Saturday, April 30, 2005

As go geese, so goes the economy

If you’ve ever noticed a flock of geese flying in V-formation, you can understand the microeconomic concept of complementary goods.

In a flock of geese, there may be 10 geese following the leader. In economics, there may be 10 different complementary goods the demand for which rises and falls with demand for the lead good.

Complementary goods are playing an important role in the economic downturn which surfaced this month. As subscribers to the current issue of my monthly investment newsletter, The Cohan Letter will see, as go lead goods automobiles, housing, and in an odd way oil; so go their complementary goods.

Let me expand on this point.

In April, GM and Ford reported that they expect significant declines in sales for 2005, specifically for gas guzzling SUVs and trucks. Every time someone buys a car, the auto’s maker needs to replenish its inventory of parts and steel – making these items the automobiles’ complementary goods. GM and Ford have responded to declining demand by squeezing their parts and steel suppliers. As a result, many auto parts suppliers have filed for bankruptcy and others – laden with debt – are suffering debt downgrades. S&P thinks that some of them will violate their debt covenants – a move that could send them into bankruptcy. Meanwhile, prices for rolled steel that goes into automobiles have declined and capacity utilization for US steel producers is tumbling.

Similarly, as housing prices have skyrocketed and housing affordability has tumbled, home foreclosures have spiked 50%. Whenever someone buys a new house, builders need to replenish their inventories of lumber and the home buyers need to buy furniture – making these items housings’ complementary goods. With the housing market peaking out, lumber prices are tumbling and furniture retailers are hurting.

Oil is a special case. When oil prices rise, so do gasoline prices. And when gasoline prices rise high enough, people stop buying other things – such as gas guzzling SUVs. Some even stop driving altogether and take public transportation. So oil is a kind of inverse complementary good. When its price reaches a certain level, people stop buying the complementary goods – such as big cars -- that they would have purchased if the price of oil was lower. According to the Dallas Federal Reserve, higher oil prices are likely to subtract 1.6% from the US GDP growth in 2005 and 2006.

That makes this inverse complementary good a pretty powerful economic factor. But it seems that there is an inherent time lag between when the lead good changes direction and the complementary goods follow that lead.

And my hunch is that this time lag suggests why the economy held up fairly well through the end of 2004; why it slowed down in the first quarter of 2005 and why that slowdown could intensify throughout 2005 and into 2006.

Friday, April 22, 2005

Specialists, newspapers, and dinosaurs

Two long awaited corporate extinctions took a quantum leap closer to reality today.

The first was represented by the merger of the New York Stock Exchange (NYSE) with the Archipelago electronic exchange. 21 years ago I worked with the NYSE to analyze electronic exchanges such as Telerate, Quotron, and Bloomberg. I know that some at the NYSE have been worried literally for decades about how its system of trading specialists could survive the efficiency benefits of information technology. But with the Grasso scandal and the continued loss of market share to electronic exchanges, the dam finally burst for the NYSE. And its CEO, John Thain, was able to jolt the NYSE into the 21st century through today’s merger. It now seems inevitable that the NYSE’s specialists will go the way of the Triceratops.

While the NYSE/Archipelago merger gained the biggest share of media attention, a far more profound leap towards extinction took place on the pages of the very medium whose extinction was advanced – newspapers. Specifically, today’s Wall Street Journal reported that Google’s “quarterly advertising revenue now outstrips the advertising revenue of most major newspaper publishers, including New York Times Co., Washington Post Co., Knight Ridder Inc. and Dow Jones & Co., which publishes” the WSJ. Advertising on Google's own Web sites represented 52% of revenue. Google brokers ads that appear on other Web sites, taking a commission on that ad revenue, which averaged about 21% during the quarter.

These simple sentences should strike fear into the heart of every newspaper shareholder and employee. With Google doubling its revenues every year, it is not hard to imagine a time in the not too distant future when newspaper advertising will shrink so much that newspapers will either need to raise their subscription fees dramatically or run out of cash. Consider the Q1 2005 results of the papers mentioned above:
  • The New York Times’ ad revenues, which represent 65% of total revenues, were flat and were it not for a non-recurring gain it would have made a very slim profit;
  • The Washington Post’s ad revenues, which represented 64% of its 2004 newspaper revenues, actually grew 5% over the year. But The Washington Post is far more diversified in its revenues than the New York Times, relying on newspapers for a relatively paltry 29% of its corporate sales and 25% of its operating income;
  • Knight Ridder’s ad revenues, 78% of revenue, squeaked up a mere 3%; and
  • Dow Jones’s ad revenues, 53% of sales, shrank 4%.

In short, Google is eating these newspapers’ lunches. And even as their businesses are imploding, some of these family owned dinosaurs are entrenching themselves in complicated Class A and B share structures which protect the founding families’ power – this week Dow Jones approved a measure that would allow members of its founding Bancroft family to maintain voting control of the company even if they sell part of their holdings. Meanwhile their founding business models crumble under pressure from Google, Yahoo! and their Internet peers.

These newspapers’ shareholders might benefit from thinking about the trends that their reporters do such an excellent job of analyzing. The NYSE’s merger with Archipelago and Google’s explosion of advertising revenue offer a stark lesson – the progress of technology can be held back only so long – and when the dam breaks, the damage can be devastating.

Wednesday, April 20, 2005

Who are you?

Identity theft is a growing problem whose costs are hitting consumers hard. But good solutions remain elusive.

Has this happened to you yet?

  • Fortune’s David Kirkpatrick clicked on the Microsoft Word document containing his passwords, code numbers, URLs for work-related websites, and credit card numbers. But when he tried to open it he saw a message that read: "File is in use by another user." As a user of an insecure wireless network, Fitzpatrick’s data was transmitted 150 feet in every direction. He immediately canceled all the credit cards and changed sensitive passwords, including the one for his online banking account. As of mid-April he had not detected any misuse of this potentially stolen information.
  • Art Sullivan of Newark, DE is one of 1,000 people in Delaware and nearly 145,000 people nationwide who got a letter in February from ChoicePoint, an information broker. The letters told them identity thieves might have gotten their names, addresses, Social Security numbers and credit reports. So every day since then, Sullivan has been checking his credit report online, thanks to a free year of credit monitoring provided by ChoicePoint. He also took ChoicePoint's suggestion that he put fraud alerts on his credit reports. “They gave me some tools to use so I can do this, I guess, for the rest of my life,” Sullivan said. “It's almost become a part-time job for me.”
  • University of California, Berkeley researcher Diana Jones wants to know why her loan application was among those stolen from Berkeley, CA's McKevitt Volvo. Besides suffering the loss of $5,000 from an ATM she had never visited, Jones said, "The perpetrator opened new accounts in my name and charged $16,000 worth of merchandise at Wal-Mart, Target and Trader Joe's in Emeryville, CA. According to Jones, “I have lost hours of time and sleep, and it's been hard on my family.”
  • Patricia Nelski of Carlton, MI, still fights to keep her credit record clean after a woman posing as her ran up $50,000 in bills, including a $4,000 loan from a Virginia bank. So Nelski did what the experts recommend - she ordered her credit report. It came back 22 pages long, filled with credit card and other accounts Nelski did not recognize. She isn't sure how the woman got her information, but when she did, she ran with it. Nearly 10 years and a second incident later, Nelski is still fighting to keep those black marks from ruining her credit “All it takes is one unscrupulous person, and your life is a wreck’’ according to Nelski.

In 1982, I wrote a paper on legal and technical issues in database privacy for an MIT Database course. 23 years later, these issues are more pressing than ever. According to a Federal Trade Commission survey released in September 2003, the latest year available, nearly 10 million Americans have been victims of some form of identity theft, resulting in $47.6 billion in damages accruing to businesses. Victims spent an average of 30 hours trying to fix the damage and suffered losses totaling $5 billion.

Some of this theft is unsophisticated -- laptops full of personal data disappear, stolen credit cards get used to make unauthorized purchases -- but a lot occurs online. Thieves hack into a consumer’s bank's computer system and steal their account numbers. Or they send scam e-mails encouraging people to renew their accounts on eBay by providing their name and other details. Or they infect a user’s computer with spyware that can extract information from the user’s hard drive. Having stolen a user’s name, date of birth, address and Social Security number, the theft can take out an auto loan or go on a credit card spree.

There is a big market for the fruits of this poisoned tree – in the form of online crime Web sites. And the government is trying to crack down on them. For example, in October 2004, New Jersey prosecutors, along with the Secret Service and the Department of Justice's Computer Crime and Intellectual Property Section, announced they had shut down three of the major online crime Web sites -- Shadowcrew, Carderplanet and Darkprofits -- and arrested 28 alleged participants who are scheduled to go on trial in October. On Shadowcrew alone, 4,000 members trafficked in 1.5 million stolen credit cards, causing $4 million worth of losses to financial institutions, according to the indictment.

The government hasn’t closed them all down. Social Security numbers can be had for $35 at and $45 at, where users can also sign up for a report containing an individual's credit-card charges, as well as an e-mail with other “tips, secrets & spy info!”

Here are seven recent cases representing the theft of 3.5 million people’s identities:

  • In mid-February 2005, ChoicePoint, the data broker and credit reporting agency with access to 19 billion records, said a criminal ring stole personal information on about 145,000 Americans. Their data had been mistakenly made available to a ring of thieves with apparent ties to Nigerian organized crime.
  • LexisNexis, whose subsidiary, Seisint, sells personal data, said thieves might have accessed information on about 310,000 people by using stolen passwords. LexisNexis initially announced about 32,000 suspected thefts of identity data, which soon balloon to 310,000; LexisNexis found that the thieves were using the log-in names assigned to former employees of Seisint customers or were correctly guessing uncomplicated ID and password combinations or accessing customers' systems through a virus. Siesent suffered 57 incidents. And there were two more at other subsidiaries.
  • Bank of America lost a backup tape containing Social Security numbers and other vital data on 1.2 million federal workers. As luck would have it, Bank of America's gaffe involved the loss of account records of U.S. senators, and that has helped galvanize Congress to consider taking action.
    HSBC and GM have recently announced that 180,000 holders of their jointly branded credit card should cancel and change their MasterCard credit cards that may have been stored in the retailer's system.
  • In April, Retail Ventures also suffered a hack of credit information on customers of more than half of its 175 DSW stores, compromising the personal data of 1.5 million consumers' personal data.
  • On April 14th, Manhattan-based Polo Ralph Lauren acknowledged that it was informed last fall that "some credit card information of its customers may have been misappropriated" after learning that data from the magnetic strip was being improperly stored in its point-of-sales system. The company, which purged the stored data, didn't disclose the extent of the breach.
  • On April 19, Ameritrade said account information may have been lost for 200,000 customers when a package containing tapes with back-up information on customer accounts went missing. Ameritrade said it was told in February that a package with four data cassettes of current and former Ameritrade account holders' information from 2000 to 2003 was misplaced by a shipping company that Ameritrade uses.

Fears of identity theft are running high among consumers; 59% say they are very concerned, according to a USA TODAY/CNN/Gallup Poll, taken in late February after the ChoicePoint disclosure.

Here are some things you can do to protect yourself:

  • Don't carry any document with the number in your wallet or purse. In addition to leaving your Social Security card at home, make sure health-insurance cards or other documents don't have the number on them.
  • If your driver's license number is your Social Security number, ask your motor-vehicle department to change it. Don't print the number on your checks.
  • If any of your financial-service or insurance providers print your Social Security number on statements or checks that move through the mail, call and ask them to stop.
  • Adopt policy of not disclosing your number without requesting an explanation of why disclosure is necessary and will benefit you. Businesses cannot require it, but they can refuse to provide you service if you do not provide it.
  • If your number is both an account number and a password for any service, change one or both of them yourself or request the service provider allow you to do so. Do not use your Social Security number as a PIN.
  • Check your credit reports once a year from all three of the credit reporting agencies.
  • Watch for people who may try to eavesdrop and overhear the information you give out orally.
  • Carefully destroy papers you throw out, especially those with sensitive or identifying information. A crosscut paper shredder works best.
  • Be suspicious of telephone solicitors. Never provide information unless you have initiated the call.
  • Delete without replying to any suspicious e-mail requests.
  • Use a locked mailbox to send and receive all mail.
  • Reduce the number of pre-approved credit card offers you receive by calling (888) 5OPT-OUT (they will ask for your Social Security number).

If you are a victim of identity theft

  • Put a fraud alert on all three credit reports. That warns creditors to contact you before approving any credit applications.
  • Call the police. That includes your local police department, as well as police wherever the thief applied for credit. Even if local police can't investigate because the crime happened somewhere else, they can validate victims' identity for other agencies.
  • Get your credit reports from the three reporting agencies so you know what accounts have been opened.
  • Contact the fraud departments of those creditors and tell them the accounts are bogus. Ask for a transaction record, which shows details of the credit application, including what type of identification the thief is using. Send those to police.
  • Keep notes on everyone you speak to, including their name, title, time of the call and what was said.
  • Make copies of every letter or affidavit. Send everything by return-receipt mail.
  • Stay organized and don't overload police with emotions and irrelevant details.
  • Pay attention to the emotional impact of the crime. It can lead to sleeplessness, paranoia, irrational outbursts and even damaged relationships.

Various legislators are trying to pass Federal and state laws to address these problems, including the following:

  • Senator Diane Feinstein is trying to pass a Federal law patterned after the California law that gives people the option of doing more than placing a fraud alert on their credit history, which can only be extended beyond 90 days if the threat of fraud is documented; instead, Californians can freeze their credit data indefinitely, so no new loans will be extended to themselves or their shadows. California also requires corporations whose data have been compromised to inform affected individuals. The breach suffered by ChoicePoint, of Alpharetta, GA, became public when ChoicePoint had to comply with California’s law and tell residents their information had been passed onto thieves. Requiring national alerts would heighten awareness and create a bigger safety net for consumers, particularly if it were combined with free annual reviews.
  • Senators Charles Schumer and Bill Nelson are introducing a bill in Congress calling for a ban on the sale of Social Security numbers and for tighter controls for companies like ChoicePoint and Seisint.
  • New York attorney general Eliot Spitzer called for state legislation aimed at reducing identity theft through regulation of data brokers, consumer opt outs, mandatory data breach disclosure and tougher penalties for identity thieves and hackers.

While government intervention seems to make political sense, the problem will not be solved until the penalties paid by the data leakers – such as Seisint and ChoicePoint – get much higher. Specifically, the problem will not be solved until the penalties for leaking data exceed the costs of the procedural and technological changes required to plug the data leaks. Should that day come, the data leakers will make the investments needed to minimize these penalties and your identity will be safer.

Until then, you are on your own.

Tuesday, April 19, 2005

Profiting from confirmation bias

Investors and business executives can profit from confirmation bias -- the notion that people eagerly gobble up information that confirms their pre-conceived ideas and reject the rest. Here are three examples:
  • Microsoft/IBM. Bill Gates tapped confirmation bias to make the most valuable business decision in history. In the early 1980s, IBM was looking for an operating system for its PC. Gates paid $75,000 to license one from Seattle Computing. Gates sold IBM the rights to the OS for use on IBM PCs for a pittance. IBM, assuming that no PC-clone market would emerge, granted Gates the license for the OS on the clones. IBM had convinced itself that Gates was naïve about the emergence of PC clones. If Gates was right, IBM reasoned, then IBM was no longer the marketing powerhouse it believed itself to be. When the PC clone market grew, Gates profited from IBM’s confirmation bias.
  • Williams Communications Group. Confirmation bias creates opportunities in stocks as well. In March 2001, Williams Companies spun off its holdings in fiber network operator, Williams Communications Group (WCG). After reviewing its finances and its prospects, I was quoted in the media that WCG, which traded for $9 a share, was likely to go bankrupt. In mid-September 2001, WCG filed a quarterly statement which brought the bankruptcy closer to reality – I was again quoted in the media predicting a WCG bankruptcy. That day I received a warm-hearted e-mail from a WCG investor suggesting that I take my family in an airplane and share the fate of the 9/11 victims. Since the investor had indicated that he was an engineer, I thought he might be interested in the facts. After sending him the data on which I based my conclusion, the investor replied that he agreed with my analysis and that he had never bothered to read the 10q. I am convinced that like many investors, he only wanted to read information that confirmed his decision to buy the stock.
  • Electronics Test Equipment Company. In the fall of 2000 I worked closely with a company whose confirmation bias kept it from seeing that it stood at the precipice of a huge revenue drop. This company, which sold testers to companies that made network switching gear for companies like WCG, was having its best year ever. After analyzing the finances and prospects of its customers’ customers, I suggested that trouble was ahead. The verdict on my speech at a corporate management meeting was dismissive: “This consultant doesn’t understand our business.” A year later the client’s revenues had declined by two-thirds and when its managers sought a reason for the decline, they realized that events had unfolded along the lines I had predicted.

The point of these stories is that confirmation bias is an opportunity for an objective analyst. If IBM had been more objective, it might have recognized that Gates was not as naïve as he appeared. If WCG investors had read objectively the information that was publicly available, they might have bailed out before WCG filed for bankruptcy. And if the test equipment company had listened with a more open mind, it could have cut costs and diversified its customer base in anticipation of the decline in its revenues.

Unfortunately, once an investor or manager has committed capital, it is very difficult to avoid the confirmation bias. Thus opportunities abound to profit from it.

Monday, April 18, 2005

Power struggle

P&G and Wal-Mart are locked in an economic wrestling match in which they both compete and cooperate. They compete over price in the products Wal-Mart distributes and for market share in some product lines. But they also cooperate to lower their joint costs. And this power struggle has important implications for managers and investors.

Wal-Mart competes with P&G by forcing it to cut prices on the $8 billion worth of consumer products P&G sells through Wal-Mart. And in some categories, such as detergent, Wal-Mart has introduced its own private label brands priced far below P&G’s price point. For example, after years of helping P&G sell its leading detergent, Tide, in 2001, Wal-Mart introduced its own brand of laundry detergent at half Tide’s price.

Wal-Mart has also taken advantage of P&G’s weaknesses to cut into P&G’s toilet paper market share. P&G had let the trademark on its White Cloud toilet paper lapse in 1994, in order to concentrate on its higher priced Charmin brand. A private entrepreneur acquired the White Cloud trademark and sold it to Wal-Mart. Wal-Mart started displaying White Cloud with open rolls so shoppers could touch and compare. White Cloud sales quickly increased, hurting P&G’s Charmin.

P&G executives felt betrayed. All the consumer market research P&G had shared with Wal-Mart on how to sell toilet paper was being used against it. According to P&G, Wal-Mart uses the upscale image of White Cloud that P&G has created, while selling the product at lower prices.

But Wal-Mart and P&G cooperate in their efforts to use technology to lower their joint costs. Wal-Mart has a long track record of using technology to improve productivity. Wal-Mart's technology lets it analyze costs and speed delivery of goods from its 30,000 suppliers to dozens of warehouses.

Wal-Mart says it has the USA's biggest private satellite communications network, one that links stores to its Bentonville, AK headquarters by voice, data and video. Suppliers tap into Wal-Mart's computers to track sales of all suppliers’ products, which improves inventory controls and cuts costs.

Wal-Mart expects vendors to monitor the data on a daily basis, and respond to problems immediately. Wal-Mart also demands cost cutting and sharing of data in return for a deal. P&G, for example, is sharing data on the Hispanic customer with Wal-Mart, to develop more effective merchandising programs. That has helped P&G identify which Wal-Mart stores receive such products as Ariel, P&G’s top selling laundry-detergent brand in Latin America.

Even as it shares information with suppliers, Wal-Mart has stopped providing data to research companies like Information Resources. This has made it more necessary for vendors to be constant touch with Wal-Mart executives to stay on top of the trends.

And in mid-2003, Wal-Mart began requiring its top 100 suppliers to install Radio Frequency Identification (RFID) tags on their products by January 1, 2005. RFID tags are small, 25-cent components including a chip, antenna and product information that Wal-Mart could track through in-store and in-warehouse RFID signal-reading machines. While Wal-Mart didn’t meet its January 1 deadline, the benefits – reduced supply chain costs, shelves stocked with what consumers want and less of the rest, as well as diminished theft could make the cooperation between P&G and Wal-Mart mutually beneficial.

But the tension between the two companies has forced P&G to continually innovate and to cuts its costs. Without such vigilance, P&G believes that it is opening the market for Wal-Mart and other competitor to take P&G’s business.

Its response to Wal-Mart has also led P&G to change in its corporate strategy. P&G has disposed of its weak brands, such as Crisco and Jif peanut butter, which P&G sold to J.M. Smucker in 2002.

And P&G has also tried to adapt to Wal-Mart by popularizing luxuries -- repositioning some of its mundane products to make them appear so desirable that Wal-Mart will feel compelled to distribute them.

P&G has achieved this feat with three products which are now available through Wal-Mart. P&G is upgrading its Olay face creams and marketing them as better than department-store brands – giving consumers the same benefits as an expensive shot of Botox at the plastic surgeon’s office. Tooth-whitening used to be an expensive process that was available only at the dentist's office. P&G's Crest Whitestrips enable the masses to whiten their teeth for a mere $25. And P&G’s Actonel osteoporosis drug helps women get bone-density tests in stores instead of at a doctor's office.

But such tinkering around the edges was not enough to strengthen P&G’s hand with Wal-Mart. So in January 2005 P&G announced its $54 billion acquisition of Gillette – hoping to popularize luxury with some of Gillette’s brands as well.

Wal-Mart has tremendous power in negotiating price to P&G and Gillette. 17% of P&G’s total sales for the year ended June 2004 were to Wal-Mart – roughly $8.7 billion. At Gillette, sales to Wal-Mart accounted for 13% of net sales in the year ended December 2003 -- about $1.2 billion.

By combining the two companies, P&G hopes to gain greater negotiating leverage with Wal-Mart. Once the deal closes, P&G will have an even more extensive product lineup and roughly 16% of its sales tied to Wal-Mart. That is almost $10 billion -- a sum even $278 billion Wal-Mart considers significant.

The combined companies’ costs are likely to decline. P&G believes that the merged companies can save $14 billion to $16 billion a year and deliver sales growth of 5% to 7% on $60 billion of annual sales. That's up from P&G's previous 4% to 6% outlook. According to P&G the combined companies could see operating margins of 24% to 25% in a decade, up from P&G's 19% to 20% today.

Wal-Mart has the upper hand in its relationships with suppliers, such as P&G. While suppliers benefit from Wal-Mart’s use of technology to reduce joint costs, Wal-Mart threatens suppliers’ profits with its tough negotiating posture and its private label initiatives.

The power struggle between P&G and Wal-Mart suggests five implications for managers doing business with Wal-Mart:
  • Anticipate and stay ahead of Wal-Mart. By analyzing Wal-Mart’s past changes in strategy, suppliers can develop reasonable forecasts of what Wal-Mart might do in the future. For a supplier that derives a significant amount of revenue from Wal-Mart, it is crucial to make investments that will position the supplier to profit from Wal-Mart’s future strategies. For example, P&G could have foreseen that Wal-Mart would try to introduce lower priced private label versions of P&G’s best selling products. P&G should be establishing very low cost operations which can blunt the impact of Wal-Mart’s private label strategy with its own, lower priced products;
  • Hunt persistently for ways to cut costs. Any company that attempts to do business with Wal-Mart must find ways to cut its costs significantly every year. Wal-Mart is constantly looking for new suppliers which can produce products that Wal-Mart customers demand at ever lower prices. For example, while many Chinese manufacturers have the lowest labor costs in the world, eventually the lowest labor costs could shift to other regions, such as Africa. In order to maintain long-term relationships with Wal-Mart, suppliers will need to plan such regional shifts effectively. P&G could benefit from following such a strategy – particularly if it could find ways to maintain its high quality standards with lower cost labor;
  • Use information to match supply and demand. Suppliers should invest in real-time information about which of their products is popular in which locations. Such information can increase the supplier’s and Wal-Mart’s profits by enabling the supplier to produce enough popular items and less of the rest. P&G and Wal-Mart have both benefited from their investments in this information. However, as we have seen, Wal-Mart cannot always be trusted to use this information in a mutually beneficial way;
  • Force your suppliers to adapt to your management systems. Unless a Wal-Mart supplier manufacturers all its parts, it will need its own suppliers. And if the suppliers’ suppliers do not keep lowering their costs and increasing their quality, then it will not be possible to adapt effectively to Wal-Mart’s changing needs. Just as Wal-Mart requires its suppliers to adapt to its management processes, so must Wal-Mart suppliers force their suppliers to adapt; and
  • Be wary of becoming overly dependent on any single customer. As the P&G case illustrates, it is dangerous to become overly dependent on a single customer. The problem facing Wal-Mart’s suppliers is that Wal-Mart is so big that any individual supplier is only likely to account for a small percentage of Wal-Mart’s sales. Therefore, the supplier is always likely to be at Wal-Mart’s mercy. Unfortunately for suppliers, Wal-Mart’s strength is forcing retailers to consolidate, as evidenced by the recent merger of Sears and K-Mart. Thus the number of potential customers for a supplier is declining and the remaining ones are getting bigger. Perhaps consolidation of big suppliers, such as the P&G/Gillette merger, will become an effective response.

The power struggle between Wal-Mart and its suppliers suggests five implications for investors:

  • Avoid investing in Wal-Mart stock. This is counterintuitive, since most investors think that a company with good financial performance should be a good investment. In the case of Wal-Mart, this conclusion is incorrect. Despite double digit revenue and profit growth, Wal-Mart stock has actually lost 25% of its value in the last five years and in the last several weeks, it has continued to decline. Perhaps the negative publicity it has received about its legal problems with workers is contributing to the poor stock performance. Despite the difficulty of explaining why it has dropped, Wal-Mart stock does not appear to be a good investment;
  • Anticipate which suppliers might merge. When P&G announced it would buy Gillette, the latter’s stock popped 18%. As noted above, if P&G is successful in its merger, other Wal-Mart suppliers might decide to merge as well. Therefore, investors should try to anticipate which Wal-Mart suppliers would make the most attractive acquisition targets and buy shares or call options in these companies. A visit to a local Wal-Mart might give an investor some ideas about where consolidation might be likely;
  • Anticipate which retailers might merge. Similarly, when K-Mart announced its merger with Sears, the latter’s stock rose as well. Such mergers may continue, particularly if overall retail sales continue to slow down as they did in March 2005. Therefore, investors should try to anticipate which retailers would make the most attractive acquisition targets and buy shares or call options in these companies. Potential targets include J.C. Penney. Dillard’s, and Saks.
  • Try to anticipate which new markets Wal-Mart might attack. Wal-Mart needs to find new markets in order to sustain its double-digit growth. In the past, Wal-Mart has successfully extended its reach from discount retailing to groceries and drug retailing. In the process of attacking these new markets, Wal-Mart has taken a big bite out of the market value of incumbents in those industries. Investors who can anticipate where Wal-Mart might strike next could sell short the shares of high cost incumbents in those markets. While anticipating Wal-Mart’s next target could be difficult, the rewards for guessing correctly could also be significant.
  • Figure out which technologies Wal-Mart is likely to choose next. Wal-Mart has demonstrated a consistent track record of using technology to increase its profitability. Currently Wal-Mart is exploring the use of RFID technology. And if Wal-Mart is successful, it will create enormous quantities of data for Wal-Mart to track, store and analyze. This should drive increased revenues for Wal-Mart’s suppliers of database and data mining software as well as its data capture and storage hardware. Investors who can forecast which technologies Wal-Mart is likely to use in the future could profit by investing in those suppliers.

It remains to be seen whether P&G’s merger with Gillette will help the combined company gain greater negotiating leverage with Wal-Mart. However things turn out, the implications of the ongoing power struggle for managers and investors are profound.

Sunday, April 10, 2005

CEO career insurance

Why did Carly Fiorina lose her job at HP and John Chambers at Cisco Systems' job appears secure? Why is Phillip Purcell at Morgan Stanley's position in the midst of a media firestorm while Lee Scott at Wal-Mart's position remains powerful? And why is Michael Eisner on his way out of Disney?

If you clicked on the links to the companies, you'll see that the difference between the secure CEOs and those in danger is not the stock price. Cisco Systems' stock is down more than HP's from its peak (74% vs. 69%). Wal-Mart is down 25% from its peak while Morgan Stanley has fallen 49%. And while Disney has tumbled 33% from its 2000 peak of $42, the company's market value appreciated considerably during Eisner's 20 year tenure.

The financial performance of the companies seems, in part, to explain the variation in CEO job security. For instance, Cisco's revenues have risen 16% since 2000 and its profits climbed 65%; whereas HP's revenues rose 63% since 2000 (in the wake of its Compaq acquisition) but its profit shrank 5%. Meanwhile Morgan Stanley's revenues fell 13% since 2000 while its net income declined 18%; while Wal-Mart's revenues grew 49% on a 63% profit boost. Disney, whose revenues rose 22% over the last five years while climbing from a $158 million loss to a $2.6 billion profit, suggests that the financial performance explanation does not wash.

I believe there's a deeper reason why some CEOs can survive a drop in stock price and others can't: constituent value creation (CVC) -- how well the CEO satisfies the specific requirements of the company's shareholders/board, customers, employees, and communities. CEOs who want to increase their chances of keeping their jobs must win at CVC. John Chambers, whose company's stock has lost 74% of its value in the last five years is winning at CVC and Phil Purcell -- who alienated a vocal group of former Morgan Stanley executives and tossed out high performing bankers -- is not doing so well. As James Stewart illustrates in DisneyWar, Eisner lost his position by alienating parts of his board, key shareholders, top employees, and powerful community members. In short, Eisner destroyed constituent value.

How can a CEO get the kind of career insurance that Chambers enjoys and Eisner squandered? First, the CEO must recognize that each constituent uses different criteria to determine how much value they receive. For example, shareholders care about quantitative factors such as stock price appreciation, return on equity, and revenue growth. Employees seek out a mixture of quantitative criteria, such as pay and bonuses, and qualitative criteria such as management respect, career opportunities, and challenging coworkers. Customers assess a company based on factors such as product quality, selection, and price. And communities look at how well a company supports local causes, abides by the wishes of government officials, and obeys laws and community standards.

Ideally, CEOs would be able to obtain all this information from their subordinates. As a practical matter, in many companies it is difficult for CEOs to rely on the objectivity of the information they receive from their employees. Some CEOs make it clear that they prefer to hear only data that confirms their views -- and those who insist on contradicting the CEO jeopardize their careers. While employees are generally diligent, I believe that their desire for career self preservation can influence how they report on their business activities.

Therefore, in order to understand how well the company meets these different value criteria, the CEO must deputize objective observers who can interview the different constituents, analyze their responses, deliver a report in confidence to the CEO, and recommend actions, as needed, to fix any problems. A CVC review provides CEOs with answers the key questions that shape constituent perceptions -- examples of which follow.


  • How well is the company's stock performing relative to the market and the company's peer group?
  • How strong is the company's revenue, profit, and cash flow growth relative to its peers?
  • How well protected is the company from credit, information, legal, competitive, and physical risk?
  • How deep is the company's management bench and how motivated is the company's best talent?
  • How well is the company balancing short-term execution and longer-term investment in growth opportunities?


  • What are the customer's ranked purchase criteria (e.g., price, quality, and selection)?
  • How well does the company satisfy these criteria compared to competing products?
  • For criteria which the company satisfies well, what capabilities enable the company to win?
  • For criteria which the company does not satisfy well, what capabilities enable competitors to win?
  • What can the company do to outperform its competitors in the most important customer purchase criteria?


  • Who are what Bill Roiter calls the company's most valuable people (MVPs)?
  • How motivated are the company's MVPs and how likely are they to stay with the company?
  • If the MVPs are not sufficiently motivated, what steps could be taken to increase their motivation?
  • How satisfied and productive are employees at different levels of the company?
  • What steps could the company take to increase their level of satisfaction and productivity?


  • Which government and community leaders are likely to have the most significant impact on the company's growth prospects?
  • How do these leaders perceive the company?
  • If these leaders' perceptions are not positive, what could the company do to improve their perception?
  • Are there leaders who feel threatened by the company and could try to harm the company?
  • Are there leaders who would like to help the company? If so, how could the company work with the leaders to create a mutually beneficial outcome?

With answers to these questions, CEOs can make a more informed assessment of how secure their position is. And if there are areas of vulnerability, the information can help the CEO take action to shore up the areas of weakness while tapping into the strengths to enhance their positions.

Friday, April 08, 2005

Price optimization software offers high returns

Pricing at most companies is a complicated endeavor. It turns out that there are at least 20 companies which have developed software to help address the challenge – through Price Optimization (PO) software. According to IDC, sales of PO software, totaled $86 million in 2003 and are expected to reach $133 million by 2007.

Yahoo! Inc., the Internet's leading global consumer and business services company, is a PO customer. Yahoo!’s pricing is especially complicated with more than 30 million advertising pricing combinations depending on price, type of advertisement, location on the Yahoo! portal, and consumer segment (e.g., 35-year old males or 42-year old housewives). Because the company experienced frequent sold-out periods, executives began to question whether existing pricing captured market willingness-to-pay in an accurate manner. Yahoo! also had a poor understanding of how selling one of its products would affect sales of its other products. And Yahoo!’s salespeople too often made up pricing on a customer-by-customer basis.

Rapt Inc. (, a pricing software company based in San Francisco, CA, provided a solution for Yahoo! -- consisting of the following elements:

  • Rapt performed a pilot, which identified an opportunity for revenue increases of 4% (roughly $15 million per month);
  • Used Rapt’s Price Director product to set prices which Yahoo! now uses for all its non-search ad inventory; and
  • Yahoo! has required it entire sales force to use a common rate card, based on Rapt, as its central system of record for pricing.

Rapt’s software helped Yahoo! increase its advertising revenues. After purchasing Rapt’s software for a price that AMR Research estimated between $2 million and $4 million, Yahoo! increased its $600 million in advertising sales by no less than 5%. I estimate that Yahoo! has earned at least a 10-fold return on its investment!

Rapt grew out of Tom Chavez’s, Rapt’s CEO, experience, between 1995 and 1998 helping Sun Microsystems set prices for its hardware. Pricing was a high stakes game at Sun but was performed mostly on ‘spreadsheets and gut feel.’ Chavez believed that there had to be a better way to address pricing issues. He wanted to determine how to set prices so that demand was in synch with supply projections and competitive products were subverted, and to understand the affect pricing had on customer migration to new products and cross-selling of new products.

Chavez collected data from Sun on who bought which products at what prices as well as competitive pricing data from IDC and others. He also obtained supply forecasts and melded all the data together into a mathematical model that could be used to set prices in a way that would increase Sun’s revenues. Chavez found that once he began using this technology, he got powerful results.

After several efforts to obtain internal support to turn the technology into a company, Chavez decided to go out on his own in 1999 – with Sun as his first customer. The current customer base includes Microsoft, Hewlett Packard, Yahoo!, and Seagate.

As noted above, Rapt is not alone in helping companies benefit from price optimization. Here are three others:

  • Metreo, a Palo Alto, CA-based pricing optimization software vendor, helps companies identify hidden costs or "profit leaks" in their transactions -- highlighting areas where prices are too low. Metreo helps companies set prices that boost margins and market share, communicates and implements them in each transaction. Metreo’s customers increase their profit margins between 1% and 4% within months of installing its product. An unnamed global manufacturer recently generated a substantial return on investment in Metreo software by raising its prices on money-losing customers and “firing” unprofitable customers who would not accept its price increases;
  • PROS (Pricing Revenue Optimization Solutions) Pricing Solutions is a Houston, TX-based pricing software firm founded in 1985 to capitalize on effective airline industry pricing strategies. PROS’ 100 clients in 29 industries have increased their revenues between 6% and 8% as a result of using PROS software which delivers better demand forecasting and segment-specific pricing by booking lead time, flight date, connections, time of day, service class, and customer preference. PROS claims it is profitable with revenues of $30 million; and
  • Zilliant, an Austin,TX-based provider of revenue optimization software, helps its clients improve profits an average of 10%. The Zilliant Pricing Suite (ZPS) allows companies to increase revenue and margins through more effective customer segmentation, segment-specific price setting, effective discount guidelines, more insightful price analysis, and more profitable deal analysis techniques. GE Transportation International Pool (TIP) and GE Modular Space (ModSpace) used Zilliant software in 2002 to pinpoint the best prices and to let managers act and react more quickly. According to GE Equipment Management division’s CFO, Michael Towe, GE TIP/ModSpace’s cycle time for matching prices with deals dropped 97% while deal response time fell 50%. According to Towe "The investment has more than paid for itself."

After years of boosting profit through cost cuts, companies are looking for ways to raise revenues. PO software could fit that bill.

Friday, April 01, 2005

2005's two rules of stock "investing"

In the first quarter of 2005, the stock market has largely obeyed two rules:
  1. If oil prices rise, the general stock averages fall; and
  2. If a company does not exceed earnings estimates and raise its guidance each quarter, the stock will instantly lose at least 5% of its value.

Operating on these two basic rules, it appears that stock investing has become an oxymoron. While the recent trend in oil prices has been up, every time the price of oil drops, the stock market goes up and oil-related stocks go down. And as a student of the history of the oil industry, I realize that massive swings in the price of oil have been an intrinsic part of the industry ever since Colonel Drake made his first commercial discovery back in 1859 in Titusville, PA.

Even oil company executives are reluctant to invest their cash hoards in exploring for more oil. So how can we mere mortals expect to make a profitable long-term investment in oil?
Having said that, it appears that for the foreseeable future, the factors pushing oil prices higher seem inexorable. Indeed on
March 31st, Goldman Sachs predicted that the price of oil would hit $105 a barrel. Is Goldman’s prediction a signal of a market top or a prescient call on even higher prices?

The second rule is equally problematic for investors. There is no way to know whether analysts’ earnings estimates are too high, too low or just right. Nevertheless, these estimates clearly set the bar for investors each quarter. And if a company succeeds in beating estimates and raising guidance, then analysts keep raising the bar each quarter until it becomes impossible for the company to deliver – thus whacking the stock.

This is what happened to
Guitar Center’s stock which had enjoyed a great run until mid-March when it announced that its revenue growth would be roughly 1% lower than it had previously guided -- prompting investors to slice 10% out of its market capitalization.

There is probably no way for investors to know ahead of time whether such adjustments to expectations are imminent. But this dynamic does suggest a way for investors to trade on the uncertainty. Investors can construct straddles in which they purchase put and call options in proportion to the probabilities assigned to exceeding and missing earnings and guidance expectations. For example, if an investor believes that there is a 70% chance that the company will miss expectations, then the investor would place 70% of his ‘hedging premium’ in put options and 30% in call options.

It’s hard to call this investing since it really amounts to short-term gambling. And most likely the gamble would not have very good odds because the price of the options would reflect the market’s best estimate of the chances for beating or missing Wall Street’s expectations.

The basic problem for investors is that there is a serious dearth of new, industry-creating ideas. The economy is highly leveraged and is being choked by unchecked increases in energy prices. Until leadership emerges to lessen our dependence on this depleting resource and to create new growth opportunities, stock investing is likely to be a tough game to win.