Success = Different, Hard to Copy, and a Valued Service/Product

Most long term business successes seem to have three things in common:

  1. The product or service is different from what most competitors are offering.
  2. The product or service is hard to copy because it depends on activities most competitors are unwilling to invest in or commit to.
  3. Customers value the product or service, as reflected by gross margins, bottom line profits, and returns on invested capital (ROIC). I define ROIC as operating income divided by the sum of working capital plus net fixed assets plus short term debt.

Right now I think this analysis is most relevant to retail companies, some of which are failing and some of which may survive.  

Costco is a great example of a company that seems to meet these three criteria. Costco does high volume, very low margin retail sales through brick and mortar stores, which is different from almost all other retailers (Sam's Club is the only domestic competitor that comes to mind). This service is hard to copy because other retailers lack, among other things, the infrastructure and the bulk purchasing power (part of Costco's activities) to profitably operate at such low margins. And customers value the service enough for Costco to generate an attractive profit and ROIC. Costco has a trailing, 12 month ROIC of 29%. 

Best Buy is another interesting retailer to examine. The company has survived despite other electronics retailers going out of business (Circuit City, Radio Shack, etc.). Best Buy has a trailing, 12 month ROIC of 56%. In a recent interview with the New York Times, Hubert Joly, the CEO of Best Buy, explained the company’s survival and success by noting the following efforts:

  1. Avoiding “showrooming” products that customers will price-check and purchase on Amazon by making sure store prices match Amazon’s (through a price match guarantee). This approach cuts into profits but keeps customers in the store and away from competitors.
  2. Differentiating from online retailers like Amazon by offering customers technical expertise/service. The company started an adviser program that offers customers free in-home consultations on what products to buy and how they can be installed.  
  3. Improving shipping times — and making immediate gratification possible — by using stores as delivery centers.
  4. Cutting costs by letting leases for unprofitable stores expire, consolidating overseas divisions, reducing the number of middle managers, and reassigning employees. 

Best Buy’s dual focus on differentiating where possible while also cutting costs and achieving price parity with Amazon is something Michael Porter talks about. Porter says a low cost producer must exploit all sources of cost advantage while simultaneously achieving parity or proximity in the bases of differentiation relative to its competititors. Competitive Advantage, by Michael Porter (The Free Press, 1985). Similarly, Porter says a company with a differentiation strategy should aim for cost parity or proximity relative to its competitors by reducing costs in all areas that do not affect differentiation. Id. Applying these ideas, Best Buy is spending more on technical expertise/service -- its source of differentiation -- while pursuing low cost parity/proximity in non-differentiated activities like middle management and divisional structure (by cutting middle management and consolidating overseas divisions). These efforts all facilitate Best Buy's price-matching efforts.

Improving ROIC

A key question for any retailer -- or any struggling business -- is how can it improve a low ROIC? If the ROIC is persistently low (say in the single digits, like 9% or less), it raises the question of whether the business should be merged, acquired, or liquidated, with any resulting monies going to shareholders. 

Any time you reduce net fixed assets you get a two-fold benefit in ROIC:

  1. Depreciation expense declines because of the reduced assets, which then improves operating income. 
  2. When net fixed assets decline the denominator in the ROIC ratio declines.

Reductions in excess cash and inventory reduce working capital, which also improves ROIC. So retailers must find a way to operate with less fixed assets, less inventory, and less cash, while also selling something different and profitable through a hard to copy set of activities.

Every retailer is different but all struggling retailers should ask themselves the following questions:

  1. Is the company doing something different from most of its competitors?
  2. Are the activities that make up the offering hard for competitors to invest in or commit to, and therefore hard to copy? Note how a niche, small market, or low cost approach can be hard for large competitors to copy because larger players may consider smaller, low end markets too insignificant or unattractive.
  3. Do customers value the offering enough to generate attractive margins, bottom line profits, and ROIC?
  4. Can the company improve ROIC by increasing sales volumes, reducing cost of goods sold, reducing expenses, reducing net fixed assets, or reducing excess cash or inventory? Could the company lease some of the net fixed assets it currently owns?