Strategic Planning Analogy #372: Spreadsheet Games

THE STORY
Sudoku is a wildly popular number game throughout the world. It is based on a 9x9 grid. This grid is further sub-divided into 9 3x3 grids. The idea is to fill all 81 squares in the grid with a number from 1 to 9 such that:

a) Every row will have exactly one occurrence of each number from 1 to 9.

b) Every column will have exactly one occurrence of each number from 1 to 9.

c) Each 3x3 grid will have exactly one occurrence of each number from 1 to 9.

Although the origins of the game go back to the 18th century, its recent popularity began back in 1986, when the Nikoli company in Japan started publishing books of the puzzles (they were the first to label the puzzles “Sudoku").

However, the global popularity didn’t begin until Wayne Gould, a retired Hong Kong judge, developed a software program making it easy to develop new Sudoku puzzles. This software started to be used in 2004. Nearly all Sudoku puzzles today are made with Gould’s software.

It is estimated that the size of the global Sudoku business is in the many hundreds of millions of dollars annually. However, neither Nikoli nor Gould see much of that money. Nikoli never bothered to trademark Sudoku outside of Japan, so they only get Japanese royalties. And Gould decided to let others use his software royalty-free (all they had to pay for was the software). It is estimated that of the hundreds and hundreds of millions made on Sudoku, Nikoli only sees about $25 million and Gould only earns about $1 million.

THE ANALOGY
Although Sudoku is a very popular number game, it has not financially benefitted Wayne Gould to anywhere near the extent of its popularity.

In strategic planning, we have a different number game which is also very popular (at least with strategists). It is the discounted cash flow analysis. The object of the game is to estimate future cash flows and then discount them back into today’s value by taking out the annual cost of capital requirements. When you solve this number puzzle, you will supposedly know how much a particular business or strategy is worth in today’s currency.

Companies spend a lot of time and money playing these discounted cash flow number games. However, I am afraid that many of the businesses using this game are like Wayne Gould. They are not reaping rewards anywhere near the size that one would expect.

In fact, I would argue that much of the claimed benefits of discounted cash flow analyses are no longer there. Much of the effort put behind them is wasted effort. You might be just as well ahead if you let your financial analysts play Sudoku as to have them play Discounted Cash Flow.

THE PRINCIPLE
The principle here is that merely solving a discounted cash flow puzzle is not the same thing as developing a sound strategy. And often, solving a discounted cash flow puzzle does not lead to as much insight as one might think. Therefore, you may want to reallocate your resources to solving fewer of these puzzles and more to deeper strategic thinking.

Is Cash Flow As Important As We Think?
Discounted Cash Flow puzzles are based on the assumption that cash flow is the most important determinant of value. And the proponents of using this game can point to historical evidence showing that cash flow has one of the strongest correlations to value. However, I believe that in the future that correlation will significantly weaken. Here is why I think so.

Cash flows measure how a business earns profits through operations. The underlying assumption is that the value of the business is based on how profitable its operations are. In other words, if you assume that business operations are the way money is taken out of a business, then modeling the cash flows of those operations will give you a good idea of what the business is worth to you.

However, it appears more and more that the primary way companies in the future will extract value out of a business will have little to do with operations. Instead, nearly all of the value will be created at the time ownership transfers.

For example, take a look at a lot of the recent activity in the digital space. Companies like You Tube, Alibaba, Webex, Google and Doubleclick created nearly all their value at the time they either sold out or went public. The value created at that instant was far in excess of any type of cash flow profits that they had created in their past or could be expected in their near future. In fact, it is hard to envision how any sort of cash flow could reasonable get to the evaluations firms such as these created at the moment of ownership change.

I think this will get even more distorted when firms like Facebook, Groupon, Zynga, Twitter and others do their change in ownership. You’re already starting to see it with the ownership money already flowing into these firms. The valuations are incredibly high.

If you put these values into a discounted cash flow model and solve for future cash flow, you get numbers which boggle the mind. Sure, I can mathematically make the models work. The models will solve for cash flow. But just because the model can determine what cash flow is needed to make the model work does not mean that those future cash flows are likely to occur.

Flip that Business
In the new reality, if value is made by ownership transfer rather than through operations, perhaps operational cash flow is the wrong place to be looking when trying to determine value.

Keep this in mind. If I know that I am running a business to create value through ownership change rather than through operations, how do you think I am going to run that business? Obviously, I am not going to fixate on operations, but rather fixate on that which influences the transfer of ownership. My definition of customers is no longer the people buying or using my product. No, my customers are now the people I am going to transfer the ownership to.

Think of the people who flip houses. These people find a distressed house, fix it up, and quickly flip it to someone else at a profit. These people have no intention of ever living in these houses. These people to not make investments which are in the best long-term interests of the house. Instead, they focus on superficial cosmetics (how nice the lawn looks—curb appeal) which make the house more appealing to the next buyer. Let the buyer beware!

Many of the businesses of the future will be operated the same way as house flippers. The original owners have no intention of sticking around long term. They are not incented to do what is best for the company long term. Instead, effort will be placed on the superficial cosmetics which increase the appeal to the next owner. Things like how many visits there are to the site (which may be adding no value but be appealing to future owners) will be focused on rather than building a viable long-term business model (the source of cash flows). Let the buyer beware!

Now you might think that future owners would still be fixated on cash flows. They may say so, and they probably should be, but that is not necessarily reality. With all of the well-financed hedge funds and deep-pocket companies out there right now, there is too much money chasing too few great opportunities. As a result, the rules of supply and demand overtake the rules of cash flow. Businesses get bid up beyond appropriate cash flow values due to supply and demand.

In addition, keep in mind that the next owner may not be a final owner, either. They may be purchasing the business in order to quickly flip it to a third buyer. Look how many businesses are taken private (new owner) just so that it can be flipped back public again a few years later (third owner). Therefore, the new owner may be just as disinterested in everyday operations as the old owner.

So What Should We Do?
If this is the case, then what should we do? If you are the owner wanting to flip the business, look for places where supply (companies) and demand (potential new owners) are in your favor. Focus on things which impact desirability at time of sale rather than fixating on cash flows.

If you are the buyer of businesses, spend more time looking beyond the hype to understand the fundamentals. Warren Buffett always puts more value on business fundamentals than on the magic of pushing around numbers in a spreadsheet. If the basic fundamentals of the business are solid and the business model is solid, then good things usually happen (regardless of the numbers).

Unfortunately, the reverse is often not true. You can make a pretty model with nice numbers, but end up with a disaster because the assumptions are not based on solid fundamentals. Without a solid underpinning, a completed cash flow model may not be any more valuable than a completed Sudoku puzzle.

This is not to say that cash flow puzzles should be abandoned. They are still a valuable tool. Think of them as like the speedometer on an automobile. If you glance at them every once in a while, they can be very useful. But if you stare at them constantly (and fail to look out the window), you will end up in a crash. Rather than agonizing over them to the utmost detail, just use them to check for broad reasonableness.

SUMMARY
As value creation shifts more towards ownership transfer and less towards operational cash flows, the value of cash flow tools also diminish a bit. More thought must be given to supplementing such analysis with deeper looks at either the fundamentals of the business model (if a buyer) or the tricks to increasing appeal to a buyer (if a seller).

FINAL THOUGHTS
Sudoku is played by a narrow set of rigid rules. This makes it easy to know if you have won. By contrast, strategy is played using a wide set of vague rules. As a result, in strategy you can solve the puzzle, yet still lose the game. Don’t assume that strategy is a simple as filling out a few spreadsheets.

We Can All Act Like Sports Franchise Owners

THE STORY
Back in 2001, Howard Schultz and 57 partners bought the Seattle Sonics professional basketball franchise for $200 million. During the time that Howard Schultz owned the Seattle Sonics, the team suffered annual losses. It is claimed that while Schultz owned the team, the combined operating losses were $60 million.

Yet, in spite of being a business that showed no signs of making a profit, Schultz and his partners sold the Seattle Sonic team in 2006 for $350 million. That is $150 million more than what they paid for the team and $90 more than they paid if you subtract the annual losses. In fact, they supposedly turned down an offer of $425 million (more than twice what they paid for the team) from Larry Ellison, CEO of Oracle, because he wanted to move the team away from Seattle.

This is not a fluke price. In 2004, the New Jersey Nets basketball franchise sold for $300 million and the Cleveland Cavaliers basketball team (and its arena) were sold in 2005 for $375 million.

Willamette Management Associates is an expert in the area of sports franchise valuation. One of their representatives says that it is very difficult to use income flows as a means of evaluating sports franchises. To quote a 2002 paper they wrote on the topic,

“The discounted cash flow method is often used in the valuation of sports franchise intangible assets. However, it may be difficult to use this method in the valuation of the sports business enterprise. This is because many sports franchises either earn negative income or do not generate sufficient income to support the prices paid in actual team sales.”

So it appears that even though the business itself can be a perpetual money loser, in the world of sports franchises that does not mean it is a bad investment. According to the Seattle Times, the annual rate of return on the investment of Howard Schultz and his partners, when you consider the selling price and other factors, was probably around 10.6%. That’s a pretty good return for investing in something that loses money.

THE ANALOGY
At the end of the day, the basic goal of capitalism is to find good returns on investment. As the story above illustrates, it is possible to get very good returns on investment on businesses that provide little to no profitability on an annual basis. The return on investment for the Seattle Sonics did not come from the operating earnings, but rather from the selling price.

Now you may be thinking that such opportunities occur only in the world of sports. However, recent trends seem to be indicating that this trend is creeping ever more into the rest of the business world. Just look at some of the prices that hedge funds have been paying recently for businesses that are not very prosperous. Even businesses that lose money are being snapped up at relatively high prices by these hedge funds.

When devising business strategies, there appears to be a strategic option to consider running a business not to necessarily make money through earnings, but rather to gain virtually all of the profits at the point when the property is sold. This is called the “build to flip” strategy.

THE PRINCIPLE
The build to flip strategy takes a different perspective on the question “who is my customer.” Instead of seeing the customer as being the person who pays you for your goods or services, this strategic alternative sees the customer as the person you eventually sell the business to. Taking the adage “please the customer” to heart, the build to flip companies run their business more to make an eventual buyer of the firm happy rather than to make the business operation’s customers happy.

For example, during the dot com bubble of the 1990s, many start-ups had as their strategy the goal of eventually selling the business to Cisco Systems. Cisco had a policy that they would only buy firms located in one of three areas—Silicon Valley, Austin Texas, or the Research Triangle in North Carolina. The reason was that it was too difficult to manage the Cisco empire if all the subsidiaries were scattered all over the place.

Start-up companies knew this policy, so if their goal was to eventually be bought out by Cisco, they knew that they had to locate the business in one of these three areas, even if it was inconvenient to them or to their operating customers. After all, they saw Cisco as their ultimate customer, and if that is what Cisco wanted, then that is what they did.

I personally saw this principle in action when I was in the grocery business. A number of independent grocers, when they got near retirement age, wanted to sell their businesses. These grocers knew how the large supermarket chains thought when considering the purchase of an independent grocer. Large grocery chains believed that it was easier to take a store with high volumes and leverage the volume into higher profitability than it was to take a low volume store and increase its volume. In fact, these chains would prefer to purchase a high volume store that lost money over a low volume store with modest profits, because they believed the high volume store had more upside potential.

Knowing this, the independent grocer thinking of retiring would for a year or two abandon the idea of making a profit and focus all of the strategic effort on doing whatever it took to increase sales volume. They would do this even if the tactic made little economic sense in the long run or even if the tactic was unsustainable in the long run. After all, the eventual buyer of the business wanted to buy sales volume and typically set its purchase price on a multiple of sales. So to give the “customer” what they wanted, the independent grocer would raise the sales volume, regardless of the consequences.

Once the sales volume from these tactics started to peak, the independent grocer would sell the company to the supermarket chain. This strategy would make the independent grocer wealthier than if they had run the business as normal prior to the sale. So as you can see, the idea of getting a good return when losing money is not just a principle for sports franchises.

Even on a smaller level, I have seen this policy used in the real estate business. It is not uncommon for someone to own property on the far outskirts of a city. The owner of the property knows that if they wait a few years, the city will grow out to where his land is. At that time, it will become very profitable to sell the land to a developer. To sell now would bring a lesser return. So what do you do with the property in the mean time, while waiting for the city to grow in this direction?

Well, you don’t want to put a lot of capital into the land, because you are going to only hold it a short time. Since you do not know how the eventual new owner will want to use the property, you don’t want to use the property in such a way that would limit the flexibility of the new owner to do what they want. So what do many of them do?

They put a miniature golf course on the property. The cost to do so is very low, and it leaves a lot of flexibility for the next owner, since a miniature golf course can be easily removed, leaving the land ready for just about any use. The golf course does not have to make a lot of money. Even if it helps cover just a portion of the interest on the real estate, it is beneficial. After all, the goal is to make most of the return on the sale of the land, not the operation of the miniature golf course.

If you are trying to sell a company, there are many decisions that you might make differently if you look at a potential buyer of the firm as the true customer. For example, if you know that potential buyers of the company prefer to operate on particular computer platforms, you may want to run your business on that platform as well, even if it is not your personal preference.

Instead of spending a lot of time making calls on operating business prospects, you may want to divert more energy to speaking at seminars or in getting articles published in places where potential buyers of the company will get exposed to you in a favorable light. The idea is to make it a priority to think about ways to make your company appear more valuable to a potential buyer of the company.

There is something to be learned from running your business as if it were a sports franchise.

SUMMARY
There is more than one way to get a good return on your investment. One way is to focus on getting nearly all of your return at the point in which you sell the company (the build to flip strategy). This tends to be the way that sports franchises have worked for decades and it appears to be an increasingly viable strategy outside the sports world. This is especially true given all of the hedge fund money out there looking for companies to buy. In this strategy, the idea is to look at the eventual buyer of the firm as your true customer and to make decisions based on how it would please this eventual buyer.

FINAL THOUGHTS
If it is true that the majority of the profits of a business strategy could come at the point at which the company is sold, then it must also be true that a lot of the value in the acquiring company could be destroyed if it purchases companies unwisely. Making most of your value by purchasing properly (rather than selling properly) is another way to build a strategy.