In every industry, you can picture thousands of unfortunate analysts across dozens of companies all doing essentially the same work.  They’re all forecasting market growth, analyzing competitors, trying to understand customers, and so on.  And they read the same news, the same financial reports, and the same market research, for the most part.  The results of this work are closely guarded proprietary analyses, yet they’re all very similar.  There’s a huge amount of duplicated effort that doesn’t add much value.

Business Analysis as Software

Does this remind you of anything?  It’s what software development used to be like when every company developed its own custom applications in-house.  Every company had its own system for everything from payroll to accounting, either done in-house or by expensive consultants.  Eventually, software development activity was consolidated through a number of mechanisms:

• Commercial off-the-shelf software
• Process outsourcing (e.g., an external company handling your entire payroll process with their in-house software)
• Higher-level software languages and components
• Open source software

As a result, software development these days results in much less duplicated effort.

This dynamic has not occurred to the same extent with business analysis, to say the least!  Most big companies still have departments that do things like economic forecasting and competitive analysis.  Certainly, a part of this thought process is unique to each company and thus valuable for informing business decisions, but most firms can’t pinpoint where the commodity information ends and the differentiation begins.  It reminds me of the old John Wanamaker quote, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.”  The same is true of business analysis.

So Why Is This the Case?

I see a few causes for this waste.  First, there’s a game theory problem.  The first company to “open source” its analysis benefits its peers but doesn’t receive any benefit in return.  So there’s no incentive for individual firms to go first.  The current equilibrium results in little or no information sharing.

Second, external information sources are opaque.  Market research reports only include conclusions and estimates, not how those conclusions were reached.  As a result, consumers of those reports end up double-checking the work to make sure it’s applicable to their situations, or redoing the entire analysis because they need a slightly different focus.  Black box information sources can’t be easily repurposed.  In order to tweak an analysis by 10%, I have to reverse engineer the whole thing.  This isn’t an accident, either.  Research vendors want their clients to remain dependent on them, and revealing any of the inputs to their analysis reduces that dependence.  It makes sense for vendors to maximize their profits, but it doesn’t exactly maximize value for customers!

Third, internal analytical departments are motivated to maintain their headcount and budgets.  Advances in efficiency are often resisted because those affected want to avoid creating a reduced need for their work.  In reality, the importance of business analysis and research services will just continue to grow.  The difference is that they will be doing more highly-skilled, value-added intellectual work and less rote data gathering and number crunching.  But like any such revolution, it’s easier for people to see the negative first-order effects than to see the positive (and overall more impactful) second-order effects.  Those attitudes will take time to change.

Where Do We End Up?

Eventually, we’ll end up in a world where business information is more readily accessible, cheaper, and easier to remix and customize to specific needs.  The opportunity to disrupt the current high-cost approach to business analysis is just too appealing for new entrants, and the potential cost and efficiency savings will be too attractive for customers.  But the barriers to change described above won’t go away overnight.  Time and effort will be needed to get people used to the new paradigm of open source business analysis.

Let’s take a closer look at LinkedIn now that the company is moving towards an IPO.

LinkedIn’s Economics

LinkedIn users should be much more profitable than general social networking users because both those users and people who want to reach them are more willing to pay for features.  According to comScore, LinkedIn had 26 million unique visitors in December 2010, which works out to revenue per user of over $9.  According to recent reports, that’s more than twice the per-user performance of Facebook.

So then why is LinkedIn, at $3 billion, worth so much less than Facebook at $70 billion or so?  It really boils down to size and profitability.  Facebook apparently made about $500 million in profits in 2010 off of $2 billion in revenue, while LinkedIn only managed $15.4 million on $243 million in revenue.  That’s a 25% profit margin versus a 6% profit margin.  As it turns out, a rough PEG (price/earnings/growth) ratio for the two companies shows that LinkedIn is valued over twice as highly as Facebook based on 2010 profits and growth!  That Facebook valuation is starting to look better.

What’s unclear is how much LinkedIn is investing in future growth and to what extent it’s simply in a lower-margin business than Facebook.  While individual Facebook users are not necessarily that valuable, the business as a whole appears to be an incredible profit machine.

Sales and Marketing Costs

What’s even more intriguing is LinkedIn’s Q1 2011 numbers.  Sales and marketing expenses went from 23% of revenue to 31%, and net income dropped from 6.3% in 2010 to just 1.4% in Q1 2011.  At first I was surprised at the big jump in expenses, but on further reflection, I don’t think this is necessarily a bad sign.  LinkedIn is in a large and relatively open market.  In fact, I can’t believe no serious competitors have cropped up.  That’s a story in itself.  Anyway, the firm is in land-grab mode.  Spending heavily on sales and marketing now to build greater barriers to entry (in the form of more registered users, data, and corporate customers for recruiting and marketing) makes sense.

Of course, that position assumes that there is no permanent shift towards a much higher cost to acquire and retain customers.  That is a potential concern.  LinkedIn’s channel mix is slowly shifting from online to field sales (up from 47% to 56% in the last two years), which according to the company’s disclosure is associated with a longer sales cycles and higher sales costs.  It does also result in higher average selling prices, so it doesn’t appear to be a significant concern yet.

However, it does illustrate the limits of LinkedIn’s virality.  Facebook has built a huge viral engine on photo tagging, newsfeeds, and social games, and the draw of professional connections is certainly weaker for the average person.  As an aside, there are of course limits to Facebook’s growth curve as well, with some claiming that Facebook penetration tops out at around 50% of the population in most countries.

Revenue Breakdown

The revenue breakdown by product also reveals a lot about LinkedIn’s future direction.  There are three product categories, hiring solutions, marketing solutions, and premium subscriptions.  Hiring solutions revenue grew 182% from 2009 to 2010 and now makes up 42% of the company’s revenue.  In contrast, premium subscriptions grew 35% on 64% growth in registered users.  Advertising growth fell in the middle at 107%.  Clearly, the average user doesn’t see much need for a premium subscription, while recruiters can’t get enough of LinkedIn’s services.  Companies tend to follow their most profitable customers, so I expect LinkedIn to start offering much more sophisticated recruiting solutions over time.  I’m curious to see how they fare against other up-and-coming recruiting companies like TheLadders, Indeed, and Simply Hired.

So Is It a Good Deal?

If LinkedIn didn’t exist, someone would have to create it.  The online resume and professional network are basic features of modern life, and LinkedIn has hitched itself to a new consumer behavior that will only continue to grow.  As an individual, I wish LinkedIn would provide more useful features, but as a hypothetical investor, I see an ongoing growth story in this company.  The question, as always, is how much one is willing to pay for that growth, and that’s one I have a hard time answering.  LinkedIn’s venture capital investors, Sequoia Capital, Greylock Partners, and Bessemer Ventures, made up of infinitely better investors than me, are sitting on their shares and not participating in the IPO.  That suggests they expect the value of the company to continue climbing sharply.

The situation is even worse for hospitals in particular.  They’re overwhelmingly complex organizations, and as a result they’re difficult to manage.  They also have high fixed costs, and there is often over-capacity in specific geographical markets, leading to intense competition.  From a Porter’s Five Forces perspective, most of the puzzle pieces look pretty bad.

Most importantly, overall healthcare costs cannot continue climbing at their current rate indefinitely.  And like the old quote says, if something can’t continue indefinitely, it won’t.  Much more significant waves of reimbursement cuts are inevitably on the way, although no one knows when they will hit.

Considering all of these factors, it seems probable that the industry will undergo painful change and consolidation over the next couple of decades.

So what kinds of providers will survive ongoing changes in the field?  Here are the likely candidates:

• Unique, mission-driven organizations like the Mayo Clinic
• Disruptive providers like specialty hospitals that can offer more standardized care with a lower cost structure
• Large organizations that can develop superior processes and leverage high-quality management talent to outperform smaller competitors (i.e., the big hospital chains)

Unfortunately, the last of the three is probably the least likely.  I assume many hospital chains will attempt to go down this road but will fail nevertheless.  Why?

• Organizational chaos – Mergers bring scale but also dysfunction.  Many hospital chains will be unable to deal with the disruption and clashing priorities that mergers introduce.
• Apathy – Big, impersonal organizations exacerbate the tendency among the rank and file to say, “That’s not my job.”  Large hospitals have a much harder time holding people accountable.  Processes have to substitute for individual initiative, but they often can’t fill the gap completely.
• Complexity – Economies of scale are only good if you can really achieve them.  Because hospitals are individually so complex, just having more locations within the same company doesn’t necessarily achieve a lot of efficiencies.  Administrative tasks like billing likely become somewhat more efficient, but I doubt large hospital chains manage their physical resources any better.

As the largest hospital chain in the country, HCA would seem to be the flag bearer for the scale strategy in the hospital industry.  The recent IPO was successful, but I’m less convinced that they will actually be able to generate the operating advantages they’re looking for.  Operating margins look like they’re in the general ballpark of public healthcare providers at about 7% – not exactly a ringing endorsement of the strategy.

As is usual with private equity deals, HCA has been fairly heavily loaded with debt.  The IPO won’t give it too much additional financial flexibility since proceeds are expected to go primarily to the current private equity owners.  So pursuing large-scale consolidation, which was Columbia/HCA’s original claim to fame, seems unlikely.  Instead, HCA plans to selectively extend its services in major markets.  The company also just reorganized to offer its shared services, like revenue cycle management and supply chain management, to other healthcare providers.

It’s not clear yet how interested investors are in the IPO, but HCA reduced the fundraising target for its IPO from $4.6 billion initially to the current price.  This suggests less than unbridled demand for shares.  One area of concern may be the impact that healthcare reform will have on HCA’s business.  The government has been making more efforts to contain the growth of Medicare and Medicaid spending, which makes up about 40% of HCA’s revenue.  Overall, it seems unlikely that shaving part of a percentage point off government healthcare reimbursements will make a big difference to HCA, but maybe investors are easily spooked these days.

HCA’s results for the fourth quarter of 2010 included a 31% jump in net income, although most of that appears due to miscellaneous accounting adjustments.  Surely just a coincidence with an upcoming IPO, right?  From a top-line revenue perspective, growth slowed down considerably in 2010.  The reason is unlikely to be the economy considering that revenue did grow well in 2008 and 2009.

In many ways, HCA is a pretty straightforward company.  I’m going to spend some time digging into HCA’s latest 10-K and their IPO prospectus and see if I can find out anything interesting about the company, or perhaps even about the healthcare industry these days.

Great companies

Clearly, companies that are executing at the top of their games are fun to hear about.  I think a lot of people marvel at Steve Jobs’ career the same way they look at LeBron James’ stat line.  It’s just fun to watch excellence.  There’s a little bit of a cult of personality involved, too.  Just look at Jack Welch and his admirers.  It’s just too bad that he didn’t really have a worthy adversary.  In contrast, car companies and airlines are often in bitter competition, but most of them seem too dysfunctional to really get emotionally invested in.  In the airline industry, the only exceptions seem to be discount competitors like Southwest, JetBlue, and Virgin.

Cool products

Dueling fertilizer products don’t exactly capture the imagination.  And although Pepsi and Coke are great companies, the cola wars don’t have the same attraction either, because they’re mostly played out in the trench warfare of distribution and advertising.  That’s why Jobs could make his sugar water pitch to John Sculley.  Big product launches require good strategic guesswork – where is the market going to go, what’s the competition going to do?  Good to Great did a good job of romanticizing some otherwise mundane companies (sorry, Gillette, Walgreens, and Kimberly Clark – let’s not even talk about Fannie Mae), but that’s the exception to the rule.

Different positioning

This goes without saying based on the previous point, but to be captivating, companies need to take different approaches to the market.  Me-too plays are just boring.  This is another reason why the cola wars can never really be all that interesting – there’s not that much potential to truly differentiate cola.  In contrast, it’s cool to see how Boeing and Airbus have staked out fairly different positions with the 787 Dreamliner and the A380

Plot twists

This one is self-explanatory.  A good contest features punches, counter-punches, and doubt as to the outcome.  The iPhone is selling like crazy, but wait, Android’s gaining share even faster!  The A380 is delayed, but wait, so is the Dreamliner.  Which one will be ready first?  The PS2 is unstoppable.  But wait, the Xbox 360 came out before PS3 and has a better game line-up.  What’s going to happen?  No, the Wii is killing everyone!  And now the Kinect is a huge game-changer in the gaming industry.  These stories go beyond basic competition and sometimes even evolve into something truly compelling.

What else defines a great business drama?  What other companies should we be following?

Christensen also wrote a book called The Innovator’s Prescription, applying the framework of disruptive innovation to the healthcare system.  MIT World has an good presentation video where Christensen walks through many of the ideas in the book.  It’s definitely worth watching for anyone involved in the healthcare system.

The core theory is that incumbents in a market find it impossible to offer “disruptive” technologies because those technologies are typically lower margin and perform worse by traditional measures.  For example, the Sony Walkman and the Compaq laptop offered poorer sound and computing speed but provided mobility that traditional products couldn’t.  There’s much more to it, and I recommend that you pick up the books.

But with regard to healthcare, the takeaway is that expecting hospitals as currently constituted to drastically cut costs or offer cheaper services is unrealistic.  They are stuck with a certain cost structure and focus (treating all the patients who walk in the door, but especially complex diseases), that constrain them from pursuing certain innovations.

The real candidates for breakthrough cost savings are two things.  One, breaking the current hospital model into components:

• High cost/high value solution shops doing difficult diagnosis and treatment
• Process hospitals that provide straightforward procedures after diagnosis
• Facilitated networks that take responsibility for helping patients manage chronic diseases

The current model loads high costs on processes that have become relatively straightforward, while creating hospital systems so complex that they require massive amounts of coordination to run.  Two, new areas that enable more cost-effective and specialized service provision:

• Retail medical clinics
• Specialty hospitals and clinics
• Telemedicine
• Medical tourism
• Molecular diagnostics
• Genetic testing

In contrast, electronic medical records (EMRs) and wellness programs likely will not deliver on the cost reductions and quality gains their proponents expect.  The challenge with EMRs is the cost and complexity of fitting them into different facilities’ operating processes, which is as bad as the heyday of enterprise resource planning (ERP) implementations.  They also fail to really change the model for healthcare delivery.  Wellness programs have the problem that oftentimes people are not motivated to comply with programs until they are already too sick to recover easily.

The next revolution in healthcare, which I think will inevitably come, won’t come from renowned medical centers or government intervention.  It’ll be something like Walmart Clinics.

While I’ve done consulting work in various parts of the industry (with providers, pharmaceuticals, and medical devices), I still don’t feel that I have a true ground-up understanding of how everything works.  So in addition to more general posts, I’m planning a series of blog posts exploring the industry from a business strategy perspective.

Here are a few of the things I’m planning to look at:

• How profitable is healthcare compared to other industries, and why?
• What explains the huge differences in profitability among sub-sectors in healthcare, like pharmaceuticals versus hospitals?
• Are there many examples of business model innovation (as opposed to R&D innovation) in the sector, and why or why not?
• What makes for a successful business strategy in healthcare?
• How are changing cultures and ownership models in healthcare changing the way business is done?

Regarding business model innovation in particular, healthcare is a challenging environment for it.  High levels of regulation make it difficult to adopt new business practices.  Requirements for clinical evidence for new treatments   Companies and employees are often rather set in their ways.  And of course third-party payment systems create a number of interesting effects.  Patients are not price sensitive and are essentially uninterested in cost reductions because they’re not paying anyway.  Meanwhile, payers are perhaps overly focused on cost and not very active in pushing for higher quality.

Having said that, there have been a number of notable innovations in the space, including increased outpatient procedures, home health care, disease management, greater use of nurse practitioners and physician assistants, the emergence of retail medical clinics at places like Wal-Mart, and telemedicine.  I’m planning on taking a look at a few of these trends and understanding what the implications are for healthcare in general.

I would also welcome your thoughts on what aspects of the healthcare business you might be interested in.  Feel free to leave a comment if you have opinions to share.