The Real Power of Pricing

One of Warren Buffett's key investment tenets relies on identifying companies that have an ability raise prices.   Certainly pricing power is a characteristic of quality earnings potential, it may also go deeper into the DNA of a firm as well.  Something as seemingly mundane as a company's pricing philosophy may indicate whether it has the vision, culture, and business model to become a long-term success.  And more importantly, whether or not it is good for investors and consumers alike.

A few years ago, I was at Southwest Airlines' headquarters for a talk led by Herb Kelleher.  When he founded the company, his goal was lofty but simple:  he wanted to democratize air travel and bring it to the masses.  As a result, Southwest built the most low-cost, efficient business model in the industry to profitably support their low fares.  They priced based on cost and could care less what others were doing.  And to this day, they continue along the same path.  Still no bag fees.  Have you ever compared fares between Southwest served cities and non-Southwest cities? Every industry needs a Southwest Airlines.

Similarly, Walmart continues to bring low prices through efficient operations and a singularly focused mission.  It has resisted the temptation to boost margins despite its size with tactics such loss-leading prices common in the industry (have you ever wondered why a gallon of milk costs so much more at Walmart?).   I was at a meeting recently with a mid level executive who proudly explained that Walmart would rather sell "10,000 items for $1 than 1 item for $10,000."  Certainly Sam Walton’s motto continues to ring true deep into the heart of the organization. 

Cheaper, however, is not always best.  The first dot com bust was a disaster and probably set internet commerce back several years.  Remember the days of CDNow and Pets.Com that would sell anything for a loss in order to build traffic and chase lofty valuations?  Amazon, in certain respects, still subscribes to this notion (see Amazon's Strategy Problem).  Diapers.com may have been forced to sell to Amazon a few years ago because of its predatory pricing tactics.  It seems the industry is still evolving as there has yet to emerge an industry leader to rationalize the marketplace. 

What is more interesting of a topic is those areas that affect us in an important way.  For example, how much should big pharma companies be allowed to charge for new blockbuster drugs?  On the one hand, the absurd prices during the patent years encourages investment in R&D, but on the other, shuts out many of the most needy patients who cannot afford to use them.  It's a good thing generic firms are gaining more market share to counterbalance the incumbents. 

Principle-based companies generally employ clear pricing tactics and the highly successful ones use their power to generate profits, sustain the industry, and solve a real need for consumers.  Industries that lack these quality leaders tend to face erratic pricing and significant turnover in the players.  There are many industries that have yet to be rationalized like our healthcare system that still lack the visionary leaders to effect cost structures and outcomes in the long run. But for now, at least we can enjoy an Abilene to Houston flight for $99.

Are HMOs back?

As the ramifications of the Affordable Care Act comes more into focus, I can’t help but wonder if the days of the HMOs are back.  As I wrote in a recent piece on the rise of ACO's, closed medical network systems are expanding at rapid rates.  What is different this time around is that the payors aren't the only ones leading the charge -  hospital systems, universities, and provider networks are all scrambling to acquire assets, build paywalls around services, and capture consumer lives.  And they are doing so at a very local level.  It was bad enough that we had few insurance companies attempt to rationalize medicine during the HMO days; are we now hoping that hundreds of localized efforts will be successful this time around?

A physician employed by a regional medical hospital system recently told me that their employee benefits changed such that visit to any provider or facility outside their controlled system would now be charged out-of network rates.  It took me by surprise not only because of the overtly limited directive, but also the fact that this system doesn't administer an insurance plan per se.  To be sure, this system has been heavily acquisitive and expansive lately (surgical facilities, urgent care, providers), but the reach is still limited.  Certainly they are testing this option with their employees first, but no doubt they plan to roll this out through the health exchanges.  I'm no expert, but this seems to be one of the smallest network footprints I have ever seen.  At least in HMO world, you couldn’t see every doctor, but had many more choices. 

The argument for closed networks is that it facilitates better outcomes and lower costs.  In other words, if a medical system keeps care within their system, they can leverage knowledge, IT, and service offerings to maximize quality and minimize cost. A patient can be guided more efficiently and effectively, focus more on prevention, and limit extraneous testing and procedures.  This theory is great on paper, but the premise relies on inefficient, for-profit entities to lead the transformation.  Remember – some of these hospital systems, for example, are the same ones that operate under the guise of a “non-profit” banner have played a leading role in our current state of out of control health care costs.

Also, how much influence can an individual ACO have? Kaiser might be the perfect model, but how scalable is it?  It has been around for years and has had little reach outside California.  And where is the optimal tradeoff between choice and cost?  These local systems may provide an option for many specialties, but how can that be enough to adequately serve individual needs of all patients?  Wouldn’t we almost be better off with a national led system with a larger reach and ability to protect choice?  These microcosms of local ACOs all seem to come at it differently with different capabilities -  there is no focus on common efficiencies or even offerings to impact the system at large.  

It’s certainly too early to tell where we're headed as implementation doesn’t really hit until 2014.  However, I don't think ownership of small health care systems are the way to cut costs and improve outcomes, rather it might merely shift market share to bigger hands at a local level.  I would rather see better use of technology and new approaches such as telemed, EMR based efforts, and home health that actually expands coverage and availability of health care.   Almost all experts agree that optimal reform would find the right balance between costs, profit, and choice that can be scaled on a national basis.  I worry, however, whether the consolidation trend at a local level is leading us astray out of the gates.  Perhaps out of this local competition will emerge better models that can be used on a more national basis.  But let's hope that the result won't leave us longing for the days of the Aetna HMO plan. 

Should You Take the Money Now?

With the reported record $100B of dry powder that private equity funds must deploy in 2013, it seems logical for a growing company to partner with a financial investor right now.  While the surplus cash can lead to favorable terms,  is it better for an entrepreneur to wait ?   Or does the current frothy investment appetite make it an ideal time take the private equity plunge?

Generally speaking, delaying a sale is better.  From a financial standpoint, valuations tend to accelerate as a company grows.  In a good market, a $1M bottom line may yield a $4M valuation (4x); but doubling the bottom line might yield a three times better valuation ($12M).  Thanks to "multiple expansion," a dollar of cash flow is worth more as an enterprise grows.  There are many factors as to why, but the primary reason is an increased supply of money available for larger deals.  There are also other critical factors that tend to work in your favor as a bigger concern, such as negotiations around corporate governance and control issues.

However, outside of price, there might be business reasons why it's better to bring in financial sponsors now.  PE firms are very well connected and good at scaling businesses.   They also can help mitigate risks such as competitive threats or large capital investments that an entrepreneur may not want stomach on his or her own.  PE shops are also good at building seasoned management teams and helping to grow company infrastructure.  If any of these areas are critical to the success in the near term, than it might be the right time for a partnership.

Of course, the timing alone is not the only consideration for taking institutional equity.  According to that same Bloomberg article, over 1/4 of PE firms are expected to fail.  Diligence around the track record of a firm is key; If the firm is not around for the second bite of the apple, then the lofty valuation on the front end doesn't mean as much.  Also, goal alignment is also important.  For example, private equity is not "patient capital."  Your business will be sold to the highest bidder at some point in time.  There's no emotional ties to the business and the clock starts on day one.

Current private equity valuations certainly offer an attractive way to deepen your company's coffers (and your personal one).  But an entrepreneur must balance taking chips off the table with avoiding giving too much away too soon.  Working from the perspective of the long-term needs of the business is probably the best thing an entrepreneur can do to decide.  It's more important to gauge whether a financial partner can help grow the your business rather than whether or not you are getting a great price.  Even though the macro environment may change, a good business will always have a buyer.  But then again, if November rolls around and there's still money on the sidelines, they may just force the island vacation on you.    

The Business Innovation Gap

With all the buzz around the pace of innovation in the marketplace, there has been very little discussion around the lack of good business models to support it.  A recent Fortune article  brought the need for  creativity to light, but clearly pricing and business models have not kept up with advances in products and service offerings.  It's interesting to address why there has been so little business invention and who are the winners and losers created along the way. 

No matter how scalable, free still doesn't work as a business.  When information first became widely available online, many, such as newspapers, rushed to post their content for free.  Partly driven by fear of the new medium, the industry failed to realize that Yahoo News was vastly different from the Topeka Gazette.  In hindsight, it seems simple - guide your subscribers to the website and charge for advertising in a similar manner.  It is hard to see how the new approach of building paywalls now will work after years of free use.  The music industry sealed a similar fate when they agreed to allow Apple sell its content for less than a buck when the current asking price at the time was closer to $15.  If the companies behind the products are open to give them away, it's difficult to ask customers to take an alternate viewpoint.

Google took a different approach.  Although the Google X factory is what most talk about, the auction pricing model was one of the most innovative and profitable inventions in recent history.  Sure Google's algorithm was the best, but Yahoo! had a decent one with an imbedded customer base.  Google figured out a unique way to charge for its technology and was not shy to ask for a hefty price for it.  And did it ever payoff - Adwords is a growing $12B / quarter business representing over 95% of Google's revenue.  There were many great technologies and websites during that time, but many failed due to the fact they couldn't figure out how to make money. 

Even the current kings like LinkedIn and Zillow have been allowed to defer their "monetization" strategy, but eventually they will have to figure it out (perhaps when the stock markets cool).  They are finding it difficult to generate revenue after the fact rather than during the initial roll-out.  How will Facebook start to extract money from its 1B users who are accustomed to ad-lite free access?  The answer is slowly, and probably sub-optimally.

There are numerous industries and companies at a crossroads with their business models.  How will Hertz alter its revenue model when ride share gains mass traction?  Manufacturers like Intel once relied on its massive factories to build barriers to entry; but technology has decoupled production from design allowing ARM and others to steal market share at more cost effective price points.   Microsoft has struggled with their cloud pricing while new entrants like SalesForce grew up SaaS-based don't at all.  Perhaps what Microsoft hasn't realize is that Office is still Office;  Why change at all ?

Don't get me wrong, I am the first to welcome the fact that the internet revolution has been led by technologists rather than MBAs.  However, many companies, whether it be incumbents trying to adapt existing business models or upstarts struggling with monetizing innovation, face challenges in the way they go to market.  Some keys to success may lie in successfully coupling the timing of product launches with a sound business plan, remaining flexible in adapting revenue models to changing market conditions, and pricing courageously based on a company's true competitive advantage.  So while it's never too late to fix broken models, it is certainly worth a shout out to Zuck and others to invite us business guys to Hacker Camp too!

The Inevitable Sleeping with the "Friend-emy"

Back when Apple was cool (circa 2012), the company liked to throw around its weight almost to a fault.  Everyone knows about the Google Maps fiasco and its decision to move entirely away from Samsung chips seems to be risky choice as well.  As companies such as Apple continue to grow, they will no doubt run into areas in which they end up partnering with competitors for a specific need.  Very few try to avoid this conflict like Apple seems to be; It leads me to the question of whether it is better to avoid enemies altogether or accept small collaboration to achieve a greater good?

There was a good Fortune article recently detailing the rationale for fierce rivals like Ford and Nissan to work collectively to develop hydrogen-based engines for cars. It seems to be obvious that sharing R&D, capital budgets, and know how will help get this emerging technology off the ground quicker and cheaper.  Plus, the expected demand for hydrogen-based cars is so huge that both should benefit from the expanding pie.  This seems to be a win-win all the way around, right? Well, it certainly seems so out of the gate.

Once this new technology matures, however, the tactical competition will most likely lure its ugly head. At some point, there will be a market share grab by Ford and Nissan, who compete for the same customers in the same markets. You see similar fates more broadly in Joint Ventures where resources are pooled by two or more companies to address new markets such as Ford and Nissan's project.  Differing incentives generally lead to withholding of information, divisive management, and jockeying power plays.   In the end, JV's usually are unwound or result in suboptimal results as the fight for market share outweighs the potential benefits of collaboration.  

Almost every large corporation deals with this kind of conflict on varying scales.  While its' channel partners have not loved Microsoft's investment in Dell and the Surface Tablet, they have no choice but to support the software giant.  AT&T, Verizon, and all the large telcos have "peering" arrangements set up to leverage the others' network infrastructure (usually for free).  Luxxotica sells frames to almost every independent eye doctor in the country, but also runs 1000 Lenscrafters stores that compete with them.  Google swallowed Motorola but Samsung still sells the bulk of the Android phones in the world.  Closed door conversations may one thing, but generally speaking, businesses seem to accept some level of channel conflict in the interest of their own bottom line.

Interdependencies are everywhere, not just in business.  China's anti-competitive behavior hurts the US Economy, but without a buyer for our cheaply priced bonds, the US would be in fiscal dire straits.  It is easier for smaller companies that are more narrowly focused to pick partners and avoid competitors.  For larger ones, it's almost impossible to avoid your rivals at least in some capacity.  While Apple's "axis of evil" list may be a psychological victory for the company,  the strategy generally doesn't make much business sense.  Long-term objectives should win over small pools of competitive partnership.  The trick is to pick the appropriate timing and level of collaboration.

A CEO's Search for Market Efficiency

One of the longest running MBA discussions is on whether capital markets truly price a security at its intrinsic value.  Whether you believe in market efficiency or not, erratic stock prices make it difficult for publicly traded companies  to manage for the long-term.  CEOs and Boards must balance its efforts between quarterly earnings targets and long term planning for company sustainability.  As most already know, these generally come in conflict.  So how can companies effectively manage these two opposing forces?  
    
First off, earnings don't mean as much as market expectations.  In an illustrative example, let’s say a company projects earnings of $10 per share and trades at the market P/E multiple of 15 for a $150 stock price.  If the company misses earnings by $1, the stock not only drops to reflect this miss, but also does  the P/E multiple oftentimes.   If the multiple drops to 12 in this example, the stock falls to $108 (12 x $9).  What’s interesting is that of the $42 drop in price, only $15 of it relates to the drop in earnings as the remainder results from a lowered expectation about the company's future.  An earnings miss means problems on the horizon to the market, whether or not it is actually true.  What's even worse, events or speculation outside the scope of a company's performance can affect the price significantly.  Ironically, while management teams almost solely focus on delivering on the financial budget, it is often outside forces such as an analyst upgrade or downgrade that really moves the price.  

So CEO's shouldn't worry about earnings or the stock price, right?  Of course they must. CEO pay is often tied to stock performance through options, equity grants, and other forms of compensation.  And if he or she can't deliver the short term earnings expected from analysts,  the CEO won't be around to benefit from some of those packages (but we can't lose sight of those healthy severance packages).  It seems counter-intuitive for shareholders to reward short-term results when a properly executed long-term vision should matter more, but patience is not a characteristic of the stock markets.  Bottom line, CEO's are expected to deliver every quarter and build a sustainable future with long-term stock appreciation at the same time. 

A few companies have been able to deliver on both fronts.  Jeff Bezos’ charisma and Amazon's sales growth allows it borrow at ultralow interest rates and command a high P/E despite an unproven earnings record.  Google’s search engine business continues to blow out earnings allowing it to invest in self driving cars and computing eyeglasses.  While very few have a cash cow like Adwords, even declining companies such as  Intel and Cisco can leverage their balance sheets and cash flow stability to delve into riskier investments that might produce a better future for them.  Building a day to day story still is step one.

Financial transactions are a  common way that companies attempt to influence stock price dynamics, but with mixed results.  Companies  that buyback their own stock do so at the highest prices.  Dividend payouts are good, but the market places little value on them (and can in fact lower stock prices due to reduced growth expectations of the company).  Many companies from Burger King to most recently Dell look to going private transactions as a way to generate value.  These transactions are usually highly leveraged and have other issues that may or may not make for stronger concerns over the long term.

Investments in innovation and new companies are another way to look to the future without impacting current results.  Spinoffs like Microsoft's home grown Expedia and EMC's divestiture of  VMWare were not only financial home runs, but also allowed these new ideas to thrive outside of the scope of a larger parent company with competing incentives.  Incubators such as ATT Foundry supports startup ecosystems while keeping the incumbent plugged into developing technologies.  Large companies can also benefit from innovation-based acquisitions, like Google's Android, to potentially develop a strong pipeline for the future.  Certainly there is more variability in the returns on these investments (which markets hate), but there is more upside in the long-run. 

In an ideal world, Management could manage companies for the long-term if markets were efficient.  But even if they are, its hard to chart a clear path to do so when quarterly earnings and outside forces seem to matter more.  Perhaps companies need to hire a psychologist to help manage market expectations.  Or perhaps companies should just stay on the sidelines like tech companies are now doing according to a recent WSJ article.  But if a company is poised to remain in the public realm, perhaps they need to develop a poker face by talking eloquently about mundane topics such as capital expenditures on the one hand, and invest in futuristic cars that drive themselves on the other hand.

The Untapped Power of Corporations

Around this time last year, I posed the question of whether companies, in addition to producing bottom line results, should be expected to improve its surroundings, spearhead charitable efforts, and contribute to the general welfare of society.  While this topic is debatable, the power of the business community to actually do so is not.  Businesses have a much broader reach, resource base, and capability than other types of organizations to help address the world's problems.  So why then do they remain silent on most of the issues that matter?  Given business entities unique strengths, shouldn't it be imperative they have a seat at the table when it comes to influencing policies and solving society's problems?

If today's climate in Washington is how government is supposed to work, then clearly something is wrong.  Generally speaking, the business community has rightly stayed clear of politics.  They have long subscribed to the notion of the less they deal with lawmakers, the better off they are to be left alone to manage their own businesses.  Since enterprise leaders have a better handle of how issues affect people and how to craft possible solutions, this practice is a shame.  Amongst the fiscal cliff debacle, it is refreshing to see business leaders come together to form the Fix the Debt coalition.  A few, like Starbucks CEO Howard Schultz, have taken a stand to end lobbying and the influence of special interests in Washington.  Only time will tell if its too late, but at least some business leaders are stepping out of the boardrooms.  Don't get me wrong, corporate lobbying has no doubt created much of the political mess, but I think a broader effort among business could certainly help rise above the ineffective voices of partisan, agenda-based politicians.  

The same sense of indifference can be seen on the charitable front.  While individuals have been very active, large corporate outreach programs have typically been PR campaigns or a way to build employee morale.  As movements in small business such as social entrepreneurship continue to grow rapidly, large corporations have largely been absent from newer trends in giving.  Whether it be microfinance or businesslike operations like the Gates Foundation, capitalistic-based solutions have long been very effective ways in addressing the world's problems.  So its too bad that the largest concerns with the most business experience are on the sidelines.  Some newer companies like Google are aggressively building their foundations, but these are small efforts compared to the opportunity.  And in the long run, CEOs know that a healthy macro climate creates an environment for enterprises to thrive.  Just like a category leader has an obligation to grow the market, the same should be felt from corporations to affect societal change.

It's not all about giving back though; over 90% of CEOs interviewed in a recent Accenture survey linked better corporate performance to sustainability and community efforts.  Certainly with larger and more complex problems looming ahead, businesses see the need to become engaged in solutions to protect the markets in which they participate.  From a societal standpoint, the benefits of corporate involvement are clear - they have the resources, capital, independence, and track record to solve problems larger than what governments or even non-profits can.  It is also a largely untapped resource as corporations have been inwardly focused for so long.  A large resource reallocation is definitely not needed as the collective power of the business community is so great, but rather a mindset shift that focusing solely on a company's P&L may not be enough to yield the same success in the future.  Perhaps with Starbucks and Google in, we can finally get the Republicans and Democrats out.