Huh?

In today's Wall Street Journal, there is an article about P&G and Colgate.  It says that the companies are beset with two problems:

 

1) Consumers are trading down from the brand name products of P&G and Colgate to cheaper store brands and private label products.

 

2) Due to the economy, people are cutting back on discretionary spending in general to save money.

 

So how did the two companies react to these trends?  Both of them raised prices.  This appears to have accelerated the defection and reduced unit volume even more.  Yet, for now, the steps preserved near-term profits.

 

According to P&G CFO Jon Moeller, "While painful, pricing to protect the structural economics of our business is the right thing to do." 

 

Protect the structural economics?  What good is a strong economic structure if the customers go away?

 

Am I missing something here?  Taking steps to accelerate the movement of customers to the competition?  Raising prices at a time when customers are the most price sensitive?  Trying to squeeze a few more pennies today which could ruin long-term prospects in the future?

 

This reminds me of an earlier blog I wrote.  It talked about how financially oriented people often get in the habit of assuming the cash flow of the current business model will always continue to flow in.  Therefore, job #1 is to squeeze as much profit as possible out of that cash flow.

 

Unfortunately, if you squeeze too many dollars out, the underlying economic model stops working.  Customers will shift to a better economic model (for them), leaving you with a broken, obsolete model.

 

It sounds like Jon Moeller needs to read that blog.

Analogy #212: Incremental Dead-Ends

THE STORY
In case you were wondering why it has been so long since I wrote my blog, two weeks ago I was on vacation. This past week I had a medical problem with my eye.

The eye doctor diagnosed it as “Recurrent Corneal Erosion.” What happened was that the outer layer of my eye became sort of detatched from the rest of the eye. It is sort of like what happens when a popped boil creates loose outer skin on your body.

Every time my eyelid rubbed against the eye, it was irritating the loose eye layer. It was sort of like the pain of pulling a bandage off a scab. The eye doctor said that she was taught in school that this is the most painful condition one can have with an eye. I don’t know if it is the most painful, but I can vouch that it was indeed very painful.

To counter the pain and help it heal, the standard recommendation was an anti-biotic inside petroleum jelly. The jelly supposedly helps lubricate the scraping of the eye by the eyelid, while the anti-biotic fights infection.

The jelly came in a little tube, like tiny toothpaste. However, when you squeezed on the tube, the jelly all rolled up into a ball, making it almost impossible to apply to the eye. I was not very good at applying it, so it was not helping. Next, I had my wife help me apply it. That was better, but still problematic. The next day I went to the eye doctor and had her put it in. I figured that since she was a pro, she could do it better. It was only slightly better. I even asked the pharmacist if she knew any tricks to applying the jelly.

Even with the jelly in my eye, it only temporarily helped ease the pain. And it made it hard to see, because I was looking through a film of jelly. So even at its best, it wasn’t very good.

Finally, my eye doctor referred me to a specialist. It only took him a couple of minutes to solve the problem. He took something like a blank contact lens and put it in my eye. The contact lens immediately and permanently protected the cornea from the eyelid. The pain was finally gone. And I didn’t have to mess with the jelly any more. I wish we would have done that a lot sooner.

THE ANALOGY
In the business world we need strategies to solve problems and grow the business. Often times, the place where we start is with the conventional thinking of the recent past. In other words, we try to create a better future by making incremental improvements to the current way of doing things.

This was what I was trying to do with my eye problem. I was trying to find incrementally better ways to apply the jelly. The thinking was that the jelly was good and the standard cure, so if I can just apply it better, I’ll have a better cure.

The solution, however, required throwing away the jelly and trying something entirely different. Instead of looking to prescription ointments, we went in an entirely different direction and tried an artificial lens-like device.

Frequently, we need to do the same thing with our strategy. Rather than trying to improve the current business model, we need to throw it away and come at the problem from an entirely different direction that has almost nothing in common with the old approach.

THE PRINCIPLE
The principle here is the concept of discontinuous improvement. Great leaps in innovation and growth rarely come from a series of small incremental improvements. Instead, the great leaps come from completely abandoning the old business models and technologies and processes and doing something entirely different.

You cannot make incremental improvements to the radio and eventually end up with an iPod. The technology is entirely different. The way the money is made in the business model is entirely different. The players in the business model are entirely different.

Similarly, you cannot make incremental changes to the stove and eventually come up with a microwave oven. The technology is totally different. The cooking is done in such a radically different way that entirely new ways of packaging and preparing food developed.

If you want to go back even further, you cannot evolve carbon paper into photocopiers. You cannot evolve slide rules into calculators. New approaches created entirely new industries, which made the old ways obsolete.

One of my favorite recent examples is Procter & Gamble. For years, they had looked for solutions for better cleaning through better chemistry. This had about run its course. Then someone got the idea of looking for cleaning solutions through better physics. Suddenly, there were several new cleaning products for Mr. Clean, such as the Magic Eraser. Swiffer was based in part on the science of static electricity. These successful new products were relying on business principles as different from traditional chemistry as my petroleum jelly anti-biotic was from contact lenses.

Speaking of contact lenses, Bausch & Lomb for years had relied on lens technology to help improve eyesight. Eventually, they had the epiphany that you can improve eyesight with treatments that have nothing to do with creating lenses. For example, Bausch and Lomb is a leader in building machines to do laser surgery. Bausch and Lomb is also a leader in producing vitamin supplements which have been found to improve particular types of eye problems.

You cannot incrementally get from lenses to laser surgery and vitamins. These are radically new approaches with an entirely different business model. It requires taking an entirely different look at your entire approach to profitability.

The pharmaceutical industry has been hitting a slump because the traditional approach has pretty much been exhausted. New blockbuster drugs are not coming out like they used to. Perhaps the problem is that we shouldn’t be looking for blockbuster drugs anymore. The age of the pill as the solution may be coming to an end.

Perhaps the next phase will be electronic signals…or nano machines…or sound waves…or implants…or whatever. These new cures may not provide any business for the local pharmacy. A whole new industry may replace it.

Some key things to remember.

1) If the current players in an industry do not embrace and lead in these new directions, eventually an outsider will try going in the new direction. As long as the old ways will eventually be cast aside and marginalized (or made obsolete), one may as well seek out the replacements.

2) Don’t be afraid of experimenting with radically different business models. I don’t think the folks at Apple are upset with the new model they created with iPod. Of course, one may need to try many small experiments before finding the next big thing.

3) Don’t look at your changes in isolation. They may not only upset the current way you do things, but also the way others in the supply chain need to operate. In fact, it may require you to reinvent yourself into taking some of the roles.

4) Rather than focus on the process, focus on the solution. When Bausch and Lomb switched their thinking from the process (making lenses) to the solution (better eyesight) entirely new growth paths came into being. Consumers buy your solutions, not your process. If a new process gives customers a better solution, they will abandon you in a heartbeat.

SUMMARY
Big new successes and major leaps in growth typically come through radical changes to the business model. Incremental improvements to conventional wisdom won’t get you there. They eventually lead to dead-ends. Instead of thinking of how to do the current thing better, think of how to create a superior solution by doing something different.

FINAL THOUGHTS
I’ve still got a ways to go before my recurrent corneal erosion is healed, but I am so grateful that someone thought out of the box and came up with a radically better solution. Otherwise, I would be lying in bed in pain rather than writing this blog.

Analogy #161: Buy My Food

THE STORY
My daughter spent many years in the Girl Scouts. As a result, I have many years of experience helping to sell Girl Scout cookies.

Back when my daughter was very young and a Daisy/Brownie scout, it was easy to sell those cookies door to door. People would see that sweet little 6 year old girl and be more than willing to buy cookies from her.

However, it seemed that as my daughter got older, the door to door selling became less productive. By the time my daughter became a teenager, it became a waste of time to go door to door. Apparently, people would much rather buy cookies from a cute little 6 year old than a 15 year old.

Therefore, as she got older, my daughter turned to other activities in order to raise money for Girl Scouts.

THE ANALOGY
Things change over time. Early successes do no imply that success will last forever. My daughter had early successes in selling Girl Scout cookies. However, over time, her success in selling cookies door to door diminished, until it was no longer worth doing.

Was it because my daughter became less capable of selling cookies? No. As she got older, she had more strength and stamina to walk to more doors. Also, she became less bashful and could make a better sales pitch.

Was her declining ability to sell door to door because nobody wanted to buy Girl Scout cookies anymore? No. The Girl Scouts still sell an enormous amount of cookies.

The problem was that my daughter matured from a little girl to a young woman. As it turns out, people are more sympathetic towards cute little girls and feel more inclined to buy from them. By contrast, it is easier to say no to a teenager.

Just as people mature, so do industries. Maturity/decline can reduce one’s potential. You may become more productive and more efficient over time (just as my daughter became better at selling skills over time). But being better at what you do does not automatically make your performance better. If the maturing industry is working against you, there is only so much you can do.

If you want growth, you may need to shift to a different (less mature) industry, just as my daughter had to shift to different fund raising strategies.

THE PRINCIPLE
The key principle here goes back to a prior blog where I quoted a study from McKinsey. That study said that if you want to be a high profit, high growth company, the best thing to do is become a company which sells high profit, high growth products (see “Dip Your Ladle in the Right Stew”). In other words, if you want success as a growth company, keep adjusting your portfolio to have products in growth industries.

We can see this by comparing two companies: Procter & Gamble (P&G) and Kraft Foods. In recent years, the business press has been far more glowing about P&G and far more critical about Kraft. Now there are a lot of reasons for this, but one major reason is because P&G did a better job keeping its portfolio centered in growth.

Both companies have a long heritage in food processing, stretching back over most of the 20th century. Both companies created or acquired strong, well known food brands with a large following.

However, the problem was that by the end of the 20th century, the food processing business was becoming highly mature. Some of the problems in maturity were the following:

1. It was harder to differentiate name brand food products from each other or from private label products. As a result, they were becoming more like commodities, which squeezes profitability.

2. The rapid growth from consolidating the industry was pretty much over. Instead of the big companies growing at the expense of little firms, they now had to battle each other for tiny share gains.

3. Discretionary spending was moving away from processed food to the restaurant industry.

4. Innovations were harder to come by, more rapidly copied, and smaller in scope.

Proctor and Gamble could see this coming, so they decided to transfer the portfolio out of industries that were less mature (like food) and into industries that were less mature (cleaning products, health care and beauty care). The facts were on P&G’s side. According to the US Economic Census, between 1997 and 2002, the value of shipments in food manufacturing grew only 8.6%. By contrast, home cleaning products grew at 16.2% and pharmacy/medical products grew at 53.7%.

So here is what P&G did to reduce its food portfolio:

1. Sold Duncan Hines cake mixes to Aurora Foods in 1997.
2. Sold Jiff peanut butter and Crisco to J.M. Smucker Co. in 2002.
3. Sold Sunny Delight to Sunny Delight Beverages Company in 2005.
4. Announced the intention of getting out of the Folgers coffee business in January 2008.

To get stronger in health care and beauty care, P&G did the following:

1. Purchased Richardson Vicks in 1985 (obtaining Vicks healthcare brands and Oil of Olay beauty products)
2. Purchased Noxell in 1989 (Cover Girl cosmetics and Noxzema)
3. Purchased Max Factor in 1991
4. Opened a health care research center in 1995
5. Got US FDA approval for its prescription drug Actonel in 2000,
6. Purchased Clairol in 2001
7. Introduced ThermaCare heat wraps in 2002.

During this same time, Kraft stuck to having basically a portfolio of food products. Even then, it was late and slow in adapting to the few areas of growth in food processing, such as organic and low cal.

As a result of this one simple difference in strategy, there is a big difference in performance. As you can see in the chart below, over the last seven months Kraft has struggled to try to keep its stock price up with the S&P 500. By contrast, P&G is performing much better than the S&P 500.


So what have we learned?

1. Don’t Just Rely on Being Better
P&G was pretty darn good at running food processing businesses, but they realized that doing an excellent job in a slow growing mature business doesn’t get you very far. More could be gained by migrating to a better industry, like health care or beauty care. It’s important to do well, but a strategy which only looks at improving execution may miss a greater opportunity that could come from shifting the product mix.

2. Get The Facts
There are many independent sources of information for determining if your portfolio is entering maturity/decline as well as point to industries on the way up. Earlier, I quoted the US Economic Census. Another great source is all of the data accumulated by Stern School professor Aswath Damodaran (look here). Understanding trends will allow you to maximize your portfolio within those trends.

3. Make a Choice
If the trends point to a need to shift, then make the choice of what to let go of and what to add on. But choose carefully. Just because an industry is growing does not mean you will do well there. Move into areas where you can add significant value. For example, in the case of P&G, they were experts at building strong national brands through mass channels. They applied that skill to health care and beauty care.

4. Make the Move
Although it may be difficult to sell off a product core to your history when it is still making money, remember this. It is easier to sell off something when it still is seen as strong by the buyer. Early action will make the sale quicker, at a higher price. In addition, the sooner you start the transition, the less pressure there is to hold a fire sale to dump old things or pay way too much to quickly get into the new things. A moderate pace, started early, allows for more rational decision-making. Rash moves are minimized.

Because Kraft waited longer, it may be more desperate in trying to quickly fix its portfolio mix. This may create less value-added in the transition.

SUMMARY
Being a good operator is nice, but operating in a good space may be even more important. The definition of what is a good space changes over time. Therefore, your portfolio may need to change over time.

FINAL THOUGHTS
My daughter couldn’t bring back the past make herself young again. She eventually had to leave the Girl Scouts and do what adults do. You cannot bring back the past, either. Get over it and move on.