Competing for Customers and Capital

Tough Choices, Bad Board

In the fall semester of 2004 I offered an MBA course at Tulane University based on the 3rd revision of the pre-publication manuscript of my book.  This was about the 4th running of the course in both the undergraduate and graduate programs.

YOUR DESKTOP REVISITED
In that semester nine teams of MBA students updated analyses in my book. One of these teams worked on the strategic group in Chapter 6 on The Battle for Your Desktop.  The companies in this group were Compaq, Dell, Hewlett-Packard, and IBM. The analysis covered the years from 1991 through 2000 – the pre-merger period. Their job was to update it from the 1st quarter of 2002 through the 2nd quarter of 2004 (the most recent data for all firms available in the fall of 2004).

Dell was the focus of this team's report. But since they ran the numbers on all four companies, they couldn't help but notice an apparent inconsistency in the results for HPQ: the company's "relative earnings productivity" under Carly Fiorina's leadership continued to improve after the merger, hitting 98.7% in the 4th quarter of 2003. Relative earnings productivity is a measure of the degree to which a company achieves maximum potential earnings. Yet, investors drove HP's value/revenue multiple down from 9.3 in her first year as CEO to just 2.8 in the 2nd quarter of 2004. See my last post "Carly Delivered While Investors Fiddled."

HP's NORTHWEST DRIFT
Roughly speaking my theory of Competitive Stock Valuation asserts that earnings productivity and the value/revenue ratio are positively correlated. Or, if the quality of earnings is increasing, so should a company's value/revenue ratio.

Picture a scatter diagram with relative earnings productivity on the vertical axis and the risk-adjusted value-sales differential on the horizontal axis. Over time you should see these metrics move toward the upper right-hand corner of the chart. In other words, a "Northeast Drift" in these numbers. HPQ was exhibiting a strong "Northwest Drift" – exactly the opposite of my prediction. Since these results were projected on huge screens in the front of the classroom, everyone wanted me to explain this result. Here is what I told them in 2004:

Considering the bad press Ms. Fiorina continued to receive and investor’s failure to reward the company’s performance under her leadership this appears to be case of bad PR coupled with poor investor relations (Competing for Customers and Capital, page 239).

Of course, the MBA students concluded my theory failed a critical test. One of them asked "How can bad press and poor investor relations disregard the facts?" I really wasn't able to answer that question until yesterday, when I read Carly Fiorina's book cover to cover.

TOUGH CHOICES, BAD BOARD
What I failed to understand about HP's problem was that the bad PR and poor investor relations were not being driven by the unseen-hand of the market:

Although not everyone could yet see it, by the end of 2004, a sustainable, successful business transformation had been achieved. It wasn't perfect, but it was perfect enough. … The only clouds on the horizon were the press and the stock price. These were not insignificant, but I believed that the strong performance we would deliver over the coming year would take care of both in time (pages 275-276).

The PR and investor relation problems were the product of several seriously dysfunctional members of HP's own Board of Directors. To find out what happened you've got read the details for yourself, but I can point to an event that occurred after the January, 2005 off-site Board meeting which documents their dysfunctional behavior. In her book Carly reports:

The following Friday afternoon I received an urgent phone call from one of our press people. The Wall Street Journal was going to print a detailed story the next Monday morning about our Board meeting. The reporter was talking to at least two, possibly three, Board members. Was it true we were going to reorganize? Did I have a comment?

It is hard to convey how violated I felt. Until a Board makes a decision, its deliberations are confidential. Whoever had done this had broken a bond of trust with me and every other Board member. … Trust is a business imperative. No Board or management team can operate effectively without it (page 290).

That article appeared in the Jaunary 24, 2005 issue of the Journal. Here's what it said:

At its annual planning meeting between Jan. 12 and Jan. 15, H-P's board discussed giving three senior executives more authority and autonomy over key operating units, according to people familiar with the matter. The board also has asked Thomas Perkins, a prominent venture capitalist and a former H-P director, to rejoin the board, these people said.

The next time I teach my course, Carly Fiorina's book Tough Choices: a Memoir will be recommended reading. It's that important in understanding how the competition for customers and capital really works, at the board level. The next time you find yourself frustrated and angered by the self-destructive behavior of those who care more about themselves than the future of your organization, just stop and read Carly's book.

~V

Investors Fiddled While Carly Delivered

THE OLD HP (NEARLY) MAXIMIZED EARNINGS
My analysis of The Battle for Your Desktop from 1991 through 2000 revealed the extraordinary performance of IBM under the leadership of Louis Gerstner. But there was another surprising story in that period. This chart shows how HP performed under the direction of Lew Platt, President and CEO of the company from 1992 through 1999.

 

During this period HP nearly maximized earnings. For example, in 1992 actual earnings (in blue) were $2.1billion, or 96% of their maximum potential.  Over the eight years of his tenure actual earnings averaged 95% of potential: Lew earned a cumulative total of $34.882 billion while his maximum potential earnings were $36.593 billion. But he began to fall short of maximum earnings in 1995 and worse, actual earnings fell in 1999. While performing at 95% of potential was good, that 5% shortfall left almost $2 billion in potential earnings on the table. And over 80% of that was lost from 1995 through 1999. Partly explaining why the board went looking for fresh leadership. They found it in Carly Fiorina and she took over as HP's new CEO in July, 1999. As they say, the rest is history. Except, in this case history got it wrong! The purpose of this post is to set the record straight.

FIORINA OUT, HP STOCK SOARS
On February 10, 2005 this was the headline in Paul La Monica's lead story on CNNMoney.com. The author calculated that HP's shares were up 6.9% on heavy trading and reported:

"The stock is up a bit on the fact that nobody liked Carly's leadership all that much," said Robert Cihra, an analyst with Fulcrum Global Partners. "The Street had lost all faith in her and the market's hope is that anyone will be better."

The article also contained a "Quick Survey" asking readers this question: Is Carly Fiorina's departure a good thing for Hewlett-Packard? Out of 27,345 responses, 71% said it was a good thing.

CARLEY TELLS HER STORY
Twenty months to the day after the HP board fired Carly Fiorina her book Tough Choices: A Memoir hit the news stands. Simultaneously, an interview by Fred Vogelstein appeared in Wired. Near the end of that interview this dialog appeared:

Vogelstein: What would you have done differently about your tenure at HP?

Fiorina: I guess what I wish I had understood at the outset -- and I clearly didn't -- is how much of a symbol of change everything about me was. Everything about me was a challenge to some people, and I don't think I understood that. … But you know, if I think back on the big things, the decisions that really defined my legacy, my tenure -- the decision to come in alone (without my own team) and engage the organization in its own transformation, the decision around the merger, even the decision about how to describe my departure from the company, as a firing as supposed to a decision to resign -- those big decisions I wouldn't do differently in retrospect.

INVESTORS' IRRATIONAL GLOOM
HP's value/revenue multiple jumped to 9.3 during Carly's first year on the job, up from 6.0 in the last three years of Lew's tenure.  But investors were unhappy with the merger from the day it was announced. And they beat up HP's stock driving its value/revenue multiple down to 2.8 during her last year on the job. Given these numbers, it's easy to see why the board asked Carly to resign.  But, as this chart makes clear, investor's suffered from irrational gloom regarding HP's performance under her leadership. Which partly explains why she refused to resign and described her departure from HP as a firing.

 

From the 4th quarter of 1999 through the 2nd quarter of 2004 actual and maximum earnings were closer under her stewardship than that of the previous CEO – with the exception of the merger expenses that hit the books in the 2nd and 3rd quarters of 2002.

Note there is marked seasonality in HP's quarterly data that was not revealed in the annual numbers reported in the first chart. And all four companies in this strategic group suffered a similar dive in earnings when the bubble burst in 2000.

WHY?
Why did investors beat up HP's stock after the merger? Was it because Carly Fiorina performed poorly? This evidence says no. Well then, did they beat it up on the stock because she rubbed her managers and engineers the wrong way? Is culture shock enough to turn investors against an otherwise solid stock with a predictably great future? Or, was it because she is a woman who was just too successful?

What do you think?

Gerstner's Rule

In Who Says Elephants Can't Dance Louis Gerstner describes a measure of "Enterprise Marketing Efficiency" (EME). I call his measure "Gerstner's Rule." Apply this rule to any public company and you can see in a flash if the emperor has no clothes. And this metric is simple to calculate.

In Gerstner's description of the problems he faced as the new CEO of the faltering giant IBM company he said:

After months of hard work, CFO Jerry York and his team determined that IBM's expense to revenue ratio – i.e. how much expense is required to produce $1 of revenue – was wildly out of range with those of our competitors.  On average, our competitors were spending 31 cents to produce $1 of revenue, while we were spending 42 cents for the same end.  When we multiplied this inefficiency times the total revenue of the company, we discovered that we had a $7 billion expense problem! (page 62-63)

He set out to solve that problem. Over the years from 1993 through 2000 he took IBM from the brink of failure to maximum earnings market share. I trace this amazing story in Chapter 6 of my book. You can see a summary of it in my audio slide show on The Battle for Your Desktop. Though Gerstner didn't say exactly what "expenses" he used to calculate the EME ratio, my analysis leads to the conclusion he must have used "Selling, General and Administrative" expenses from the income statements of IBM and its competitors.

CAN YOU OFFER SOME INSIGHT?
In my April 16th post on "Microsoft's $8 Billion Problem" I applied Gerstner's Rule to the newest contestants in the continuing battle for your desktop: Google, Yahoo! and Microsoft. In his comment on my post Jonathan Knowles asked these questions:

… (can) you 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%?

In this short series of questions he is asking for a sweeping basic research study on the behavior of the EME ratio. And I intend to complete such a study in time. For now, all I can do here is take a first cut at answering his first question: What constitutes excellence in EME? But, to keep it in context I've applied the EME ratio to ten high-tech industries. In addition, I decided to look at the extremes of performance, including both excellence and inferiority, in the EME ratio.

EME AVERAGES IN HIGH-TECH
This table reports the EME to revenue ratios and their coefficients of variation (COV) for 549 companies in ten high-tech industries in 2005.

Let's take a close look at the first industry listed in this table: Computers and Software Wholesalers. The 18 companies reporting the data in SIC 5045 booked $62 billion in revenues and spent $3 billion on SG&A expenses. The expected value of their EME ratio was $0.05 [$3/$62 billion]. That these high-tech wholesalers spent only 5¢ to generate $1.00 in revenues should come as no surprise. After all, most of their business is repeat purchases from large customers.

The standard deviation in the EME ratio of the 18 computers and software wholesalers of $0.20 was 4.2 times the expected value. Such a large coefficient of variation suggests big differences among the reported SG&A expenses by these companies.

The highest enterprise marketing expense per dollar sales was incurred by the 277 companies in the Packaged Software industry. The relatively small COV of 1.5 suggests that even if there were a wide range between the minimum and maximum EME ratio, they tended to cluster close to the mean of 47¢ per dollar of sales. This relatively high expense ratio should also come as no surprise. It just happens that this was Microsoft's EME ratio in 2006. Remember Google's ratio? It was just 27¢. That's where MSFT's $8 billion dollar problem came from. You could argue this is the real source of Microsoft's Google envy.

EME EXTREMES IN HIGH-TECH
The first table gives the impression of a pretty orderly underlying pattern. But as the next table shows this is far from the truth. The real underlying pattern is one of surprising extremes. I've highlighted three of them.

France Telecom's 1¢ per dollar of sales was the lowest among the 64 telephone companies. Proving once again, until you lose it, monopoly power makes selling a snap!

First Avenue Networks, in the Radio Telephone industry, spent $11 to get $1 in revenues in 2005. This was the lowest bang per buck of any of these 549 high-tech companies. In all fairness to First Avenue Networks, it was a start-up in 2003 and since has merged with Fibertower. Its march 31, 2007 income statement shows the EME per dollar sales have dropped to $1.70.

Finally, it comes as a surprise that Steve Job's little Apple Computer jumped over the likes of Silicon Graphics (46¢), Sun Microsystems (42¢), and Cray Inc (42¢) by spending only 17¢ to generate a dollar in revenues! And we see in Apple's March 31, 2007 SEC filing that its EME ratio dropped to 16¢. So much for scale efficiencies in enterprise marketing expenses.

MOMENTUM-POWERED COMPANIES
By chance, I'm in the middle of reading the pre-publication manuscript of a new book by my friend and co-author of Readings in Marketing Strategy J.C. Larreche, the Alfred H. Heineken Professor of Marketing at INSEAD.

The book's about momentum powered companies … like Apple Computer  … and how they manage to produce greater market caps than their competitors with relatively lower enterprise marketing expenses. More importantly, with this book you can learn to do the same. Stay tuned. While JC's book may not hit the streets till early next year, I'll be telling you as much about it over the next months as Wharton Publishing will allow.

~V

Microsoft Reboot!

In my post on Microsoft’s $8 Billion Problem I suggested that Double-Click might offer a solution to its sagging value/revenue multiple – 6 compared with Google’s 14. But, I didn’t take the Yahoo option seriously until this morning when Andrew Ross Sorkin contributed the following to a Deal Book report in the New York Times:

Microsoft has made a preliminary overture to Internet giant Yahoo, and the two companies are in very early discussions about a possible merger, according to people briefed on the discussions.

Then this moring Henry Blodget asked (and answered) these questions in his blog:

Would it be a smart strategic move for Microsoft and Yahoo to combine forces? Absolutely. Is the best way to do this to have Microsoft suck into the massive Windows/Office empire? Absolutely not. If Microsoft buys Yahoo, Microsoft should immediately spin the Yahoo-MSN business out as a separate company. If it doesn't, both Yahoo and MSN will die.

Given the pre-market pop in Yahoo’s shares others apparently are taking this report seriously too.

So, this brings me back to Microsoft’s $8 billion dollar problem. That problem is based on the company’s enterprise marketing efficiency compared with that of Google.

Gerstner's cost per dollar (CPD) rule is simple and revealing: how much does it cost MSFT to generate a dollar in sales revenue compared with Yahoo and Google? It's one of two measures of enterprise marketing efficiency I use in my audio slide show on The Battle for Your Desktop.

In 2006 it cost MSFT $0.46 to generate a dollar in revenue, compared with Google’s $0.27 per dollar in revenue. This is Microsoft’s $8.4 billion problem [$44.3*(0.46-0.27)]. How about Yahoo? It cost them $0.42 per dollar. So Yahoo has a $1 billion dollar problem compared with Google [$6.4*(0.42-0.27)].

Do you think combining the two and creating a $9 billion problem will help much? Even if Yahoo-MSN is spun off as Henry recommends? In the history of financial markets has it ever really helped for two companies suffering from the same symptoms to join forces?

~V