Analogy #194: A Bigger Better

THE STORY

Once upon a time, there were two small neighboring kingdoms: the Kingdom of Lin and the Kingdom of Bath. Because they were small, both kingdoms were afraid that a larger kingdom would invade each of their territories and take them over. The King of Lin and the King of Bath got together to discuss the issue. They decided that the best thing to do would be for each kingdom to build a giant monster to scare away their larger enemies. So each king went back to his kingdom to build a monster.

The King of Lin wanted to get a monster built as quickly as possible, so that he could scare the enemy right away. Therefore, in only a few days, the kingdom of Lin had built a huge monster-like puppet out of cloth and paper mache. The monster came with stilts. A man would climb into the puppet and parade around the castle in it by walking on the stilts. From a distance, it looked pretty scary.

The King of Bath took a different approach. Rather than just building a monster that looked scary, he wanted a monster that was scary. Therefore, he decided to build a huge, mechanized iron robot, complete with weapons. It took a lot more time and effort and resources to build this robot. As a result, the kingdom of Bath had no monster for awhile, leaving them vulnerable to attack. However, once the mechanized iron robot was completed, he was a frighteningly effective weapon. The iron robot was not as large as the paper mache puppet, but much more powerful.

When the larger kingdoms came to attack Lin and Bath, they were at first frightened by Lin’s giant paper mache puppet and stayed away. The people of Lin were so confident in their puppet that they got lazy and failed to prepare for war. Eventually, however, the enemy figured out that this puppet was not a real threat, so they attacked the kingdom of Lin and easily took it over.

By contrast, the efforts in building the iron robot taught the people of Bath much about weapon design. And because they had to go a long time without their monster, they always kept alert and prepared for war. As a result, the invading armies could not defeat the people of Bath. In fact, the kingdom of Bath became so strong that it started invading other kingdoms and enlarged its territory, including taking over the area formerly held by the King of Lin.

THE ANALOGY

In the business world, a lot of emphasis is placed on speed and size. The general consensus is that good planning should help you become big, and do it as quickly as possible. Bigness is desired to create economies of scale and momentum with the consumer so that you can survive any industry shakeout. Speed is needed to get “first-mover-advantage” and keep ahead of the competition in a rapidly changing world.

Although size and speed can be good things, it is not always the case that the biggest and the fastest wins.

If you want to become “big quickly” in the worst way, you may find the worst way to become big quickly. This is what happened at the Kingdom of Lin. Yes, they were faster and yes, their monster was bigger, but the Lin creation was not a real monster. It was just a phony puppet.
The puppet gave the kingdom of Lin a false sense of security. Once reality was known, the kingdom was overrun by invaders who were not afraid of paper mache.

The output from the kingdom of Bath was not as big, and it took a lot longer to create. However, in the end it was a very powerful weapon, capable of beating its foes.

Therefore, in businesses, we must not always just rush head-first into a blind mad dash for size and speed. Not everything big is powerful. Sometimes all one builds is a big pile of junk.
Quality and sustainability must also be considered. Therefore, it is better to take the path of Bath than of Lin. We shall see a specific business example of this below.

THE PRICIPLE

The principle here is that size and speed are only relevant if the outcome is strong and powerful. Not all paths to quick size create this type of outcome. For example, one way to get big quickly is to go on an acquisition binge, buying every business in sight. Unfortunately, most acquisitions are not cost effective and the process of trying to integrate a lot of different businesses quickly can lead to a real mess. In most cases, this path may get you big quickly, but it usually collapses under its own weight and leads to self-destruction.

Another way to get big quickly is to try to buy market share at any cost. This is what happened at the height of the original dotcom bubble. The idea was that being big and being first would eventually pay off in the long run, even if the tactics looked foolish and expensive in the short run. Unfortunately, many of these business models were as phony as that paper mache puppet. It didn’t matter how big or how fast they grew. They were based on models too weak to survive, and eventually collapsed. Had more time been spent on the quality of the model, rather than the size, more would have survived.

Sometimes, however, the principle can be more subtle. Let’s look in detail at a comparison of two US retailers—Linens N Things versus Bed Bath and Beyond. If one went back to the years 1993 and 1994, the two companies would look rather similar. Their size in terms of sales were very similar—both having sales of around $375 million. They were both the big leaders in their industry. Their net profits back around 1993 and 1994 were also similar, at about $25 million (a fairly healthy 6-7% of sales.

On the surface, it would have appeared in 1993/1994 that the two firms were very similar…same basic store format with similar sales and profits. Both appeared to have gotten big quickly and both looked like they had a bright future. Some might have argued that Linens N Things had a slight edge. It was slightly bigger in sales than Bed Bath & Beyond and it had the strong backing of its owner, the Melville/CVS organization. Hence, it was bigger on its own, as well as the advantage of being a part of a big retail conglomerate.

However, if one moves forward to today, one would see a much different picture. Linens N Things recently declared bankruptcy and is rapidly shutting down a large number of its stores. By contrast, Bed Bath and Beyond is even more profitable now as a % of sales than it was back in 1994.

Even before the bankruptcy, one could see the vast differences in their fate. If you average the performance for 2005 to 2007, Bed Bath and Beyond had sales of about $6.5 billion, which was 2.3x the sales of Linens N Things. The gap was even larger when it comes to net profits. Bed Bath and Beyond had net profits of 8.8% of sales while Linens N Things had a loss of 3.8% of sales.

How could two companies which looked so similar in 1994 look so different in 2007? As it turns out, although both firms were similarly big in size 2004, the quality of that bigness differed significantly.

Linens N Things had built their bigness like the kingdom of Lin, out of paper mache. By contrast, Bed Bath and Beyond built its bigness like the kingdom of Bath, out of strong iron (notice the similarity in the kingdom and company names?).

Let’s look at the income statement in more detail. Although both companies had similar profitability in 1994, they got there by different paths. Linens N Things at the time had a cost structure (Selling, General and Administrative Costs) that was 14% higher than Bed Bath and Beyond. It’s sales per store were less than 40% those of Bed Bath and Beyond.

In essence, Linens N Things had terribly unproductive stores (in terms of both sales and costs). In contrast, Bed Bath and Beyond had strong and productive stores. The only reason why Linens N Things could match up with Bed Bath & Beyond back in 1994 was because:

a) Linens N Things had a lot more stores than Bed Bath and Beyond (143 vs. 61). Thus, although the stores were less productive, there were a lot more of them.

b) Linens N Things had the backing of Melville Corp., so it was able to avoid long term debt (and interest expense). Linens N Things had no long term debt at the time, while Bed Bath & Beyond did.

However, over time, the added productivity at Bed Bath and Beyond gave them the cash flow to eventually build more stores than Linens N Things (by 2007 Bed Bath and Beyond had 1.5x the store count of Linens N Things). Also, the productivity allowed Bed Bath and Beyond to get completely out of long-term debt. By contrast, the financial troubles at Linens N Things forced it into a highly leveraged privatization.

In other words, the monster of Linens N Things in 1994 was paper mache. It was a weak and ineffective business model. It only looked strong back then because they got a lot more stores open earlier (like the kingdom of Lin who got their monster built earlier).

By contrast, Bed Bath and Beyond took longer to develop a stronger business model. But when developed, it was as strong as iron (like at the kingdom of Bath). Eventually, the iron wins out over the paper mache.

SUMMARY

Size and speed are not enough. If what you are building is weak, it will not stand—no matter how large. In the end, quality of the business model is most important. You can be a little slower, if you are ultimately better. This is not to say that superiority wins if you remain slow and small. But superiority creates a better environment for building size quickly which is sustainable over the long haul.

FINAL THOUGHTS

In planning meetings, I’ve witnessed a lot more time being spent on looking for growth than in looking for superiority. Lots of talk on tactics to improve sales or talk on expansion but much less time on molding a better business model. The irony is that if the business model is superior enough, you won’t need to spend so much time working on sales and expansion—it will come almost on its own.