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?

Investing 101 and "Cheap is Good Enough"

The quote “cheap is good enough” comes from a very successful value investor named Walter Schloss. Schloss, along with Warren Buffett, formerly worked for Benjamin Graham, the father of value investing. Graham believed that if you always held low PE stocks with conservative balance sheets, ideally trading close to tangible book value (the balance sheet value of the hard assets, less total debt and preferred stock), then you would do pretty well as an investor. See Concepts page and discussion of Benjamin Graham. High PE stocks aren't cheap relative to trailing earnings. The danger of a high PE stock is that anticipated earnings growth won’t materialize and the stock will tank.

The danger of a low PE stock is that earnings will disappear, the company will go out of business, and the stock will tank (also known as a “falling knife”). Graham tried to address this risk by investing in low debt companies with strong working capital positions — i.e., companies with low credit risk and plenty of money to pay the bills. He also dealt with it by looking for companies trading at or below tangible book value, which gives some downside protection in the event of liquidation. Warren Buffett deals with downside risk by looking for companies with great brands, wide competitive moats or barriers, and highly predictable future cash flows, like Coca-Cola. See Concepts page and discussion of Benjamin Graham and Warren Buffett.

So which of these approaches makes more sense?

Scenario One

A company with a high trailing PE, say 30, is like a guy coming to you and saying, “my business earned $1,000,000 last year, but it’s growing like crazy and should continue to do so, so I’d like you to pay $30,000,000 for it.” As an investor, you should ask whether you’d really be interested in this kind of deal. The initial earnings yield in this scenario is 3.33% (1/30), slightly above the 2.47% yield currently available from risk free 30 year Treasury bonds.

Scenario Two

A company with a low trailing PE, say 10, is like someone coming to you and saying, “my business earned $1,000,000 last year and I’ll sell it to you for $10,000,000.” With an earnings yield of 10% (1/10), well above the risk free Treasury rate, you might be interested. But you’d also want to know if the company is going to be around for a while, so you’d look at whether earnings are growing, flat, or declining, whether earnings are steady and predictable, whether the company has plenty of cash to pay bills, whether there’s a lot of debt to pay down or very little, and what the hard assets of the company are worth after subtracting total debt.

You probably wouldn’t be interested in a company with declining earnings, unless you felt the situation was temporary or the company’s tangible book value was well above the asking price (suggesting you could make a profit by liquidating the hard assets and paying off the debt; this would have to be verified by estimating the fair market value of the hard assets, instead of just relying on the assets’ stated book value). If the company’s earnings were flat or growing, and relatively predictable, you might be interested, since your undiscounted payback period (the time it takes to recoup your initial $10,000,000 investment) would be around 10 years.

To summarize, a Scenario Two company typically has: (1) an unleveraged, low debt balance sheet; (2) a strong working capital position; (3) steady and hopefully growing earnings; and (4) a low price relative to earnings. Investors who are fans of Graham, Schloss, and Buffett generally prefer this type of investment. They’re unwilling to pay a big premium for earnings growth, because high growth rates frequently disappear (often unexpectedly) as competition increases and markets saturate. And it's better if a Scenario Two company isn't facing a low end or new market disruption, a la Clayton Christensen. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and Clayton Christensen.

Low end or new market disruption is often the reason low PE companies go out of business. Amazon has disrupted thousands of brick and mortar retail businesses through new market disruption. Brick and mortar retailers have difficulty matching Amazon’s online, low cost business model. Leveraging its low cost model, Amazon has helped create a vast new market of online consumers who shop at their computer (the new context/situation) instead of shopping at a brick and mortar store. See Concepts page and discussion of Clayton Christensen.

Amazon currently has no meaningful trailing PE, because its EPS for the past 12 reported months is negative. Its forward PE based on estimated earnings for the next 12 reported months is 333, making it a Scenario One stock. Amazon investors seem to believe the company can deliver higher future earnings with no material, concurrent impact on its sales, growth, and ability to compete with other low margin retailers like Wal-Mart, Costco, Sam’s Club, eBay, Target, Alibaba, and Google Express. Applying Michael Porter's five forces, retail industry profits are constantly pressured by: (1) high rivalry (lots of competing retailers doing the same thing -- reselling goods made by others); (2) high buyer power (buyers with lots of information and the ability to comparison shop); and (3) a high threat of new entrants (it's easy to start an online store or brick and mortar store). See Concepts page and discussion of Michael Porter.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.