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?

Focusing on the Long View and Jobs-to-be-Done

I just watched two excellent YouTube videos of lectures given by Clayton Christensen in June, 2013 at Oxford University. One of the lectures addresses key management issues/problems and one addresses the need for companies to continue investing in disruptive innovations instead of just efficiency innovations. Below are the key points from these two lectures:

  1. Disruptive innovations are the real long term drivers of growth and employment, but often look unattractive in the short term due to uncertain returns and the CapEx and new fixed assets they require, which can hurt short term profitability measures like gross margin %, return on net assets, return on capital employed, and IRR. The problem is that disruptive innovations may take five to ten years to start providing attractive returns, while management is being judged on the next quarter or the next year. For this reason management tends to favor investments in efficiency innovations, which can quickly improve short term profitability measures but which do little for the prosperity of a company going five to ten years out. Continued, repeated investment in efficiency innovations, without sufficient investment in disruptive innovations, leads to declining growth and employment, sometimes at both a company level and a country-wide level (a la Japan).
  2. The cause of the Innovator's Dilemma, whereby incumbents flee upmarket and eventually get driven out of business by new entrants, is the pursuit of profit (often reflected by the short term pursuit of a higher/target gross margin %). Christensen suggests companies give additional weight to net profit margin %, since high volumes of lower end products can be attractive on a net margin basis if they help absorb fixed overhead costs. 
  3. Management tends to game profitability measures like financial ratios. For this reason "the key is to measure profitability in ways that cause people to do good things." Businesses need to search for profitability measures that cause them to do good things
  4. Market segmentation is often done through an arbitrary classification like product category or customer demographic or geographic region. These classifications then have an outsized, damaging impact on every decision the company makes, whether it's determining who to compete against, what products and market opportunities to pursue, or how the company measures success. Arbitrary market segmentation can have a large, negative impact on what the company chooses to focus on. 
  5. The alternative way for a company to segment the market and focus its efforts is to analyze the job-to-be-done. To understand what causes a purchase decision, you have to understand what job the customer is trying to get done. Don't focus on the customer or the product category in segmenting or analyzing the market -- focus on the job-to-be-done.
  6. Once you understand the job-to-be-done performed by a product, then it becomes very clear how to improve the product (which helps prevent meaningless improvements that overserve). 
  7. A company first has to understand the job-to-be-done (including the job's functional, emotional, and social elements). It then has to determine what experiences must be delivered to satisfy this job, and what services, processes, and systems should be integrated to make these experiences happen.
  8. Companies that focus, organize, and integrate around a job-to-be-done historically have no competitors -- other companies may sell the same products or services, but they typically can't compete with an integrated, end-to-end user experience that solves a job perfectly
  9. Companies must make a conscious decision about what to focus on, ideally based around the job-to-be-done. 
  10. The job itself typically doesn't change much over time, while the means of accomplishing the job may change dramatically. Over the centuries, one such job has been fast and certain delivery of a package from point A to point B. At first the hired solution for this job was delivery by horseback, followed by train delivery, followed by airplane delivery, followed by FedEx. The job stayed the same but the hired solution changed dramatically.   
  11. Because the job-to-be-done tends to stay stable over time, companies that focus on the job are in a good position to see what's coming next and be ready for the next better solution. Companies that focus on an irrelevant, arbitrary unit of market analysis -- like the product category or the customer -- have difficulty seeing what new, better job solutions are coming and are more likely to be surprised/disrupted.
  12. Business models and businesses converge when people need different products/services at the same point in time and space. People need gasoline at the same time they need a snack or junk food, so convenience marts have merged with gas stations. 
  13. Conversely, one business model or business will diverge into two when people need the offered products/services at different points in time and space. Wal-Mart electronics merchandise is also sold by a specialized retailer like Best Buy, while Wal-Mart hardware merchandise is also sold by a specialized retailer like Home Depot. Best Buy does the most business on holidays and birthdays, which is its unique point in time and space, while Home Depot does the most business on weekends, which is its unique point in time and space.