Strategic Planning Issue: 3 Pieces of Paper

BACKGROUND
There has been a lot of discussion about how we have entered a “new economy” or a “post-capitalism business environment.” The idea is that businesses can no longer be managed like they used to. Profit has become less important. Being a good corporate citizen has become more important. A new relationship with employees is needed. And on and on the list goes. If you want to be successful now, you have to abandon the old rules and embrace the new rules. Traditional capitalism is passé. Embrace the new economy.

A lot of sophisticated reasons are usually given for the need to change. They usually include factors something like these:

1. Changing Customers: The internet has shifted the balance of power from the company to the customer, and the customer isn’t all that interested in how profitable you are, but rather how nice you are.
2. Changing Employees: The Millennial generation expects more from its employers than mere profit machines. If you want to hire the best of the Millennials, you have to satisfy their more diverse requirements for an employer.
3. Changing Approach to Problem Solving: The world is full of serious global problems. Individual governments have not proven themselves to be particularly effective at solving them (they just talk and squabble with each other). However, if you point large international businesses at these problems, you may get a more effective outcome.

These all sound so noble and sophisticated and academic. And there is some truth in all of this. But I think the main reason why business is changing is a lot less noble, sophisticated and academic.

I think the main driver of change is the change in the type of paper we use to compensate employees.

THE OLD PAPER: CHECKS
In the middle of the 20th century, most of one’s compensation came in the way of a check. The vast majority of it was in the form of a regular paycheck. Then, at the end of the year was a bonus check.

The most important thing one needs to know about checks is that they only have value if there is enough money in the checking account to cover the check. Therefore, to keep the employees from rioting, you need to ensure that money is flowing into the checking account at levels to cover the checks.

In the middle of the 20th century, the primary source for the money in the company’s checking account was either profits or standard bank debt. And you couldn’t get standard bank debt unless you could prove to the bank that the company was on a path to create enough profits to pay off the debt.

Therefore, success at that time required a high focus on creating profits and significant cash flow on a regular basis. And the best way to do that was via traditional capitalism. It was all about profit, so that you could keep writing those checks.

THE TRANSITIONAL PAPER: STOCK CERTIFICATES
As we moved towards the later portion of the 20th century, compensation practices were changing. For executives, the percentage of their total compensation from their base of paychecks was shrinking. Non-base compensation as a percent to total was increasing. And instead of just being a bonus check, the non-base compensation was increasingly coming from stock or stock options.

Now stocks are different from checks. You don’t need a lot of money in the bank to issue stock. In fact, you don’t need any money at all in the bank to issue stocks. I had a lot of friends who worked at Best Buy in the early days, when the company always seemed to be on the verge of bankruptcy. The company couldn’t afford to write bonus checks, so it kept giving everybody tons of Best Buy stock. 

Although the stock had little value at the time, there was at least the hope that it could become very valuable in the future (which is better than a bounced check). And, in the case of Best Buy, eventually that stock did became extremely valuable (and made many of my friends very wealthy).

In a compensation world full of stock paper rather than check paper, management priorities start to change. It is no longer about focusing on keeping the checking account balance high through growing today’s profits. Now, it was about finding ways to increase the value of the stock.

Yes, the economists will tell you that there is a correlation between profits/cash flow and stock price. In other words, if profits keep going up, stock prices tend to go up. But the correlation is not as close to 100% as it is with check balances. Other things now start getting in the way.

As it turns out, there are a variety of other tools to increase stock price beyond activities to increase current profits. They include activities like:

1. Changing People’s Perception of the Future: If you get people to think to that the future will get a lot better for your company, the stock price will go up, even if nothing is different in profitability today.
2. Making the Company Bigger via M&A: At that time, growth through acquisition tended to increase stock prices, because the combined bottom line was larger. However, if you paid too much for the acquisition without meaningfully changing the rate of profitability, you were actually destroying value. But this was sometimes overlooked by the market at that time.
3. Stock Buy-Backs: Earnings per share is a ratio. There are two ways to increase the ratio: either increase the numerator (earnings) or decrease the denominator (number of shares). So by buying back shares, I can increase the price per share without having to deal with profits.

So, as you can see, by shifting the paper from checks to stocks, I’ve moved a bit further away from pure capitalism. The profit motive is diminished a bit and other things are coming into play.

Probably the best example of this transitionary period would be to look at Enron. Enron was one of the most extreme at using stock as a compensation tool. It dominated the total compensation package, it was administered quarterly, and it was the driving force behind Enron’s everyday decision-making.

The extreme focus on raising stock prices at Enron lead to far less focus on profits. In fact, in the final years of Enron, they typically weren’t paying taxes, because they weren’t really making profits. But the stock price kept skyrocketing, making the employees wealthy, because of the stock tricks they were using.

Of course, eventually they lack of a profitable business model eventually caught up with them and the company collapsed (along with the stock price).

THE NEW PAPER: DEAL PAPER
The new economy of today tends to be more about start-ups in the social media and technology space. There are a couple of things worthy of note in how these companies operate.

First, their checking accounts are not filled with money from profits or standard bank debt. They are filled with money from firms that invest in start-ups. In other words, the start-ups are writing checks that draw from someone else’s source of money, not their own.

Second, nearly all of the compensation comes from when the start-ups cash in, by either going public with an IPO or by selling at some outlandish price to someone like Google, Facebook or Apple. Regular payroll checks are an insignificant percent of the total compensation. The work is done to get to the point of cashing in. You’re looking to sign the deal paper that makes the cashing in possible. Practically your whole life’s earnings come from that single point in time when you sign the deal paper and sell out.

In this scenario, profits have moved from being less important to almost being non-important. Since the money at first comes from private equity investors and later from whomever you sell out to, profits are never a big part of the equation.

If the profit prognosis in the early stages becomes too dire, you typically don’t try to fix it. Instead you shut down the start-up and try again. That is why I sometimes refer to this as the “Lottery Economy”: You just keep trying start-ups until you luck into a winner.

When the whole operating model is built around getting to the “cash in” deal paper, you naturally have moved quite far away from traditional capitalism.

It is like people who flip houses for a living (buying houses with no intent of living there, but only to sell at a profit). They don’t invest in improving the foundational issues in the house. They invest the cosmetic issues that make a house more appealing to the next buyer without having to spend a lot (called curb appeal).

In the same way, the start-ups in the new economy don’t build the foundation for profits but work on the cosmetics that make it more appealing when it is time to cash in.

IMPLICATIONS
The implications here are that although there are some noble, sophisticated reasons for why the economy has changed, that is not the whole story. It may not even be the main story. The main story may be about how people are getting compensated.

Knowing the primary cause of the change is important because of what it implies. If the new economy is primarily a result of a changing environment, then we have to adapt to the new environment. But if it is primarily due to a change in compensation tactics, then perhaps the old rules of capitalism are not as obsolete as we think.

My fear is that extremism in the Deal Paper economy may lead to the same thing as extremism in the Stock Certificate economy. We may end up with a repeat of Enron, where the abandonment of profit as the focus eventually catches up to us and everything collapses.

SUMMARY
Yes, the economy appears to be operating under new rules. But until we fully understand the cause, we may want to be careful about the extent to which we embrace them. The dominance of profits in business may not be completely dead—just asleep.

FINAL THOUGHTS
This only briefly touches on the subject. It is too much to cover in a single blog. But hopefully this can get the conversation started.

Strategic Planning Analogy #533: Planning the Periphery

THE STORY
Last week I got bumped off an airplane in exchange for a ticket voucher discount for a future trip. I thought that was a pretty good deal until I tried to redeem it.

The airlines said I had to redeem it on their online site. Unfortunately, there was a flaw in the website making it impossible for me to redeem the voucher online. As a result, I had to call the airline on the phone.

After a terrible phone experience, I finally got an email notification of my transaction. There were two parts of the email that irritated me. First, they still had not corrected the problem. Second, they charged me a $25 service fee for using the phone to do my booking.

So I had to call the airlines a second time. It struck me that this was a pretty good deal for the airlines. By creating incompetency on their website and on the phone, they were able to create numerous $25 services fees they would not otherwise receive.

They were getting rewarded for incompetence as my travel voucher was becoming less of a deal.

THE ANALOGY
Airlines have an interesting pricing strategy. They sell the seat ticket at unsustainably low prices and then make up the difference by charging all sorts of associated fees, like the $25 I had to pay for calling them on a telephone. They have other extra fees for things like luggage, earlier pre-boarding, seats with slightly more legroom, pillows, blankets, meals and a host of other things.

How did it get to this point? Well, the core business of selling a seat to get you from one airport to another became commoditized. Let’s face it. There is very little difference between the standard seat experience in one airline over another. If you closed your eyes, you’d never be able to determine which airline you were flying.

I remember one time flying from London to Germany. I was about to go up the boarding steps to the airplane door when I noticed that the steps had the wrong airline logo on them. At first I thought that I might be boarding the wrong plane. But then an airline employee came along with a magnetic sign with the right airline logo. He put in on top of the other logo. Voila! Suddenly I was going up the proper airline set of stairs.

But that’s how it is. The standard airline service is so commoditized that you could slap any logo on it and it wouldn’t make a difference.

And we all know what happens when a core service becomes commoditized. The only way to create a preference is by lowing the price. So all the airlines lowered ticket prices to unsustainably low levels.

Since the airlines could no longer make a profit on the seats, they had to get the money somewhere else. That’s why I had to pay $25 to make a phone call to complain about a defective website.

And the point of this blog is that nearly every industry is moving in a direction towards this airline pricing model. Core businesses in numerous sectors are becoming commoditized. If you cannot come up with ways to make money on the periphery of your business (like charging for phone calls), you will have an unsustainable business model.

THE PRINCIPLE
The principle here is that in industry after industry, the core business is becoming commoditized. The commoditization is causing core businesses to be priced as a “loss leader.” To remain viable, one has to get nearly all of the profit from non-core elements on the periphery. So, ironically, one’s strategy may need to be more focused on the periphery than the core if one wants to succeed.  So much for all that literature on “sticking to one’s core.”

Fast Food Example

This is not just an airline problem. Look at the fast food industry. The basic hamburger is commoditized. All the major fast food restaurants sell the core hamburger at a loss.

With the core product priced at a loss, the only way to make money is by focusing on the periphery. So McDonald’s adds fancy coffees and fruit smoothies. They all start putting a slice or two of bacon on everything so that they can charge a premium price. They push the higher margin fries and beverages. They try to get you to upsize to a larger combo meal and to add a dessert.

This is their version of what the airlines do. They come up with all sorts of peripheral things to charge you for, because the core item on the menu (the hamburger) can no longer make it on its own.

Others

Or how about the cable TV industry?  Cable TV in the US is commoditized. They all give you essentially the same channels in the same way. When watching your favorite show on TV, the viewing experience is identical, regardless of the cable company piping it to your screen.

As a result, US cable TV companies can no longer price their core TV business at a profit. The only way to earn a profit is by focusing on the periphery—phone service and internet service. Cable TV service has become a loss leader in order to sell the periphery.

In a similar fashion, phone companies sell talking over the phone at a loss and have to make it up on peripheral services like data transfer.

In social media, it is quite common for companies to give away the core business for free and then try to recoup their losses in sales of peripheral features to peripheral customers (think of LinkedIn). It’s called the “Freemium” model. It is very common in gaming, where the core game is free and you pay for periphery features which help in the game experience.

It’s common for digital companies to use the word “monetization.” It is their way of saying that they have to give away the core for free in order to build out network to a critical mass. So, to make a profit, you have to create a secondary strategy for collecting cash—the “monetization.”

When you try to buy something at the store, they try to get you to pick up impulse items at the checkout, get the extended warranty, add on the optional extras, get a matching belt for the pants, and so on. Why? Because the core products are not profitable. The money is made on the peripheral goods. Even big ticket items like cars are sold this way.

I could go on and on, but you get the idea.

Implications

So what should a strategist do? Well, first one can try to fight the commoditization by creating uniqueness at the core. It can be difficult, but some can succeed. I’ve talked about this in a prior blog. The problem is that if everyone starts adding the same “uniqueness”, then that becomes a commodity as well.

Therefore, one should seriously consider the periphery while developing the core strategy. The periphery strategy may be even more important than the core strategy. After all, if the core truly is commoditized, all you need to do is copy industry best practices and build scale to get credibility at the core.

It is in the periphery where you not only get a chance to make extra margin. It is also the place where you have the best shot at creating differential advantages. The periphery is where you have a shot at creating a sustainable reason to be preferred over the competition.

For example, Comcast has a reputation for absolutely horrible customer service. A cable TV competitor can take the peripheral element of customer service and create a meaningful advantage over Comcast. Southwest Airlines has created an advantage by treating the peripheral business of baggage differently from its competitors.

Apple tries to get around commoditization in smartphones through the unique peripheral features in the closed system it attaches to its phones. All along, it has been the closed systems circling on the periphery (like iTunes) which have made all the Apple innovations truly successful.

So the periphery may not be at the core of the industry, but it is probably at the core of what helps you to win and make a profit. So treat it accordingly when doing your planning.

SUMMARY
There is a tendency for the core business of all industries to become commoditized and/or become a loss leader in price. As a result, if your strategy only focuses on the core, you will most likely never achieve sufficient profitability to make your business a financial success. Real profit tends to come from the periphery, where there are more opportunities to enhance your margins. As an added bonus, the periphery also often is the best place to create meaningful differentiation. With all those potential benefits coming from the periphery, one should not leave the periphery to chance. It needs strategic planning emphasis as much as the core, if not more.

FINAL THOUGHTS
I know a lot of social media companies have a singular focus on building out the core. They say they will get around to figuring out how to monetize it later. That’s like saying I have a great strategy, except that it does not provide me with a differentiating position or a way to make a profit. You’d never settle for a strategy like that. Why would you settle for a business like that?

Strategic Planning Analogy #336: Gold Rush

THE STORY
Over the centuries, there have been numerous occurrences of people discovering deposits of gold or some other precious metal. Once the word gets out, almost immediately thousands upon thousands of people rush to the site to make their fortune.

The ones that come to mind for me are the San Francisco Gold Rush of 1849 and the Klondike (or Yukon) Gold Rush of 1897. San Francisco (then called Yerba Buena) went from being a small town of 79 buildings and a few hundred people the year before the gold rush to a population of 100,000 in the following year. In Klondike, the population went from practically nothing to around 40,000 after gold was discovered there. That’s a lot of people looking for gold.

Unfortunately, whenever a gold rush occurs, only a small handful actually become rich off the gold. Most soon leave the area and return home as poor as when they started (or worse). Many mining towns quickly disappear once the gold disappears, leaving just abandoned buildings. The gold may be precious, but the places where it is found (and the people finding it) are treated as disposable.

THE ANALOGY
The business world is a lot like those gold miners. When word gets out that there is a hot, new growth industry, lots of businesses flood into the marketplace. Soon there is a glut of businesses all fighting to make their fortune in an over-crowded space. Recent examples would be the rush of business into the dot-com boom of the 1990s, the Web 2.0 boom of the 2000s and now the rush into sustainable energy businesses.

And, like with the miners, only a few of these businesses actually survive and make a fortune. Most of the businesses soon go under. I remember being in Seattle and San Francisco soon after the dot-com bubble burst. There were abandoned office spaces all over the place, almost like the mining ghost towns that were abandoned.

THE PRINCIPLE
The key principle here is that just because an industry becomes hot does not mean that everyone who tries to make a fortune in that industry will become hot. Most of the companies who flock into such an industry will, in fact, fail. Just as most gold miners do not make a fortune in mining, even when they are in a “hot” location, most businesses do not make a fortune in hot industries.

As Michael Porter likes to point out, it is very difficult to earn high profits in an industry which is historically not very profitable (think airlines in the US). But this does not mean that it is very easy to make profits in an industry with higher profits. The reason? Profits do not flow equally to all players.
A few will do very well while the rest struggle. For every Amazon and Ebay that successfully came out of the dot-com boom, there are thousands who died a horrible death.

So what can we learn from the gold miners to help us be one of the few that makes a fortune in a hot market?

1) Choose a Prosperous Position
Just because gold was found near San Francisco in 1848 and near Klondike in 1897 does not mean that every patch of land near San Francisco or Klondike was full of gold. A few spots were full of gold, but most were not. If you wanted to make a fortune in gold, you needed to stake a claim to a spot rich in gold. The rest of the stakes were fairly worthless. It doesn’t matter how industrious you are at panning for gold when the creek has no gold.

The same is true in the business world. Just because some people were having success in some spots during the dot-com boom does not mean that every dot-com business plan was destined for fame and fortune. During that period, I saw a number of dot-com business plans that were absolutely horrible. The business models were not well thought out. Many projected costs higher than revenues into perpetuity. For some reason, these people felt that if you took a bad business model and put it on the internet, something magical would happen, causing it to suddenly be a great business plan.

Just as successful miners positioned themselves near where the larger deposits of gold were, successful businesses need to be concerned with their business positioning. You need to position your business at a place where you can provide high value to a chosen customer—high enough value so that they will pay you more for your offering than what it costs you to deliver it.

Rushing into a hot market without a sense about how you are positioned to win is like rushing to Klondike without a sense of where the gold is.

Over the years, I’ve heard a number of businesses who enter a hot market without a plan positioning them to win say something like this: “We’re not strong enough to take the leading position, but the market is so big and so prosperous that we will get our fair share and still do alright.” Who said that market share is “fair” and handed out proportionately to everyone who shows up? Markets always eventually go through a consolidation, with the strong getting stronger and the weak going away. If you do not have a position where you can win, you will not get that “fair share” of markets or of profits. You will end up with nothing.

It is not enough to just find a hot market. You need to find a place within that market where you can win.

2) Protect Your Stake
When a gold miner found a prosperous stake, their next worry would be to protect that stake from those who would want to take it away from them. These people might try to steal the location away from them, go upstream to get closer to the gold source before it reached them, or build as close to the successful miner as they could to siphon gold away from their operation.

The same situation exists today. If you find success, others will try to take that success away from you. They may try to “steal” your market share by copying you or take you to court to slow you down or shut you down.

The point is that just because you are in a hot business does not mean that you are safer. In some ways, you are less safe because there are more people trying to “steal” your business.

Therefore, you must become like the successful miners and not sit back and relax in your success. You need to protect your stake by aggressively working to protect your winning position. This may require reinvestments to extend your lead in providing value. It may require getting closer to your customers so they have less reason to leave you.

Amazon survived the dot-com bust because it worked hard to create the greatest value in its field. Rather than take profits out of the business early, it reinvested to create leading edge benefits.

3) Consider Support Services
Back during the San Francisco gold rush, there was a man who heard all the miners complaining about their pants. They said that mining was rough work and their pants were not strong enough to hold up under the work. They were tired of always having to replace their pants.

Well, when this man heard these complaints, he looked for solution. He found a supply of heavy denim cloth and rivets, originally brought to San Francisco to make tents for the miners. He took these materials and made pants out of them. The pants were a huge success.

And that was how denim blue jeans were invented. The man who invented them, Levi Strauss, made a fortune with his Levi’s jeans.

The point here is that often the most prosperous part of a hot market is not in the center—where competition is intense—but on the edge, supplying support to the core business. In these mining towns, often the most prosperous place to be was not as a miner, but as someone catering to the needs of the miner. This included supplying them with denim jeans, supplying them with food, and providing places for them to gamble away all that they earned.

Just as Levi Strauss made more money selling jeans to the miners than what most of the miners made, Cisco made more money selling servers to the dot-com businesses than the dot-com businesses made during the boom. A lot of the profitability in the internet boom has also gone into the pockets of support delivery services like FedEx or DHL. In the current rush to build electric cars, I would not be surprised if the battery suppliers make more money than the car companies.

Therefore, when looking for a prosperous strategy in a hot market, consider opportunities on the edge to support core. It may be a better option.

SUMMARY
Don’t be lulled into thinking that just because you are operating in a hot industry, all your problems are over. Success in a hot industry is not a given. In fact, most of the players in a hot industry fail. To succeed, you still need to work on the basics—creating a winning position in the marketplace, building barriers so that others cannot steal away your success, and looking at support businesses as a source of profits.

FINAL THOUGHTS
I once visited an abandoned gold mine where most of the gold had long since been extracted. It had been turned into a tourist attraction. They let us pan for gold. Eventually, after many tries, I got this one tiny little flake of gold. I can see why miners would eventually give up if their stake was not in a superior location. Better to spend your time up-front choosing a superior location than to rush to work at an inferior position.

Strategic Planning Analogy #328: Change Neighborhoods

THE STORY
There’s one thing that has always puzzled me when I watch the local news on TV. It seems like the majority of crimes and burglaries take place in the poor and run-down sections of the city.

I don’t know. It seems to me that if I wanted to be a burglar, I would try to rob from the wealthy people who have a bunch of great stuff to steal. Yet it seems that most of the burglaries shown on local TV take place in poor areas where there is not a lot of great stuff to steal.

I’m reminded of the famous burglar Willie Sutton. When he was asked why he robbed banks, he replied, “Because that is where the money is.” That makes sense to me…steal from the people who have lots of money.

Why do so many try to steal from the poor? I’ve been told that the reason is because burglars tend to prefer staying in familiar surroundings. Since most of the burglars live in the run-down neighborhoods, that is where the burglaries take place.

Maybe if the burglars started stealing from rich people, they could afford to live in the nicer neighborhoods.

THE ANALOGY
Like these burglars, many businesses prefer to stay in familiar surroundings—the industry where they started. Unfortunately, over time many nice neighborhoods (or nice industries) can deteriorate and become run-down. They can move from being dynamic and exciting growth industries to declining, obsolete or mature industries. Just as it can be very difficult to become wealthy stealing from poor people, it is very difficult to be an exciting growth company when you stay in a declining industry.

If burglars want great wealth, sometimes they need to move to wealthier neighborhoods. Similarly, if your want great growth and profitability for your company, sometimes you need to move the business to industries where the prospects for growth and profitability are brighter.

Run-down and poor neighborhoods are not great places to rob. Neither are run-down industries great places for a business to find growth and prosperity. Sometimes, you need to move to a new neighborhood.

THE PRINCIPLE
The principle here is that it is often easier to find growth and profitability for your firm when the firm seeks a position in a growing and profitable area. If your firm is not currently operating in such an area, it may be time to move to such an area.
It may not be comfortable leaving the neighborhood your firm is comfortable in, but sometimes the best way to have growing results is to get into a growing business. We’ve talked about this idea of abandoning old businesses and moving on to a better neighborhood in a number of prior blogs, so I will just summarize some of the examples we’ve gone into greater detail on in earlier blogs and then provide a link.

1. Textron
Textron started out in the textile business, making yarn back in the 1920s, and was still principally a textile-based business until the 1950s. Unfortunately, the US was no longer a place where the textile industry could thrive (the neighborhood had turned poor and ugly). Therefore, Textron got out of textiles and diversified into more prosperous industries, including Bell Helicopters, Cessna Aircraft, and other such non-textile businesses. For more details, go here.

2. Procter and Gamble
As recently as 1995, processed food products made up about 12% of their portfolio. Most of these categories of food are now very mature (the neighborhood has gotten run down). As a result, P&G has divested of all food except Pringles and has built up its portfolio in higher growing areas like health care and beauty care, which now make up over 50% of the mix (up from around 295 in 1995). For more details, go here.

3. Intel
The Intel company built its initial reputation around DRAM memory chips. This was their heritage—what they were known for—and management had strong emotional ties to the business. Unfortunately, over time that DRAM “neighborhood” had turned ugly and unprofitable. It was tough for Intel to walk away from that heritage, but they did and reinvented the company around newer technologies, which were growing faster and were more profitable (a better neighborhood to steal from). For more details, go here.

4. GE and Limited Brands
GE has continually shifted its portfolio over the years so that “poor neighborhood” industries are shed, and growing, more profitable industries “better neighborhood” are added. Limited Brands started as a ladies’ sportswear retailer with a chain of stores called The Limited. Over time, the mall-based apparel retail industry in the US has matured. Growth slowed. So Limited Brands sold off its apparel retail operations, including its namesake brand, and put its emphasis behind the faster growing and more profitable areas like lingerie (Victoria’s Secret) and beauty care (like P&G).

For more details, go here. As a side note, this blog also discusses a McKinsey study which found that the greatest determinant of being a growing company is to build a portfolio around growing industries. In other words, if you want to steal nice stuff, go to a neighborhood full of nice stuff.

5. Cardinal Health
Back in the 1970s, the company started out in the grocery wholesaling business, under the name of Cardinal Foods. It’s primary customer was the independent grocer. Unfortunately, the big grocery store chains were putting the small independent grocers out of business. It’s not much fun being in a business where your customers are disappearing (sort of like stealing from people whose money has already disappeared). Therefore, Cardinal got out of that declining business and moved to the faster growing industry of health care (a much better neighborhood). For more details, go here.

6. IBM
IBM started out essentially as a manufacturer of large equipment for business. For a time, it was making a fortune off of that business, particularly in computers. Over time, however, that business matured and was no longer very profitable. The profits and growth had moved to software and services. Therefore, IBM sold its PC business to Lenovo and reinvented itself as primarily a software and services company

We could go on and look at a lot more examples, but I think the point has been made. Just like the McKinsey study found, if you want to get the big prize (big growth and fat profit margins) you need to continually modify your portfolio to include more industries where growth and fat profit margins are already occurring. Sometimes this means totally abandoning your heritage and doing a major reinvention. It may sound emotionally and operationally daunting, but a lot of companies have been successful in doing it.

SUMMARY
Achieving high growth and profitability is a lot easier if you are in industries with naturally high growth and high profits. Therefore, fill your portfolio with these naturally good industries. However, one cannot rest there. Just as neighborhoods can deteriorate over time, so can industries. Therefore, this is a continual process of moving out of the old and moving into the new.

FINAL THOUGHTS
Timing is very important when moving to the new neighborhood. If you stay too long in the old, deteriorating neighborhood, you will not get much when you sell the house. If you wait too long to get into the hot new neighborhood, you will have to pay more to get into the more limited open spaces. Therefore, it is better to make the switch early.

Analogy #158: It’s in the Bag

THE STORY
I love those brown paper bags from the supermarket. When I was a young child, they were my favorite toy. I liked to cut them open, lay them out flat and draw miniature cities on them. Then, I’d get my little toy cars and run them up and own the streets. Other times, I’d draw a board game on the back and try to get my sister to play the new game with me. You could also turn the bag into a mask.

When I got a little older, I used the brown grocery bags to cover my school books. They were great. Not only did they protect my books, but they gave me lots of space to doodle on.

As I became an adult, the bags were very handy for covering packages that I wanted to mail. I also loved to use them when packing for long car trips, because the bags wouldn’t tip over.

Now, I use the bags to sort out my recyclable bottles and cans. When the supermarket asks me if I want paper or plastic, I usually say paper, because paper bags have so many more uses around the house. Sometimes, however, I get the plastic bags because my cat likes to sleep on them.

ANALOGY
From the point of view of the supermarket, the bags are nothing more than a cost to be minimized. Plastic bags are cheaper and more efficient for the baggers, so that’s what they want to use.

For me, those bags are a valuable resource around the house. Sure, they help me get the groceries home. But after that, I still find additional uses for them. That’s why I tend to prefer the paper bags.

So there is a disconnect on perception regarding the bags. The store sees it as a cost, while I see it as a valuable resource. This explains why they push plastic while I prefer paper.

Perceptions can impact all sorts of strategic decisions. Depending on how we perceive something, we will make different strategic decisions. If something is perceived as a cost, the attempt will be to minimize it or eliminate it. However, if we look at the situation differently, we may see a new source of value within that cost. Now, instead of trying to eliminate the process, the goal is to extract a monetary return out of that newfound value.

THE PRINCIPLE
The principle here is that strategic planning needs to do more than just examine the current sources of profit. Concurrently, a good strategic plan should look for additional profit sources within the system. Often times, things that are currently perceived as burdensome costs could actually be untapped sources of profit if we were just to look at them a little differently. For example, if you want a valuable bag when shopping for groceries at Aldi, you have to pay for it.

Since “burdensome costs” would be treated differently in a strategy than “untapped sources of profit,” it is important that we label things properly when creating our strategy. With “untapped sources of profit” sounding a lot more desirable than “burdensome cost,” it may be worth your while to ponder ways to convert costs into profits.

In this blog, we will look at a few examples of this principle in action.

Example #1
Australians drink a lot of beer. In the process of brewing beer, a waste product is developed, called a yeast extract. At first, this would be seen as a wasteful byproduct of brewing—something costly to dispose of. Fred Walker, however, looked at the situation differently.

Fred realized that this yeast extract had nutritional value. It is extremely concentrated in B vitamins. The trick was to find a way to exploit this hidden value in the waste product. So, in 1923, Fred’s chief scientist, Dr. Cyril P. Callister, added a few ingredients and converted the yeast extract into a sandwich spread. It was named Vegemite.

In the 1930s Fred Walker’s company teamed up with Kraft Foods and really started to promote Vegemite. In the 1940s, Vegemite was a key part of an Australian soldier’s rations. There are songs and poems about Vegemite. Australian children get in the habit of eating it at a very early age.

Today, over 22 million jars of Vegemite are sold by Kraft every year. That is more than one jar a year for every man, woman and child in Australia. So much for yeast extract being a wasteful byproduct.

Example #2
Tyson Foods is one of the world’s largest meat processors. In the process of preparing meat, a lot of byproduct waste is produced. Much of that waste is in the form of meat fat. Instead of just viewing this as a wasteful cost to be disposed of, Tyson Foods looked for a way to make this fatty byproduct more valuable.

What they discovered was that ConocoPhillips had found a way in Ireland to convert fat into fuel. Therefore, on April 16, 2007, Tyson announced an alliance with Conoco Phillips to convert their fatty by-product into biodiesel fuel.

The expectations are that by 2009, this byproduct will produce 175 million gallons of biodiesel per year. That would represent about 3% of the diesel produced by ConocoPhillips in the US.

Later, on June 25, 2007, Tyson Foods made another announcement. They had formed a 50/50 joint venture with Syntroleum, a synthetic fuels technology company. The new venture, called Dynamic Fuels LLC, would use the byproducts from Tyson to create diesel, jet and military fuel.

The first facility would produce about 75 million gallons of synthetic fuel annually. Construction would start in 2008 and fuel production would begin in 2010.

By using a new set of eyes, Tyson has converted its fatty waste into usable fuel. Their new strategy has allowed them to diversify from food processing into renewable energy development.

Example #3
On any given day, Wendy’s fries a lot of hamburgers. If a meat patty is left on the grill too long, it starts to get dry and hard—unsuitable for use as a hamburger. Sometimes, Wendy’s will fry up more than they can sell, creating this unsuitable hamburger meat.

So what do you do with this waste, throw it out? Looking at this situation differently, Wendy’s converted this cost into a profit center. They found a way to remoisten the meat by putting it into a chili sauce. Now, instead of having to throw the meat away, they have another profit center, Wendy’s Chili. This was then extended into even more profit centers by putting the chili on baked potatoes and salads.

Example #4
There was a period of time when HEB Supermarkets in Texas had a reputation for running a state-of-the-art information technology department. HEB was always getting requests from other firms who wanted to tour their IT facilities. Eventually, HEB decided to charge a fee for these tours. Then they started to do a little IT consulting for other firms at an even higher fee. It may not have amounted to a lot of money, but it helped subsidize the IT department and helped HEB continue to afford to be state-of-the-art.

Example #5
One of the biggest costs for McDonald’s is real estate. The rent cost on all of those restaurant sites is huge. So the question is—how can McDonald’s convert that cost into another profit center?

Well, those restaurants tend to be in places near a lot of houses and a lot of people. Not only is there a lot of demand for burgers in these locations. These are also places where cell phone usage demand would be high. However, these also tend to be neighborhoods where the local folks do not want to see ugly cell phone towers near their houses.

So, McDonald’s pondered this concept—could we design our restaurants in such a way that you could hide a cell tower in them that would not create an eyesore? AT&T is supposedly working with McDonald’s on this solution. The upside potential for McDonald’s in collecting fees from AT&T is enormous.

SUMMARY
One of the objectives of strategic planning should be to help executives take a fresh look at the business. By doing so, one may find that items which today are seen as burdensome costs can actually be new sources of profit. These types of discoveries can help create new strategies for growth and expansion that would otherwise have been missed. The beauty is that because these new ventures are already related to your core processes (and often turn waste into profit), the returns should be fairly good.

FINAL THOUGHTS
This idea of turning waste into profits plays well with the green movement. Therefore, not only may you find new sources of profit, but you may also improve your image as a green citizen. What more could you ask for?

Dip Your Ladle in the Right Stew

THE STORY
Once upon a time there was a man who fancied himself to be a bit of a gourmet. He enjoyed making his dinner time as pleasurable as possible.

His kitchen was well stocked with all of the latest gourmet cooking gadgets. The only thing he was missing was good ladle for dishing up stew. He had a vision in his mind of what the perfect ladle should be. It should be sturdy enough to hold a full portion at a time. The handle should be designed for perfect balance. The bowl of the ladle needs to be shaped so that it is easy to get the stew out of the stew pot and easy to pour the contents into the stew bowl.

This gentleman could not find any ladle in the market which pleased him, so he commissioned a craftsman to produce a special one-of-a-kind ladle meeting his strict qualifications. After several attempts, the craftsman finally produced a ladle meeting the needs of the gourmet.

The gourmet couldn’t wait to try out his new ladle. He went straight home, ladled out a perfect portion of stew, and effortlessly poured it into his soup bowl. Then he tasted the stew. He suddenly got very ill and had to spit out what he had partaken.

As it turns out, he had waited so long for his ladle that his stew had gone rancid. It was unfit for human consumption.

THE ANALOGY
Sometimes we can get so fixated on perfecting a small portion of what is in front of us that we miss the bigger picture. In our story, the gourmand was so fixated on getting the proper ladle that he failed to take care of the stew. In the end, the stew is the prize…it is what you eat. The ladle should only be a means to the end. Having a perfect ladle does one no good if the stew is inedible.

In the strategic process, one can become fixated on perfecting that strategy—getting all of the nuances correct and so on. You may end up with an excellent approach that will win in the marketplace and give you all sorts of market share growth. When you put it into practice, it may even work as brilliantly as you designed it. You could end up winning in the market place even more than planned.

However, if the prize you have won is as rotten as the stew of our gourmand, then you really haven’t won much. Having a good, well-functioning strategic ladle is fine. But spend some time making sure you are dipping it in a place that will deliver tasty results.

THE PRINCIPLE
According to Harvard professor and strategic planning guru Michael Porter, the first principle of strategy is to choose a profitable industry. The logic is quite simple. Some industries have higher profit margins than others. If you create a strategy to win in an industry without much profitability, you haven’t won much. Yes, you can congratulate yourself on being a winner, but the prize is not worth the effort.

If you are going to go to all of the cost and effort of creating and executing a strategy, one may as well target an industry where there is money to be made. Otherwise, you can be like the man in the story who had the ideal ladle, but no edible stew to dip it in. I’d rather have a mediocre ladle dipped into a rich pot of stew than the perfect ladle dipped into an empty pot.

The point of doing strategy is to help one make better choices. Within some limits, you can choose what industry you will participate in. Don’t assume that you are permanently stuck within the industry you currently operate. Look at GE. Over the years, it has continually reinvented itself from being in basic manufacturing to high tech manufacturing to financial services to entertainment. As industries matured and became less profitable, GE moved to places where the total profitability potential was higher. In a psychological milestone, GE just got out of the plastics business, one of few remaining reminders of strategies past.

In the retail sector, the Limited is getting out of the lower profit apparel retailing business and concentrating on lingerie and personal beauty care items, because this is a richer industrial sector in which to play. The margins on “bottles of goo” are far higher than the margins these days in apparel. As long as you are selling something, why not choose to sell the items with the inherent and naturally higher margins, provided you have a strategy to win in retail?

Because it takes time to make these types of transformations, you have to develop your strategy far enough in advance to provide time for a smooth transition. You need to look out more than just a year or two. These are the types of transformations that typically do not come out of an annual budgeting process. You have to think bigger.

Some recent research has made the imperative to do this even stronger. This past week, the McKinsey consultants announced the results of a major study looking at how companies grow. They studied over 200 companies across the globe. The idea was to determine what the key differences were between the companies with consistently high growth over the years versus companies experiencing much lower growth.

What they discovered was very interesting. Yes, having great strategies which allow a company to gain market share are useful in creating growth. However, a company’s ability to gain or lose market share only accounted for only about 20% of the difference in the growth performance of companies.

Instead, a much greater contributor to growth was the choice of the subindustries and product categories which a company chose to operate in. Based on these results, McKinsey concluded that “executives should identify and allocate resources to fast-growing segments in which a company has the capabilities and resources to compete successfully.”

Well, this pretty much takes us back full circle to what Michael Porter said. If you want lots of profits, enter profitable industries. Or to paraphrase McKinsey, if you want lots of growth, enter high-growth industries. Gee, it doesn’t sound as special when you put it that bluntly. But it’s the truth.

How do you find industries with high profits? Industries with high profits tend to have high barriers to entry, making it harder for new firms to enter and start a price war for market share. Michael Porter likes to point to trucking as one such industry. It is relatively easy to get into the trucking business, therefore supply and demand pressures cause low bidders to suck the profitability out of the industry.

Traditionally, the pharmaceutical industry has had much fatter profit margins, because it is such a difficult business to enter from scratch. Of course, the irony here is that once you’ve identified these high profit industries which have high barriers to entry, it may be difficult to find a way to enter them. That is why time is needed to develop a strategy.

SUMMARY
Without taking time to develop strategies, one is typically stuck just making incremental improvements to the status quo. If you want to make significantly better returns or achieve significantly higher growth, it typically requires transforming your portfolio to businesses with inherently more profit or more growth. This transformation will not occur on its own. It requires long-term strategic planning.

FINAL THOUGHTS
There’s an old saying which goes something like this: “I have good news and bad news. The good news is that I won the Wal-Mart account and will now be one of their suppliers. The bad news is that I won the Wal-Mart account and will now be one of their suppliers.”

Be careful what you wish for. You just might get it, and then later choke on it like bad stew.