Strategic Planning Analogy #555: Managing the Full Cycle

THE STORY
A friend of mine recently explained to me how his parents survived a lifetime of farming. He said their farm tended to run on a five-year cycle. In general, over that five-year span, one of the years would be extremely profitable, two would suffer big losses and two would be about break-even.

So this is what his parents did. When they had that one great year on the farm, they would shrewdly invest the windfall into the stock market. This investment would have enough of a return to get them through the four years of breakeven and losses. Then, when the next great year came again (about five years later), they’d start over again, investing the windfall in stocks to cover the next four years.

Over time, they got to be very good at stock investing. It makes you wonder if their true occupation was really farming or investing.

  

THE ANALOGY
This family was able to survive a lifetime in farming because they did not think in terms of individual years or growing seasons. Instead, they planned their business around the full five-year cycle. They knew there would be highs and lows across the five-year cycle which they did not have a lot of control over. For example, commodity prices would swing wildly and weather would change dramatically. You can compensate for a bit of this in the short term, but not most of it. Hence the highs and the lows in farming were pretty much a given.

Therefore, my friend’s parents needed a bigger plan—one that invested during the high points, so that they would have supplemental income to get through the low points.

Other businesses tend to be no different. Margins rise and fall based on all sorts of market pricing issues outside a business’ control. And, like weather, the external environment for businesses can also dramatically change. Fickle customers can abandon your business category for the next fad and cause as much damage as when the rain stops falling on the farm and goes somewhere else.

Hence, all businesses should consider their actions in terms of the full cycle. They need to reinvest the highs in order to be prepared for the lows. Unfortunately, as we will see below, not all businesses do this.

THE PRINCIPLE
The principle here is that if you try to optimize individual years rather than the full multi-year cycle, you will be on a path to destroy the business. First, if good years are optimized on their own, you end handing out the profits to all the stakeholders. That will not leave any money for the lean years. So then, the only way to optimize the lean years on their own is to cut back on everything (R&D, service, quality, etc.).

This starts the death spiral. The cutbacks in lean times make the company less viable when the good times return, so the highs get progressively smaller. Debt piles up in the lean years until it is unsustainable. None of the money ever gets reinvested for the long term, so the business gets old and unfit for the changing times. Bankruptcy is almost inevitable.

I was reminded of this principle when I saw a recent article online from Fortune. It was a list of the ten largest bankruptcies in U.S. retailing over the last few years. As I thought about this list, I realized that in a majority of these cases, the retailer failed because it did not plan for the full cycle. 

Bankruptcy usually came from a combination of:

1.     Taking out too much money in the good times (usually via a leveraged buyout)

2.     Taking on too much debt that could not be maintained when the bad times came.

3.     Was not ready when “bad weather” came (a negative change in the external environment).

4.     Did not invest the money from the good times into projects that would pay out in the future (adapting to the “new weather”).

Here are a few examples, which I’ve simplified for the sake of time.

Circuit City

Circuit City sold low margin electronics products. The margins suddenly got a lot lower when Wal-Mart and online retailers like Amazon aggressively went after the business. Circuit City did not have enough cushion to absorb the drop in prices. Then, Circuit City made matters worse in the lean times by cutting way back on sales service. It was the aggressive sales service team which was able to talk customers into buying the more profitable attachments and extended warranties for the low margin basic goods. Without the sales people to aggressively boost the margin in the shopping basket, the margins got even lower. Eventually the losses got too great to be sustainable.

Linens N Things

Linens N Things was almost identical to its competitor Bed Bath & Beyond. The only major difference was that Bed Bath and Beyond operated on a lower cost structure (a structure designed for lean times). When the lean times came, the lower cost structure allowed to Bed Bath & Beyond to still make money when Linens N Things could not. Bed Bath & Beyond became more aggressive with its coupon promotions, making it even harder for Linens N Things to compete in the lean times. Finally, Linens N Things sold out to leveraged buyout, which created a debt level that could not be maintained.

A&P

A&P is an example of a supermarket company that could not keep up with the changing weather. It had old stores, run the old way, with old union contracts. When the good times were there, A&P did not reinvest and modernize or build a lot of stores in the growing markets. Instead, it took the profits out of the stores. That left A&P with the oldest stores in the oldest neighborhoods without the changes needed for the modern grocery business. When the bad times came, A&P kept cutting back. But due to their old union contracts, they were forced to first lay off the younger, less expensive (and more productive) employees. This left them with even higher costs relative to competition. It’s hard to survive when you have a combination of the most outdated offerings and the highest cost structure.

Sbarro

Sbarro had most of their pizza restaurants in malls. They thrived in the good times by taking advantage of the traffic already created by the mall. Unfortunately, the weather changed. Malls became far less popular. Mall traffic dropped significantly. Eating in malls dropped significantly. Sbarro did not have a business model designed to draw its own traffic or survive on lower traffic. So when the mall traffic dried up, it was like when a farmer’s land dries up…profits evaporate. It didn’t help that Sbarro had also gone through a leveraged buyout, which drained them of the extra cash needed for lean times.

Blockbuster and Borders

Blockbuster and Borders were two retailers who sold tangible media (Blockbuster: movies; Borders: Books). The digital revolution changed their weather. When movies and books became digital, customers did not need brick and mortar stores any more. Plus, the price of digital movies and books were so low, that Blockbuster and Borders couldn’t compete on price. These company's failures wasn’t inevitable. Others invested to adapt to the new weather of the digital world. Blockbuster and Borders, however, did not make those heavy investments in a timely manner. Hence, they failed. They, like A&P, did not do like my friend’s parents and invest during the good times. You cannot live off the investments you do not make. And without investments into the new, you become obsolete.

Quicksilver

Quicksilver is a retailer specializing in clothing and gear for the surfing culture. Teens paid a premium to shop at Quicksilver because appearing to be part of the surfing culture made you look cool. But then the weather changed. Cool transferred from surfing culture to smartphone culture. The Apple store was now the cool destination. Money that used to go to clothes went to technology. The clothes still bought tended to come from cheaper stores, like H&M, because the money you saved on clothing could be used to buy more cool technology. Quicksilver could not adapt its cost structure and merchandising for these leaner times.

SUMMARY
Business life is not a straight line of consistency. Instead, there are periods of ups and downs. Many of the ups and downs are influenced by external factors that are not completely under your control.

Therefore, if you want your company to last over the long haul, it must be built in such a way as to survive the entire cycle of good times and bad times. That means, that in the good times, you should:

1. Put some money aside for the bad times.
2. Invest some money in things that will improve your relevancy as markets evolve.
3. Not let your cost structure rise to levels that can only be supported in good times.

Then, in the bad times:

1. Live off some of the money set aside in the good times rather than destroy your offering (and image) through overly excessive cost cutting.
2. If it looks like the weather has changed permanently for the worse, be ready to make radical moves to become relevant again. Don’t just try to wait it out if it looks like business is not ever coming back to your business model. In the best case scenario, you would have started investing in these changes back when times were still good.

FINAL THOUGHTS
To be a good farmer, my friend’s parents had to know more than just how to farm. They also had to be good investors. Similarly, good businesses cannot just be managed by people who only know how to operate the current business model. They also have to know how to invest in what will replace the current business model.

Cutting Your Way to Prosperity? (part 3)

THE STORY
Once there was a farmer who thought he had come up with the secret formula for living the good life. When he was young, this farmer had noticed how so many other farmers were struggling to make ends meet. Not wanting to live that way, this young farmer’s goal was to live well by farming differently.

Therefore, the young farmer spent time investigating what other farmer’s were doing, to find out why they were having trouble making ends meet. After a thorough analysis, he came to his conclusion: Farmer’s do not live well, because they foolishly waste their money. He saw many ways in which farmers were wasting their money:

1) They would let portions of their land lay fallow each year rather than plant something they could make money off of.

2) They put all kinds of money into fertilization and irrigation. Why spend all that money on something Mother Nature supplies for free? (rainwater and fertile soil)

3) They would waste money buying expensive seeds when they could just get seeds for free off of part of the prior year’s crop.

So the young farmer put his plan into action. He planted his entire land every year. He would use “free” seeds from what was produced in last year’s crop. He cut way back on irrigation and fertilization, relying on the “free” resources of Mother Nature.

At first, this plan seemed to work quite well. The money he saved on irrigation, fertilization, and seeds was used to live the good life—a nice home, nice car, luxury lifestyle. He was proud that he had “beaten the system” and could live well on the farm. Over time, however, the plan seemed less successful—every year the fields supplied less and less produce. Eventually, it got so bad that eventually the farmer had to declare bankruptcy.

THE ANALOGY
The farmer in the story failed because he had a tragic flaw in his logic. He assumed that the farmland would continue to produce at peak performance forever without replenishing the soil. Yes, Mother Nature may have gotten him started out with good soil, but if you do not replenish the soil through fertilizer, irrigation, and letting it lay fallow, it will eventually become depleted—unable to produce crops. Weak crops do not produce the kinds of seeds which create healthy crops the following year—and are nowhere near as effective as specially grown hybrid seeds.

The farmer’s success was an illusion. What he thought was high profits from current operations was actually stealing the profits from future crops by failing to reinvest in the soil. These were not extra profits—they were the costs of doing business which he was refusing to pay. By not paying the price of reinvestment into the soil, he was destroying his own future.

Does it sound silly that a farmer would not be smart enough to take care of his soil? Well, I’ve seen otherwise smart business people destroy their future by not reinvesting in their businesses. Yes, it is wise to not be extravagant in your business spending. Keeping costs low can be a good thing, especially during the tough times. But a continual effort to starve a business of investment, even during the good times, can cause a business to have the same fate as this farmer.

THE PRINCIPLE
This is the third and final blog in a series on the pitfalls of cost-cutting. In the first blog, “part 1”, we looked at how some cuts are really not cuts at all, but are rather just shifting of costs from one location in the company to another. In “part 2” we looked at the problems that can occur when cost-cutting is done without being connected to strategy. In this third blog, we will look at what happens when extreme cost-cutting becomes the norm, even in good times.

Extreme cost-cutting means not reinvesting into the future cash flow streams of the company and instead taking the money out as today’s extra profits. It may make you look like a genius today, but in the long run it depletes the business of what it needs to produce future profits. Businesses are like soil, they need to be replenished.

The temptation to take the money out rather than reinvest seems greater today, with top executives spending ever less time in their position. If the leaders only expect to be hold the position for a couple of years, why worry so much about the long term? In the world of marketing, the average CMO lasts less than two years in a job. Often times, as in the recent case at Macy’s, the rapid change in CMOs is a result of a conflict between near-term sales promotion and long-term brand building. The CMOs trying to invest in the long-term strength of the brand are losing favor to leaders trying to take the profits out now.

There are three main reasons why reinvestment is crucial to long-term success:

1) Things Wear Out
2) Customers are Fickle
3) Technology Improves

These are discussed below.

1) Things Wear Out
Cutting back on repairs and maintenance may work for a short period of time, but eventually, lack of repairs and maintenance will cause thinks to break down. There is an old Fram auto parts advertising campaign where a mechanic would say “Pay me now or pay me later.” The implication was that you could spend a few dollars now on a Fram oil filter or put it off until your engine breaks down and then pay hundreds and hundreds of dollars on engine repair.

This principle may seem obvious for equipment and machinery. However, other things can also wear out if money is not put into them. For example, in retailing, shopping centers and entire neighborhoods can wear out and become tired. It may become necessary to spend the money to move a store a few miles to a more vibrant neighborhood, even though the store itself may still be in relatively good condition.

Strategies themselves can wear out overtime and become less relevant in a changing environment. With the current movement to green environmentalism, an old formerly successful strategy viewed now as environmentally wasteful could severely damage a company. It is better to invest time and money in strategic thinking on a continual basis to stay in front of these changes, rather than waiting until it is too late to efficiently react.

2) Customers Are Fickle
Even if everything in your business is in fine working order, it does not mean that there is no need to reinvest. Customers are fickle. Loyalty is weak. Just being in fine working order may not be enough if competition is investing in the latest and the newest gizmos and gadgets. Shiny new things from the competition can catch the eye of your consumers and make you look dull and drab by comparison, even if there is nothing inherently wrong or broken in your process.

The goal is not to be serviceable. The goal is to be superior (in some way versus competition). Superiority is a relative term. Today’s exciting superiority can fall behind competition if they invest at a faster rate than you do.

3) Technology Improves
Even if your investment is in fine working order, that does not ensure top performance. For example, you may have the absolute best computer operating system available in the 1980s (which is when you purchased it) and you may have kept it in fine working order all these years. However, there have been so many technological advances since the 1980s that you would be woefully uncompetitive in the marketplace versus significantly more efficient competitors who are using the power of more up-to-date computer technology.

It could even be more subtle than this. In retailing, one could have perfectly serviceable cash registers which do a good job of scanning the price tag and letting the customer pay you. However, modern cash registers (which are now called Point of Sale computer terminals), can do so much more—capture customer data, process credit cards faster, allow more sophisticated pricing programs, suggest add-on selling opportunities, handle customer loyalty programs, and so on. By not investing in the new terminals, one is missing out on opportunities and falling behind those that do make those investments.

SUMMARY
Continual aggressive cost cutting may be seen by some as being efficient, but it does not necessarily mean that you are effective. By not reinvesting in your business on a regular basis, you can deplete it of its ability to produce revenue in the future.

FINAL THOUGHTS
The biggest problem with chronic underinvestment is that by the time one can see the problem, it is often too late to fix it. The soil of the business is too depleted. Too much time and money would be needed to bring it back to life. And you don’t have the money, because you took it out in extra profits. And without new income coming in, you do not have the time to wait until the soil is brought back to life.