2 Wrongs Don’t Fix JC Penney

JCPenney's board fired the company CEO 18 months ago.  Frustrated with weak performance, they replaced him with the most famous person in retail at the time. Ron Johnson was running Apple's stores, which had the highest profit per square foot of any retail chain in America.  Sure he would bring the Midas touch to JC Penney they gave him a $50M sign-on bonus and complete latitude to do as he wished.

Things didn't work out so well.  Sales fell some 25%.  The stock dropped 50%.  So about 2 weeks ago the Board fired Ron Johnson.

The first mistake:  Ron Johnson didn't try solving the real problem at JC Penney.  He spent lavishly trying to remake the brand.  He modernized the logo, upped the TV ad spend, spruced up stores and implemented a more consistent pricing strategy.  But that all was designed to help JC Penney compete in traditional brick-and-mortar retail. Against traditional companies like Wal-Mart, Kohl's, Sears, etc.  But that wasn't (and isn't) JC Penney's problem.

The problem in all of traditional retail is the growth of on-line.  In a small margin business with high fixed costs, like traditional retail, even a small revenue loss has a big impact on net profit.  For every 5% revenue decline 50-90% of that lost cash comes directly off the bottom line – because costs don't fall with revenues.  And these days every quarter – every month – more and more customers are buying more and more stuff from Amazon.com and its on-line brethren rather than brick and mortar stores.  It is these lost revenues that are destroying revenues and profits at Sears and JC Penney, and stagnating nearly everyone else including Wal-Mart. 

Coming from the tech world, you would have expected CEO Johnson to recognize this problem and radically change the strategy, rather than messing with tactics.  He should have looked to close stores to lower fixed costs, developed a powerful on-line presence and marketed hard to grab more customers showrooming or shopping from home.  He should have targeted to grow JCP on-line, stealing revenues from other traditional retailers, while making the company more of a hybrid retailer that profitably met customer needs in stores, or on-line, as suits them.  He should have used on-line retail to take customers from locked-in competitors unable to deal with "cannibalization."

No wonder the results tanked, and CEO Johnson was fired.  Doing more of the tired, old strategies in a shifting market never works.  In Apple parlance, he needed to be focused on an iPad strategy, when instead he kept trying to sell more Macs.

But now the Board has made its second mistake.  Bringing back the old CEO, Myron Ullman, has deepened JP Penney's lock-in to that old, traditional and uncompetitve brick-and-mortar strategy. He intends to return to JCP's legacy, buy more newspaper coupons, and keep doing more of the same.  While hoping for a better outcome.

What was that old description of insanity?  Something about repeating yourself…..

Expectedly, Penney's stock dropped another 10% after announcing the old CEO would return.  Investors are smart enough to recognize the retail market has shifted.  That newsapaper coupons, circulars and traditional advertising is not enough to compete with on-line merchants which have lower fixed costs, faster inventory turns and wider product selection. 

It certainly appears Mr. Johnson was not the right person to grow JC Penney.  All the more reason JCP needs to accelerate its strategy toward the on-line retail trend.  Going backward will only worsen an already terrible situation.

Do you think you can fix that? – Filene’s, Syms, Home Depot, Sears, Wal-Mart

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In the back half of the 1990s Apple was clearly on the route to bankruptcy.  Sun Micrososystems seriously investigated buying Apple.  After a review, leadership opted not to make the acquisition.  Sun’s non-officer management, bouyed on rumors of the acquisition, was heartbroken upon hearing Sun would not proceed.  When Chairman Scott McNeely was asked at a management retreat why the executive team passed on Apple, he responded with “Do you think you can fix that?”

Sun leadership clearly had answered “no.”  Good for a lot of us that Steve Jobs said “yes.” 

Sun has largely disappeared, losing 95% of its market cap after 2000 and being acquired by Oracle.  Why did Mr. Jobs succeed where the leadership of Sun, which couldn’t save itself much less Apple, feared it would fail?

For insight, look no further than the recent failure of Filene’s Basement (“Filene’s Saga Ends” Boston.com) and its acquirer Sym’s (“Retailers’s Sym’s and Filene’s Go Out of Business” Chicago Tribune.)  Most of the time, when a troubled business is acquirerd not only is the buyer unable to fix the poor performer, but investments incurred by the buyer jeapardizes its business to the point of failure as well.  Given the track record of corporations at fixing bad businesses, Mr. McNeely was on statistically sound footing to reject buying Apple.

Why is the track record of corporate management so bad at fixing problem businesses?  Largely because most of their time is spent tyring to extend the past, rather than create a business which can thrive in the future.

The leadership of Sun didn’t see a future filled with mobile devices for music, movies or telephony.  They were fixated on the Unix-based computers Sun built and sold.  It was unclear how Apple would help them sell more servers, so it was a management diversion – a “poor strategic fit” – for Sun to acquire a technology intensive, talent rich organization.  They passed, stayed focused on Unix servers and high-end workstations, and failed as that market shifted to PC products.

Much is the same for Filene’s Basement.  A great brand, Sym’s bought Filene’s in an effort to continue pushing the discount model both Filene’s and Sym’s had historically pursued.  Unfortunately, the market for discount department store merchandise was rapidly shifting to higher end middle-market players like Kohl’s, and for deeply discounted goods the internet was making deal shopping a lot easier for everyone.  Because management was fixated on the old business, they missed the opportunity to make Filene’s and Sym’s a leader in new retail markets – like Amazon has done.

Remember in 2006 when Western Auto’s leader (and former hedge fund manager) Ed Lampert bought up the bonds of KMart, then used that position to acquire Sears?  The market went gaga over the acquisition, heralding Mr. Lampert as a genius.  Jim Cramer urged on his television program Mad Money that everyone buy Sears.  Now the merged KMart/Sears company has lost much of its value, and 24×7 Wall Street claimed it was the #1 worst performing retail chain (“America’s Eight Worst-Performing Retail Chains“.)

Chart courtesy Yahoo.com 11/11/11 (note vertical scale is logarithmic)

Both KMart and Sears were deeply troubled when Mr. Lampert acquired them.  But he largely followed a program of cost cutting, hoping people would return to the stores once he lowered prices.  What he missed was a retail market which had shifted to Wal-Mart for the low-end products, and had fragmented into multiple competitors in the mid-priced market leaving Sears Holdings with no compelling value proposition. 

Mr. Lampert has turned over management, fired scores of employees, closed stores and largely led both brands to retail irrelevancy.  By trying to do more of the past, only better, faster and cheaper he ran into the buzz saw of competitors already positioned in the shifted market and created nothing new for shoppers, or investors.

And that’s why investors need to worry about Home Depot.  The company was a shopper and investor darling as it maintained double digit growth through the 1980s and 1990s.  But as competition matched, or beat, Home Depot’s prices – and often the capability of in-store help – growth slowed. 

The Board replaced the founding leader with a senior General Electric leader named Robert Nardelli.  He rapidly moved to operate the historical Home Depot success formula cheaper, better and faster by cutting costs — from employees to store operations and inventory.  And customers moved even more quickly to the competition.

As the recessions worsened job growth remained scarce and eventually home values plummeted causing Home Depot’s growth to disappear.  The company may be good at what it used to do, but that is simply a more competitive market that is a lot less interesting to shoppers today.  Because Home Depot has not shifted into new markets, it is in a difficult situation (and considered the 5th worst performing retailer.)  Who cares if you are a competitive home improvement store when your house is only worth 75% of the outstanding mortgage and you can’t refinance?

Chart source Yahoo Finance 11/11/11

And it is worth taking some time to look at Wal-Mart.  The chain is famous for its rural and suburban stores selling at low prices, both as Wal-Mart and Sam’s Club.  But looking forward, we see the company has failed at everything else it has tried.  It’s offshore businesses have never met expectations and the company has left most markets.  It’s efforts at more targeted merchandise, upscale stores and smaller stores have all been abandoned.  And the company remains a serious lagger in understanding on-line sales as it has continued pouring money into defending its historical business, providing almost no return to investors for a decade. 

The market is shifting, competitors have attacked its old “core,” but Wal-Mart remains stuck trying to do more, better, faster, cheaper with no clear sign it will make any difference as people change buying patterns. How can any brick-and-mortar retailer compete on cost with a web page?

Chart Source Yahoo Finance 11/11/11

All markets shift.  All of them.  Poor performance is most often an indication that the company has not shifted with the market.  Competition in lower growth markets leads to weak revenue performance, and declining profits.  Trying to “fix” the business by doing more of the same is almost always a money-losing proposition that hastens failure. 

It is possble to fix a weak business.  Moving with shifting markets into mobile has been very valuable for Apple investors.  Two decades ago IBM shifted from hardware sales to a services focus, and the company not only escaped bankruptcy but now is worth more than Microsoft.  

“Fixing” requires focusing on the future, and figuring out how to compete in the shifting market.  Rather than applying cost-cutting and operational improvement, it is important to determine what future markets value, and deliver that.  Zappos figured out that it could take a big lead in footwear and apparel if it offered people on-line convenience, and guaranteed taking back any products customers didn’t want (“What Other Businesses Can Learn from Zappos” CMSWire.com.)  It’s sales exploded.  Toms Shoes tapped into the market desire for helping others by donating a pair of shoes every time someone bought a pair, and sales are growing in double digits (CNBC video on Tom’s Shoes).

History has taught us to be pessimistic about fixing a troubled business.  But that is largely because most management is fixated on trying to defend & extend the past.  But turnarounds can be a lot more common if leaders instead focus on the future and meet emerging needs.  It simply takes a different approach. 

In the meantime, in retail it’s a lot smarter to invest in Amazon and retailers meeting emerging needs than those fixated on cost cutting and operational improvement.  Be wary of Sears, Home Depot and Wal-Mart as long as management remains locked-in to its past.

Gladiators get killed. Dump Wal-Mart; Buy Amazon

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Wal-Mart has had 9 consecutive quarters of declining same-store sales (Reuters.)  Now that’s a serious growth stall, which should worry all investors.  Unfortunately, the odds are almost non-existent that the company will reverse its situation, and like Montgomery Wards, KMart and Sears is already well on the way to retail oblivion.  Faster than most people think.

After 4 decades of defending and extending its success formula, Wal-Mart is in a gladiator war against a slew of competitors.  Not just Target, that is almost as low price and has better merchandise.  Wal-Mart’s monolithic strategy has been an easy to identify bulls-eye, taking a lot of shots.  Dollar General and Family Dollar have gone after the really low-priced shopper for general merchandise.  Aldi beats Wal-Mart hands-down in groceries.  Category killers like PetSmart and Best Buy offer wider merchandise selection and comparable (or lower) prices.  And companies like Kohl’s and J.C. Penney offer more fashionable goods at just slightly higher prices.  On all fronts, traditional retailers are chiseling away at Wal-Mart’s #1 position – and at its margins!

Yet, the company has eschewed all opportunities to shift with the market.  It’s primary growth projects are designed to do more of the same, such as opening smaller stores with the same strategy in the northeast (Boston.com).  Or trying to lure customers into existing stores by showing low-price deals in nearby stores on Facebook (Chicago Tribune) – sort of a Facebook as local newspaper approach to advertising. None of these extensions of the old strategy makes Wal-Mart more competitive – as shown by the last 9 quarters.

On top of this, the retail market is shifting pretty dramatically.  The big trend isn’t the growth of discount retailing, which Wal-Mart rode to its great success.  Now the trend is toward on-line shopping.  MediaPost.com reports results from a Kanter Retail survey of shoppers the accelerating trend:

• In 2010, preparing for the holiday shopping season, 60% of shoppers planned going to Wal-Mart, 45% to Target, 40% on-line
• Today, 52% plan to go to Wal-Mart, 40% to Target and 45% on-line.

This trend has been emerging for over a decade.  The “retail revolution” was reported on at the Harvard Business School website, where the case was made that traditional brick-and-mortar retail is considerably overbuilt.  And that problem is worsening as the trend on-line keeps shrinking the traditional market.  Several retailers are expected to fail.  Entire categories of stores.  As an executive from retailer REI told me recently, that chain increasingly struggles with customers using its outlets to look at merchandise, fit themselves with ideal sizes and equipment, then buying on-line where pricing is lower, options more plentiful and returns easier!

While Wal-Mart is huge, and won’t die overnight, as sure as the dinosaurs failed when the earth’s weather shifted, Wal-Mart cannot grow or increase investor returns in an intensely competitive and shifting retail environment.

The winners will be on-line retailers, who like David versus Goliath use techology to change the competition.  And the clear winner at this, so far, is the one who’s identified trends and invested heavily to bring customers what they want while changing the battlefield.  Increasingly it is obvious that Amazon has the leadership and organizational structure to follow trends creating growth:

• Amazon moved fairly quickly from a retailer of out-of-inventory books into best-sellers, rapidly dominating book sales bankrupting thousands of independents and retailers like B.Dalton and Borders.
• Amazon expanded into general merchandise, offering thousands of products to expand its revenues to site visitors.
• Amazon developed an on-line storefront easily usable by any retailer, allowing Amazon to expand its offerings by millions of line items without increasing inventory (and allowing many small retailers to move onto the on-line trend.)
• Amazon created an easy-to-use application for authors so they could self-publish books for print-on-demand and sell via Amazon when no other retailer would take their product.
• Amazon recognized the mobile movement early and developed a mobile interface rather than relying on its web interface for on-line customers, improving usability and expanding sales.
• Amazon built on the mobility trend when its suppliers, publishers, didn’t respond by creating Kindle – which has revolutionized book sales.
• Amazon recently launched an inexpensive, easy to use tablet (Kindle Fire) allowing customers to purchase products from Amazon while mobile. MediaPost.com called it the “Wal-Mart Slayer“

 Each of these actions were directly related to identifying trends and offering new solutions.  Because it did not try to remain tightly focused on its original success formula, Amazon has grown terrifically, even in the recent slow/no growth economy.  Just look at sales of Kindle books:

Source: BusinessInsider.com

Unlike Wal-Mart customers, Amazon’s keep growing at double digit rates.  In Q3 unique visitors rose 19% versus 2010, and September had a 26% increase.  Kindle Fire sales were 100,000 first day, and 250,000 first 5 days, compared to  80,000 per day unit sales for iPad2.  Kindle Fire sales are expected to reach 15million over the next 24 months, expanding the Amazon reach and easily accessible customers.

While GroupOn is the big leader in daily coupon deals, and Living Social is #2, Amazon is #3 and growing at triple digit rates as it explores this new marketplace with its embedded user base.  Despite only a few month’s experience, Amazon is bigger than Google Offers, and is growing at least 20% faster. 

After 1980 investors used to say that General Motors might not be run well, but it would never go broke.  It was considered a safe investment.  In hindsight we know management burned through company resources trying to unsuccessfully defend its old business model.  Wal-Mart is an identical story, only it won’t have 3 decades of slow decline.  The gladiators are whacking away at it every month, while the real winner is simply changing competition in a way that is rapidly making Wal-Mart obsolete. 

Given that gladiators, at best, end up bloody – and most often dead – investing in one is not a good approach to wealth creation.  However, investing in those who find ways to compete indirectly, and change the battlefield (like Apple,) make enormous returns for investors.  Amazon today is a really good opportunity.

Let Sears Go! No Subsidies, and Sell the Stock. Invest in Groupon

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Sears is threatening to move its headquarters out of the Chicago area.  It’s been in Chicago since the 1880s.  Now the company Chairman is threatening to move its headquarters to another state, in order to find lower operating costs and lower taxes. 

Predictably “Officals Scrambling to Keep Sears in Illinois” is the Chicago Tribune headlined.  That is stupid.  Let Sears go.  Giving Sears subsidies would be tantamount to putting a 95 year old alcoholic, smoking paraplegic at the top of the heart/lung transplant list!  When it comes to subsidies, triage is the most important thing to keep in mind.  And honestly, Sears ain’t worth trying to save (even if subsidies could potentially do it!)

“Fast Eddie Lampert” was the hedge fund manager who created Sears Holdings by using his takeover of bankrupt KMart to acquire the former Sears in 2003. Although he was nothing more than a financier and arbitrager, Mr. Lampert claimed he was a retailing genius, having “turned around” Auto Zone. And he promised to turn around the ailing Sears. In his corner he had the modern “Mad Money” screaming investor advocate, Jim Cramer, who endorsed Mr. Lampert because…… the two were once in college togehter.  Mr. Cramer promised investors would do well, because he was simply sure Mr. Lampert was smart.  Even if he didn’t have a plan for fixing the company.

Sears had once been a retailing goliath, the originator of home shopping with the famous Sears catalogue, and a pioneer in financing purchases.  At one time you could obtain all your insurance, banking and brokerage needs at a Sears, while buying clothes, tools and appliances.  An innovator, Sears for many years was part of the Dow Jones Industrial Average.  But the world had shifted, Home Depot displaced Sears on the DJIA, and the company’s profits and revenues sagged as competitors picked apart the product lines and locations.

Simultaneously KMart had been destroyed by the faster moving and more aggressive Wal-Mart.  Wal-Mart’s cost were lower, and its prices lower.  Even though KMart had pioneered discount retailing, it could not compete with the fast growing, low cost Wal-Mart. When its bonds were worth pennies, Mr. Lampert bought them and took over the money-losing company.

By combining two losers, Mr. Lampert promised he would make a winner.  How, nobody knew.  There was no plan to change either chain.  Just a claim that both were “great brands” that had within them other “great brands” like Martha Stewart (started before she was convicted and sent to jail), Craftsman and Kenmore. And there was a lot of real estate.  Somehow, all those assets simlply had to be worth more than the market value.  At least that’s what Mr. Lampert said, and people were ready to believe.  And if they had doubts, they could listen to Jim Cramer during his daily Howard Beale impersonation.

Only they all were wrong.

Retailing had shifted.  Smarter competitors were everywhere.  Wal-Mart, Target, Dollar General, Home Depot, Best Buy, Kohl’s, JCPenney, Harbor Freight Tools, Amazon.com and a plethora of other compeltitors had changed the retail market forever.  Likewise, manufacturers in apparel, appliances and tools had brough forward better products at better prices.  And financing was now readily available from credit card companies. 

Surely the real estate would be worth a fortune everyone thought.  After all, there was so much of it.  And there would never be too much retail space.  And real estate never went down in value.  At least, that’s what everyone said.

But they were wrong.  Real estate was at historic highs compared to income, and ability to pay.  Real estate was about to crater.  And hardest hit in the commercial market was retail space, as the “great recession” wiped out home values, killed personal credit lines, and wiped out disposable income.  Additionally, consumers increasingly were buying on-line instead of trudging off to stores fueling growth at Amazon and its peers rather than Sears – which had no on-line presence.

Those who were optimistic for Sears were looking backward.  What had once been valuable they felt surely must be valuable again.  But those looking forward could see that market shifts had rendered both KMart and Sears obsolete.  They were uncompetitive in an increasingly more competitive marketplace.  As competitors kept working harder, doing more, better, faster and cheaper Sears was not even in the game.  The merger only made the likelihood of failure greater, because it made the scale fo change even greater. 

The results since 2003 have been abysmal.  Sales per store, a key retail benchmark, have declined every quarter since Mr. Lampert took over.  In an effort to prove his financial acumen, Mr. Lampert led the charge for lower costs.  And slash his management team did – cutting jobs at stores, in merchandising and everywhere.  Stores were closed every quarter in an effort to keep cutting costs.  All Mr. Lampert discussed were earnings, which he kept trying to keep from disintegrating.  But with every quarter Sears has become smaller, and smaller.  Now, Crains Chicago Business headlined, even the (in)famous chairman has to admit his past failure “Sears Chief Lampert: We Ought to be Doing a Lot Better.”

Sears once built, and owned, America’s tallest structure.  But long ago Sears left the Sears Tower.  Now it’s called the Willis Tower by the way – there is no Sears Tower any longer.  Sears headquarters are offices in suburban Hoffman Estates, and are half empty.  Eighty percent of the apparel merchandisers were let go in a recent move, taking that group to California where the outcome has been no better. Constant cost cutting does that.  Makes you smaller, and less viable.

And now Sears is, well….. who cares?  Do you even know where the closest Sears or Kmart store is to you?  Do you know what they sell?  Do you know the comparative prices?  Do you know what products they carry?  Do you know if they have any unique products, or value proposition?  Do you know anyone who works at Sears?  Or shops there?  If the store nearest you closed, would you miss it amidst the Home Depot, Kohl’s or Best Buy competitors?  If all Sears stores closed – every single location – would you care? 

And now Illinois is considering giving this company subsidies to keep the headquarters here?

Here’s an alternative idea. Using whatever logic the state leaders can develop, using whatever dream scenario and whatever desperation economics they have in mind to save a handful of jobs, figure out what the subsidy might be.  Then invest it in Groupon.  Groupon is currently the most famous technology start-up in Illinois.  Over the next 10 years the Groupon investment just might create a few thousand jobs, and return a nice bit of loot to the state treasury.  The Sears money will be gone, and Sears is going to disappear anyway.  Really, if you want to give a subsidy, if you want to “double down,” why not bet on a winner?

It really doesn’t have to be Groupon.  The state residents will be much better off if the money goes into any  business that is growing.  Investing in the dying horse simply makes no sense.  Beg Amazon, Google or Apple to open a center in Illinois – give them the building for free if you must.  At least those will be jobs that won’t disappear.  Or invest the money into venture funds that can invest in the next biotech or other company that might become a Groupon.  Invest in senior design projects from engineering students at the University of Illinois in Chicago or Urbana/Champaign.  Invest in the fillies that have a chance of winning the race!

Sentimenatality isn’t bad.  We all deserve the right to “remember the good old days.”  But don’t invest your retirement fund, or state tax receipts, in sentimentality.  That’s how you end up like Detroit.  Instead put that money into things that will grow.  So you can be more like silicon valley.  Invest in businesses that take advantage of market shifts, and leverage big trends to grow.  Let go of sentimentality.  And let go of Sears.  Before it makes you bankrupt!

 

Not All Earnings are Equal – Revenue Growth Matters! (Sell Microsoft)

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For the first time in 20 years, Apple’s quarterly profit exceeded Microsoft’s (see BusinessWeek.com “Microsoft’s Net Falls Below Apple As iPad Eats Into Sales.) Thus, on the face of things, the companies should be roughly equally valued.  But they aren’t. This week Microsoft’s market capitalization is about $215B, while Apple’s is about $365B – about 70% higher.  The difference is, of course, growth – and how a lack of it changes management!

According to the Conference Board, growth stalls are deadly. 
When companies hit a growth stall, 93% of the time they are unable to maintain even a 2% growth rate. 75% fall into a no growth, or declining revenue environment, and 70% of them will lose at least half their market capitalization. That’s because the market has shifted, and the business is no longer selling what customers really want. 

At Microsoft, we see a company that has been completely unable to deal with the market shift toward smartphones and tablets: 

• Consumer PC shipments dropped 8% last quarter
• Netbook sales plunged 40%

Quite simply, when revenues stall earnings become meaningless. Even though Microsoft earnings were up, it wasn’t because they are selling what customers really want to buy. In stalled companies, executives cut costs in sales, marketing, new product development and outsource like crazy in order to prop up earnings.  They can outsource many functions.  And they go to the reservoir of accounting rules to restate depreciation and expenses, delaying expenses while working to accelerate revenue recognition. 

Stalled company management will tout earnings growth, even though revenues are flat or declining.  But smart investors know this effort to “manufacture earnings” does not create long-term value.  They want “real” earnings created by selling products customers desire; that create incremental, new demand.  Success doesn’t come from wringing a few coins out of a declining market – but rather from being in markets where people prefer the new solutions.

Mobile phone sales increased 20% (according to IDC), and Apple achieved 14% market share – #3 – in USA (according to MediaPost.com) last quarter. And in this business, Apple is taking the lion’s share of the profits:

Image provided by BusinessInsider.com

When companies are growing, investors like that they pump earnings (and cash) back into growth opportunities.  Investors benefit because their value compounds. In a stalled company investors would be better off if the company paid out all their earnings in dividends – so investors could invest in the growth markets. 

But, of course, stalled companies like Microsoft and Research in Motion, don’t do that.  Because they spend their cash trying to defend the old business.  Trying to fight off the market shift.  At Microsoft, money is poured into trying to protect the PC business, even as the trend to new solutions is obvious. Microsoft spent 8 times as much on R&D in 2009 as Apple – and all investors received was updates to the old operating system and office automation products.  That generated almost no incremental demand.  While revenue is stalling, costs are rising.

At Gurufocus.com the argument is made “Microsoft Q3 2011: Priced for Failure“.  Author Alex Morris contends that because Microsoft is unlikely to fail this year, it is underpriced.  Actually, all we need to know is that Microsoft is unlikely to grow.  Its cost to defend the old business is too high in the face of market shifts, and the money being spent to defend Microsoft will not go to investors – will not yield a positive rate of return – so investors are smart to get out now!

Additionally, Microsoft’s cost to extend its business into other markets where it enters far too late is wildly unprofitable.  Take for example search and other on-line products:
Chart source BusinessInsider.com

While much has been made of the ballyhooed relationship between Nokia and Microsoft to help the latter enter the smartphone and tablet businesses, it is really far too late.  Customer solutions are now in the market, and the early leaders – Apple and Google Android – are far, far in front.  The costs to “catch up” – like in on-line – are impossibly huge.  Especially since both Apple and Google are going to keep advancing their solutions and raising the competitive challenge.  What we’ll see are more huge losses, bleeding out the remaining cash from Microsoft as its “core” PC business continues declining.

Many analysts will examine a company’s earnings and make the case for a “value play” after growth slows.  Only, that’s a mythical bet.  When a leader misses a market shift, by investing too long trying to defend its historical business, the late-stage earnings often contain a goodly measure of “adjustments” and other machinations.  To the extent earnings do exist, they are wasted away in defensive efforts to pretend the market shift will not make the company obsolete.  Late investments to catch the market shift cost far too much, and are impossibly late to catch the leading new market players.  The company is well on its way to failure, even if on the surface it looks reasonably healthy.  It’s a sucker’s bet to buy these stocks.

Rarely do we see such a stark example as the shift Apple has created, and the defend & extend management that has completely obsessed Microsoft.  But it has happened several times.  Small printing press manufacturers went bankrupt as customers shifted to xerography, and Xerox waned as customers shifted on to desktop publishing.  Kodak declined as customers moved on to film-less digital photography.  CALMA and DEC disappeared as CAD/CAM customers shifted to PC-based Autocad.  Woolworths was crushed by discount retailers like KMart and WalMart.  B.Dalton and other booksellers disappeared in the market shift to Amazon.com.  And even mighty GM faltered and went bankrupt after decades of defend behavior, as customers shifted to different products from new competitors. 

Not all earnings are equal.  A dollar of earnings in a growth company is worth a multiple.  Earnings in a declining company are, well, often worthless.  Those who see this early get out while they can – before the company collapses. 

Update 5/10/11 – Regarding announced Skype acquisition by Microsoft

That Microsoft has apparently agreed to buy Skype does not change the above article.  It just proves Microsoft has a lot of cash, and can find places to spend it.  It doesn’t mean Microsoft is changing its business approach.

Skype provides PC-to-PC video conferencing.  In other words, a product that defends and extends the PC product.  Exactly what I predicted Microsoft would do. Spend money on outdated products and efforts to (hopefully) keep people buying PCs.

But smartphones and tablets will soon support video chat from the device; built in.  And these devices are already connected to networks – telecom and wifi – when sold.  The future for Skype does not look rosy.  To the contrary, we can expect Skype to become one of those features we recall, but don’t need, in about 24 to 36 months.  Why boot up a PC to do a video chat you can do right from your hand-held, always-on, device?

The Skype acquisition is a predictable Defend & Extend management move.  It gives the illusion of excitement and growth, when it’s really “so much ado about nothing.”  And now there are $8.5B fewer dollars to pay investors to invest in REAL growth opportunities in growth markets.  The ongoing wasting of cash resources in an effort to defend & extend, when the market trends are in another direction.

Value goes to growth – Apple, Microsoft, Sears/Kmart

Apple now has a market cap of $210B.  Microsoft has a market cap of about $260B.  To traditionalists, this must seem contradictory.  Apple has fought its way into new markets, and has domination in none (except maybe the narrowly defined individual music download business).  Microsoft has near monopolistic market presence in personal computer operating systems and office software. According to modern business theory from business schools, and the output of books such as Business Strategy by Michael Porter, the monopolist company has entry barriers protecting its return – and thus the ability to almost print unlimited profit.  Yet this has not happened.

At SeekingAlpha.com "Apple versus Microsoft: The Value Gap is Closing" the case is made that the value difference is all due to growth.  Apple's business for music devices and content is growing – quickly.  Its business for mobile devices and mobile device applications is also growing very fast.  Those offer substantial positive cash flow today, as well as dramatic cash flow growth in the future.  So much so that many analysts wonder what Apple will do with all that money.   And that doesn't even count the iPad sales which have exceeded expectations – before even available to ship.  And businesses are starting to build applications for the iPad, as explained in the BusinessWeek article "Businesses want Apple's iPad, too."

On the other hand, the demand for PCs is sluggish – at best.  People increasingly leave their laptop at home for extended time while the use their mobile device instead.  But Microsoft is stuck in a loop of upgrade development and launch.  But because of the market shift, these investments are yielding less and less return.  Complexity cost is going up, and profits are going down, and growth is dropping precipitously.  Products in music, mobile phones and advertising have all lost significant share to Apple, Google and others as attention has remained on the "core" business.  So even though current cash flow is strong, value has gone absolutely nowhere for several years, and there's precious reason to think it will go up.

When you lose growth, even if you prop up profits with draconian cost cutting and inventory sales, you lose value.  Just look at Sears/KMart.  Investors were really excited when Mr. Lampert used his takeover of KMart to acquire Sears.  Predictions flew that he would get Sears growing again, while simultaneously monetizing the huge real estate portfolio.  But as detailed in Chicago Tribune "Sears and KMart Still Standing, but Market Share Dwindles," value has declined.  Mr. Lampert has proven very good at whacking cost.  But when it comes to growing revenue – something that will drive ongoing growth in cash flow for a decade or more, he's shown nothing.  You can't cost cut your way to long term success.

You gotta move beyond your “base” – expand beyond your “brand”

What is a brand worth?  Do you spend a lot of time trying to "protect" your brand?  A lot of marketing gurus spent the last 20 years talking about creating brands, and saying there's a lot of value in brands.  Some companies have been valued based upon the expected future cash flow of sales attributed to a brand.  Folks have heard it so often, often they simply assume a recognized name – a brand – must be worth a lot.

But, according to a Strategy + Business magazine article, "The trouble with brands," brand value isn't what it was cracked up to be.  Using a boatload of data, this academic tome says that brand
trustworthiness has fallen 50%, brand quality perceptions are down 24%,
and even brand awareness is down 20%.  It turns out, people don't think very highly of brands, in fact – they don't think about brands all that much after all. 

And according to Fast Company in the article "The new rules of brand competition" the trend has gotten a lot worse.  It seems that over time marketers have kept pumping the same message out about their brands, reinforcing the  message again and again.  But as time evolved, people gained less and less value from the brand.  Pretty soon, the brand didn't mean anything any more.  According to the  Financial Times, in "Brands left to ponder price of loyalty," brand defection is now extremely common.  Where consumer goods marketers came to expect 70% of profits from their most loyal customers, those customers are increasingly buying alternative products.

Hurrumph.  This is not good news for brand marketers.  When a company spends a lot on advertising, it wants to say that spend has a high ROI because it produces more sales at higher prices yielding more margin.  Brand marketers knew how to segment users, then appeal to those users by banging away at some message over and over – with the notion that as long as you reinforced yourself to that segment you'd keep that customer.

But these folks ignore the fact that needs, and markets, shift.  When markets shift, a brand that once seemed valuable could overnight be worth almost nothing.  For example, I grew up thinking Ovaltine was a great chocolate drink.  Have you ever heard of Ovaltine?  I drank Tang because it went to the moon, and everyone wanted this "high-tech" food with its vitamin C.  When was the last time you heard of Tang?  It was once cache to be a "Marlboro Man" – rugged, virile, strong, successful, sexy.  Now it stands for "cancer boy."  Did the marketers screw up?  No, the markets shifted.  The world changed, products changed, needs changed and these brands which did exactly what they were supposed to do lost their value.

Lots of analysts get this wrong.  Billions of dollars of value were trumped up when Eddie Lambert bought Sears out of his re-organized KMart.  But neither company fits consumer needs as well as WalMart or Kohl's for the most part, so both are brands of practically no value.  People said Craftsmen tools alone were worth more than Mr. Lampert paid for Sears – but that hasn't worked out as the market for tools has been flooded with different brands having lifetime warranties — and as the do-it-yourselfer market has declined precipitiously from the days when people expected to fix their own stuff.  So a lot of money has been lost on those who thought KMart, Sears, Craftsman, Kenmore, Martha Stewart as a brand collection was worth significantly more than it's turned out to be.  But that's because the market moved, and people found new solutions, not because you don't recognize the brands and what they used to stand for.

Every market shifts.  Longevity requires the ability to adapt.  But brand marketers tend to be "purists" who want the brand to live forever.  No brand can live forever.  Soon you won't even find the GE brand on light bulbs.  That's if we even have light bulbs as we've known them in 15 years – what with the advent of LED lights that are much lower cost to operate and last multiples of the life of traditional bulbs.  GE has to evolve – as it has with jet engines and a myriad of other products – to survive.

Think for a moment about Harley Davidson.  Once, owning a Harley implied you were a true rebel.  Someone outside the rules of society.  That brand position worked well for attracting motorcycle riders 60 years ago.  As people aged, many were re-attracted to the "bad boy" image of Harley, and the brand proliferated.  A $50 jacket with a Harley Davidson winged logo might sell for $150 – implying the branding was worth $100/jacket!!  But now, the average new Harley buyer is over 50 years old!  The market has several loyalists, but unfortuanately they are getting older and dying.  Within 20 years Harley will be struggling to survive as the market is dominated by riders who are tied to different brands associated with entirely different products.

If you see that your sales are increasingly to a group of "hard core" loyalists, it's time to seriously rethink your future.  Your brand has found itself into a "niche" that will continue shrinking.  To succeed long-term, everything has to evolve.  You have to be willing to Disrupt the old notions, in order to replace them with new.  So you either have to be willing to abandon the old brand – or cut its resources to build a new one.  For example, Harley could buy Ducati, stop spending on Harley and put money into Ducati to build it into a brand competitive with Japanese manufacturers.  This would dramatically Disrupt Harley – but it might save the company from following GM into bankruptcy.

The marketing lore is filled with myths about getting focused on core customers with a targeted brand.  It all sounded so appealing.  But it turns out that sort of logic paints you into a corner from which you have almost no hope of survival.  To be successful you have to be willing to go toward new markets.  You have to be willing to Disrupt "what you stand for" in order to become "what the market wants."  Think like Virgin, or Nike.  Be a brand that applies itself to future market needs – not spending all its resources trying to defend its old position.

Don't forget to download the new ebook "The Fall of GM" to learn more about why it's so critical to let Disruptions and White Space guide your planning rather than Lock-in to old notions.

Avoid succumbing to conventional wisdom – Target & Pershing Square

"Target heads toward the Crossroads" is the Marketwatch headline today.  Like almost all large retailers, Target has had a tough year.  Profits dropped, and Target hit a growth stall.  If not careful, the company could fall away into noncompetitiveness, like KMart did.  At the same time, some think Target is the only strong competitor to WalMart.  Just to rough up the problem, outside investors led by raider Bill Ackman are trying to pressure Target to "restructure" and spin off its real estate into a publicly traded trust. Management isn't helped by a Wall Street Journal report "Proxy firm backs critics in Target vote" recommending shareholders vote to put Mr. Ackman on the Board. At this time, in the Flats, is when management teams are most vulnerable – and more often than not make decisions that doom the company.

It's at this time, when growth has stalled and vultures are swirling around, that management is most likely to turn to Defend & Extend Management.  They look backward, and try to implement old practices hoping it will ward off attacks.  They stop Disrupting, instead forcing high levels of conformance among employees.  They jump into short-term cost cutting actions, which kill off new growth ideas, and shut down White Space projects to conserve cash.  Instead of heading toward new markets, they emulate traditional competitors and focus on short-term actions.  Unfortunately, these actions throw the company into the Swamp, hurting their ability to compete long term and making them victims of competitors.  Look at Motorola, which swung from an intense high into the throws of near-failure when the executive team turned toward D&E management after Carl Icahn attacked the company.  Instead of going after market growth, the D&E practices plunged the company into a cash drain leading to cataclysmic drop in sales and market share.

The worst thing Target could do is try to be Wal-Mart.  Nobody can beat WalMart at being WalMart.  And WalMart has its own troubles, including saturation of its stores as well as declining customer interest in its low-cost format.  Recent resurgence, linked to the worst economy in 70 years, does not reflect a change in what customers want from retailers long-term.  Rather, it's a short-term blip for a Locked-in Success Formula that has seen declining returns on investment for over a decade.  If Target were to try emulating WalMart, in format or approach, it would be disastrous.

Nor is doing what Target always did the right thing to do.  The market has shifted.  What worked in 2005 cannot be assured of working in 2010.  Trying to refind its "core" and do more of the same practices would again be a Defend & Extend approach which will hurt results.  Amplifying those D&E practices by taking radical actions, such as spinning out its real estate in a short-term financial machination, would only reduce the variables Target can use to regain growth.  Following the recommendations of raider Ackman and his Pershing Square firm will attempt to short-term spike profitability, but at the grave risk of killing the company long-term.

What Target needs to do now, more than ever, is study the market.  The retail industry is under a major shift as on-line participants increase capability and share, per-store numbers struggle to maintain, and as underlying real estate values tumble.  Customer expectations, from baby boomers to GenY are different than they were in 2001, and all retailers need to adapt to these changes.  The retailers that do, with new approaches – perhaps mixed approaches that combine on-line with traditional, and/or combine mega-stores with specialty, etc. – will be the ones that capture share as pent-up consumer demand re-emerges in the future.  What scenario of the future looks most likely to attract and retain customers in 2015?

Simultaneously, Target needs to study competitors, to define its positioning that produces best results.  The good news is that the biggest competitor (WalMart) is so locked in that it's easy to predict.  Target can study WalMart, Kohl's, Gordman's, J.C.Penney and others to identify what actions it can take that will avoid head-to-head battering and instead provide rapid growth.  Especially by focusing on on-line competitors, including Netshops.com, much can be learned about how the market is shifting and where Target should go to maximize growth.

Above all, Target needs to take this opportunity to Disrupt old behaviors and convince employees, and shareholders, that Target will pull out all stops to become the leading retailer by 2020.  WalMart is so Locked-in that it can easily decline (and if you doubt that, just look at other market leaders and how they did coming out of downturns – like GM and Sears).  The right retailer, making the right decisions, can become the next leader.  But not by just doing more of the same.  It will take a concerted effort to open the doors for trying and doing new things.

And right now Target needs to be throwing up test stores and new concepts – White Space projects – where it can learn what will work for the next great retailing Success Formula.  No amount of planning is worth as much as experimentation.  The newest ideas in retailing need to be reviewed and tested to see what can work now.  Maybe the time has finally arrived for home grocery shopping, for example. Who knows?  What we do know is that the company that uses this market transition period to build a new Success Formula aligned with changing customer expectations will be positioned to be the new market leader.

Conventional wisdom would say that Target should cut costs, emulate WalMart, get really cheap with prices, tighten its supply chain, spin out all "non core" assets and focus on returning to practices that made a profit in 2004, 05, 06 and 07.  But our studies for The Phoenix Principle showed that those practices almost always doom the competitor.  Instead, at this critical lifecycle point, it's more important than ever to focus on GROWTH and return to the Rapids – otherwise you end up in the Swamp, moving along toward the Whirlpool, like Woolworths, S.S. Kresge, TG&Y, Sears, KMart and Sharper Image.