Tuesday, June 10, 2008

Analogy #184: Don’t Cut Down All the Trees

Did you ever wonder what it would be like if countries were colored like they are on maps? When you look at a map, one country may be colored brown. Immediately on the other the side of the border, the next country on the map is colored green. Wouldn’t it be something to see such a border in reality, where everything is brown on one side and green on the other?

Well, the island of Hispaniola is something like that. The island of Hispaniola is in the Caribbean Sea, located southeast of Cuba. The western half of the island is the nation of Haiti. The eastern half of the island is the Dominican Republic.

You would think that because the island is so small, and since both are surrounded by the same body of water, that the climates in both countries would be nearly identical. They are not. Haiti is like a dry, barren desert. It is brown. The Dominican Republic is a lush, tropical area which gets plenty of rain. It is green. It’s almost like those multi-colored maps, brown on one side of the border, green on the other.

Why are the climates so different? It has to do with trees. In a desperate search for fuel, the Haitians have cut down nearly every tree on their half of the island. By contrast, the people of the Dominican Republic did not cut down all of their trees.

It is an interesting quirk of nature that if you want a lot of rain, you need a lot of trees. The trees interact with the atmosphere in such a way to promote the growth of rain clouds. Without the trees, the clouds do not form. With virtually no trees in Haiti, there is virtually no rain in Haiti. Because the Dominican Republic still has lots of trees, they get a downpour nearly every day.

When Haiti had lots of trees, their climate was like that of the Dominican Republic. But those days are long gone and now they suffer from a shortage of water.

This is a tough problem for Haiti to fix. It would take generations to re-grow a large forest. In the meantime, there is still a desperate shortage of fuel, so the temptation to cut down the trees for fuel would be great. Finally, Haiti does not have the monetary resources necessary to pull off such a project. With all of the immediate problems that they have, it is hard to commit to something with a payback so far into the future.

At first, it is hard to see the connection between trees and rain. It is not necessarily intuitive. Therefore, when the trees are being cut down for fuel, people do not make the connection between this act and its consequences to the climate. They seem like separate, unrelated issues. However, whether we see it or not, the two are interrelated. And the consequences are quite dire. By the time people figured it out, it was too late to do much on a near-term basis.

Business models also have many interrelated parts. Sometimes it is difficult to see how the pieces all interrelate. Therefore, we think we can do certain things in one area of the business without it impacting the rest of the business. Unfortunately, just like losing those trees lead to losing water, disruptions in one part of the business model could cause a financial drought for the entire company that would take generations to repair.

The principle here is about managing the interrelated pieces of complex business models. In many ways, you have to manage all of the pieces together, like a delicate ecosystem. Piecemeal approaches that only look at one isolated decision at a time can end up destroying that delicate business ecosystem.

For example, outside investor activists often do not have the same level of intimate knowledge that insiders do about the interdependencies of the business model. Therefore, they come bursting in with all sorts of ideas to break up the company and sell off pieces (or some other such restructuring).

Many times, these can be good ideas. A fresh perspective can be useful. However, other times, these suggestions may be the equivalent of telling Haiti to cut down all of its trees. Without realizing it, these innocent looking breakups end up selling off a key resource that makes the whole business ecosystem work. Without it, profits for the whole business dry up, because they sold of f what helps create the rain.

Recently, an executive of Southwest Airlines was talking to financial analysts/reporters. An analyst mentioned the fact that Southwest has some great long-term pricing contracts on jet fuel at favorable rates. Those contracts are extremely valuable in today’s environment. It was suggested that Southwest could make a bundle of money by selling those contracts.

But Southwest knows that those fuel contracts are their trees. They help create the low-cost structure upon which the entire business model is dependent. The executive correctly responded to the analyst that yes, they could make a lot of money on such a deal, but immediately after that, they would be out of business as an airline. Without the fuel contracts, Southwest’s entire business model would be in an irreversible drought.

Similarly, analysts and activist investors over the years have suggested that fast food chains divest of the restaurants they own. The idea is that they could fetch a lot of money from spinning the restaurants out to the franchisees. In addition, it would help them better focus on the franchisor side of the business.

The fast food companies contended that although the relationship may not be so obvious, owning a few of the restaurants does indeed improve the overall business model. By owning a few restaurants, they better understand the problems of the franchisees. It helps keep them closer to the ultimate customer. And it provides easy ways to experiment. As a result, they make the companies better franchisors, who can better serve the needs of franchisees and customers. Hence, without this so-called “fringe” business, the core business would suffer. They are like trees…an integral part of the entire business model.

If you have to cut down some trees, have plans to replace them. In the retail business, I have seen what happens when you keep taking money out of the business and don’t put any back in. Stores start to look run-down. The shopping centers deteriorate and become less desirable places to shop. Eventually customers give up on the run-down stores and shop the shiny new competitors.

Some have argued that Eddie Lampert is going down that path with Sears. By under-investing, in Sears, it is like cutting down all the trees and not planting any replacements. The stores become barren wastelands, as the customers depart for greener pastures. More on this topic can be seen in the blog “Don’t Eat Your Seed Corn.”

Before you start to break up a portfolio, or restructure the business, or pull back resources from a particular area, first check how those pieces inter-relate with the rest of the business model. Although it might not be obvious on first glance, they may play a vital indirect role in the prosperity of the core business.

Losing those pieces may have dire long-term consequences. Just as it could take generations for Haiti to replace its trees, it could take your firm a long time to replace a vital resource once it is lost.

The water shortage in Haiti due to a lack of trees has gotten so bad that salt water is seeping into the freshwater supply, ruining what little water there is. Vacuums tend to get filled. And if you’ve taken away the elements that create success, the vacuum may be filled with things that hurt you.

No comments:

Post a Comment