The wrong way

Probably 95% of investor relations departments don’t have this kind of mandate. To pick on a recent example, let’s consider Strabag, one of Europe’s leading construction companies. The firm recently shut down its communications Twitter account because no one was tweeting them. Of course, the company didn’t use the account for anything except for relaying analyst ratings and the status of its order backlog – not exactly captivating.

Strabag made a variety of mistakes. All marketing, but especially social marketing, is a content-driven activity. If you don’t have interesting things to say, no one will listen. You don’t have to be in a sexy business to come up with meaningful content (look at Zappo’s in shoe retailing), but you do have to think about what your audience wants to hear. Strabag could have engaged in a dialog with analysts, better understanding their information needs and perceptions of the company. A primer for investors unfamiliar with the construction market would have been even better. I won’t belabor all the usual social media points beyond that.

Tactically, Twitter is an awful channel for arbitrary data points (output is up 6%!) lacking context. Even order backlog is probably interesting to investors and equity analysts, but it should at least link back to a chart and spreadsheet showing the trend over time, comparisons with competitors, and implications. There’s no reason for online communications to mimic the dry facts of a stock ticker. Help people draw conclusions!

The right way

In contrast, I was blown away by the exchange between Reed Hastings from Netflix and a hedge fund short seller on Seeking Alpha (brilliant site, by the way). The hedge fund manager lays out his concerns about Netflix’s valuation, new competition, the costs and quality of licensed streaming content, and a few other reasons for his short position. Hastings addresses them all openly and dismantles most of them. Finally, the short seller posts again to say that he’s covered his position and why. For a business geek like me, their dueling analyses are such fun to read, and they do an excellent job of illuminating the company’s strategy, the industry landscape, and possible risks and upsides. I probably could have read Netflix’s entire 10-K filing and come away with much less understanding of their business than after reading those posts. It’s also brilliant investor relations, and Hastings and his team eliminated a potential stock performance issue, thus allowing them to stay focused on the core business. Now, this kind of response requires that your company actually have a very well thought-out strategy and evidence to back it up. Most firms probably couldn’t hack it, but it is something to aspire to.

Expand your mandate

Various corporate functions have been transformed from rote work to strategic assets over the last few decades. Human resources used to be about job postings and benefits management. Now, ideally, it’s about selecting, recruiting, and retaining the best possible talent. Traditionally, purchasing was probably one of the dullest jobs imaginable (no offense). However, in the context of strategic sourcing, the job is more about partnering with suppliers, understanding their impact on product quality and strategy, and forecasting the evolution of your industry value chain than just about issuing purchase orders.

The same thing needs to happen with investor relations. Investors are critical stakeholders in public companies, and we’ve seen various examples of firms crippled by short sellers over the last few years. Investor relations should be a strategic communication channel to cultivate a supportive investor base and to funnel market information back to management. It’s time to go beyond conference calls and financial filings.

]]> http://www.brekiri.com/blog/477/the-new-paradigm-of-investor-relations/feed/ 5 http://www.brekiri.com/blog/362/3par-overbidding-is-a-sign-of-cookie-cutter-dell-strategy/ http://www.brekiri.com/blog/362/3par-overbidding-is-a-sign-of-cookie-cutter-dell-strategy/#comments Mon, 30 Aug 2010 13:34:37 +0000 Greg http://www.brekiri.com/blog/?p=362 One of the things that was so thrilling about Dell’s early business strategy was how clear and simple it was.  Dell built high-quality but essentially commodity computers faster and cheaper than anyone else and developed superior supply chain and order taking processes that took years and years for competitors to even approximate.  Looking at Dell [...]]]> One of the things that was so thrilling about Dell’s early business strategy was how clear and simple it was.  Dell built high-quality but essentially commodity computers faster and cheaper than anyone else and developed superior supply chain and order taking processes that took years and years for competitors to even approximate.  Looking at Dell and HP’s bidding for 3PAR recently, I think M&A run amok like this usually means the companies involved don’t have a lot of other strategy ideas to execute.  It’s a shame to see Dell trying to buy growth now in contrast to their early strategic clarity.

I thought I’d dig a little deeper, so I took a look at Dell’s 2010 analyst meeting presentation.  It’s a solidly put together presentation, but it bears the clear signs of a big company that has little insight into how to change markets.  Dell’s big strategy is to execute a “growth strategy built on delivering enterprise solutions and growing operating income and cash flow.”  In a nutshell, to grow and make more money, or in other words to be successful.  The problem is that a strong strategy should explain how you’re going to achieve your goals, not just what they are.  The “…by doing X, Y, and Z” portion of the strategy is largely missing or perfunctory.

Dell does make a few motions at discussing product strategy, but stating that you’re going to provide “integrated, best-of-breed solutions,” for example, is unenlightening if not a contradiction in terms.  Likewise, aiming to be make products both “capable and affordable” seems like a strategy to get stuck in the middle, neither truly differentiated nor a cost leader.  Perhaps Dell is keeping the good parts of its product strategy to itself, but at least taken at face value, it’s not very convincing.

The same theme continues as you go further into the presentation, with Dell listing goals like the following:

• Improve profitability
• Get our fair share of IT spend
• Deliver strong cash flow + ROIC
• Disciplined capital structure

Similar bullets appear in the investor presentations of most Fortune 500 conglomerates.  While those goals aren’t bad from an execution perspective, they signal a focus on running the existing business more or less as is rather than changing the market.  I haven’t had a chance to look at the investor presentations of HP or IBM recently, but I have a feeling that Dell could boil its slides down to, “Do what our competitors are doing, but slightly better.”

What do you think?  Is Dell as strategically aimless as they seem from their investor communications, or is there something I’m missing?

In my last post, I held Clorox up as an example of a cost leadership strategy, but I have realized since that I was wrong.  The company is actually pursuing more of a differentiation strategy.  See the Clorox background section below for details.  Nevertheless, let’s use the company as an example for a cost analysis.  Along the way, we’ll also compare them with Procter & Gamble and Method Products to continue to add more depth to our understanding of the overall value chain analysis.

This post is a long one, so my feelings will not be hurt if you choose to skim it.  Think of it as a reference work.

Clorox Background

The Centennial Strategy Clorox has been pursuing since 2007 convinced me that they are not primarily seeking cost leadership.  The strategy (investor presentation) has a handful of legs:

• Compete with superior capabilities in the odd-sounding areas of Desire, Decide, and Delight
  • Desire – Use marketing communications to drive broader demand for Clorox brands and expand the scenarios in which people use them
    • Targeting ad spending of 9-10% of sales, almost as high as P&G
  • Decide – Work with retailers to formulate store shelf strategy and develop innovative promotion that will drive category growth based on Clorox brands and provide value that private label brands cannot provide
  • Delight – Deliver high-quality, consumer-preferred products that provide unique benefits (e.g., easier to light Kingsford charcoal, stronger Glad ForceFlex bags) to grow market share
• Clorox sees consumer trends, like health, wellness, and environmental stability, as growth drivers, and the firm is trying to capitalize on that growth with products like:
  • Green Works, a line of cleaners using natural ingredients launched in early 2008 and marketed with the Sierra Club that now has over 40% market share in its category
  • Burt’s Bees, a natural cosmetics and personal care line acquired for $925 million in 2007
  • Brita, the German water filter products that Clorox distributes in the US
• The company is also focused on operational effectiveness (better organizational structure and accountability) and driving out waste (cost cutting)

Most of that strategy is driven by differentiation and marketing execution rather than cost.  In recent earnings calls, Clorox also mentioned private label growth and price pressure as two of their biggest challenges, especially for brands like Kingsford, Clorox bleach, and Glad.  That comment validates the idea that they are being attacked from below on pricing rather than being in a cost leader position.

Analyzing Cost Advantage

Porter uses ten factors to analyze cost.  Ten!  It’s been a while since I’ve read Competitive Advantage, so when I saw that, I was not happy.  If you apply all ten factors across all functions and look at customer and product segments, you are looking at an enormous amount of work.  I guess that’s the kind of thing that keeps consultants in work.  At one of my previous positions, a leading consumer products company paid $1.5 million just to have its competitors’ SG&A costs analyzed in detail… in one category!   As you can imagine, the focus of this post will be how to plan this analysis to take the least possible amount of work and still deliver some insight.  We’ll definitely be following the 80/20 rule, but as with all such things, it’s important to be clever in how you cut things out.

So let’s walk through the ten cost factors and come up with a plan for a cost analysis specific to Clorox:

1. Scale

This factor refers back to economies of scale, a relatively straightforward concept.  At greater scale, fixed costs like plant maintenance, advertising, and salespeople can be spread over a bigger production volume , reducing cost per unit.  It’s not quite that simple, however.  For manufacturing in particular, there is often a minimum efficient scale (MES) beyond which greater scale doesn’t particularly reduce costs further.  Large operations can also have diseconomies of scale if they get unwieldy.  Finally, you have to be careful at which level you measure scale.  For advertising, global scale matters.  For a sales territory, scale within that territory is most important to making sure the salesperson’s time is used effectively.  And so on – each activity will have a different measure of scale.

For Clorox, production plants are probably already at MES across all competitors given the maturity of the industry, and we can probably ignore those.  Clorox may get some economies of scale in advertising in categories like bleach, so we should take a closer look at SG&A expense ratios.

2. Learning

Learning refers to the fact that products typically get cheaper to manufacture as you learn how to be more efficient.  Research has shown that experience causes costs to go down by 10-30% per unit every time cumulative production doubles, so the second million widgets will cost 20% less on average than the first million.  Since products like bleach and toilet bowl cleaner have been around forever, we can assume that learning effects have played themselves out.  This driver might be more relevant for newer product lines like Green Works (due to the different ingredients and formulations) and Brita filters.

3. Capacity Utilization

Capacity utilization is often confused with economies of scale.  Basically, fixed costs for a plant are allocated across the units made in that plant.  If the plant is running at 90% of capacity, more units are being made, and each one needs to absorb less fixed costs than if the plant were running at 60% capacity.  When companies over-estimate demand, they end up with empty factories and sometimes take huge hits on capacity utilization.  Since most of Clorox’s products are in stable, slow-growth categories, it seems unlikely that they have capacity utilization issues.  I would still plan on double-checking since this factor can make such a big impact.

4. Linkages

The way different activities are coordinated, or linked, can impact costs, both within the firm and working with suppliers and customers.  Clorox’s investor presentations make mention of providing value-added services to retail chains, so linkages with customers would be a fruitful area to explore.  However, it seems unlikely that Wal-Mart, Clorox’s biggest customer, allows much variation in how it deals with suppliers.  Clorox is also very active in working with suppliers to make relationships more efficient (i.e., “supplier relationship management”).  Further research is warranted into relationships with both major customers and suppliers.

5. Interrelationships

Interrelationships are similar to linkages but across business units within a company.  This concept feels a bit dated since multi-divisional conglomerates are no longer as prevalent as they were from the 50’s through the 80’s, back when Avis was owned by a meat packing company and Paramount Pictures was owned by a metal stamping company.  Wow.  Anyway, Clorox doesn’t have any readily apparent business unit interrelationships, so this is another factor to keep in mind but avoid spending much time on.

6. Integration

Integration refers to whether activities are conducted in-house or outsourced.  Neither approach is inherently more cost-efficient than the other, but differences in integration strategy within an industry can have significant cost impacts.

Based on some brief research, here are some facts on Clorox’s in-house versus outsourced activities:

• IT was outsourced to HP starting in 2006 (P&G also outsources IT to HP, as well as HR to IBM and some communications and networking to BT – quite the acronym soup).
• Both Clorox and P&G do their own blow-molding for plastic bottles.
• Clorox shipping is handled by trucking vendors, and some distribution centers may be outsourced as well.
• Manufacturing of a few smaller product lines like steel wool pads is outsourced, based on a lack of economies of scale in those areas.

There’s nothing here that makes me think Clorox is pursuing a different approach than major competitors like P&G, but it would be worth checking for exceptions.

7. Timing

This factor mostly applies to rapidly-evolving industries, where being a first-mover or a follower can have significant cost (and differentiation) effects.  Companies that follow counter-cyclical strategies, purchasing assets and acquisitions during down periods, can also reap cost benefits.  Clorox acquired Burt’s Bees in 2007 at the height of the market, which might not have been ideal from a strategic point of view.  Otherwise, I think this factor is not very relevant due to the maturity of the industry.

8. Policies

This category is a bit of a catch-all.  It includes things like compensation policies, product configurations, the level of service provided, customer segments targeted, and so on.  It’s a mess, and Porter’s framework starts to get a little jumbled here, to be honest.  For Clorox and its CPG competitors, I would look primarily at compensation (executive compensation information from financial filings and rank-and-file comp from job postings and salary review sites) and SKU complexity.  Between Clorox and Procter & Gamble, many of these areas probably don’t lead to significant cost differences.  Method probably incurs lower costs here due to being a private company, having a smaller set of products, and distributing primarily through Target rather than every corner store in the country.  However, I’m sure those cost savings are more than offset by the costs of growth, premium product packaging and manufacturing, and smaller scale.  Method’s not successful because of the cost base, but rather because it’s focused and differentiated.  We’ll get to that in another post.

9. Location

Location affects labor, transportation, and raw materials costs, among other things.  It’s complex to analyze because these cost components often move in different directions – for example, moving closer to raw materials may increase outbound transportation costs.  I would mainly look at inbound and outbound transportation costs here.

10. Institutional Factors

Finally we come to institutional factors, which encompass externally-driven factors like unionization and regulatory policy.  It would be interesting to find out whether Clorox is more or less unionized than Procter & Gamble.  Additionally, I would look into whether one company or the other tends to get into more trouble with the EPA, and whether environmental regulations are making a significant impact on costs.  For example, Clorox recently decided to stop shipping chlorine to its seven bleach plants due to regulatory concerns, and is now instead shipping high-strength bleach and then diluting it.

Other Cost Analysis Concerns

Phew, that’s a lot of factors, right?  Before we move on to Clorox itself, there are a couple of additional nuances to keep in mind.  First, there are interrelationships among factors – reducing one cost driver often raises another.  Everything functions as a system, which is why a cost leadership strategy can be quite complex.

Second, consider segments – costs can be very different for different product lines or customer segments, so you may need to analyze some of these factors at the segment rather than business unit level.  For example, the Clorox bleach business is very different from Burt’s Bees personal care products.  It’s obvious, but you need to actually incorporate it in your analysis.  Third, cost dynamics – trends over time change the balance between cost drivers.  When oil went from $50 to $150, transportation costs suddenly became much more important, and companies with less efficient location networks were at a disadvantage.  Predicting cost trends ahead of competitors can be a big factor in achieving cost advantages. The classic example is when Southwest Airlines hedged its fuel purchases before oil prices went through the roof, creating an enormous advantage over the other airlines.

Analyzing Clorox

To recap, here’s the initial list of analyses I would want to do if I were doing a real cost analysis on Clorox for a project:

The real value comes from understanding what Clorox can improve and also what competitors do differently.

How would I get the data?  If I were working for Clorox, much of it would be a combination of accounting data and internal analysis.  Note that you can’t necessarily use accounting data in its raw form because it often combines activities with different economics and because it might not be correctly allocated.  Some form of activity-based costing is ideal.

If I were working for a competitor, I would go through the following progression:

• Use internal data as a benchmark
• Do secondary research (i.e., online sources, analyst reports, etc.) to start to identify differences in how activities are organized at various companies
• Work with internal experts to do what-if analyses based on those differences
• Use primary research to validate and fine-tune the what-if results

High-Level Financial Metrics

Not to go into too much detail, but looking at gross margins and SG&A costs is also a good way to develop hypotheses about cost versus differentiation strategies.  For example, Clorox’s gross margin tends to hover around 43%, while Procter & Gamble’s is significantly higher at 51%.  Likewise, Clorox has lower SG&A expenses, at around 22% versus 30% for P&G.  These contrasts are consistent with Clorox taking more of a cost-driven strategy than P&G, although it seems like they’ve been moving closer to P&G’s approach.  Differentiation naturally implies premium pricing, resulting in higher gross margins, and it also requires greater non-manufacturing activities, including R&D and marketing.  Within a given industry, margins can be an excellent first indication of how company strategies differ, although of course the quality of execution makes a big difference as well.  Of course, Clorox also competes in more price-sensitive categories than P&G (e.g., bleach and trash bags), which also causes margin differences.

The Clorox Takeaway

Clorox illustrates a few interesting points about Porter’s competitive strategy frameworks.  First, they do not necessarily capture growth dynamics well.  One of Clorox’s biggest problems is its concentration in developed markets like the US and Europe because it missed the boat on expanding into high-growth emerging markets and allowed its competitors to build barriers to entry.  This lack of access to growth doesn’t show up explicitly in the competitive strategy framework, although good strategists weave it in.

Second, the core framework works pretty well but requires some interpretation.  Clorox is stuck in the middle in some product categories but differentiated in others, like Greenworks.  This doesn’t mean that the company can’t be profitable at all in categories where it’s stuck in the middle.  Rather, it means that the firm can’t make an “economic profit,” defined as being higher than the cost of capital.  Good execution with a less than optimal strategy can still return your cost of capital in many industries, but over time competitors not stuck in the middle will pull away.  I would expect Clorox to find maintaining profitability in commodity product areas harder and harder over time.

Finally, the competitive strategy framework dovetails with Porter’s industry analysis approach (the Five Forces).  Trash bags are a less attractive segment than some of Clorox’s other businesses, given limited opportunities to differentiate and around 40% private label market share.  Clorox’s steps, like introducing new bag features, help raise the barriers to entry somewhat, but it’s often very hard to change the equilibrium in a market.

Overall, Clorox has a few product lines that are very strong and runs a decent business based on strong execution and hustle.  But the company does not have a strong competitive advantage in much of the business.

Next Up

Looking at Porter’s analysis of differentiation.

That low-revenue scenario seems to have been the fate of most social networks except for Facebook, which luckily cracked the piggy bank of social gaming (not to mention raising an enormous amount of money).  Bebo is a great example.  They are apparently profitable for the moment, but AOL is getting ready to shut the site down (or sell it) because they can’t afford to build out the more robust product necessary to compete.  MySpace may yet end up in the same boat.

A lot of online content destinations are in similar situations.  If your business model consists of riffing off of news broken by old media sources, generating a thin advertising revenue stream, and making a profit by keeping costs extremely low, you end up being a break-even business and not having the resources to build the company into something more meaningful.  This is a fundamentally weak strategic position to be in because there’s little or no unique content at the heart of it.

Finally, I would also lump Digg into that category.  Digg is a good example of how companies with a weak revenue model end up cutting corners on user experience.  The Diggbar enabled them to grow traffic and revenue numbers, but they had to damage the user experience to do it.  I’m curious to see whether they can get out of that cycle now that Kevin Rose is back in charge and the bar is being done away with.

Good old-fashioned price segmentation

So how do you avoid falling into this trap?  It’s basically a customer and price segmentation problem.  You have to find the power users, the ones who need more features than average and are willing to pay for those features.  Finding those customers, building the right feature set for them, and doing it all before you’ve trained them to expect it for free are all a bit challenging, of course.  The popular term for it these days is freemium.

LinkedIn did it by offering monthly subscriptions to recruiters and others who needed to make lots of contacts without relying on slow and iffy introductions.  Apparently, less than one quarter of LinkedIn’s revenue now comes from advertising.

Google did it with Gmail and Google Apps.  I find this example particularly interesting.  Yahoo and Hotmail tried to upsell premium individual users to premium subscriptions for more storage, but that strategy never worked very well.  Google correctly realized that the power users who would pay for additional functionality were companies, not individuals.  Google Apps is now the email system of choice for many small companies, and the product is also making inroads into universities and larger companies.

Other freemium examples that have recently gotten attention include Flickr, Skype, and Evernote.  They have all done a good job of building scale and encouraging trial with a free version and then converting users with the greatest requirements and greatest willingness to pay to a premium paid version.

I also like what GigaOm, the technology blog, is trying to do by offering paid research reports on top of its basic news coverage.

What they should have done

So let’s second-guess the strategies of other online companies and think about how they might have improved the revenue model.

Evite – They should have created a premium version for corporate events or those that required more attractive or customized invitations.  Fund-raisers, weddings, and networking events are all potential segments that they didn’t manage to capitalize on.  Eventbrite is one company that seems to be doing this well.

MySpace – Attractive customers to go after would have been either music buyers or musicians themselves.  They could have been a great lead generation partner for a music vendor like Amazon looking to better compete with iTunes.  I can also think of a lot of premium marketing features they could have offered to musicians and labels looking to better promote themselves.  Of course, now social gaming is an even more obvious option, and perhaps that revenue source will still keep the site afloat.  At this point, however, they seem to have been lapped by Facebook in terms of both functionality and user engagement.  They’re on the wrong end of the network effect now.

Offline revenue challenges

The same dynamic occurs in a lot of other industries, especially in ones where the economics are driven by capacity utilization and low marginal costs.  Brutal price competition, among other reasons, has made it difficult for any airline to truly offer a differentiated experience.  Since marginal costs per seat are basically zero, the incentive for airlines to compete based on price is often overwhelming.  The resulting poor margins prevent investing in any unique competencies to create differentiation.  However, airlines are making some progress in breaking out “premium” services like checked bags and priority lines and charging for them.  Of course, it’s harder to do so after you’ve already established customer expectations that those things are free, and the airlines are definitely experiencing some backlash for trying to squeeze more money out of unhappy travelers.

Of course, much of the character of these industries is also determined by customer behavior.  We’re almost all price shoppers when it comes to air tickets, so maybe we shouldn’t be quite so surprised that we get what we pay for – a cheap ticket, not a great experience, and getting nickel and dimed where the airlines can get away with it.

The strategy implication

Every company should work on the price segmentation strategy will be from day one.  The specific segment or features might not be clear initially, but you should at least have a set of hypotheses to test.

Offline, companies should get better at emulating the thinking behind the freemium model and charging more for premium version or additional services.  Avoid loading up your core offering with tons of premium services and then being forced to sell it at a low margin once price-based competitors enter.

What are your war stories about developing a strong revenue model?

To bring the value chain to life, I thought I would take an example from consumer packaged goods that includes each of the generic competitive strategies:  cost advantage, differentiation, and focus.  I’ll be looking at Clorox, Procter & Gamble, and Method Products in detail over multiple posts.  I don’t know much about these companies to start with, so you’ll have a chance to see the good, the bad, and the ugly of a value chain analysis done from scratch.

Breaking down the value chain

In Porter’s analysis, a company’s activities are by default categorized as follows:

• Primary activities
  • Inbound logistics – receiving inbound materials, including material handling and inventory
  • Operations – making whatever it is you make
  • Outbound logistics – getting products to the distribution channel or customer
  • Marketing and sales – creating and satisfying demand, communicating with customers
  • Service – fulfilling any needs customers have after they make a purchase, which could include training, installation, maintenance, and so on
• Support activities
  • Firm infrastructure – management, finance, legal, and so on
  • Human resource management
  • Technology development – includes R&D but is also more general, including the development of proprietary business processes
  • Procurement

You can tell that this list is somewhat manufacturing-centric.  A services firm may have little logistics and procurement, and operations would include things like managing consulting projects.  Consider this list customizable based on the industry, although it’s useful to go through the list and think about each item’s relevance regardless of industry.

One complaint I do have about the value chain is that some of the magic that makes certain companies tick, like culture, can get overly broken down among activities.  When you do a value chain analysis, take extra care to make sure that the parts you’ve identified don’t end up being less than the whole.

From these functional categories, activities should be broken down to the relevant level of analysis, first by sub-function (what Porter calls activity types) and then individual activities.  In copier manufacturing for example, operations would include:

• Component fabrication
• Assembly
• Testing
• Maintenance
• Facilities operation

From there, look for relevant individual activities.  Activities should be broken down if they:

• Have different economics (different economies of scale or splits between fixed and variable costs, for example)
• Provide an opportunity to differentiate
• Are a significant fraction of costs

In industries like steel or paper manufacturing, where individual machines can cost millions and be as big as buildings, you would probably want to go down to the machine level in your analysis.  For a software company, the right unit of analysis might be product group.  In consulting, it could be industry or functional practice or a geographical breakdown.

Linkages

Porter is big on linkages among activities.  At a very basic level, linkages address coordination.  For example, poor demand forecasting in sales and marketing impacts manufacturing and logistics, potentially leading to overtime and other extra charges if demand outstrips capacity.  Likewise, manufacturing quality problems strain the sales, marketing, and service functions.

More generally, choices in one area affect other functions.  Purchasing higher-quality inputs may increase purchasing costs but improve quality and reduce manufacturing costs.  Marketing based on quality raises the requirements for performance in manufacturing.  These concepts are bread and butter for strategy as well as disciplines like Six Sigma and Lean Manufacturing, but Porter’s framework tries to help make their impacts explicit and quantifiable.

The concept of linkages also extends to a company’s suppliers and customers.  For example, Zara has a network of small textile suppliers in Spain that is critical to its strategy of fast-cycle clothing design and sales based on changing fashions.  Competitors with arms-length relationships with Asian suppliers find it difficult or impossible to imitate this strategy because of the different way they manage supplier relationships.  Porter calls these vertical linkages, and they segue into the concept of scope.  Companies decide to play in different parts of the value chain (e.g., one competitor may outsource manufacturing while another does it in-house), different industries, or different geographies.  These all fall under the concept of scope and will also impact our analysis.

Introducing our consumer packaged goods example

Ok, now that we’ve done a quick run-through of the framework, let’s look at our CPG examples (I’m not an expert on the industry, so please feel free to comment with any additional context or corrections).

The Clorox Company

Founded in 1913, Clorox has been something of a poster child for the cost advantage strategy.  The eponymous bleach is dirt-cheap, and the headquarters is in Oakland, California.  Major brands include Clorox bleach, Glad bags (actually a joint venture with P&G, it seems), Burt’s Bees cosmetics (through acquisition in 2007), and ArmorAll car products.  It’ll be interesting to see whether all of the brands really follow a cost advantage strategy, and if not, how effective it is for Clorox to have units that are more differentiation-oriented within a cost-focused company.  Typically not a recipe for success…

Clorox made an operating profit of 14.9% on $5.5 billion in revenue in 2009.  Not too shabby.

Procter & Gamble

P&G produces many of the world’s best-known brands, including Tide, Ivory, Crest, and Pampers.  The company is also considered the birthplace of brand management as a discipline, and the strategy hinges on differentiation through branding and product innovation.  Like any company, P&G has not always been successful in achieving true differentiation, but it should serve as a classic example of the strategy.

Revenues were $79 billion in 2009, with an operating margin of 20%.  Now that’s pretty amazing work.

Method Products

Method is a relatively newcomer in consumer products, founded in 2001.  I picked Method as an example of the focus strategy because they are targeting “progressive domestics” rather than all consumers.  The idea is to differentiate themselves with a cooler brand, innovative product and packaging design, and environmentally friendly products.

Method’s a private company, so details on its operations will be a bit harder to come by.  Based on sparse and contradictory published figures, it looks like the company made $100-200 million in revenue in 2009.  Profitability will be hard to figure out, but it’s safe to assume the company has been highly successful based on its astronomical growth.

Coming up

• Part 3, a cost analysis discussion of Clorox

Anderson makes a great point from the perspective of the distribution channel.  Amazon, Netflix, and other companies have made a huge virtue of carrying a massive selection.  It’s both part of the value proposition, and to a lesser extent, a driver of profitability.  I’m less convinced that the long tail is a reality for content producers.  Can you really be profitable (or pay the rent) if you have the 100,000^th most popular book on Amazon?  Content publishing, whether in books, music, or movies, has traditionally been a scale game.  Companies needed to maintain a big taste-making apparatus and also to subsidize up-and-coming works through hits.  Between piracy and a high cost base, the industry incumbents no longer have a viable economic model, but what will the new equilibrium look like?  Will they be replaced by a sea of mom and pop producers, or simply by a new wave of large publishers better able to deal with digital distribution challenges and opportunities?

Goodbye to variable costs

Variable costs are of course much lower with digital content.  They are practically zero for each additional copy, apart from bandwidth.  But fixed costs still exist.  You still have to create the content and edit it.  More importantly, you still have promotion costs, which tend to be fixed because you have to commit a certain level of effort and advertising before you know whether the product will be a success.  So you still need a certain level of sales to cover those costs and be profitable.  And there are still benefits to scale.  You can spread your fixed costs over more products, build knowledge of consumer tastes, and build and maintain expertise in production and promotion.

The audience becomes the gatekeeper

In the past, some great content didn’t even make it through the pipeline.  You had to go through a TV network, music label, or publisher, and they rejected most content with an eye to finding the next blockbuster.  However crudely, the taste-makers did perform the valuable function of sorting good content from not so good.

Big media companies are becoming less relevant, but there are still high hurdles to sales because 1) most content isn’t very good and 2) despite everything, it’s very hard to get people to pay attention to you.  Top-tier talent is still scarce.  The audience’s time and attention span are still as finite as ever, and the competition among media for that attention has grown exponentially.  The guerrilla/social/word of mouth alternative to traditional centralized marketing is much harder and more costly to pull off than is commonly acknowledged.  So the shape of the blockbuster landscape may have changed somewhat, but it still exists.  You can now have a niche success more easily in the past, but in each niche, it’s typically still a winner-take-all contest because getting heard above the din is so difficult.  If there are a dozen cooking bloggers making a living without being blessed by The Food Network or Conde Nast first, there are still thousands of others toiling in obscurity.

A thought experiment

To illustrate the point, let’s think about a solo book author before and after the rise of the long tail.  The author’s book sells for $10, and in a traditional scenario, let’s say she gets $2 per copy sold.  Using digital distribution, the per-copy margin is a much more generous $7 (with the rest going to Amazon or Apple).  If the author spends six months writing the book and expects to make $30,000 in income, what’s the break-even point at which book-writing makes economic sense?

In the before scenario, it would be 15,000 copies.  Note that the media company likely would be losing money on this book but subsidizing it from the latest Stephen King novel.

In the after scenario, let’s add one more complication.  Promoting the book requires an additional three months of time, whether blog writing, Tweeting, touring and speaking, or what have you.  Now we need to make $45,000 to make the whole endeavor worthwhile.  The resulting break-even is about 6,400 copies.  Less than before, certainly, but there is still a broad range of sales results where being a writer is a losing proposition.  The same is probably even more true for other forms of media.  YouTube may be doing a decent business in part on user-generated video, but only an infinitesimal fraction of the creators of those videos are earning a living on it.  In contrast, old-fashioned blockbusters do better than ever because there’s a bigger distribution pipe that reaches a bigger audience for that content.

What’s the upshot?

So yes, somewhat more content is rising out of obscurity to become a profitable hit these days.  But the long tail concept implies that content is profitable for the creators most of the way down the tail.  In reality, there’s a modest chance of high profitability (if you can become a hit) combined with a high chance of not making any money.  The best hedge is still a big portfolio of content that can cover your fixed costs and pay for specialized promotion.  Mid-tier content originators stand to gain because a moderate level of sales, and especially a loyal core following that mitigates marketing challenges, can now be quite profitable.  But the real long tail is still the province of the amateur, and less blockbuster profits will be available to subsidize bets on up-and-comers or to fund vanity content that is highly regarded but doesn’t sell.  The pool of winners is growing somewhat, but if you reside further down the long tail, it’s not at all clear that you’re better off.

Really?  I don’t think so.

Customer service fixation

Like Godin says, this definition of excellence is a moving target.  Once you slow down and your competitors provide the same level of service, you’re no longer excellent.  In my mind, contrary to popular opinion, sometimes chasing a moving target like that is a bad idea.  Or maybe more to the point, don’t chase the same moving target everyone else is.

Let’s take Godin’s most salient example of excellence – the amazing customer service provided by companies like Ritz-Carlton, where every employee is empowered to fix customer complaints on the spot.  What if you want to provide service that’s as memorable in order to grow your business?  Well, there’s a reason that kind of service makes such an impression – people who have that kind of attitude towards customers are scarce.

So how are you going to recruit them and keep them?  How do you train them?  How do you ensure that your customer service isn’t seen as fake (like the people at my gym who have been trained to say hello and goodbye every time I come and go but are otherwise unremarkable)?  You can’t just have an inspiring idea about good service, you have to figure out how to deliver it.  Does it require spending more time on recruiting?  Higher employee pay?  A bigger training budget?  How much will it cost to resolve customer complaints in a way that makes them raving fans?  Will it mean raising prices or accepting lower margin?  Maybe.  You can’t will your company to be more delightful.  You need to have a strategy for making it happen.

And let’s say you’ve figured it all out, your service is amazing, and business goes through the roof.  What happens then?  Your competitors try as hard as possible to copy you.  They will offer your best employees higher salaries to leave, they will work on reverse engineering your training processes, and they will figure out other ways to make customers happier to keep up with you.  Take a look at Ritz Carlton, for example.  In San Francisco, TripAdvisor barely has them in the top 10% of hotels based on customer reviews, with another 20-30 hotels coming out as good or higher.  If your 20 closest competitors make people as happy as you do, are you still “indispensable”?  Still excellent?

Old-fashioned competitive advantage

There are many more ways to be indispensable than service.  Let’s look at that “boring” local grocery store down the street.  How do they stay in business?  Location – it’s more convenient to pick up stuff a block from my apartment.  Safeway?  They have a big selection and aren’t too far away.  Whole Foods – premium food, a crunchy granola brand, and usually a great shopping experience (ok, so service does make a difference).  Trader Joe’s – a unique approach to merchandising rotating private label foods that allows for low prices and unique selection.  They’re not all trying to win on the same thing.

And companies like Toyota have won and lost market share and billions of dollars on boring, old-fashioned concepts like quality, despite sometimes less than stellar reputation for service and snazzy design.

In reality, there’s often a big tradeoff to be considered between customer delight and success.  Consider the humble deli.  Zingerman’s Deli in Ann Arbor, Michigan is an amazing customer service organization and is revered around the country by people who look for the best customer service and some of the best food.  What’s the catch?  They only have one location and are basically a break-even business last time I checked.  Yet they’re indispensable to their customers.  Meanwhile, Subway has mediocre food and service yet makes over $9 billion in annual revenue.  There’s no justice in business, except by accident.

Or what if you’re an up and coming freelancer or consultant.  Should you spend 50% more time on a project to be indispensable to that client, or should you spend that time going out and finding additional clients to grow your business?  The answer is probably somewhere in between and maybe closer to the latter, something that the motivational business press sometimes fails to mention.

Sometimes you really do win based on old-fashioned competitive advantage.  Things like lower costs, barriers to entry, and all that strategy stuff do matter.

I’m not saying that companies like Zappo’s and Southwest haven’t done amazingly well by focusing on service, but making that level of service work is hardly a slam dunk, nor is it right for every company.

Strategic alignment

So what is right for every company?  Figure out:

• Which customers you want to focus on?
• What those customers care about?
• What you are uniquely positioned to provide?
• What your competitors are unable or unwilling to do?

Don’t try to sell to every customer.  For every flyer who swoons over Southwest’s folksy charm, there’s a business traveler who wants stodgy lounges and frequent flier miles instead.  You can’t please everyone, so pick a segment and stick to it.

Figure out what they want more than anything else.  If you’re selling to purchasing agents, it might be price.  For engineers, it might be quality.  For time-starved professionals, it might be convenience.  You’ll know you’ve hit the right thing when customers buy more from you as a result.  If it doesn’t affect their buying behavior, it’s not that important.

What can you be the best at?  If you’re not a people person, it’s probably not cheery service.  But maybe you’ll be the most reliable.  Maybe you’ll just be open 24 hours.  But whatever it is, it has to fit with your personality, talents, and ideally background.  If you’ve spent 10 years as a reporter, starting your own interior design business is going to be a bigger hill to climb.  Passion still trumps experience in the end, but be careful about knowing what you’re doing.

Finally, pick something that can’t be copied.  Of course, nothing’s ever completely unique.  But if 20 of your competitors start doing exactly the same thing you are (or even worse, you copy what they’re already doing), the odds aren’t good.  Articles about great companies focus on a handful of things, but the secret is that every decision in the company is focused on achieving the same goal.  Every process, every hiring decision, and every analysis is aligned towards that goal.  That kind of alignment is what competitors have the hardest time copying, and it’s what leads to sustainable success.

If you can get all these answers to match up, you have a great shot at being indispensable.  And you might be indispensable for boring reasons, but it won’t matter.

From a financial perspective, the 2009 fiscal year at Cisco was a difficult one.  Revenue was down by 9%, operating income by 22%, and operating margins by 3.6 percentage points (20.3% versus 23.9%).  However, a big part of the reason for the drop was Cisco’s continuing investment in future growth in the face of the recession.  Cisco maintained R&D spending despite the revenue drop and acquired Pure Digital of Flip video camera fame.  After the end of the fiscal year, Cisco also snapped up Tandberg for $3.4 billion and Starent for $2.9 billion.  The company also apparently expanded the number of “internal startups” it funds, from 20 to 30, and made a somewhat controversial push into the server market with its Unified Computing System initiative.

I am a huge fan of contrarian business strategy, and Cisco is a great example of it.  Investing while other companies are pulling back is a wonderful way to position yourself for growth down the road.  Cisco is one of the few firms that can afford to do it in spades, sitting on $35 billion in cash at the end of the fiscal year.  Some complained that Cisco overpaid for Starent, which made equipment for smartphone networks, but that arena will clearly be one of the main growth drivers in networking equipment for the foreseeable future.  In addition, Starent turned in 74% revenue growth the year before being acquired.  Cisco has also built one of the best track records for successfully integrating acquisitions and generating value from them.  So in my mind, a slightly richer acquisition price is warranted.

That’s not to say that Cisco hasn’t seen a misfire here and there.  They acquired Navini in the WiMax equipment market for $330 million in 2007 and recently announced that they were exiting that market due to lackluster results.

Opinions are also mixed on their Unified Computing System strategy, where Cisco is seeking to sell bundles of servers as well as networking equipment to their enterprise data center customers.  This approach pits them against HP and IBM, both of which have the potential to nudge customers away from Cisco in their roles as vendors and technology consultants.  Of course, given that blade servers are one of the few bright spots in the $50+ billion server market, maybe taking risks like that is warranted.

The bigger problem  from a stock perspective is that Cisco is now a huge company, and huge companies tend to produce only modest revenue and profit growth.  Circa 2000, Cisco’s enormous valuation was driven by growth and potential.  Since then, revenue has risen only modestly.  Average revenue growth between 2002 and 2008, the most favorable endpoints I could find, was only 11%.  The company has certainly achieved much of its potential, but meeting expectations doesn’t result in an ever-higher stock price.  Recently, Cisco has also seen a bit of market share slippage in its core product lines of switches in routers.  That development merits its own line of analysis, but at face value it’s not reassuring.

Cisco has been addressing the organizational aspects of size with a big culture shift.  The top management team traditionally ran the company in a top-down manner, but over the last several years, CEO John Chambers has led a drive to delegate authority down the chain.  Now a variety of internal teams are empowered to rapidly launch products without the involvement of senior executives.  It’s hard to say whether this change will be enough to keep Cisco nimble as a larger company, but the company deserves credit for going through a challenging internal transition to attempt to avoid becoming too slow to react to market changes.

Overall, I’m still quite confident in Cisco’s business strategy and its ability to continue to rule the networking market and perhaps make strong inroads into a number of adjacent markets.  Having said that, I will be surprised if the company can generate enough growth to move its stock price significantly upwards.  Sometimes the stock market doesn’t really capture the value a business generates for customers, and this looks like it will continue to be one of those cases.  Or more accurately, the huge run up in the stock in the late 90’s captured the value of the company’s good execution now and perhaps into the future.

Further reading:

• Recent Wall Street Journal review of Cisco’s current strategy
• Fast Company piece on the recent organizational changes
• ChannelWeb discussion of Cisco’s new server strategy