Tides vs. Tsunamis

Last Christmas we were horrified by videos of people who went out to pick up shells on the beach in Thailand only to be overwhelmed by the tsunami which rushed in and created total devastation.  Some people (most) thought the situation was a mere outgoing tide (larger than usual, to be sure).  A few, however, recognized this was no mere tide, but a tsunami about to unleash.  Instead of going to the beach, they ran as fast as possible the other way.  These few saved themselves.

How do business leaders know when a problem in their business is merely the tide going out, and when it will be a tsunami challenging (possibly wrecking) their business model?  This question is critical for leaders and investors.  When the business is in the Rapids, and short-term problems can be fixed, then staying the course is the right thing to do.  But, if the problems are actually signals of much deeper challenges then a lot more is needed before the business is dumped into the swamp and returns become elusive.

Wal-Mart stock has been dumped lately.  Due to concerns about hurricane Katrina's impact driving gas prices higher, investor's have driven Wal-Mart's value down to levels similar to the market collapse after terror on 9/11/01.  Is the tide going out on Wal-Mart, sure to come back in and raise Wal-Mart to greater value, or should we be more worried about the future?

The key is to move beyond short-term concerns and look at longer-term trends.  Wal-Mart has been struggling to maintain its value since peaking in the dot.com boom.  Since 2000, the stock has gone sideways.  Why?  There have been a series of problems for Wal-Mart:  Union problems/threats, store failures in Europe, lost customers to more trendy Target and Kohl's, rising costs from energy prices, employee lawsuits over discrimination, government investigation for hiring illegal immigrants, and top executives fired for misappropriation of expense monies to wage illegal union-busting activities.  Problems with customers losing discretionary spending dollars to high gas prices is merely the most recent in a series of concerns about Wal-Mart's ability to re-invigorate growth and its profits.

One reason we review quarter-to-quarter results is it helps us determine if a company is in the Rapids, or not.  When in the Rapids businesses can tweak their operations to recover from problems.  But, when in they move into the Swamp we see recurring problems that aren't easily overcome.  Results are always promised to improve - and historical glory regained.  Improvement is always just around the corner from China expansion, investments in lower-cost distribution, and store extensions.  And internal problems are diminished by explaining away lawsuits and executive misdeeds as "one off" occurences.  In the Swamp, there are so many alligators and mosquitos nipping at the operations we wonder if management has time to focus on how to get back into the Rapids!

Everyone wants large and successful institutions to regain their glory.  But that is rare.  Smart leaders have to know how to recognize when the market is changing, and they are looking at a tsunami - not just the outgoing tide.  Long-term success requires honestly seeing the recurring problems as the symptoms of something much worse - and not always doing what was done (picking up the fish on the beach) but instead taking much more drastic action to address fundamental challenges.

Oops! for the Oracle

Warren Buffet is often called the Oracle of Omaha.  His track record at making money for investors in his company - Berkshire Hathaway - was remarkable for several years.  Many have heard the story about how a mere $1,000 invested inthe late 1970's is worth over $80,000 today.  But, if you look closer, you'll see that the company stock is about the same today as it was in 1998.  Buffet really hasn't made a lot of money for investors the last several years.

It's foolish to attack an investing legend, yet it is worthwhile to look at whether what worked for Buffet for years is still working.  As we know, the future is not the past and any company is subject to lock-in and deteriorating returns.

Last year Buffet's Berkshire made a big investment in Pier 1 Imports.  This helped prop up Pier 1's stock price for a few months, but since then the company's value has declined about 50%.  This year the company suffered it's first quarterly loss in history.  According to Business Week, the company's CEO has admitted he's ashamed of company performance.  Oops! Buffet hasn't commented.

About 8 years ago Buffet's Berkshire made a big investment in Coca-Cola.  Such a large investment they put him on the Board.  After that investment Coke's market value doubled by 1998 - but then it started a slide that has Coke's value back again to about what Buffet paid.  Other than dividends, Berkshire hasn't made any money.  Oops! (And if you invested after Buffet you would have lost money.)

Buffet made a huge fortune with a strategy that worked incredibly well.  But will it work going forward?  He enjoyed buying companies that had a large asset which he perceived as undervalued and then hanging on while that asset rose in value.  But increasingly these kinds of assets aren't able to regain their old value.  Companies like Pier 1 and Coke have hit growth stalls that have been deadly.  Attempts to implement short-term fixes to their business models have been ineffective in the face of larger challenges to those models. 

No one bats 1.00 (to use a baseball analogy) on their investments.  But it's increasingly obvious that Berkshire Hathaway's strategy hasn't been hitting so well.  Their insurance and re-insurance investments aren't producing like before, and even Mr. Buffet has been required to give testimony on intercompany relationships with scandals such as AIG.  Oops! (This is not to impune Mr. Buffet - there have been no accusations of wrong doing by him or Berkshire Hathaway.) 

Has Berkshire Hathaway hit a growth stall itself?  Is the Oracle of Omaha locked-in, and possibly missing opportunities to improve shareholder return?  Time will tell, but short term (looking at the last 10 years) Buffet shows all the signs of lock-in, and a stall - and that would trouble me if I owned Berkshire Hathaway stock.  Mr. Buffet well deserves his opportunities on the public stage, yet it's worth some hard thinking the next time you're tempted to follow his lead on investments.

What outsiders can see

Today's Chicago Tribune had a front-page article on declining innovation in the midwest (Illinois Could Use a Few Good Edisons).  Rightly so that this should make the front page and not just the business section.  Declining innovation is often a harbinger of economic decline.  People in Illinois should be worried.

Looked at individually, the leaders in Illinois innovation (Motorola, Abbott, Caterpiller, ITW, etc.) all took actions since 2000 to improve their performance.  No one has faulted them for cutting costs - especially in an area where the payoff is as long-term as R&D. (A companion article discusses the strategy at Motorola for curbing its appetite for patents.) Moving the focus to better profits has, generally, pleased analysts and supported their stock price.  Each of these companies has acted to defend and extend their business model. 

But looked at by an outsider, the implications are really shocking.  Illinois is now the 22nd state in patents - 22nd - even though it's home to some of America's biggest companies.  What the Tribune can see no locked in company can.  That from the inside, cutting these innovatoin expenses looks very different than it looks to someone from the outside. 

It's important for businesses to listen to outsiders.  There is no way that any business can avoid having blinders.  The quest for profits simply leads to lock-in and focus.  Outsiders often see what insiders simply can't.

They never see it coming

Some of you may remember the old war movies in which the soldiers say "it's the bullet you don't hear that gets you."  There have been a lot of movies in which the people who are killed make the point that it's not what you see that gets you, it's what you don't see.  There is no "Cry of the Banshee" prior to receiving the deadly blow.  In business, it's the same thing.  It's not the factors you plan on that kills your profitability, it's what you don't see.  It's not the threat from the direct competition that makes you business model unviable - it's something that you never expected.

During 2005 there are two remarkable businesses that never saw it coming - and now they are facing great pain.  They are household names with tremendous legacy and unbelievably profitable histories.  But I can't find any analysts who think they have growth in their future - and even the companies themselves admit they are facing a lower growth future.  And their market values, employees, vendors and customers are all facing difficulty

Wal-Mart and Merck.

Wal-Mart has done about everything a discount retailer can do right.  They've cut costs, appealed directly to their customers with lower prices.  Created tremendous careers for their employees.  But what they didn't predict was a tripling of gasoline prices taking a relatively huge bite out of the discretionary incomes of their target customers.  Now, with energy costs eating up the money they'd spend at the Wal-Mart stores the company is struggling to find a way to keep up its growth history.

Merck was the darling of Wal-Street in 1987.  It was the highest P/E in the DJIA.  It's growth was spectacular.  Not one analyst thought you could go wrong by buying Merck stock (and in all fairness if you bought it then you would have made a lot of money).  But no one ever figured that one questionable drug (Vioxx) could destroy billions of dollars in shareholder wealth.  The Merck business model made them rich while improving the lives of millions of people.  But that same business model pushed Merck to aggressively market drugs directly to patients (rather than to doctors only), and to possibly push drugs into market use a bit quicker.  And now the very health of Merck itself is in question.

Both these companies have been undeniably successful.  World leaders.  And they honed and pruned their business models to perfection for the competitive marketplace they were in.  They locked-in that business model, and worked to defend and extend it as fast as possible.  And that lock-in to the successful past practices meant they never saw it coming - they didn't see what would cause them to stall.  They didn't see what could eventually knock them off their top spots. 

Lock-in is painful

This story hurts almost too much to tell.

This last spring a friend of mine for 25 years called asking for help with his small 2-year old business.  He was competing in a fiercely competitive wireless data marketplace, where the rewards were potentially huge but no sure thing.  His ambition was high, but his performance was struggling.

I met with him, and all too quickly realized that he was locked into management practices he had learned 15 years earlier as a successful executive in a very, very large wireless company.  He was trying to run his new company, his much smaller company, the same way he ran the very large division of the much larger corporation.  He wasn't nimble, he wasn't agile.  He wasn't holding the door open for extensive innovation amongst his 80 person staff, but instead he was trying hold to "hold everyone's feet to the fire on performance" (against standards he was setting.)  He wasn't experimenting with new options, new ways of competing and disruptive market practices - instead he was trying to compete head on with much larger and better healed (although unprofitable) competitors.

I worked with him for two weeks trying to increase his agility.  I offered him lots of options.  He wasn't willing to try new approaches, but rather he wanted someone to help make his business model more productive (and successful).  At one point I pointed out that he wasn't being as flexible as he might consider, to which he responded "I'm not inflexible, it's just that there's only one way to do this kind of business."

He stayed locked in to his business model, to his behavioral model and to his single-minded approach.  I learned within the last two weeks that he's now out of his company (his investors pushed him out) and the company is floundering - likely to be shut down shortly.

Lock-in can afflict any company of any size or age.  Lock-in doesn't only apply to large and mature organizations.  And no matter where lock-in takes hold, it is both painful and deadly.