Competing for Customers and Capital

Coca-Cola's Brand Bonds

EDDIE LAMPERT’S IDEA PAYS-OFF
In an earlier post I discussed "Sears Brand Bonds." What's the difference between these and the “Bowie Bonds” of ten years ago? In short the royalties were paid under contract to an independent third party. But there may be a way to make Eddie Lampert’s bold idea pay-off … by releasing Coca-Cola and its bottlers from “Marketing Hell.”

INTANGIBLE VALUE
It's widely known that 60% to 80% of the market cap of public companies is due to intangibles. Jonathan Knowles in his 2005 presentation to the CMO Council on "Brand Equity and Shareholder Value" reported that:

In 2003, the net tangible assets on the balance sheets of the companies comprising the S&P; 500 accounted for only 22% of their market value.

For a quick rundown on the components of intangible value see my audio slide show on Enterprise Marketing Expenses.

What's less widely known is which companies have the lion's share of their market cap driven by intangibles. Many of these companies are identified in my paper on Marketing Meets Finance (see Table 4, page 12). Coke, of course, is one of those companies.

COKE'S INTANGIBLES
The Coca-Cola Company (KO) had a market cap ($50.28 per share times 2.32 billion shares) of $117 billion on April 10, 2007. The book value of its assets was $30 billion. The book value of its intangible assets was $5 billion including $1.4 billion in Goodwill.

Subtract Coke's intangibles from total assets and assume the remaining $25 billion book value of tangible assets is a fair approximation of their replacement cost. This puts the market value of the company's intangibles at around $92 billion, or 79% of its market cap. Notice that the book value of Coke's intangibles (that $5 billion) is just 6% of their market value. This reflects the challenge accountants face in valuing intangibles.

CASH OUT OF MARKETING HELL
Can the Coca-Cola Company and its bottlers escape "Marketing Hell" by issuing "brand bonds?" Consider the possibilities of blending the approach taken by Bowie Bonds with that of the Sears Bonds.

Interbrand calculated the 2006 intangible value of the Coca-Cola brand at $67 billion. If this number is correct, compared with the company's $92 billion intangible market value, the remaining $25 billion represents the intangible value of the company's other brands.

Did you know The Coca-Cola Company offers more than 400 brands in over 200 countries? Well, we do! From Inca Kola, a soft drink found in North and South America, and Samurai, an energy drink available in Asia; to Vita, an African juice drink, and BonAqua, a water found on 4 continents, our product variety spans the globe!

Coca-Cola's other brands are marketed in six major categories: Energy Drinks, Juices, Soft Drinks, Sports Drinks, Tea & Coffee, and Water. In soft drinks alone there are fifteen brands and only three of these bare the Coca-Cola logo (Classic, Light, and Zero). Some of the other brands are Barqs, Fanta, Sprite and Fresca.

MONETIZE COKE'S "OTHER BRANDS"
So why not monetize their value by assigning ownership of the other Coca-Cola brands to a new independent company "OCC IP" (Other Coca-Cola Intellectual Property). Like Bowie's songs, these other brands are probably not worth enough individually to monetize. But taken as a group they are. And since the Coca-Cola brand remains the property of Coke, its market value likely will not be diluted.

FLOAT COKE'S OTHER BRAND BONDS
Like the Sears bonds, OCC IP would license both the Coca-Cola Company and Coca-Cola Enterprises to use the brands in exchange for ongoing royalty payments. Unlike Sears bonds, OCC IP would not be subsidiary of Coke. It would float the brand bonds at marketable coupon rates, face values, and maturity dates. So the market will determine the value of Coke's portfolio of other brands. The result would be an immediate increase in the enterprise value of both companies. And they would split the proceeds, reinvesting the cash to increase their shareholder value. Will this allow Coke and its bottlers to escape marketing hell? Please share your thoughts on this concept.

Thanks,

~V

The Secret Solution

In his Business Week cover story "Wal-Mart's Mid-Life Crisis" Anthony Bianco concludes:

… the Arkansas giant's fundamental business problem is that selling for less no longer confers the overwhelming business advantage it once did. Low prices still define the chain's appeal to its best customers, the 45 million mostly low-income Americans who shop its stores frequently and broadly. But the collective purchasing power of these "loyalists," as Wal-Mart calls them, has shriveled in recent years as hourly wages have stagnated and the cost of housing and energy have soared.

He also reports that Wal*Mart stock has dropped 30% below its 2004 high while Morgan Stanley's Retail Index has increased 180%.

THE SECRET SOLUTION
Wal*Mart management began deliberations last year on how to boost the company's sagging stock price. The board's secret report was completed in October, 2006. When early in 2007 a security engineer was fired for releasing some confidential information from that report to the Wall Street Journal a secret solution was revealed:

"The program, called "Project Red," included a consideration of, among other ideas, a possible spinoff of Wal-Mart's Sam's Club warehouse-store unit."

SPIN-OFF SAM'S CLUB?
Here's the question I'm going to answer in this post: Would the sale of Sam's Club bring Wal*Mart close to maximizing its earnings?

The answer is: Yes. It appears that "Project Red" proposed a solution that works. The spin-off would reduce the company's revenue by 27%, increase EBITDA by 66% and bring it within a stone's throw of maximum earnings. This would boost stock price, no matter how Sam's did on its own, and yield cash from the sale to upgrade stores and increase dividends. But before we dig into the details a little background is needed. Starting with the concept of enterprise marketing expenses.

YOU CAN'T SAIL A SHIP FROM THE GALLEY
Marketing is too narrowly defined to deal with strategic issues of which it is a part. "Advertising and promotion" expenses are only a small piece of the marketing challenge. A bigger window is needed to address fundamental marketing questions like those posed by the Sam's Club spin-off.

That bigger window on enterprise marketing expenses is found in Selling, General & Administrative expenses. This is the 800 pound guerrilla of the income statement. All the expenses that drive intangible market value are found in this account. In 2003 over half of Wal*Mart's $229 billion market cap was driven by intangibles (see my paper Marketing Meets Finance Table 4, page 12).

CMOs fail because they are charged with sailing the ship from the galley. You've got to equip the CMO with tools to translate financial concepts into enterprise marketing strategies.

BEING GOOD AT THE WRONG THING ISN'T GOOD AT ALL
Market share is the most widely reported marketing metric in the world. But it's used in the wrong ways: as hindsight instead of foresight; at the segment, but not the enterprise level; as a goal rather than a variable. Market share should be:

• Used to create the future, not just report on the past
• Measured at the enterprise as well as the segment level
• Planned to rise and fall to the level that maximizes earnings

This last point that is critical in understanding the role of enterprise marketing. How exactly do you plan for market share to "rise and fall to the level that maximizes earnings?" It isn't easy, either to calculate or to implement. It requires that management create the future, rather than wait for it to happen.

It turns out Wal*Mart's secret solution offers the perfect opportunity to test my theory of maximum earnings market share. It's as if the board of the biggest enterprise in the country handed me a natural experiment in which to test The Rule of Maximum Earnings! What's this rule? It's surprisingly simple:

SPEND MONEY ON MARKET SHARE UNTIL THE PROFIT FROM ACQUIRING THE LAST SHARE POINT JUST EQUALS ITS COST.

The main reason managers find the result of applying this rule so difficult to accept is too often it points to a significant decline in sales revenues. That's what makes the secret solution proposed in Project Red such an interesting case … the board is considering a $41.6 billion reduction is Wal*Mart's revenues by spinning off Sam's Club. Not because management has run the numbers I'm about to, but because they know their ugly duckling is losing its shoot-out with Costco.

FULL DISCLOSURE
This analysis is based entirely on the theories in my book and 10-K filings with the SEC. I neither have access to management thinking nor inside knowledge about the companies. The results are purely theoretical visualizations of the impact spinning-off Sam's Club would have on Wal*Mart's sales, costs, and earnings in a strategic group with three of its main competitors.

CARVE OUT THE FOREIGN OPERATIONS
Sears Holding Corp, Target Corporation, and Costco Wholesale do not have the same extensive foreign operations that Wal*Mart has. They all have outlets in Canada and Puerto Rico. But Wal*Mart also has many stores in Europe, Mexico, South America, and Asia. The Mexican company's stock (WMMVY) is traded in U.S. markets as an ADR.

To achieve comparability I had to carve out the European, South American, and Asian numbers from Wal*Mart's income statement. Fortunately, the company reports on these operations in sufficient detail to do this with just three assumptions: the ratios of "Cost of Sales" as well as "Operating, Selling, General and Administrative" expenses to revenues are constant across of Wal*Mart's foreign operations and the percent of sales in a country is identical to its percent of worldwide square footage. The company's worldwide sales were $345 billion. Carving out all international sales except Canada and Peurto Rico leaves adjusted sales of $284 billion.

A LOW THRESHOLD AND A HIGH CEILING
Calculating maximum earnings market share requires only twelve of the numbers in the following table: sales revenue, gross margin and selling, general & administrative (SG&A) expenses for each company. Maximum earnings market share is one of those theories where a few simple calculations (the low threshold) can lead to big discoveries (a high ceiling).

ENTERPRISE MARKET SHARE
Let's begin at the beginning. I use a two year time frame (2006-07) because their fiscal years have different closing dates. The fiscal years of Mal*Mart (WMT) and Sears (SHLD) closed in early 2007 while those of Costco (COST) and Target (TGT) closed in late 2006. The companies generated $456.6 billion in combined sales revenues. Wal*Mart's share was 62.2 percent of group revenues. The market shares of its three competitors were 13.2, 13.0 and 11.6 percent.

ENTERPRISE MARKETING EFFICIENCY
To calculate a company's maximum earnings market share we need a standardized measure of its enterprise marketing efficiency: a metric with an expected value of 1.00. This requirement is met using the ratio of a company's actual SG&A expenses to its market share maintenance SG&A expenses.

In the long run, competition will drive a company to the point where actual and share maintenance SG&A expenses are equal. Very inefficient companies will pull themselves up by their employee's bootstraps through massive layoffs. That's what happened to IBM from 1991 to 2000 (see my audio slide show on The Battle for Your Desktop). Extraordinarily efficient ones will be bested by new business models. That's what Costco did to Wal*Mart: WMT's marketing efficiency is 1.04. COST's marketing efficiency is 0.49. This means that COST is paying just $0.49 for SG&A resources that cost WMT, TGT and SHLD $1.04, $1.29, and $1.22 respectively. This finding holds generally even though Costco's definition of SG&A expenses excludes warehouse and transportation costs while Mal*Mart includes them. For a short discussion of what's behind these numbers see my audio slide show "In Search of Maximum Earnings" beginning with slide number 7 "The Sundown Rule."

MONEY DOWN THE DRAIN
Wal*Mart's incremental cost per share point (the upward sloping red curve in the following chart) was $2.24 billion. Its incremental earnings per share point (the flat green schedule) were just $1.07 billion. To hold on to that 62nd share point the company threw $1.2 billion down the drain in 2006. The rule of maximum earnings states that:

WMT SHOULD DECREASE SG&A EXPENSES UNTIL EARNINGS FROM THE LAST SHARE POINT EQUAL ITS COST.

Wal*Mart's incremental SG&A expenses equal its incremental earnings per share point at 45.3 percent of group revenues.

How can this be? It goes right back to the fundamental problem cited in the Business Week story: "… selling for less no longer confers the overwhelming business advantage it once did." Their margins are too thin relative to their competitors. This is due partly to Sam's Club and partly to its failure to attract middle class consumers without alienating its loyal low-income shoppers.

PROJECT RED WINS
The next chart tells the story of the secret solution. If management spins-off Sam's Club they would jettison $41.6 billion in revenues and a big chunk of SG&A expenses. Sam's would become the 5th free-standing player in the space and Wal*Mart's share of group revenues would fall to 53.1 percent. Its SG&A expenses should decrease to around $36 billion and enterprise marketing efficiency should increase to 0.83, resulting in an increase in EBITDA from its current $17 to $28 billion. The company's maximum earnings market share in this reconfigured space is 50.4 percent.

BINGO!
WMT's stock price pops and they pocket cash from the sale of Sam's Club to payout in dividends and upgrade existing stores. A virtuous circle is in place. And the beauty of the "secret solution" is that management isn't cutting revenues, they're just maximizing earnings!

~V

Sears Brand Bonds

LEAVE IT TO A ROCK STAR
It took rock star David Bowie's financial advisor David Pullman to figure out how to monetize an intangible asset like the future royalties on his albums.

A bond can be secured by any dependable stream of revenue—corporate earnings, tax receipts, mortgage payments ... Wall Street financier David Pullman ... in 1997 rocked investors with " Bowie bonds," backed by royalties on the songs of David Bowie ...

Bowie Bonds are asset-backed securities of current and future revenues of the first 25 albums (287 songs) of David Bowie's collection recorded before 1990. Issued by David Bowie in 1997, they were bought for $55 million by the Prudential Insurance Company.

A BOND BY ANY OTHER NAME
The meaning of the word "bond" is symbolic of the huge gap between the language of corporate finance and traditional marketing. In corporate finance "bond" is a noun. As used in the article "The New Alchemy At Sears" in the April 16, 2007 issue of Business Week.

In traditional marketing "bond" is a verb describing the relationship between a consumer and a brand. If you were to search the Internet for the phrase "Brand Bonds" before this Business Week issue hit the news stands, most of the returns would refer to the traditional marketing definition.

For example Susan Fournier, a Boston University Marketing Professor, in her Harvard Business School working paper "The Consumer and the Brand" presented:

… empirical support for the phenomenological significance of consumer-brand bonds.

The strategy consultant Stephen Landis on his web site recommends that:

Ensuring that brand innovations are aligned with your strategy strengthens the brand bonds that drive profitable growth.

And Martin Lindstrom argues that:

Finding the human story for your online brand is therefore essential for you to build even stronger brand bonds.

SEARS NEW ALCHEMY
The new alchemy at Sears Holding Corp (SHLD) refers to the financial meaning of a "bond." Edward Lampert's financial engineering took the meaning of asset-backed securities to a new level:

BusinessWeek has learned that Sears has created $1.8 billion worth of securities based on the brand names Kenmore, Craftsman, and DieHard. In essence, it has transferred ownership of the brands to another entity, which it then pays for the right to use the brands."

OUT OF WHOLE CLOTH
What's so different from this and what David Pullman did for David Bowie ten years ago? In short: royalties paid under contract with an independent third party. Sears transferred ownership in these three brands to a company called KCD IP owned by a subsidiary that issued $1.8 billion in bonds backed by the (declared) intellectual property value of the brands:

Sears has, in essence, created licensing income from whole cloth. First it transferred ownership of the brand names into KCD. Now, KCD charges Sears royalty fees to license those brands and uses the royalties to pay the interest on the bonds.

Why did Business Week say the licensing income was created out of whole cloth? Probably because the $29 billion market cap of Sears Holding (on April 10, 2007) was barely equal to the $30 billion book value of all its assets … including the $5 billion book value of its Goodwill and other Intangibles. Also because the bonds have not been released to the market, so we don't know the real value of these intangible assets.

MONETIZING OTHER BRAND VALUES
If Eddie Lampert's ideas were applied to other brand portfolios will it set off the kind of action suggested in by Don Davis in the Business Week article?

Don Davis, managing director and general counsel at Commercial Strategy, a Boston intellectual property consulting firm, says the potential for a market in bonds backed by intangible assets could be even bigger than the market for junk bonds, given that 70% to 80% of the total value of the stock market rests on intangibles such as intellectual property. "The scale is astounding," he says.

Is he right about the potential for brand bonds? Have you got any ideas on where and how to create other brand bonds?

~V

Goliath and the Three Davids

In his comment on Microsoft's $8 billion problem Jonathan Knowles suggested that I run the enterprise marketing efficiency (EME) numbers on all public companies. I've been working with Gerstner's "Cost per Dollar Sales" for years and it never occurred to me to do a large sample study of this metric. It's so easy to lose sight of the forest for the trees!

In the meantime I went back to my analysis of The Battle for Your Desktop and pulled up a table on the EME ratios for IBM and three of its troublesome little competitors beginning in 1991.

GOLIATH AND THE THREE DAVIDS
In 1991, a couple of years before Lou Gerstner took the helm, IBM's sales were $64.8 billion and its enterprise marketing (SG&A) expenses were $28.0 billion. It cost the company 43¢ to generate a dollar of sales. Hummm, somehow IBM's enterprise marketing efficiency (the first red column in this table) is troublingly close to Microsoft's cost of 45.5¢ per dollar sales in 2006 (see my last post Stuck in a Rut). Here's the data for IBM and the three Davids over the decade:

 

Gerstner and his team were able to drive IBM's enterprise marketing (in)efficiency down to 24¢ by 2000. Which in its own right was extraordinary. Even so IBM never could catch up with Compaq (CPQ), Hewlett-Packard (HPQ) and Dell (DELL). These three Davids didn't amount to much in 1991 with sales of just over $18 billion. But their enterprise marketing expense per dollar sales (the second red column in this table) was only 35¢ in that year and fell to 17¢ by 2000!

ENTERPRISE MARKET SHARES
You can easily calculate from the sales data in this table what happened to IBM's enterprise market share over the last decade of the 20th century. It fell from 78% in 1991 to 43% in 2000. And we know what happened to the market caps of the three Davids during the decade.

In 2006 Microsoft's sales were $44.3 billion. Google and Yahoo! together generated sales of $17.0 billion. Microsoft's market sahre was 72%. Is it destined to become the IBM of the 21st century? I guess that depends on whether or not Microsoft can fix it's $8 billion dollar problem. Before it gets to be an even bigger one.

~V

Stuck in a Rut

In enterprise marketing two markets are always in play: the markets for customers and capital. And we know they interact. Increased sales revenues feed back on market valuation with the promise of greater cash flow. And higher a market valuation feeds back on revenues by providing cash for growth through acquisitions.

This table shows the un-level playing field for three search/ad space companies and the group's total. Using the 2006 data in Yahoo! Finance they generated $61.3 billion in revenues and created $469.5 billion in market value. This led to a value/revenue (v/r) ratio of 7.66 for the three companies combined. Overall they created $7.66 in market value for every dollar of sales revenue.

THE VALUE/REVENUE RATIO
In my study of The Value/Revenue Ratio of all public firms from 1950 through 2005 I found the average to be 1.1 which means long-run revenues and market cap are about equal. The standard deviation in the v/r ratio increased systematically from 1.2 in the decade of the 1950s to over 70 in the volatile period from 2000 to 2005. In the the1991-1999 sample of 50,472 firms the standard deviation in the v/r ratio was 7.92. So the combined performance of this Internet group in 2006 was rather modest.

STUCK IN A RUT
Notice in the table above that Microsoft generated only $6.31 in value for each dollar of sales, while Google generated $13.83 in market value for every dollar of sales. Microsoft's value/revenue ratio is just like another major player in software and servers: in 2006 Oracle's was 6.97.  The gaming segment accounted for about 10% of Microsoft's revenues. Nintendo, a stand alone competitor with similar gaming revenues, had a v/r ratio of 4.50 in 2006. Microsoft is stuck in a rut they want to get out of. That's why Redmond saw DoubleClick as part of the solution to its $8 billion problem.

GERSTNER'S RULE
The first thing we need to know in order to understand what's driving these value/revenue results is the enterprise marketing efficiency for each player. Lou Gerstner, in his book Who Says Elephants Can't Dance?, laid out a rule of thumb on enterprise marketing efficiency. It's simple and revealing: how much does it cost to generate a dollar in sales revenue compared with your competitors? This is Gerstner's cost per dollar (CPD) rule. It's one of two measures of enterprise marketing efficiency I use in my analysis of The Battle for Your Desktop.

REDMOND, YOU HAVE A PROBLEM
Enterprise Marketing Expenses (EME) are all the costs of the people and programs that influence how customers and investors think, act and feel about a company.

In 2006 Microsoft spent $6.584 billion on R&D, plus an additional $13.576 billion on Selling, General and Administrative expenses (which include their traditional marketing and sales force expenses). So, the company's total bill for enterprise marketing came to $20.160 billion. Divide this total into the company's sales from the first table to calculate its CPD: it cost Microsoft 45.5¢ to generate one dollar in sales in 2006.

Google spent $1.229 billion on R&D, plus another $1.601 billion on Selling, General and Administrative expenses for a total enterprise marketing expenditure of $2.830 billion. So, Google's CPD was just 26.7¢.

IT ADDS UP TO $8 BILLION
It cost Microsoft 18.8¢ more to generate a dollar in sales than it cost Google. Multiply that 18.8¢ times its sales revenues and you find that Microsoft has an $8.3 billion dollar problem. That's how much the company was over-spending on enterprise marketing in 2006 compared with Google. Increased sales revenue feeds back on market valuation with the promise of greater future cash flow. And increased market valuation feeds back on revenues by providing more cash for acquisitions. Microsoft's overspending problem might have been solved by the acquisition of DoubleClick. But Google took that prize away.

SOUR GRAPES
This morning the TimesOnline reported that "Microsoft matched Google’s $3.1 billion (£1.56 billion) bid for DoubleClick but was snubbed by the largest independent broker of online display advertising." Support for this report appeared in the form of a call by Microsoft's:

Bradford L. Smith, Microsoft’s general counsel, told The New York Times an interview Sunday that Google’s purchase of DoubleClick would combine the two largest online advertising distributors and thus “substantially reduce competition in the advertising market on the Web.”

Sure sounds like sour grapes coming from the general counsel of a company that spent years fighting an anti-trust suit. And a legal battle will just magnify Microsofts problem.

WHAT'S NEXT?
Are there other acquisition targets out there that might help Redmond solve its $8 billion dollar problem?

~V

Double Your Money?

THE BUZZ
The wires were abuzz last week with the Wall Street Journal report that Google had joined Microsoft in the race to buy DoubleClick. We know that DoubleClick is majority-owned by San Francisco private-equity firm Hellman & Friedman and they have hired Morgan Stanley to find a buyer for it at $2 billion. We also know from the Journal's report that Time Warner's AOL unit and Newscorp are customers of DoubleClick. Yahoo! also has talked acquisition with the company.

AN INSIDE VIEW
You can be sure that senior managers of all these companies, as well as their board members and investment bankers are discussing the pros and cons as well as running the numbers on DoubleClick right now.

I wondered if this acquisition was in Microsoft's best interests, so I went searching for DoubleClick's 2006 revenues and found Don Dodge's web log. Don is currently Director of Business Development for Microsoft's Emerging Business Team. Here's what he thinks about the acquisition:

DoubleClick could be a good strategic fit for Microsoft's AdCenter and online business. At some price it makes sense. The numbers have to work. Heck, Microsoft can even overpay a little and make it work in the long run. But, at $2 billion...I would pass.

AN OUTSIDE VIEW
But Larry Dignan, Executive Editor of ZDNet news and blogs thinks the acquisition is a good idea:

It's unclear whether Microsoft would pull the trigger on a big deal, but it may add up. Consider the options for Microsoft. It could buy Yahoo in an expensive deal. It could continue to invest in online services that aren't getting traction. Or it could take the middle ground, which would be acquiring DoubleClick.

Given these conflicting views, I decided to run some basic enterprise marketing numbers on the three main players in this game: Microsoft, Google and Yahoo! The results are surprising.

TWO MARKETS
In the enterprise marketing framework two markets are always in play: the markets for customers and capital. And we know they interact. Increased revenues feed back on market valuation with the promise of increased cash flow. And higher market valuations feed back on revenues by providing cash for aquisitions.

This table shows the un-level playing field for the three companies and the group totals. Using the 2006 data in Yahoo! Finance the companies generated a total of $61.3 billion in revenues and created $469.5 billion in market value. This led to a value/revenue (v/r) ratio of 7.66 for the three combined. Overall they created $7.66 in market value for every dollar of sales revenue.

THE VALUE/REVENUE RATIO
In my study of The Value/Revenue Ratio of all public firms from 1950 through 2005 I found the average to be 1.1 which means in the long-run revenues and market cap are about equal. The standard deviation in the v/r ratio increased systematically from 1.2 in the decade of the 1950s to over 70 in the volatile period from 2000 to 2005. In the the1991-1999 sample of 50,472 firms the standard deviation in the v/r ratio was 7.92. So the combined performance of this Internet group in 2006 was rather modest.

STUCK IN A RUT?
Notice in the table above that Microsoft generated only $6.31 in value for each dollar of sales, while Google generated $13.83 in market value for every dollar of sales. Microsoft's value/revenue ratio is just like another major player in software and servers: in 2006 Oracle's was 6.97.  The gaming segment accounted for about 10% of Microsoft's revenues. Nintendo, a stand alone competitor with similar gaming revenues, had a v/r ratio of 4.50 in 2006. Is Microsoft stuck a rut they want to get out of? If so, DoubleClick might be part of the solution.

GERSTNER'S RULE
The first thing we need to know in order to understand what's driving these results is the enterprise marketing efficiency for each player. Lou Gerstner, in his book Who Says Elephants Can't Dance?, laid out a rule of thumb on enterprise marketing efficiency. It's simple and revealing: how much does it cost to generate a dollar in sales revenue compared with your competitors? This is Gerstner's cost per dollar (CPD) rule. It's one of two measures of enterprise marketing efficiency I use in my analysis of The Battle for Your Desktop.

REDMOND, YOU HAVE A PROBLEM
Enterprise Marketing Expenses (EME) are all the costs of the people and programs that influence how customers and investors think, act and feel about a company.

In 2006 Microsoft spent $6.584 billion on R&D, plus an additional $13.576 billion on Selling, General and Administrative expenses. So, the company's total bill for enterprise marketing came to $20.160 billion. It cost Microsoft 45.5¢ to generate one dollar in sales in 2006.

Google spent $1.229 billion on R&D, plus another $1.601 billion on Selling, General and Administrative expenses for a total enterprise marketing expenditure of $2.830 billion. So, Google's CPD was just 26.7¢.

THE PUNCH LINE
It cost Microsoft 18.8¢ more to generate a dollar in sales than it cost Google. Multiply that 18.8¢ times its sales revenues and you find that Microsoft has an $8.3 billion dollar problem. That's how much the company was over-spending on enterprise marketing in 2006 compared with Google. At the beginning of this post I said increased revenues feed back on market valuation with the promise of increased cash flow. And higher market valuations feed back on revenues by providing cash for acquisitions. Can Microsoft's overspending problem be solved by the acquisition of DoubleClick? What do you think?

~V

The Falcon and the Inchworm

Falcons are said to be the fastest moving creatures on the planet, reaching speeds of over 200 miles an hour when diving on a prey. Inchworms, on the other hand, are among the slowest moving creatures on earth. When disturbed, some species even stand erect and motionless, like twigs on a tree!

THE FALCON
Intel Corp (INTC) was one of the biggest, fastest growing companies in the world.  From 1998 to 1999 the company's market cap increased 39% to $275 billion. That's when Andy Grove retired as CEO. Since then its stock price has been sinking. By March 30, 2005 INTC's market cap had dropped 46% from its peak to $148 billon.

Here's a snapshot of Intel's fall, taken through the lens of the competition for customers and capital:

 

The blue circles are Intel's share of the market value (year-end stock price times number of common shares outstanding) created by the top 23 semiconductor manufacturers from 1991 through 2005. The green diamonds are Intel's share of sales revenues generated by those competitors.

In all but four of the years up to the one where Grove retired, the company posted a positive differential in its share of value over share of revenue. In 1998 that differential reached 18 points with Intel creating 69% of the industry's $286 billion market cap, while it generated just 51% of its $52 billion in revenues. The shareholder value created by Intel was five times greater than its sales revenue. This was a good thing. By December 31, 2005 Intel's fortunes had reversed. Intel's 35% of the industry's $291 billion market cap was 14 points less than its 35% of $80 billion strategic group revenues.  The company was no longer a winner. Its market cap was in steady decline. The falcon was falling.

The slowdown after 1996 and the roller coaster in the years that followed resulted in a fifteen-year enterprise marketing risk of 19.2. This is a big number. Enterprise marketing risk is a measure of volatility calculated by the standard deviation in the difference between a company's share of value and share or sales over time. This volatility suggests that investors can expect further lare swings in Intel's value-sales differential. Can the new CEO and his team change this picture?

A FOCUS ON EVERY MARKET
Paul S. Otellini is the first CEO in the company's history without an engineering degree. Before he joined Intel in 1974 he got an undergraduate degree in economics and a business degree from Berkeley. Now, as CEO he plans to change everything. Business Week's January 9, 2006 cover story was "Inside Intel:"

Under Grove and successor Craig R. Barrett, Intel thrived by concentrating on the microprocessors that power personal computers. By narrowing the company's focus, the duo buried the competition. They invested billions in hyper-productive plants that could crank out more processors in a day than some rivals did in a year. Meanwhile, they helped give life to the Information Age, with ever-faster, more powerful chips. Otellini is tossing out the old model.

Instead of the intense focus that drove Intel under Grove's leadership, Otellini plans to enter a dozen or more new markets ranging from health care to cell phones. And to do it he's given marketing a powerful seat in the board room.

CLEAR OUT THE COBWEBS
Otellini hired Eric B. Kim away from Samsung to be Intel's new CMO in November, 2004. And Kim reported directly to Otellini. At a gathering of senior executives on October 4, 2005 Kim revealed the bones of the company's new marketing strategy. Quoting "Inside Intel" once again:

Kim declared that Intel must "clear out the cobwebs" and kill off many Grove-era creations. Intel Inside? Dump it, he said. The Pentium brand? Stale. The widely recognized dropped "e" in Intel's corporate logo? A relic.

A CONTINUOUS WORLD
Everyone thinks the world has gone digital. In fact, it's a continuous world and always has been. Sounds, images, time, temperature, distance, speed, weight, and height all are continuous dimensions of reality.

So how do you convert all these things to a digital format? With analog integrated chips! An analog chip is needed to convert music to zeros and ones for efficient digital storage on a CD. And to convert it back again so we can hear it. Same thing for DVDs. And cell phones.

THE INCHWORM
A 2006 Forbes article on "America's Best-Managed Companies" calls analog chip design the black art of engineering:

At 25-year-old Linear Technology, where high-performance analog chips are made for 15,000 different products, 250 analog engineers each spend a year and a half to make a new design. … Linear manufactures its own chips and focuses on markets where it can get designed into a machine or product for the long haul …

Linear Technology (LLTC) is the most efficient company in the business with gross margins of 79% compared with Analog Devices Inc. (ADI) of 60%. Intel's gross margin is 52%. In 2006 LLTC sales revenue was $1.13 billion. Its gross profits were $890 million. In that Forbes article the CEO, Lothar Maier said "Linear takes the creativity of our engineers and turns it into cash."

PRICING POWER
Donald Mitchell and Carol Coles provide insight on how Linear Technology does it in the fifth part of their essay on "How to Enhance Your Organization's Business Model." The authors say Robert H. Swanson, Jr., LLTC's previous CEO figured:

… that reducing power usage would make cellular telephones and other portable electronic devices (such as laptop computers, digital still cameras, MP3 players and personal digital assistants) more valuable to end users by increasing how long the equipment could be operated between battery charges and changes … Improvements in battery technology would make the company's power management chips even more valuable by adding new dimensions to what portable devices do.

AN INCHWORM RISING
The blue circles in this chart are LLTC's share of market value created by the same 235 companies in the Intel graph above, along with the company's share of group revenues. In most years the company's share of value was three times its share of revenues. This is a picture of an inchworm rising:

 

Linear Technology's enterprise marketing risk was a small 0.9. This suggests that investors can expect the pattern to continue in the future.

PUT YOUR MONEY DOWN
Well there you have it. Two short stories about the Falcon and the Inchworm charting their future in an industry with a 2005 market value of $2914 billion. Where would you put your money? On the falling Falcon with a billion dollars a month in free cashflow and a strong marketing voice on the board, or the rising Inchworm that turns its engineers into cash? Don't keep your choice a secret. Post it with your comments!

~V

Marketing Hell Redux

APPLES AND ORANGES
Shoartly after my previous post on "Marketing Hell," I received an email from a friend who said:

Your point about monopoly pricing on syrup is right on the money. When I was doing work at KO this was a constant source of tension between the company and the rest of the Coca-Cola bottling system.

Then he added this really important question:

How do you take into account the components of Pepsi's business that are not competitive with Coca-Cola (e.g. Frito-Lay division)?  Isn't this an apples and oranges comparison?

CUSTOMERS AND CAPITAL
The answer depends on whether you're talking about Coke and Pepsi's competition for customers. Or their competition for capital. I'm talking about their competition for both customers and capital. Because success (or failure) in capital markets feeds back on success (or failure) with customers. And vice versa.

An article on how "Buffet Helps Pepsi Beat Coke to get Gatorade" had this to say about Pepsi's 2000 acquisition of Quaker Oats:

So long the underdog to the ubiquitous Coca-Cola, Pepsi is starting to fight back. Last week saw PepsiCo, the world's second-ranked soft drinks maker, steal a march on its old rival by agreeing a takeover of Quaker Oats, the US company that controls the hugely successful Gatorade brand -- considered one of the hottest properties in soft drinks worldwide.

This article "Quaker Acquisition a Big Winner for Pepsi" recently appeared in Chicago Sun-Times:"

Five years ago, Pepsi bought Chicago-based Quaker to get its hands on the Gatorade brand. Today, the Quaker portion of the Quaker Tropicana Gatorade division is performing like a champ, with revenues up 10 percent. The food line is not quite out of the shadow of the powerhouse sports drink, but it's doing well enough to get its parent's attention -- and praise.

MARKETING AND MERGERS
What decisions that carry an important enterprise marketing component have the biggest, most immediate (as well as long term) impact on a company's market cap? The answer is mergers and acquisitions.

Wait you say, those are just financial decisions! That's precisely the problem. One of the reasons 50% to 80% of otherwise carefully vetted mergers and acquisitions fail to produce the predicted windfall to shareholders is they are treated as purely financial decisions. Even though they also have an important enterprise marketing component.

Unfortunately, CMOs are so focused on traditional marketing questions (read campaigns and segmentation) they rarely are consulted on M&A opportunities. Never mind identifying these opportunities in advance. And merger specialists are so focused on the financial details they fail to consider the enterprise marketing challenges.

Robert Bruner, Dean, Darden School of Business, in a post to his blog on March 11, 2007 titled "Sometimes Learning is Costly" concluded:

... my years of experience as an educator and my studies of merger failures and financial crises suggest that large errors tend to emanate less from shallow depth (the failure to dig deeply into arcane technical matters) than from too-narrow breadth (the failure to ask fundamental questions, often borrowed from other perspectives and disciplines).

After all, Warren Buffet, one of the greatest financial minds in the country and Coke's biggest shareholder at the time, reportedly blocked its intended acquisition of Quaker Oats on the belief that the foods division was a dog! As a result Pepsi won the bidding war for the company.

ACCOUNTING MAGIC
My friend's email concluded with this important comment:

Before its public offering Pepsi owned their bottling system in the US (COBO) outright unlike KO that "unbundled" their ownership of the heavy fixed capital parts of the system (i.e. Bottling plants).  This was all part of Doug Ivestor's "49 percent solution" back in the 80's.

Here's what Morningstar had to say about Pepsi's public offering in 1999:

In spinning off its major bottler but retaining an equity interest between 20% and 50%, PepsiCo follows the lead of its rival Coca-Cola KO, which did the same thing back in 1986. Coke's spinoff of Coca-Cola Enterprises CCE was engineered by an accounting whiz named Douglas Ivester, who's now the company's CEO; it gave a considerable boost to the company's margins, since Coke's bottling operations are just as low-margin and capital-intensive as Pepsi's.

The author went on to explain how there's enough accounting magic in the parent retaining an "equity interest" in a spin-off to make up for the marketing hell created with its bottlers:

The reason has to do with the differences between the consolidation accounting method (used when the parent owns 50% or more) and the equity method (used when it owns 20%-50%). … The amount of profit is ultimately the same under the two methods, but reported revenue is less under the equity method, increasing the company's net margin (profit divided by revenue).

MARKETING HELL REDUX
How did the 1999 spin-off of Pepsi's company owned bottling group fair in the stock market? On December 31, 2006 the Pepsi Bottling Group (PBG), 42% owned by Pepsi, had a value/revenue ratio of 0.57; not much different that of Coca-Cola Enterprises (0.49) on the same date.  Coke's v/r ratio was 4.60 and Pepsi's was 2.94. Looks like marketing hell is in the DNA of syrup based cola's! How do you avoid the syrup trap? Return the bottling companies to private ownership and get into health drinks and bottled water! Or, float brand bonds!

~V