [ah, this is why these thoughts reconnect for me a few months later...neural synapses, funny things] several years ago. (Click here to read </span><a href="http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm" style="background-color: white;">Blowing Up: How Nassim Taleb Turned the Inevitability of Disaster Into an Investment Strategy</a><span style="background-color: white;">.) 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. </span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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. </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">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 </span><a href="http://www.noogenesis.com/pineapple/Taoist_Farmer.html" style="background-color: white;">source</a><span style="background-color: white;">):</span></div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq">
<i><span style="background-color: white;">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?"</span></i></blockquote>
<blockquote class="tr_bq">
<i><span style="background-color: white;">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?"</span></i></blockquote>
<blockquote class="tr_bq">
<i><span style="background-color: white;">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?"</span></i></blockquote>
<blockquote class="tr_bq">
<i><span style="background-color: white;">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.</span></i></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">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.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<span style="background-color: white;">So goes success, and so the path is circuitous and the arrow points forever further.</span></div>
</div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><b>Henry Blodget</b></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><b><br /></b></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">I'm hesitant to admit such a fascination with him, but after several posts quoting or featuring him, I must now confess a bit of an obsession with Henry Blodget. To refresh on his story, you may turn to Wikipedia <a href="http://en.wikipedia.org/wiki/Henry_Blodget" target="_blank">here</a>. </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
It helps to know the back story to understand the context of why he posted this image on his business news aggregator Business Insider back in April:</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="http://1.bp.blogspot.com/-DLaCGMTQrb8/T5acSGcOjEI/AAAAAAAADQ8/QSMkEIW4duo/s400/success-sketch.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="231" src="http://1.bp.blogspot.com/-DLaCGMTQrb8/T5acSGcOjEI/AAAAAAAADQ8/QSMkEIW4duo/s320/success-sketch.png" width="320" /></a></div>
<div style="text-align: justify;">
The grit required to stage a comeback (it's in process) after being laid so low is a much better story - a Greek tragedy reversed - than a straight line success story. </div>
<div style="text-align: justify;">
<br /></div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-66168843167598239102012-07-05T17:15:00.001-04:002012-07-05T17:15:16.706-04:00Nike Entering Shleifer Effect Watchlist<div class="separator" style="clear: both; text-align: center;">
<a href="http://4.bp.blogspot.com/-kklrg-3U72o/T_X-K5u1QuI/AAAAAAAADts/r1pmxHZbBZk/s1600/nike.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="155" src="http://4.bp.blogspot.com/-kklrg-3U72o/T_X-K5u1QuI/AAAAAAAADts/r1pmxHZbBZk/s320/nike.png" width="320" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
I'm catching up on some of my screens from last week, and I notice that Nike (NKE) took a big hit on news that it missed consensus earnings estimates by about 15 percent. The price dropped over nine percent on the news.</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
MarketWatch provides a news write-up <a href="http://articles.marketwatch.com/2012-06-29/industries/32466191_1_chief-executive-mark-parker-nike-market">here</a>. Revenue was up 12 percent for last quarter, but earnings dropped about eight percent. Costs went up, the company increased marketing spending in preparation for the London Olympics, orders from China dropped quite a bit, and it reduced it earnings growth guidance for the year.</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
Here are some of the analyst quotes pulled from MarketWatch article (mainly for entertainment purposes):</div>
<div class="separator" style="clear: both; text-align: justify;">
<br /></div>
<blockquote class="tr_bq">
It’s “a rare miss for Nike,” said UBS analyst Michael Binetti, who added he’s “disheartened to hear” that the company’s gross-margin recovery will be pushed out again after three straight quarters of missing its own targets.<br /> <br />“Nike becomes a much trickier stock from here,” according to ISI Group analyst Omar Saad. Sales “may no longer be enough for investors to overlook the company’s perplexing ongoing margin pressure.” Saad also said the margin miss makes him “a little concerned that this highly sophisticated, dominant, global consumer company does not have as good a handle on its costs as one would hope.”</blockquote>
<br /><div style="text-align: justify;">
<span style="background-color: white;">Nike is an incredible brand. An icon really. It's down about 20 percent from its 52-week high, but that $115 price was being fueled by a lot of optimism. It's now trading around 20x earnings trailing twelve month earnings. That's not cheap unless we think those earnings are depressed for some reason. A quick view of Morningstar data shows that Nike is actually near an all time earnings peak. </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><br /></span></div>
<div style="text-align: justify;">
<span style="background-color: white;">For now it's on the watchlist, but I would want to see some more healthy pessimism behind this before saying it's a prime Shleifer Opportunity.</span></div>
<br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br />Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-12367668624740088452012-07-02T10:53:00.000-04:002012-07-02T10:55:26.887-04:00Scale Advantage and The Great Coke Scandal<span style="background-color: white; text-align: justify;">Profits are good. And our <a href="http://adjacentprogression.blogspot.com/2012/06/profitability-bias.html">profitability bias</a> - that preference to own, to cover, to work for, to partner with companies that turn a profit - is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition. </span><br />
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It's not as if they don't recognize that everyone prefers they were profitable. It's that they understand that <a href="http://adjacentprogression.blogspot.com/2012/06/profits-as-marshmallows.html">delaying the gratification of immediate profits</a>, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Profits can be very nice, but they do not necessarily make for the best businesses. The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Of the major categories of competitive advantage - strong brand, legal protection, captive demand, and scale - the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>The Curious Case of the Coca-Cola Secretary</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke's most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Pepsi wasn't so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it's nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Coca-Cola's competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary's shop. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990's with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn't even get most grocery stores in his native UK to give his drinks a shot. When you can't gain entry through basic distribution channels, you must know your future is grim. Price doesn't even matter. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke's scale. As a last resort of scale, Coke could always fall back to its balance sheet - it has plenty of cash - and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola's most valuable secrets. In reality, Coke's competitive advantages are hidden in plain sight. A big piece resides with its brand...but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.</div>Unknownnoreply@blogger.com2tag:blogger.com,1999:blog-4639118222654980229.post-1133499610120865532012-06-28T12:27:00.000-04:002012-06-28T16:18:18.085-04:00Competitive Advantages - The Umbrella Categories<br />
<div style="text-align: justify;">
Sometimes it makes sense to deny the <a href="http://adjacentprogression.blogspot.com/2012/06/profitability-bias.html" target="_blank">profitability bias</a>, the investor's case of the <a href="http://adjacentprogression.blogspot.com/2012/06/profits-as-marshmallows.html" target="_blank">Marshmallow Test</a>, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For <b>brand</b>, 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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Bigger-smarter-richer companies could not replicate Apple's connection with customers. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For <b>legal protection</b>, 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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when <a href="http://www.businessweek.com/ap/financialnews/D9RNTN0O0.htm">its patents finally expired in November 2011</a>. 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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For <b>captive demand</b>, "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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Finally, we have <b>economies of scale</b>, 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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We'll dig more later on the benefits of scale...</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-54955074182312365852012-06-25T12:26:00.000-04:002012-06-25T12:26:00.079-04:00Profits As Marshmallows<br />
<div style="text-align: justify;">
Let's continue the thought from our last post regarding the <b>profitability bias</b>... </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer's 2009 article <a href="http://www.newyorker.com/reporting/2009/05/18/090518fa_fact_lehrer"><i>Don't </i>from <i>The New Yorker</i></a>. By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you've spent much time around young children, you'll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel's experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths - getting that immediate surge of sugar energy - even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Next, let's talk about what those competitive advantages are...</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-291346250942613092012-06-22T12:18:00.000-04:002012-06-22T12:18:00.256-04:00The Profitability Bias<br />
<div style="text-align: justify;">
When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a <b>profitability bias</b> in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there's money left over, it's a profitable company. And the bigger the profits, the better the company.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you're using a framework to understand and assess businesses, it's fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor. Your business suddenly looks less valuable as the profits from yesterday don't translate into profits tomorrow. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Enter the competitive advantage. That post is next...</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-45206096483228792732012-06-21T12:09:00.001-04:002012-06-21T16:29:28.579-04:00BBBY Entering Shleifer Effect Watchlist<div class="separator" style="clear: both; text-align: center;">
<a href="http://3.bp.blogspot.com/-IwnMqESxFGM/T-NAkwWRBNI/AAAAAAAADow/rkJVcNZUWHo/s1600/BBBY+chart.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="193" src="http://3.bp.blogspot.com/-IwnMqESxFGM/T-NAkwWRBNI/AAAAAAAADow/rkJVcNZUWHo/s400/BBBY+chart.png" width="400" /></a></div>
<br />
<div style="text-align: justify;">
The share price of Bed Bath & Beyond (BBBY) fell over 15 percent today, and this looks like a classic Shleifer Effect Watchlist opportunity.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
To net it out, expectations have been building (as we can see from the rising stock price above) for most of 2012. BBBY did pretty well during the economic downturn, and recovered faster than most people expected. In the meantime, they exceeded expectations for revenue and earnings growth, creating a halo effect for the company and its management. And creating even higher expectations.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And now those expectations have been crushed. Why did they miss? I'm not sure exactly, but I am sure that there's an overreaction in play when a company was valued near $18 billion yesterday and only $14.5 billion today despite net sales rising 5.5 percent, comparable store sales increasing three percent, and earnings actually going up 24 percent. But, alas, they missed consensus estimates and provided lower guidance for the next quarter than Mr. Market had hoped. So it tanked.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I've owned BBBY in the past. It's an interesting business - a category killer - though I've had a hard time understanding how they differentiate themselves enough to stop people from buying much of their core merchandise (linens) at Walmart or Target or online. Somehow they keep moving sales forward, due in no small part (I think) to a very permissive attitude toward promotions and returns. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
All that to say, the big drop has my attention, and I'm watching it. I don't count it among the companies that are so high quality (lots of growth, lots of barriers to entry, etc.) that I would buy them on any overreaction drop, but I'll watch to see if another bad news story leads to the kind of overreaction that's just too alluring to pass up. </div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-82995766073964828512012-06-18T15:28:00.000-04:002012-06-18T15:28:00.210-04:00Amazon Secrets Hiding In the Open<br />
<div style="text-align: justify;">
People continue saying Bezos is secretive, and I continue to contend that he simply hides his secrets in places where everyone can find them...but leaves the thinking part (to understand the secrets) up to them. The result? People continue saying Bezos is secretive.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Amazon provides a lot of information about how it works inside of its SEC filings. If you're interested in understanding what the business is doing over the long haul, the filings are very informative. If you're just eager to get a scoop on the next piece of technology, next partnership, or next earnings results...you're going to be disappointed. Bezos continues to be very hush on specifics.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here's a piece included in the 2011 10-K that provides a high level view into the strategy of running Amazon. </div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
<i><u>We seek to reduce our variable costs per unit and work to leverage our fixed costs</u>...Our fixed costs include the costs necessary to run our technology infrastructure and AWS; to build, enhance, and add features to our websites, our Kindle devices, and digital offerings; and to build and optimize our fulfillment centers. Variable costs generally change directly with sales volume, while fixed costs generally increase depending on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts available to us from suppliers, and reduce defects in our processes. To minimize growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.</i></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Very dry stuff, right? Yes, but in the appropriate context, it's incredibly meaningful. The first thing to understand - points driven home by Bezos on any interview that includes the topic of Amazon's business model - is that ecommerce is a scale business. (See what he said <a href="http://adjacentprogression.blogspot.com/2012/05/everything-you-need-to-know-about.html" target="_blank">here</a> in a 2001 Charlie Rose interview.) Businesses operating on small- or medium-scale cannot compete against those operating on a large-scale. Scale comes into play with the size and complexity of the software, the purchasing power of the business, the distribution capabilities (among other factors). These are fixed costs.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Growth is a tension between timing your increase in fixed costs (in a way that is necessarily messy as you increase headcount, expand your fulfillment centers, improve your software, etc.) with the additional profits those investments should bring. Proponents of Economic Value Add (EVA) insist that growth must show a quick return by way of earnings boost that demonstrates higher value added than the cost of the capital invested to generate it. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It makes me think of Yogi Berra's "In theory there's no difference between theory and practice. In practice there is." </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Messy growth requires extended time frames. That's not to let management off the hook. They still must make good decisions with allocating capital. But it would be plain silly to avoid investments that take several years to develop and mature if, at the end of the investment period, they provide strong returns and are protected by some sort of competitive advantage. That's the whole idea of having a franchise. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The interesting part of this comment in the 10-K is that it tells anyone willing to pay attention, exactly what happens as Amazon starts cleaning up the messy part of its growth. When it grows into a new geography or with a new category of products, Amazon does it with a mind to win customers. It builds selection quickly. It prices the products competitively. It uses sheer effort to make up for what it lacks in systems. It markets more heavily than usual, rewarding its affiliates with a higher percentage of sales for referrals. All of this to build the customer base quickly and help them create the habit of buying those specific products from Amazon. This is the messy part.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Then, as the main thrust of the growth subsides, Amazon circles back and cleans up the mess. Among the most important things it does is cozies up to product suppliers. Where it has been going through middlemen to source new products, it hammers out deals directly with the manufacturer to cut its price. Where it has been buying in small lots as it attempts to learn its customer's demand for products, it aggregates its purchases and demands better pricing for the higher volume. And then it just reduces defects.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When we look at the Amazon numbers, we must ask: what is hidden in the expenses? Amazon is that rare business that has long demonstrated an ability to grow customer demand as quickly as it expands its own capacity to service that demand. And if that growth is messy and costly (showing up in the expense category, thereby reducing earnings; or showing up on the balance sheet, thereby increasing invested capital)...just how profitable would this business be if it slowed down its growth?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I don't know the answer. It's probably impossible (even for Bezos) to come up with a precise response. But it's fair to say <a href="http://adjacentprogression.blogspot.com/2012/03/contemplation-on-owner-earnings.html" target="_blank">owner earnings</a> are much higher than reported earnings. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is why Amazon trades at such a high multiple to its earnings...a good chunk of its expenses are investments in growth. These value of these investments will compound with time, and those earnings will grow as a result. </div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-50530667442110560912012-06-14T15:54:00.000-04:002012-06-14T15:54:04.672-04:00Facebook, Henry Blodget & the Shleifer Effect<div style="text-align: justify;">
God bless Henry Blodget and his Business Insider concept. He's taken pieces from the Huffington Post and Gawker models and brought them to business media, a "journalism" market most would say is far too buttoned down for sensational style reporting. </div>
<div style="text-align: justify;">
<br />Well, it turns out business readers are just as big of suckers for tabloid headlines as any other group. I count myself in there, too. I confess to being an avid (perhaps too avid) follower of all Blodget posts on Business Insider. I'm not ashamed of it. The dude is smart and occasionally very insightful. (Following him on Twitter, however, will exhaust you. He can give the best teenage gossip girls a run for their money.) The piece he wrote for New York Magazine about Mark Zuckerberg, <a href="http://nymag.com/news/features/mark-zuckerberg-2012-5/" target="_blank"><i>The Maturation of the Billionaire Boy-Man</i></a>, was an impressive specimen of long form journalism. And he went deep on analysis and commentary (<a href="http://www.businessinsider.com/dear-facebook-investors-heres-what-mark-zuckerbergs-letter-really-means-2012-3?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+sai_henry_blodget+%28Silicon+Alley+Insider%3A+Henry+Blodget%29&utm_content=Google+Reader" target="_blank">here</a>) of Zuckerberg's letter to investors from Facebook's S-1 filing, to the benefit of anyone interested in understanding the CEO's motivations. Finally, he provided a sensible perspective on the whole sham of IPO pops with this article: <span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: left;"><a href="http://www.businessinsider.com/ipo-pops-2012-5#ixzz1xnZ0fV6r" target="_blank"><i>Everyone Who Thinks IPO "Pops" Are Good Has Been Brainwashed</i></a>. </span></div>
<div style="text-align: left;">
<span style="font-family: arial, helvetica, sans-serif; font-size: x-small;"><span style="line-height: 16px;"><br /></span></span></div>
<div style="text-align: justify;">
But you must take Blodget's approach with a grain (or two...or three) of salt. You must recognize that his purpose is to entertain as much (or more so) as it is to inform with a journalist's rigor. Blodget's job is to give his audience that fix of instant analysis, irrespective of whether the facts queue up in a straight line.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Since I bought shares of Facebook (write up <a href="http://adjacentprogression.blogspot.com/2012/05/facebook-fb-entering-shleifer-effect.html" target="_blank">here</a>), I've been particularly interested in his coverage there. It's been a fun ride. Let's do a quick re-cap...</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The latest was this story from the afternoon (caps are his): <i><a href="http://www.businessinsider.com/facebook-new-mobile-ads-2012-6?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+sai_henry_blodget+%28Silicon+Alley+Insider%3A+Henry+Blodget%29&utm_content=Google+Feedfetcher" target="_blank">GOOD NEWS FOR FACEBOOK: Big Advertiser Says Performance of New Mobile Ads Is Very Promising</a></i>. A positive news story, of course. But it's reversing course from his standing trend, as demonstrated by these headlines:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
</div>
<ul>
<li><a href="http://www.businessinsider.com/author/henry-blodget#ixzz1xnWtSR6e" style="font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: left;" target="_blank">DEAR FACEBOOK: It's Time To Build A Real Email System</a><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: left;"> (June 14, 2012)</span></li>
<li><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: left;"><a href="http://www.businessinsider.com/author/henry-blodget#ixzz1xnXBWILF" target="_blank">Here's How Facebook Is Hitting Up Small Companies Who Want To Reach People Who "Like" Them</a> (June 8, 2012)</span> </li>
<li><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: left;"><a href="http://www.businessinsider.com/author/henry-blodget#ixzz1xnXQq8UV" target="_blank">Well, We Just Asked A Bunch Of Big Advertisers What They Think Of Facebook Ads..</a>.(June 8, 2012)</span><a href="http://oascentral.businessinsider.com/RealMedia/ads/click_lx.ads/businessinsider/moneygame/post/549349597/Top1/default/empty.gif/726d474a4330397251725541437a715a?x" style="color: #1d637d; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px; text-align: center; text-decoration: none;" target="_top"><img alt="" border="0" height="1" src="http://imagec18.247realmedia.com/RealMedia/ads/Creatives/default/empty.gif" style="border: 0px;" width="1" /></a></li>
<li><span style="text-align: left;"><span style="font-family: arial, helvetica, sans-serif; font-size: x-small;"><span style="line-height: 16px;"></span><span style="background-color: white;"></span><span style="background-color: white;"></span></span><a href="http://www.businessinsider.com/facebook-stock-outlook-2012-6#ixzz1xnY038qg" target="_blank">Here's What The Smartest Investor I Know Thinks Will Happen To Facebook Stock</a> (June 1, 2012)</span></li>
<li><span style="text-align: left;"><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px;"><a href="http://www.businessinsider.com/facebook-payments-revenue-2012-5#ixzz1xnYZRgJY" target="_blank">Here's Another Concern For Facebook Investors--"Payments" Growth May Suddenly Flatten</a> (May 30, 2012)</span></span></li>
<li><span style="text-align: left;"><span style="font-family: arial, helvetica, sans-serif; font-size: x-small;"><span style="line-height: 16px;"><span style="background-color: white; font-size: 13px;"><a href="http://www.businessinsider.com/facebook-phone-is-a-bad-idea-2012-5#ixzz1xnYoSvA0" target="_blank">If Facebook Really Goes Into The Mobile Hardware Business, Investors Should Run Away Screaming</a> (May 27, 2012)</span></span></span></span></li>
<li><span style="text-align: left;"><span style="font-family: arial, helvetica, sans-serif; font-size: x-small;"><span style="line-height: 16px;"><span style="background-color: white; font-size: 13px;"><a href="http://www.businessinsider.com/author/henry-blodget?page=4#ixzz1xnZOHOml" target="_blank">BOMBSHELL: Facebook Bankers Secretly Cut Forecasts For Company In Middle Of IPO Roadshow</a> (May 22, 2012)</span></span></span></span></li>
<li><a href="http://www.businessinsider.com/facebook-stock-sale-2012-5">GREAT NEWS: Everyone Who Loved Facebook Last Week Can Now Buy It At 10%-15% Less!</a> (May 21, 2012)</li>
<li style="text-align: left;"><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px;"><a href="http://www.businessinsider.com/what-is-facebook-worth-2012-5" target="_blank">Well, Now That Everyone Has Sobered Up, Let's Figure Out What Facebook Is Actually Worth...</a>(May 21, 2012)</span></li>
<li style="text-align: left;"><span style="background-color: white; font-family: arial, helvetica, sans-serif; font-size: 13px; line-height: 16px;"><a href="http://www.businessinsider.com/muppets-facebook-hype-2012-5" target="_blank">Well Done, Muppets! Great Job Not Getting Sucked In By The Facebook Hype...</a>(May 18, 2012)</span></li>
<li><span style="background-color: white;"><a href="http://www.businessinsider.com/secrets-to-facebooks-success-2012-5">The 13 Secrets To Facebook's Success</a> (May 17, 2012)</span></li>
<li><span style="background-color: white;"><span style="font-family: arial, helvetica, sans-serif; font-size: x-small;"><span style="line-height: 16px;"><a href="http://www.businessinsider.com/facebook-ipo-price-2012-5" target="_blank">DEAR GIDDY FACEBOOK IPO BUYERS: Are We Looking At The Same Numbers?</a> (May 16, 2012)</span></span></span><span style="background-color: white; color: #222222; font-family: arial, helvetica, sans-serif; font-size: medium; line-height: 16px; text-align: left;"> </span></li>
</ul>
<div style="text-align: justify;">
Blodget is a one man Shleifer Effect machine! In the course of a month he takes us from enthusiast to depressive and back again, spinning the story each time for maximum attention-grabbing affect. That's his spiel, and I don't fault him for it. But I do see his hyperactive approach as a microcosm for what traditional financial media does, just much slower turnaround. Blodget cycles from mania to depression a few times a day, eager for the clicks and agnostic to what might generate them. Traditional financial media works in slower waves, but they're no less captivated by the prevailing mood and only slightly less eager to portray complex issues as absolutely bad or absolutely good.</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-13541148671949761682012-06-14T09:26:00.000-04:002012-06-14T09:26:00.171-04:00Amazon's Rapid Sales Growth...Buying the New Business?<br />
<div style="text-align: justify;">
<b>Sales, Gross Margin and Expense Infrastructure</b></div>
<div style="text-align: justify;">
</div>
<div style="text-align: justify;">
<br /></div>
<br />
<div style="text-align: justify;">
From Bezos' 1999 shareholder letter:</div>
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
<i>In part because of this infrastructure [having expanded its distribution capabilities by 300,000 square feet], we were able to grow revenue 90 percent in just three months...As far as we can determine, no other company has ever grown 90 percent in three months on a sales base of over $1 billion.</i></div>
</blockquote>
<br />
<div style="text-align: justify;">
And now, from the 2011 annual report:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
"North America sales growth rate was 43%, 46%, and 25% in 2011, 2010, and 2009...Increased unit sales were driven largely by our continued efforts to reduce prices for our customer, including from our shipping offers, by a large base of sales in faster growing categories such as electronics and other general merchandise, by increased in-stock inventory availability..."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That sort of growth would impressive for any small- or medium-sized business. That sort of growth would be impressive for a business that could scale with a very elastic infrastructure (like cloud computing). But for a business to grow at those rates when starting from a base of many billions ($19 billion to $25 billion to $34 billion to $48 billion) AND selling mostly physical goods that must be procured, stored, and shipped...It's absolutely unreal. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It brings a few thoughts to mind. First, it demonstrates how the demand for Amazon products outstrips its ability to satisfy customers willingness to do business with them. I can't think of any other example of a large business with the proven ability to grow like this. Every time they open a new product category or expand their geographical reach, they find welcoming customers that want to buy more. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is a testament to the tenets upon which the business built. Low price, widest selection, and good customer experience is a good place to go.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
My second thought anticipates what the critics have to say about the growth...<b>Amazon bought the growth</b>. It came at the expense of profitability with earnings dropping from $1,152 million to $631 million. It came from subsidizing shipping even more heavily. It came from every category of expense increasing as a percent of revenue: fulfillment up from 8.2 to 9.2%; marketing up from 2.9 to 3.5%; tech and content up from 4.4 to 5.4%; and even general and administrative is up from 1.1 to 1.2%. </div>
<br />
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
These are very fair criticisms. Let me address the fulfillment matter first. In 2011, Amazon's shipping revenue (charges for shipping) was $1,552 million while its costs were nearly $3,989 million for a net loss of $2,437. That's what Amazon pays to subsidize shipping for its customers. The subsidy increased by almost $1.2 billion from 2010. </div>
<br />
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Interesting to me, fulfillment is filed under Amazon's cost of sales. Despite all that extra money plowed into the fulfillment subsidy (read: a lot more Prime Members ordering a lot more stuff), Amazon's gross margins held steady around 22% for the third straight year. I interpret that to mean that Bezos and company like that 22% margin for now. It feels right to them. They've demonstrated the ability to make it better (and their process of shoring up their purchasing processes and reducing defects in their overall operations has to be reducing other pieces of their cost of sales), which leads me to believe they're practicing the art of off-setting. My guess is they're sticking to the 22% margin and giving back any cost off-sets by way of price reduction and subsidized fulfillment.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Note also that Walmart sports a 25% gross margin. Let's assume it marks up its products the same as Amazon - very little. That's makes for a surprisingly small difference in gross margin between the company that is not only considered world class in driving the meanest bargain for every item they buy from suppliers...but also buys upwards of ten times more merchandise than Amazon AND sells fare fewer individual SKU's than Amazon. Is it not surprising that such a higher volume of spend across fewer items of merchandise does not translate into a wider cushion of margin points over Amazon? Walmart should have huge advantages in buying costs over Amazon! I suspect the difference is made in distribution, with Walmart's need to get goods to its hundreds of distribution centers and many thousand stores being much more expensive than Amazon's costs to stock 70 fulfillment centers. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So, Amazon can afford to subsidize shipping without being too far from Walmart's cost structure. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The other criticisms about Amazon's expenses growing faster (in every category) than its revenue...they're fair, too. When revenue increases but profitability declines, our PROFITABILITY BIAS leads us to conclude that the company is just buying new business. It's lowering prices too much. Or marketing too hard. Or providing too many incentives like coupons. And that's not a sustainable economic model, right?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
That depends on the reasons the company is increasing expenses. I wrote extended series about the idea <a href="http://adjacentprogression.blogspot.com/2012/03/amazon-amzn-playing-offense-or-defense.html" target="_blank">here</a>, but it really boils down to this: if the company is increasing its expense infrastructure in a way that leverages its competitive advantages while turning the screws on the competition, there's no reason to look at the higher expenses as anything other than an investment in the future earnings of the business. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In that view, yes, it is buying new sales. But it's doing it in an intelligent way (e.g., encouraging shopping at Amazon as a habit), and that will pay dividends (literally) in the future.</div>
<div style="text-align: justify;">
<br /></div>
<br />
<span style="text-align: justify;">On the </span><a href="http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-audioarchives" style="text-align: justify;" target="_blank">Q4 earnings call</a><span style="text-align: justify;">, CFO Tom Szkutak made it clear that Amazon likes its investments in Prime, AWS, expanding its media content, and expanding its fulfillment infrastructure. All will continue in 2012 and beyond.</span><br />
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Growth and Earnings</b></div>
<div style="text-align: justify;">
<br /></div>
<br />
<div style="text-align: justify;">
A lot of people get nervous watching those Amazon earnings. While the revenue goes up, those earnings have not been on a predictable trend. This drives analysts and investors batty! We've discussed before how they have a mean PROFITABILITY BIAS when it comes to businesses, and therefore far too little patience with businesses investing for long-term growth. Why?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
2011 earnings $631M. Down from $1,152M in 2010. Which was up slightly from $902M in 2009. Which was up impressively from $645M in 2008.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And now Amazon is telling us that earnings might actually drop to zero or below in the next few quarters?! (See guidance from quarterly results reported <a href="http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-reportsOther" target="_blank">here</a>.) This drives them crazy.</div>
<br />Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-82736829743258783002012-06-12T12:17:00.000-04:002012-06-12T12:17:00.306-04:00Amazon's Sales Tax Issue<span style="text-align: justify;">From Amazon's 2011 10-K filing: </span><br />
<div style="text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>More than half our revenue is already earned in jurisdictions where we collect sales tax or its equivalents." [But new state taxes] "...could result in substantial tax liabilities, including for past sales, as well as penalties and interest.</i></blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This will be interesting to watch over time with Amazon. The sales tax issue has the potential to create a <a href="http://adjacentprogression.blogspot.com/2012/04/shleifer-effect-watchlist.html" target="_blank">Shleiffer Effect</a> flash point in that so few people understand what it means to Amazon's business if (once) they are required to collect sales tax in all U.S. states. There exists a sentiment that it will curtail demand for Amazon products since consumers will no longer get the benefit of a tax-free subsidy, raising the price of Amazon products compared to traditional retailers.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So when the tax issue finally hits, there's a good chance that it produces an overreaction, a load of negative press, and a falling stock price drops. In other words, classic Shleiffer Effect and a buying opportunity.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Amazon's strategy has been interesting. Nothing short, actually, of brilliant negotiating born of dividing your enemies state by state. And I think it will continue: fight state by state attempts to force Amazon to collect sales tax, pushing for federal legislation that provides a blanket approach to collecting sales tax from online retailers as opposed to a patchwork approach. This buys Amazon time, helps it influence any such federal legislation (especially because Amazon will want it to include an amnesty provision that protects it from any historical liability for uncollected taxes), and allows Amazon to strike opportunistic deals on a state by state basis in which it will agree to collect those taxes in exchange for building distribution centers there.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
One is reminded of old <a href="http://en.wikipedia.org/wiki/Br'er_Rabbit" target="_blank">Br'er Rabbit</a>. Please sir, please! Don't throw me into the brier patch! </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The coalition pushing so hard for Amazon to collect sales tax is likelyto get a mean taste of unintended consequences. When Amazon begins collecting in a state, it then has full liberty to build and run operations there as it sees fit. Its late-2011 <a href="http://www.bloomberg.com/news/2011-11-16/amazon-parts-with-ebay-to-lobby-for-streamlined-online-sales-tax.html" target="_blank">deal to collect taxes in California</a> allowed the company to immediately break ground on new distribution centers there, meaning it will soon be able to deliver its packages to San Diego, Los Angeles, and San Francisco much (MUCH) more quickly than before. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
These are huge and important markets for all retailers. I suspect Amazon had been serving them out of its Nevada and Washington fulfillment centers, and still getting pretty good two day turnarounds for delivery. The retailers pushing for the sales tax must now ask...what does it do to our business if Amazon can deliver packages overnight to our customers' doorsteps? What if having a dense network of fulfillment centers near these population centers means Amazon can deliver the same day?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Please, says Amazon, throw me into that sales tax brier patch.</div>
<br />Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-38186084951213888142012-06-08T09:42:00.000-04:002012-06-08T09:42:00.359-04:00The Most Significant Battle in Amazon History (Why Bezos Celebrated the Bubble Popping)<br />
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post <a href="http://adjacentprogression.blogspot.com/2012/05/everything-you-need-to-know-about.html" target="_blank">here</a>. (And you can watch the full broadcast of the video <a href="http://www.charlierose.com/view/interview/3056" style="-webkit-transition: color 0.3s; color: #009eb8; display: inline; outline: none; text-decoration: none;" target="_blank">here</a>.) </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
To remind you of the context, the interview corresponds with the steepest part of the dot-com collapse. Amazon's stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn't end until shortly after 9/11 when it hit a $6 bottom. Bezos own net worth dropped by half a billion dollars (reference <a href="http://news.cnet.com/Tech-chiefs-net-worth-takes-a-hit/2100-1017_3-803231.html" target="_blank">here</a>). </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
And yet Jeff Bezos was doing all he could to hide his ebullience. </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments. </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<div style="margin: 0px; outline: none; padding: 0px;">
Bezos had this to say about it with Charlie Rose:</div>
<blockquote class="tr_bq" style="color: black; font-family: 'Times New Roman'; font-size: medium; line-height: normal;">
<i>So all these companies could get funded. And that's what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time...many of those companies might have been able to build the scale to be successful.</i></blockquote>
</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. <b>Amazon invested in these businesses as a hedge.</b> Bezos was already working toward the lofty goal of being the <a href="http://adjacentprogression.blogspot.com/2011/06/overstockcom-ostk-part-five-thinking.html" target="_blank">ubiquitous force in online retail</a>...the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn't get there immediately. He had to prioritize where the company invested its money and time. So he adopted the <b>land rush mentality</b>, investing in a broad swath of developing web retailers in early stages of growth. </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
If the competitors could reach any sort of scale - with their software, merchandising expertise, and distribution capabilities - they could begin expanding into adjacencies. It didn't matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon's objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends.
</div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren't the ones we were going to do first...Pets.com, wine.com, etc....there were a bunch of things that we were invested in that didn't work out. We knew we weren't going to do those things anytime soon, but we wanted placeholders in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by...a land rush mentality...It's hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we...behaved that way.</i></blockquote>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
Then the crash came. The talking heads wanted to focus on Amazon's foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn't need Wall Street for more money, and you had scale.</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing. </div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>In the early days, that's when the company's destiny is really not in its own control. At this point in time, with the brand name that we have...we have so many assets now, now <b>it really is under our control</b>. <b>We don't worry about externalities now</b>. What we worry about now is that we don't do our job. And I'll tell you one of the things in this period that I kind of like is that it's a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn't lose.</i></blockquote>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
And this conclusion:</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<blockquote class="tr_bq">
<i><b>Charlie Rose</b>: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What's the odds of the first being true versus the second?</i></blockquote>
<blockquote class="tr_bq">
<i><b>Jeff Bezos</b>: Let's put it this way: we get to decide, nobody outside the company can decide that. </i></blockquote>
</div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
<br /></div>
<div style="background-color: white; color: #333333; font-family: 'Helvetica Neue Light', HelveticaNeue-Light, 'Helvetica Neue', Helvetica, Arial, sans-serif; font-size: 14px; line-height: 19px; margin: 0px; outline: none; padding: 0px; text-align: justify;">
Jeff Bezos was history's happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business...the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon's future.</div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-91422237042326990502012-06-07T16:14:00.000-04:002012-06-07T16:15:54.687-04:00FaberNovel's Facebook & Amazon PresentationFaberNovel did a thought provoking presentation on Amazon (<a href="http://www.slideshare.net/faberNovel/amazoncom-the-hidden-empire" target="_blank">Amazon.com: The Hidden Empire</a>) last year, and they followed it up this year with <a href="http://www.slideshare.net/faberNovel/facebook-the-perfect-startup" target="_blank">Facebook: The Perfect Startup</a>. Definitely worth reading both of these.<br />
<br />
<div style="width:425px" id="__ss_13120821"> <strong style="display:block;margin:12px 0 4px"><a href="http://www.slideshare.net/faberNovel/facebook-the-perfect-startup" title="Facebook, The Perfect Startup" target="_blank">Facebook, The Perfect Startup</a></strong> <iframe src="http://www.slideshare.net/slideshow/embed_code/13120821?rel=0" width="425" height="355" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" style="border:1px solid #CCC;border-width:1px 1px 0" allowfullscreen></iframe> <div style="padding:5px 0 12px"> View more presentations from <a href="http://www.slideshare.net/faberNovel" target="_blank">faberNovel</a> </div> </div>
<div style="width:425px" id="__ss_7928875"> <strong style="display:block;margin:12px 0 4px"><a href="http://www.slideshare.net/faberNovel/amazoncom-the-hidden-empire" title="Amazon.com: the Hidden Empire" target="_blank">Amazon.com: the Hidden Empire</a></strong> <iframe src="http://www.slideshare.net/slideshow/embed_code/7928875?rel=0" width="425" height="355" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" style="border:1px solid #CCC;border-width:1px 1px 0" allowfullscreen></iframe> <div style="padding:5px 0 12px"> View more presentations from <a href="http://www.slideshare.net/faberNovel" target="_blank">faberNovel</a> </div> </div>Unknownnoreply@blogger.com0tag:blogger.com,1999:blog-4639118222654980229.post-26942756260346143632012-06-06T12:30:00.000-04:002012-06-06T12:30:00.559-04:00The Amazon Credo (And Who Are the Middlemen Exactly?)<div class="tr_bq" style="text-align: justify;">
Here's an important note about the Amazon.com philosophy. The world is composed of three types of entities. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
First, you have <b>creators</b>. They write books. They invent things. They code software. They record music. They program video games. They manufacture products. These people and entities are the basic unit of innovation and productivity in the world. They are to be empowered.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Next, you have <b>customers, </b>the consumers of the output from creators<b>. </b>They are the buyers, the readers, the end-users, the watchers, the listeners, and the players. They are the core asset of Amazon. They are to be invested in. They are to be defended. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Finally, you have <b>middlemen</b>. These are the people and entities that stand between the creators and customers. Oftentimes they have a purpose. But when they become <b>gatekeepers</b> that prevent access to the market by creators...or when they become <b>toll-takers, </b>charging fees to creators or customers in excess of the value they generate, they are the enemy of Amazon. They are to be disintermediated.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Amazon operates on a pretty straightforward credo. It goes something like this:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>Fidelity to the customer; Fraternity with the creators; and Contempt for the Middlemen. </i> </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Amazon's fidelity to the customer is a thing of legend. At the moment, I don't think it requires much additional commentary. Things get more interesting as you think about the company's approach to the other two players. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Fraternity with the creators is an intensely interesting topic when thinking about Amazon. It's steeped in the passions of CEO Jeff Bezos. Here's a remark he made in an interview with Charlie Rose in 2001 (you can view it <a href="http://www.charlierose.com/view/interview/3056" target="_blank">here</a>):</div>
<blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention...A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country.</i></div>
<i></i><br />
<div style="text-align: justify;">
<i><br /></i></div>
<i>
</i><br />
<div style="text-align: justify;">
<i><i></i></i><br />
<div style="display: inline !important;">
<i><i><i>That's not true anymore.</i></i></i></div>
<i><i>
</i></i></div>
<i>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<i>What drives economies is the education of the people and the innovation that they can then create. And I see a world which - in part because of the internet - is about ready to explode with innovation everywhere.</i></div>
<div style="text-align: justify;">
<i></i><br />
<div style="display: inline !important;">
<i><i></i></i></div>
<i>
</i></div>
</i></blockquote>
<blockquote>
<i></i><br />
<div style="text-align: justify;">
<i><i></i></i><br />
<div style="display: inline !important;">
<i><i><i>...It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.</i></i></i></div>
<i><i>
</i></i></div>
<i>
</i></blockquote>
<div style="text-align: left;">
<span style="text-align: justify;">Bezos sees creators as kindred souls. He draws inspiration from the idea that his company is nurturing the media creators can use to produce and sell their wares (be that music, books, products, software, etc.). These are the <b>marketplaces</b> of Amazon...<a href="http://www.amazonservices.com/content/sell-on-amazon.htm/ref=footer_soa?ld=AZFSSOA#!how-it-works" target="_blank">Selling on Amazon</a>, <a href="http://aws.amazon.com/" target="_blank">AWS</a>, <a href="http://kdp.amazon.com/" target="_blank">Kindle Direct Publishing</a>, <a href="https://www.createspace.com/" target="_blank">CreateSpace</a>, <a href="http://www.mturk.com/" target="_blank">Mechanical Turk</a>, and more. There is much written about these marketplaces.</span></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The real point of interest comes in with Amazon's approach to the middlemen. The contempt is almost palpable, but far from universal. While I think it's accurate to say Amazon is on a long-term mission to disintermediate the middleman from every industry in which it either currently does business or will do business in the future, the company has a long history of tolerating them while they provide value to Amazon. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I think the best example of that is the book wholesalers with which Amazon did business in its early days. At the time, Amazon was so small that there was no chance publishers would do business directly with it. It was not their model anyway. They preferred to sell books to distributors whose job then became getting the product into the proper retail channel. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
These wholesalers were happy to work with Amazon the start-up. It was another channel for selling. And for a time, this was a harmonious relationship. But as soon as Amazon built some clout through its buying volume, it used its new standing to knock on the door of the publishing companies. Cut out the middleman wholesalers, it told them. Sell directly to us. It will be cheaper for both of us. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Eventually they did, and the major wholesalers were cut out...disintermediated in Amazonian parlance. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I would assume the publishers liked this arrangement for many years. But with the advent of a viable commercial ebook platform, Amazon started getting that hungry look in its eye when it looked over the price of books when publishers produce, promote, and distributed them. And the costs of keeping this analog player as part of the digital world? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Publishers were middlemen, and the worst kind. They were gatekeepers (preventing many an aspiring author from being published) and toll-takers (charging too high a fee for the services they provide). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
He who was once the friend of the wolf has become the dinner for the wolf.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This question of middlemen becomes particularly interesting as you look at all the companies with whom Amazon does business today across all its businesses. I doubt many think of themselves as middlemen. I'm quite certain most of them are treated as valued partners. But will they always be? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I see a lot of software companies preparing to offer their products on the AWS marketplace. I think they need to consider what the long-term implications of that move might be. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There is, of course, one middleman that Amazon can tolerate...Amazon. As the medium for buying and selling, that's exactly what it is. The world cannot be rid of middlemen. But I think Jeff Bezos thinks of there being only one. And, in his mind at least, as defender of the customer and facilitator of the creators, this middleman is playing a very important role.</div>Unknownnoreply@blogger.com0