Stuck in a Rut

In enterprise marketing two markets are always in play: the markets for customers and capital. And we know they interact. Increased sales revenues feed back on market valuation with the promise of greater cash flow. And higher a market valuation feeds back on revenues by providing cash for growth through acquisitions.

This table shows the un-level playing field for three search/ad space companies and the group's total. Using the 2006 data in Yahoo! Finance they generated $61.3 billion in revenues and created $469.5 billion in market value. This led to a value/revenue (v/r) ratio of 7.66 for the three companies combined. Overall they created $7.66 in market value for every dollar of sales revenue.

THE VALUE/REVENUE RATIO
In my study of The Value/Revenue Ratio of all public firms from 1950 through 2005 I found the average to be 1.1 which means long-run revenues and market cap are about equal. The standard deviation in the v/r ratio increased systematically from 1.2 in the decade of the 1950s to over 70 in the volatile period from 2000 to 2005. In the the1991-1999 sample of 50,472 firms the standard deviation in the v/r ratio was 7.92. So the combined performance of this Internet group in 2006 was rather modest.

STUCK IN A RUT
Notice in the table above that Microsoft generated only $6.31 in value for each dollar of sales, while Google generated $13.83 in market value for every dollar of sales. Microsoft's value/revenue ratio is just like another major player in software and servers: in 2006 Oracle's was 6.97.  The gaming segment accounted for about 10% of Microsoft's revenues. Nintendo, a stand alone competitor with similar gaming revenues, had a v/r ratio of 4.50 in 2006. Microsoft is stuck in a rut they want to get out of. That's why Redmond saw DoubleClick as part of the solution to its $8 billion problem.

GERSTNER'S RULE
The first thing we need to know in order to understand what's driving these value/revenue results is the enterprise marketing efficiency for each player. Lou Gerstner, in his book Who Says Elephants Can't Dance?, laid out a rule of thumb on enterprise marketing efficiency. It's simple and revealing: how much does it cost to generate a dollar in sales revenue compared with your competitors? This is Gerstner's cost per dollar (CPD) rule. It's one of two measures of enterprise marketing efficiency I use in my analysis of The Battle for Your Desktop.

REDMOND, YOU HAVE A PROBLEM
Enterprise Marketing Expenses (EME) are all the costs of the people and programs that influence how customers and investors think, act and feel about a company.

In 2006 Microsoft spent $6.584 billion on R&D, plus an additional $13.576 billion on Selling, General and Administrative expenses (which include their traditional marketing and sales force expenses). So, the company's total bill for enterprise marketing came to $20.160 billion. Divide this total into the company's sales from the first table to calculate its CPD: it cost Microsoft 45.5¢ to generate one dollar in sales in 2006.

Google spent $1.229 billion on R&D, plus another $1.601 billion on Selling, General and Administrative expenses for a total enterprise marketing expenditure of $2.830 billion. So, Google's CPD was just 26.7¢.

IT ADDS UP TO $8 BILLION
It cost Microsoft 18.8¢ more to generate a dollar in sales than it cost Google. Multiply that 18.8¢ times its sales revenues and you find that Microsoft has an $8.3 billion dollar problem. That's how much the company was over-spending on enterprise marketing in 2006 compared with Google. Increased sales revenue feeds back on market valuation with the promise of greater future cash flow. And increased market valuation feeds back on revenues by providing more cash for acquisitions. Microsoft's overspending problem might have been solved by the acquisition of DoubleClick. But Google took that prize away.

SOUR GRAPES
This morning the TimesOnline reported that "Microsoft matched Google’s $3.1 billion (£1.56 billion) bid for DoubleClick but was snubbed by the largest independent broker of online display advertising." Support for this report appeared in the form of a call by Microsoft's:

Bradford L. Smith, Microsoft’s general counsel, told The New York Times an interview Sunday that Google’s purchase of DoubleClick would combine the two largest online advertising distributors and thus “substantially reduce competition in the advertising market on the Web.”

Sure sounds like sour grapes coming from the general counsel of a company that spent years fighting an anti-trust suit. And a legal battle will just magnify Microsofts problem.

WHAT'S NEXT?
Are there other acquisition targets out there that might help Redmond solve its $8 billion dollar problem?

~V

Comments

[Jean-Marie Le Ray]

Hi Victor,

Here is the translation : http://adscriptum.blogspot.com/2007/05/gym-une-analyse_10.html#2007/05/gym-une-analyse_10.html#Indicateurs
Thanks again. Kind regards,

Jean-Marie

[Jean-Marie Le Ray]

Thanks very much, Victor, I'll let you know when it'll be done.
Jean-Marie

[Victor Cook]

Jean-Marie,

I am delighted you would like to publish a French translation of this post on your blog. Please feel free to do so. And thank you for your kind words too!

~V

[Jean-Marie Le Ray]

Absolutely brilliant! Would you authorize me to translate it into French to publish on my blog? It's a translation lab for French speaking people.
Best regards,
Jean-Marie Le Ray

[Jonathan Knowles]

I think this is a compelling analysis of the relative efficiency of enterprise marketing spend. For too long, SG&A and R&D have been treated as "overhead" or "a necessary cost of doing business" - just the act of treating them as "marketing spend" encourages a more demanding mindset about the benefits that these types of spending are meant to generate.
Peter Drucker said that "only marketing and innovation create value" so it is great to see someone doing this kind of analysis on how much revenue and value is being generated for each dollar invested in SG&A and R&D.
On the specifics of the Microsoft situation, it is clear that Microsoft has lower efficiency of marketing spend than Google - but then I suspect so do 95% or more of US businesses (Vic - perhaps you could run the analysis on where Google ranks on EME within the S&P 500?). I am not saying this to excuse Microsoft, but just to suggest that a mature business (and many parts of Microsoft's business are mature even if paid search is not one of them) may find it hard to have an EME ratio that diverges significantly from the mean for its peer set.
Vic - perhaps you can offer some insight into what constitutes excellence in EME in more mature industries? If my revenue growth is above the industry average and my EME ratio is 95% of the industry average, am I a star?? Or does it need to be 90%? 80%?
Thank you for your insight.