Competing for Customers and Capital

Double Bull's Eye

Morgan Stanley's operating income before depreciation in the quarter ended May 31, 2007 was $4.2 billion. The company's theoretical maximum earnings also were $4.2 billion. I guess Morgan Stanley (NYSE: MS) is World Wise in more ways then we know.

BANKING'S "COST OF GOODS SOLD"
For most companies in Standard & Poor's COMPUSTAT database, available through Research Insight and Wharton Research Data Services, their income statements are "standardized" so that every revenue dollar is divided into three parts. I call these the domains of executive action:

1. Cost of Goods Sold,
2. Selling, General and Administrative Expenses
3. Operating Income Before Depreciation.

What's the cost of goods sold for an investment bank? It depends on what you think banks do. There are two different points of view in the academic literature (see Mitchell and Onvural page 184-185). One is called the "intermediation approach" and the other (not quoted) is the "production approach." 

"The intermediation approach views banks as using deposits together with purchased inputs to produce various categories of bank assets, measured by their dollar values. Total cost is defined as the interest expense of deposits, less service charges, plus the expense of purchased inputs."

I know this is not the view taken by most practitioners, none-the-less I use the intermediation approach in this analysis. In this view, interest expense is "cost of goods sold," purchased inputs are "enterprise marketing expenses" and the residual is "operating income before depreciation."

If banks actually had a zero cost of goods sold, like electronic futures exchange markets, my analysis would work just fine. But since interest expenses are a significant cost of doing business, ignoring them would cause distortions in a company's enterprise marketing efficiency and hence its maximum earnings market share.

DOMAINS OF EXECUTIVE ACTION
The following table reports the three domains of executive action as a percent of revenues for six investment banks. In order to iron out near term changes in the prime rate, the percentages are based on cumulative numbers beginning with December/March 2005 and ending with March/May 2007.

Take Citigroup (NYSE: C) for example. Its "cost of goods sold" was 39% of gross revenue. Enterprise marketing expenses were 32% of gross revenue. Leaving a residual operating income before depreciation of 29%.

J. P. Morgan (NYSE: JPM) had a very similar cost and earnings structure, though the company spent more on enterprise marketing and earned less from operating income. Also notice in this table that Lehman Brothers (NYSE: LEH) had the lowest enterprise marketing expenses as a per cent of revenue (25%).

In an earlier post in this series a viewer commented "... in a levered financial institution, a company can only prudently engage in activities which are supported by its capital and liability structure." My question was: Do Citi and JPM have significantly different capital and liability structures than the other four investment banks in this table? Judging by their much lower interest expense over ten quarters I concluded they do. As a result, I excluded Citi and JPM from this analysis of marketing efficiency and maximum earnings because they appear not to be comparable with the other four firms.

MARKETING EFFICIENCY MATTERS
Enterprise marketing efficiency is a measure of how much a company spends to generate a dollar in gross revenue. This Cost per Dollar (CPD) of revenue is as easy to calculate and as it is revealing. It includes spending on everything and everyone that can have any influence on how clients/investors perceive a bank. For the details of what's included see "Citigroup's Enterprise Marketing Expenses: The Middle Line." For a more general discussion of CPD across industries see "Gerstner's Rule in High-Tech Industries."

It cost Morgan Stanley just $0.26 to generate a dollar in revenue in the most recent quarter. Lehman Brothers was slightly more efficient with a CPD of $0.25, followed by Merrill Lynch at $0.30 and Goldman Sachs at $0.31 per dollar. Is the 5 cent difference between Morgan's and Goldman's CPD significant? Hum, let's see. Multiply Goldman's $20.4 billion revenue in the quarter ending May 31, 2007 by $0.05 and it turns out the company has a $1 billion problem. That's nearly a third of its operating income before depreciation in that quarter. Like Eddie Foy, Jr. sang in the 1954 Broadway hit The Pajama Game, 7½ cents doesn't buy a hell of a lot, until you multiply it by [some very large number].

As you might expect, enterprise marketing efficiency plays a critical role in calculating maximum earnings market share. A company that has a lower CPD pays less for resources than a competitor with a higher CPD.

ROADBLOCKS TO ENTERPRISE MARKETING
The concept of maximum earnings market share is simple and the math is Econ 101. You start by expressing a company's earnings after enterprise marketing expenses as a function of its market share in a strategic group. Then you take the first derivative of this function and solve for that market share for which the difference between marginal cost and marginal earnings is zero. That's maximum earnings market share. So, if it's so simple why has no one done it before? There are four powerful roadblocks to thinking about marketing at the enterprise level:

Roadblock # 1: The Apples and Oranges Problem. Most everyone reading this believes that market share is meaningful only in the case of competing brands, offering the same solution to the same customers in the same geographic market segment.  Forget that micro-marketing principle. Morgan Stanley competes with Lehmann Brothers around the globe just as surely as Coke competes with Pepsi.

Roadblock # 2: The Hindsight Problem. Most everyone reading this has worked with market share as an historical artifact. It's safe to say that no one in investment banking has ever used a forecast of market share to estimate the company's future revenues. Yet, to include the effects of competition on your revenues, there is no other practical way to do it. Except by specifying a system of simultaneous econometric equations to estimate cross-elasticities. And there are not enough consistent quarterly observations at the enterprise level to pull this off.

Roadblock # 3: The Lagged Effects Problem. Everyone reading this believes marketing has carry-over effects and to exclude them is to misrepresent reality. But, enterprise marketing and micromarketing are not the same thing. Did you ever hear of anyone including the carry-over effects of R&D spending in a discounted cash flow analysis?

Roadblock # 4: The Aggregation Problem. There are two sub-texts to this one that make it a killer roadblock. First, there's the belief that "our chaps are twice as good as theirs." Of course, if that were true we'd be paying them twice as much or they'd be hired away by a competitor. Either way it's a wash. Second, there's the "we spend our money in more efficient ways than they do."

The first three roadblocks are cognitive. If you believe that these investment banks compete head to head, that the future impact of competition can best be built into you’re your plans by using market share, and that lagged effects might be nice but not necessary, read on.

What about Roadblock # 4? The effectiveness/efficiency problem is solved by the "cost per dollar of revenue" metric. But to make the math work, I've normalized the cost of marketing resources (people and programs) to $1.00. A marketing efficiency ratio greater than 1.00 means the company is inefficient. It's spending more than the group's average cost of resources. A ratio less than one means the company is more efficient than its competitors since it costs are less than the group's average.

THE FOUR FACTORS MODEL
Maximum earnings market share, symbolized as "m hat," is the square root of the ratio of four factors that drive the competition for customers in a strategic group. Two of these factors (in yellow) are outside your control: competitors' enterprise marketing expenses (f) and strategic group revenues (R). Happily, the two factors in green are under your control: your gross margins (g dot) and your enterprise marketing efficiency (x).  In the competition for customers, gross margin and marketing efficiency rule. [Click on the chart to enlarge]

I provide a proof of this equation in my book Competing for Customers and Capital (pages 251-52). If you want to follow the logic through a detailed application to Southwest Airlines see my 14 minute Adobe Connect presentation on "The rule of Maximum Earnings." If not, here's the result of applying the four factors model to Morgan Stanley. You can check it on the back of an envelope with a calculator.

MORGAN STANLEY HITS THE BULL'S EYE
This chart shows the underlying marginal cost and earnings schedules for Morgan Stanley in a strategic group with Merrill Lynch (NYSE: MER), Goldman Sachs, and Lehman Brothers in the quarter ended May 31, 2007. Unlike the marginal cost and revenue schedules your professor drew on the board in microeconomics 101, these are based on audited financial reports.

The upward sloping schedule in red is Morgan Stanley's marginal enterprise marketing expense per share point. Adjusted for the effectiveness/efficiency of spending, the marginal expense of the next share point is always greater then the one before. The flat green schedule is Morgan Stanley's marginal earnings per share point. At its current scale of operations marginal earnings are $354 million. This schedule is flat because I assume the difference between Morgan Stanley's actual and maximum earnings fall within a feasible range of operations that do not require a change in the firm's assets.

This next chart tells the story more dramatically. Morgan Stanley's operating income before depreciation increases continuously from 20% to 33% of the group's $85 billion quarter revenues where it earned $4.175 billion. Then it hits the sweet spot where earnings of $4.193 billion peak at a 34% share of gross revenues. Beyond that point earnings rapidly decline.

The difference between Morgan Stanley's actual and maximum earnings was just $18 million (0.4%). And, the company's marketing efficiency ratio was 0.93. Meaning they paid $0.93 for enterprise marketing resources that cost the average competitor $1.00. Seven cents doesn't sound like a hell of a lot, but it is. Morgan Stanley hit the bull's eye ... twice in that quarter.

How did the other firms do in this static analysis? Not too great. Lehman Brothers missed the mark by 9.9 share points, leaving $359 million, or 18% of earnings on the table.  Goldman Sachs was off by 7.2 share points and $290 million (8%). Merrill Lynch was short 4.6 points and $109 million (3%). By the way, LEH was even more efficient that MS: they paid just $0.77 for enterprise marketing resources that cost an average competitor $1.00. While GS and MER were inefficient with ratios of $1.17 and $1.12 respectively.

DOES THIS MAKE ANY DIFFERENCE?
As a stand-alone single quarter result, some may say it's just a fascinating intellectual exercise. After all, who wouldn’t expect one of the most savvy investment banks on the planet to maximize its earnings? 

So what difference does it make to you? Well, it's good cocktail party conversation for one! But, as you will see in later installments in this series, it's worth more than that. When you add a dynamic analysis of relative earnings productivity to the mix, and tie this to the trend in a company's risk-adjusted differentials, you end up with a competitive stock pricing model. And this gives you a tool to visualize new opportunities to maximize shareholder wealth in your competition for customers and capital.

Stay tuned. Same time, same place. Thanks for viewing.

~V

The Middle Line and 3D Marketing

Does an investment bank need to be as big as Citigroup (NYSE: C) to be as efficient? No. In the most recent quarter, Lehman Brothers (NYSE: LEH), at just one-third the size, had lower enterprise marketing expenses per dollar revenue than Citigroup. Do risk-adjusted differentials change with strategic group membership? Yes. The numbers change, but trends and rank orders don't.

SUMMARY OF 1st POST IN THIS SERIES
In "Citigroup's Enterprise Marketing Expenses: The Middle Line" I compared the company's enterprise marketing cost per dollar of revenue with four competitors. Citi reported the lowest of them all: just $0.23 in March, 2007. Morgan Stanley (NYSE: MS) was the runner-up with a CPD of $0.26 in May, 2007.

Over the ten most recent reporting periods the CPD numbers for Citigroup and Morgan Stanley dropped dramatically from $0.39 and $0.63 respectively. In the same reporting periods J. P. Morgan's (NYSE: JPM) fell from $0.65 to $0.32; Goldman Sachs (NYSE: GS) declined from $0.41 to $0.31; and Merrill Lynch (NYSE: MER) went from $0.50 to $0.30. A lot of belt tightening was going on in this strategic group.

In the same post I found that Citigroup's 40% share of revenues in March, 2005 was almost double that of JPM 's weak second place 21% share of revenues. I speculated there may be scale economies in Citi's enterprise marketing cost per dollar.

SUMMARY OF 2nd POST IN THE SERIES
In "Citigroup's Differentials: 3D Marketing Metrics" I compared the risk-adjusted differentials of the five companies. Again, Citi won hands down with a differential of +3.7 in March, 2007. Citi's differential was a standard deviation of 3.7 above the expected value (zero). Merrill Lynch earned a risk-adjusted differential of -3.8. Or, MER's differential was 3.8 points below the expectation. What does this mean? In this strategic group Citi's risk-adjusted value creation was 3.7 times its revenue churn. Merrill's revenue churn was 3.8 times its value creation.

These two posts were visited several hundred times. One viewer spent 12 seconds on my site. It's safe to say he or she wasn't at all interested. Another viewer spent 80 minutes on the site. It's safe to say he or she was very interested. In fact one of the viewers, using the pseudonym "Veryinterested," posted a series of thoughtful comments regarding these two questions:

• Does Citigroup belong in this strategic group?
• What happens if Citigroup is removed?

MARKETING'S MYOPIA
The greatest roadblock to understanding enterprise marketing was planted in the mind of business school students by marketing professors ... including myself. Our micro-marketing perspective asserted that only brands compete. And then, only if they serve the same customers, fulfill the same needs, and deliver the same solutions, in the same geographic market segment. Marketing's myopia has led almost everyone here to believe you must drill down to the geographic market segment to conduct a proper competitive analysis.

STRATEGIC GROUP THEORY
Fortunately, there are countervailing points of view that offset micro-marketing's myopia. One of these of course is Michael Porters "Competitive Strategy." His "five forces model" is enterprise based. A second countervailing point of view is found in the literature of business strategy. There you will find the concept of "strategic groups." Theoretically, companies are direct competitors within a strategic group if they have (or might acquire) a high degree of "market commonality" and "resource equivalence." If you're interested in the details, see the 11 minute Adobe Connect presentation "Who's in My Strategic Group?"

A trade-off between "shared customers" and "deep pockets" is involved in the definition of a strategic group.  In the broadest sense, every firm is in competition with all other firms in its competition for capital; however, a limit is imposed by the requirement for some level of current (or anticipated) product market commonality.  Otherwise, we lose an important dimension of the competitive effects (shared customers) embedded in a strategic group.

What does this mean in practical terms? If the companies in a strategic group currently do (or might in the future) share a lot of customers and have similarly deep pockets they are direct competitors. Using these criteria the five investment banks in the first two posts in this series can properly be treated as direct competitors. Many others also might also be included as either "potential" or as "indirect competitors;" among them are European and Asian banks.

LEHMAN'S MIDDLE LINE
Everyone on the planet follows "The Top Line" and "The Bottom Line" performance of public companies. But do they ever look closely at "The Middle Line?" Rarely. What's the middle line? It is the resources and infrastructure Lehman Brothers brings to the table in cross-border and domestic deals. These resources and infrastructure are the enterprise marketing expenses that support Lehman’s sales revenue. In the last four quarters ending May 31, 2007 LEH's total revenues (including interest income) were $54,261 million. This table documents the $12,279 billion the company spent on enterprise marketing and its share of total revenues.

Each line item in this table is reported exactly as it appears in Lehman's 10-Q income statements from the EDGAR Online I*Metrix financial data service. Notice, that "Marketing" is not mentioned, except in the summary line I added at the bottom of this table. I suspect a lot of what appears in "Business Development" would fit in the traditional meaning of marketing – that is advertising expenses. But that's not the point. What matters is that every dollar was paid for people and activities that influenced how customers (and potential customers) and investors (as well as potential investors) perceived Lehman Brothers.

COST PER DOLLAR AND ENTERPRISE MARKET SHARES
In the following chart I use the enterprise marketing expenses for Lehman and five major competitors to calculate their cost per dollar of revenue. The left-hand x-axis shows the ten most recent reporting periods beginning with February 28, 2005 and ending with May 31, 2007. The right-hand x-axis lists the six companies by their ticker symbols. Enterprise marketing costs per dollar of total revenue (including interest income) is on the Y-axis. [Click to enlarge charts]

In 58 of the 60 company-quarters Lehman had the lowest enterprise marketing expenses per dollar of revenue. And this chart shows it was not a result of scale economies.

Lehman Brothers had the lowest market share of all six firms over the ten quarters. Yet, it was the most efficient in generating revenues.

CANDLESTICK CHARTS OF TWO STRATEGIC GROUPS
To show the impact of mixing more heterogeneous competitors in a strategic group, I ran the analysis of risk-adjusted differentials (RAD) again with two changes in its membership:

1. Lehman is added to the original group of five banks
2. Both Citi and J.P. Morgan are removed from the group.

The risk-adjusted differential is standard-normal whole numbered index of a firm’s simultaneous performance in stock and product markets. For details on the theory and measurement see my 18 minute Adobe Connect presentation on "Y'All Buckle That Seatbelt." Or go back to the previous post in this series.

Candlestick charts are an efficient way to summarize the risk- adjusted differentials of all six companies over the ten quarters. In this chart three companies (GS, C and LEH) have green candles because they each have an ending RAD in March/May 2007 greater than a beginning RAD in December/March 2005.Three companies (MER, MS, and JPM) have red candles because they each have an ending value less than a beginning one. The size of a candle represents the spread between beginning and ending RADs and the wicks represent extreme departures from the beginning and ending numbers. The dotted lines are control limits of plus and minus two standard deviations from the expected value of RAD (zero).

In this group of six "investment banks" investors placed a significantly higher relative value on JPM and Citi then on the four other competitors. As it happens, JPM and Citi are the only ones with both significant consumer banking operations as well as investment banking operations. In fact, this is precisely what the viewer “VeryInterested” questioned in his or her comments on my posts. And it's a fair thing to question.

In this next chart I removed both JPM and Citi from the strategic group. For the most part, three of the four firms now are contained within the 95% confidence intervals of plus and minus two RADs.

But notice, the pattern is the same as in the previous chart: trends and rank orders are unchanged. Can Merrill Lynch management now be pleased with their performance? Not really. Should Lehman Brothers management be concerned? Yes. This final chart shows the time series for both.

The trend in Merrill's numbers remains unfavorable. And there's still that big drop in the last quarter. Lehman management, on the other hand, has more serious reasons for concern. Seven of its risk-adjusted differentials are less than -2.0.  Just when it looked like investors had pulled LEH out of its slump, February, 2006 rolled around and things went downhill again.

VISIONS OF WHAT MIGHT BE
Strategic groups are inherently dynamic collections of companies that compete simultaneously for customers and capital. The companies that managers think are their competitors will change from year-to-year, if not from quarter-to-quarter.

You can't control the dynamic process behind strategic group formation. After all, a little over ten years ago Citibank would have been excluded from the group by law. At that time Citibank was prohibited from owning Smith Barney. For a short history of banking law see "The Long Demise of Glass-Steagall."

Today Citibank and Smith Barney are joined at the hip in a Boston test market. As the branch manager who runs the Citi Smith Barney side of the business said in Section 1, page 19 of its 2006 annual report: "It's exciting—and a little nerve-wracking—to pioneer new ways of growing our company and changing how we reach out to and serve clients."

The manager who runs the Citibank side of the business at the same branch agreed, saying: "If we're successful—and I've no doubt we will be—what we're doing here could help grow the business significantly. Imagine the possibilities when we put more and more of the company's resources and products at our clients' disposal."

Enterprise marketing analysis is not limited to what is. Its very essence is to visualize what might be, so you can make it happen ... if what you visualize makes sense. Does it make sense for Lehman Brothers, Morgan Stanley, Goldman Sachs, or Merrill Lynch to acquire significant consumer banking assets? What do you think?

In the future I'll compare the impact of changing strategic group membership other posts in this series. Stay tuned. Same time, same place.

Thank you for visiting.

~V

3D Marketing

Did you ever notice that financial metrics are two dimensional? Take the most recent reports on Citigroup (NYSE: C) from Yahoo! Finance:

P/E (Price to Earnings);
EPS (Earnings per Share);
P/S (Price per Share);
EV/R (Enterprise Value per Revenue).

All two dimensional. What's the missing 3rd dimension? Competition. When I tell my students this, one of them always says:

"That's easy to fix. Just compare the company on each ratio with its peers." 

Sorry, but that's not the point. Applying a 2D metric to competitors does not a 3D comparison make. Does it really matter? Yes, it can matter a lot. As you'll see in this report. The second in my series on investment banks.

The purpose of this post is to document the different results produced by 3D enterprise marketing metrics. And to explain their significance to management and investors. I apply these metrics to Citigroup and four of its competitors: Goldman Sachs Group (NYSE: GS); JPMorgan Chase Co (NYSE: JPM); Merrill Lynch & Co. Inc. (NYSE: MER); and Morgan Stanley (NYSE:MS). I call these metrics "Differentials."

MARKET SHARE IS THE 3rd DIMENSION
Performance in a strategic group is relative.  Management's belief in the superiority of their company's performance matters far less to investors than how it stacks up against its peers. In making comparisons with peers, it's the interaction between two separate but equally important markets that determine a company's shareholder value. There is simple and revealing way to assess how any public company is doing in both markets: compare its share of value (SOV) in equity markets with its share of revenue (SOR) in product markets. Market share is the 3rd dimension.

VALUE SALES DIFFERENTIALS
The following table reports SOV and SOR for each company in either the 1st or 2nd quarter of 2007 (depending on their fiscal year end). The first step in capturing the 3rd dimension in enterprise marketing is to take the difference between a company's SOV and its SOR. The result is the Value-Sales Differential (VSD).

Consider Citigroup. At the close of its first fiscal quarter in March, 2007 the company created $254.0 billion in shareholder value. This was 37.6% of the combined $675.8 billion value of all five firms. Yet, Citi's $43.0 billion in revenue was only 30.3% of the $142.1 billion in combined sales revenues. The VSD was +7.3 points. In short, Citigroup's value creation in the period exceeded its revenue churn by over seven points.

On the other hand, at the close of its first fiscal quarter in March, 2007 Merrill Lynch created $71.4 Billion of the group's total $675.8 billion in shareholder value. This was only 10.6% of the group's total value. In the same quarter MER generated revenues $21.5 billion, or 15.1% of group sales revenues. Leading to a value-sales differential of -3.8 points. In short, MER's revenue churn exceeded its value creation by almost four points in May, 2007.

Finally, notice the sum of value-sales differentials over the five companies is zero. Is this an accident? No. The sum of V-S differential across a sample of companies in the same time period has to be zero.  That's because we're taking the differences between two sets of integers that both sum to 100.

WHY A DIFFERENTIAL?
You may wonder why I use a differential rather than the ratio of value to revenue. Actually I use both, but for different reasons. There are three reasons for using a differential in this 3D enterprise marketing metric.  First, a differential is derived from my theory of enterprise market shares. If you're interested in the details see the 18 minute Adobe Connect presentation "Y'all Buckle that Seatbelt." Second, a differential is better behaved than a ratio.  It's bounded by upper and lower limits of +100 and -100 points.  The upper limit of a ratio is unbounded.  Third, no matter how large or small the differential is for any given company, the sum of the differences for a cross-section of companies will always be zero. These properties ensure that value-sales differentials are comparable across strategic groups of any size and time period.  In short, the value-sales differential is a standardized 3D enterprise marketing measure of relative firm performance in stock and product markets.

WHAT ABOUT RISK?
Of course these differentials change from period to period. How do I control for that? In basically the same way risk is handled in corporate finance ... by adjusting for volatility. The classic risk-adjusted rate of return in finance is calculated in two steps.  First, the risk-free rate of interest is subtracted from the returns on a given portfolio over time.  Each of these returns then is divided by their standard deviation.  I use a simple variation on this theme.  First, share of revenue is subtracted from share of value in a given strategic group over time. Each of these differentials is then divided by their standard deviation.

CALCULATING RISK-ADJUSTED DIFFERENTIALS
This chart shows Citigroup's share of value (in green) and its corresponding share of revenue (in blue) over the ten quarters from December, 2004 through March, 2007. In contrast to the table above (where Citi's SOV and SOR were 37.6% and 30.3% respectively in M-07) here you see the whole time series. [Click on chart to enlarge]

Citigroup's VSD increased from +4.7 points in D-04 to +7.3 points in M-07. It peaked at +9.3 in M-06. If you calculated the standard deviation of Citi's ten differentials you would find it's 1.97. Dividing each VSD by 1.97 creates a risk-adjusted series. For example, the company's risk-adjusted differential in M-06 was +4.7 (9.3/1.97). Make a note that both SOV and SOR are multiplied by 100 to create a whole-numbered index.  This transformation is important because it makes the results much easier to interpret. Also note that RAD is a standard-normal variable: its standard deviation is 1.0 and its expected value is zero. This is a particularly useful property when interpreting its meaning.

INTERPRETING RISK-ADJUSTED DIFFERENTIALS
RAD is standard normal whole numbered index of a firm’s simultaneous performance in stock and product markets. As a result, you can draw several conclusions from a firm's risk-adjusted differentials. Here are just three general cases. Whenever RAD:

• Hovers around zero for a number of periods, investors have neither awarded a premium to nor discounted from the company’s share of market value relative to its share of revenues. This reflects average expectations for the company's future product/stock market performance.

• Is a positive number and greater than +2.0, investors have awarded a significant premium to the company’s share of market value relative to its share of revenues. An unbroken series of RAD numbers greater than +2.0 reflects high investor expectations for a company's future product/stock market performance.

• Is a negative number and less than -2.0, investors have significantly discounted the company’s share of market value relative to its share of revenues.  An unbroken series of RAD numbers less than -2.0 reflects low investor expectations for a company's future product/stock market performance.

Of course, the world is not this simple. Given the definition of RAD it is rare to observe numbers either greater than +2 or less than -2 over several time periods. The investment banks in the following analysis make this point.

LEADING AND FOLLOWING BANKS
This chart shows risk-adjusted differentials for the leader (Citigroup) and a follower (Merrill Lynch) in a strategic group of five competitors. The Y-axis calibrates risk-adjusted differentials, ranging from -8.0 to +8.0. The X-axis calibrates time in quarters. The dashed gray lines at +2.0 and -2.0 are akin to statistical control limits at two standard deviations above and below the expectation. Any observation above or below these limits is statistically significant at a 95% confidence level. [Click on chart to enlarge]

Citigroup is one of those exceptional cases. It posted RADs greater than two standard deviations above the mean in all ten quarters. In a study I did of 38 Marketing Science Institute member companies and 299 of their competitors from 1991 through 2000, I found only twelve (3%) posted RADs greater that +2.0 in every period. So it is with good reason that I call companies like Citigroup "High-Flyers."

As you would expect, the lion's share (91%) of all firms in my study of MSI companies and their competitors posted RADs that remained between plus and minus 2.0 over the entire decade. Merrill Lynch is one of these "Average Joes." But there's more information in MER's numbers. First, notice all of its RADs are less than zero – it performed below average in all ten quarters. Second, the trend is not favorable. Third, this already unfavorable trend dropped to -3.8 in March, 2007. This is not a good sign.

CANDLESTICK RADs
The candlestick chart is an efficient way to summarize the risk- adjusted differentials of all five companies over the ten quarters. In this chart two companies (GS and C) have green candles because each has an ending RAD in March/May 2007 greater than a beginning RAD in December/March 2005.Three companies (MER, MS, and JPM) have red candles because each has an ending value less than a beginning one. [Click on chart to enlarge]

The size of a candle itself represents the spread between beginning and ending RADs. For example, MER's candle portrays the beginning and ending ones in the earlier time series chart, 0.4 and -3.8 respectively. It also captures the downward trend since no value outside this range appears as "wick" on top of MER's candle.

The wicks on each candle in this chart represent extreme departures from the beginning and ending RAD numbers. For example, Morgan Stanley posted a low of -7.2 in one quarter. And while Goldman Sachs posted a big increase, from -2.2 to -0.2, it none-the-less experienced a low of -3.7 in one quarter along the way.

SHOULD YOU WORRY?
Should Merrill Lynch, Morgan Stanley, and Goldman Sachs be worried about their risk-adjusted differential performance? Yes. Investors are telling management that something's substantially wrong ... relative to the performance of their peers. You can't pick up this signal from any two-dimensional financial indicator. In fact, some of the common indicators used in stock valuation can be downright mollifying.

Consider the market value/revenue multiple for example. Merrill's v/r multiple (ttm) slipped the most from 1.55 to 1.07; a 31% drop. And Citigroup's fell from 1.98 to1.64; an 18% drop. While Morgan Stanley's went from 1.18 to 0.99; a 16% decline. Finally, JPMorgan's fell from 1.61 to 1.56; this 3% decline was the smallest of all five companies.

2D IS TOO NARROW
Two dimensional financial metrics are too narrow because they fail to incorporate directly the effects of competition. Should investors re-evaluate Citigroup and its peers in light of the added information contained in their 3D enterprise marketing metrics? What do you think?

Stayed tuned for the third installment in this series on investment banks: "Citigroup Enterprise Marketing Risk and Efficiency" will appear next week. Same time, same place.

~V

The Middle Line

In his July 2, 2007 Business Week column "How Citi Fixed its M&A Business" Steve Rosenbush wrote:

"In the fiercely competitive mergers-and-acquisitions field, the world's largest bank has emerged from the ongoing M&A boom stronger than ever. Once in the middle of the bulge bracket, it's now neck and neck with leaders Goldman Sachs Group (GS) and Morgan Stanley (MS) in the race for market share. The M&A unit's share of the global market has grown from 18.9% in 2004 to 27.1% as of mid-June, putting it within one point of its rivals, according to researcher Dealogic. Its compound growth rate of 12.8% over the last three years is the fastest of any major investment bank."

In this article Frank Yeary, head of Citigroup's (NYSE: C) global M&A business was quoted as saying: "One reason we have taken as much share as we have is our ability to commit resources and infrastructure to cross-border deals."

THE MIDDLE LINE
Everyone on the planet follows "The Top Line" and "The Bottom Line" performance of public companies. But do they ever look closely at "The Middle Line?" Rarely. What's the middle line? It's the resources and infrastructure Citigroup brings to the table in cross-border deals ... as well as domestic deals. These resources and infrastructure are the enterprise marketing expenses that support Citigroup’s sales revenue.

Why focus on banks in this look at the middle line? Because their income statements report enterprise marketing expenses in their purest form. Manufacturing companies can easily load overhead expenses into the cost of good sold without anyone noticing. From an intermediation perspective the "cost of goods sold" in banking is interest expense. And banks aren't allowed to load overhead into interest expenses. They also have far less wiggle room in reporting overhead costs as line items in their income statements. All of the data in this post were downloaded from EDGAR Online I*Metrix exactly as reported in company SEC filings.

ADVERTISING AND MARKETING
It's not widely known, but the advertising and marketing expenses of some banks are as big as those of leading consumer product companies. For comparison, Ford Motor Co. spent $2,458 million in 2004 making it 7th on the list of Leading National Advertisers. While Citibank reported spending even more -- $2,577 million -- on "Advertising and marketing expenses" in the four quarters ending March 31, 2007. Note LNA measures only media costs, while the advertising and marketing expenses reported by Citigroup include non-media costs like road shows, marketing research, and ad production. Even so, the traditional marketing expenses of banks pale by comparison with their total enterprise marketing expenses. For the details on measuring these costs see my 12 minute Adobe Connect presentation on "Enterprise Marketing Expenses."

YOU CAN'T SAIL A SHIP FROM THE GALLEY
Marketing is too narrowly defined as "Advertising and marketing expense."  These twins are only a small piece of the enterprise marketing challenge. In the case of Citigroup that $2,577 million represented only 1.7% of revenues in the four quarters ended March 30, 2007. To think that revenues are driven by these expenses alone is to loose sight of land. (Click to enlarge the table)

CMOs fail so often because they are charged with sailing a ship from the galley. You've got to be at the helm to address the fundamental enterprise marketing challenge: optimizing the costs of everyone and everything that influence how customers and investors perceive your company. If you aren't you're either drifting aimlessly or on autopilot.

Citigroup's enterprising marketing expenses include $30,713 million in employee compensation and benefits. Every employee is a marketing representative. There is also the $3,855 million spent on technology communications. Every email, customer statement, letter and phone call is a marketing message. And what about the $9,724 million in other operating expenses?  Countless marketing expenses large and small are built into this line item, from business cards to building services. This is not to say that advertising and marketing are any less important. Rather, that revenues and stock price are driven by all these expenses. And it is the job of enterprise marketing to determine the impact of them on future market share, revenue, earnings and stock price.

JPM's $820 MILLION PROBLEM
In Who Says Elephants Can't Dance Louis Gerstner introduced a measure he called the cost per dollar (CPD) of revenue. I call it "Gerstner's Rule." It boils down to this – less is more:

... CFO Jerry York and his team determined that IBM's expense to revenue ratio – i.e. how much expense is required to produce $1 of revenue – was wildly out of range with those of our competitors.  On average, our competitors were spending 31 cents to produce $1 of revenue, while we were spending 42 cents for the same end.  When we multiplied this inefficiency times the total revenue of the company, we discovered that we had a $7 billion expense problem! (pages 62-63).

How did Mr. Gerstner measure competitors' spending? It appears he used the line item in their income statements called "Selling, General and Administrative" expenses to calculate the cost per dollar. For the details see my 17 minute presentation "The Battle for Your Desktop."

In the following chart I use the enterprise marketing expenses for Citigroup and its major competitors to calculate their cost per dollar of revenue. The left-hand x-axis shows the ten most recent reporting periods beginning with February 28, 2005 and ending with May 31, 2007. The right-hand x-axis lists the five companies by their ticker symbols: Morgan Stanley (NYSE:MS); JPMorgan Chase Co (NYSE: JPM); Citigroup Inc. (NYSE: C); Goldman Sachs Group (NYSE: GS) and Merrill Lynch & Co. Inc. (NYSE: MER). The enterprise marketing cost per dollar of total revenue (including interest income) is on the Y-axis. (Click to enlarge the chart)

Even if you work for one of these banks, some of the results probably will come as a surprise. For example, if you work for MS you probably didn't know the company's cost per dollar dropped systematically over the ten quarters. In F-05 it cost you $0.63 to generate $1.00 in revenues. By the close of business in May 2007 it cost you just $0.26. JPM posted a $0.32 cost per dollar in March 2007. The 6 cents difference between MS and JPM doesn't seem like a heck of a lot. Until you multiply it by the $13.7 billion difference in their last four quarter revenue and discover that 6 cents becomes an $820 million enterprise marketing problem for JPM.

Then you see Citigroup with the lowest CPD in both periods. Are there enterprise marketing scale efficiencies involved here? There may be, considering the company has 1,400 branches and 3,800 ATMs in 46 countries around the world.

Both Goldman and Merrill CPD schedules look a bit like roller coasters. In both November of 2005 and 2006 Goldman actually posted two of the lowest CPDs of all five companies in all ten quarters: in those two periods it cost GS just $0.24 and $0.18 respectively to generate $1.00 in revenues. Looks like seasonal lows in spending. Merrill's CPD schedule is similar to Goldman's, except it cost the company more in every period except F-07.

BEING GOOD AT THE WRONG THING
Market share is the most widely used marketing metric in the world. But it's most often used in the wrong way … only at the segment and not the enterprise level, as hindsight instead of foresight and as a goal rather than a variable. Being good at the wrong thing isn't good at all. Market share should be:

1. Measured at the enterprise and the segment level
2. Used to assess product/stock market interactions
3. A variable in marketing efficiency and risk
4. Used to peer into the future, not report on the past
5. The pivotal point in earnings maximization
6. Used to drive future company sales revenues
7. A variable in forecasting competitive stock price.

ENTERPRISE MARKET SHARES
Let's take the first step in this journey and jump to the enterprise level so we can track each company's share of total revenues. In this chart I've arranged the companies from lowest to highest enterprise market share. Total revenues in the strategic group, including interest income, in the last quarter were $142.1 billion. Over the last four quarters, group revenues were nearly $500 billion. (Click to enlarge the chart)

Here are the two important things to take-away from this chart. First, the three smallest firms increased their shares (in green) over the ten quarters:

MER went from 10.44 to 15.12 percent,
increasing share by 468 basis points;

GS rose from 13.27 to 14.32 percent,
increasing share by 105 basis points; and

MS from 15.44 to 19.52 points,
increasing share by 408 basis points.

Second, most of the 981 basis points that these three players carved out of the market came from Citigroup. The other 12 were dropped by JPM.

CITIGROUP REVENUE LOSS
The Citi's decline in market share reflects a loss of $13 billion in revenues, with an accompanying increase in enterprise marketing expenses. Steve Rosenbush concluded his article by saying:

"Citi's lack of proprietary trading may have hurt in recent times, along with a flat share price and a 300,000-plus-member workforce that many analysts consider bloated. CEO Chuck Prince has sought to trim costs, only to minimal effect. …
But when it comes to the M&A trade, Citi’s financial supermarket approach is confronting the white-shoe rivals squarely—and winning."

What impact will all this have on the future of Citigroup? In forthcoming posts I'll follow the remaining six steps along the path to understanding Citi's competition for customers and capital. Stay tuned. And please feel free to contribute your thoughts.

~V

A Mexican Standoff

This is my final article on the exchange wars. If you missed the first two you can check them out at "Exchange Wars: ICE vs. CME" and "Exchange Wars: Play It Again Sam." A series of comments about these posts that I exchanged with a CME trader provide useful background. Bottom line? My analysis leads to a Mexican standoff. Both merger combinations, ICEBOT as well as CMEBOT, have their strengths and weaknesses. But, it's important to note that BOT shareholders win no matter what.

You also will discover an unexpected new approach to stock valuation. In this approach the impact of market growth, maximum earnings and enterprise marketing productivity are just as important in assessing the quality of a merger as are cost and revenue synergies.

A CLEAN CASE
In several ways, the bidding war between CME and ICE for BOT offers an ideal market in which to document the implications of my theory. Why? For one thing, futures exchanges have virtually zero cost of goods sold. What's the marginal cost of an electronic trade made in 100 milliseconds? Virtually zero. Which means overhead costs cannot be loaded onto trading costs.  In fact, ICE reports its sales revenues are equal to its gross profit. Also, there are no third-party resellers sandwiched between the customer and the supplier. Finally, the enterprise marketing costs of futures exchanges are enumerated as line items in their income statements. In short, it’s a clean case.

A TOP DOWN APPROACH
The first thing you'll notice about this new approach to stock valuation is it begins with market demand, not company sales. The tail-wind factor-- growth in strategic group revenues -- creates a favorable environment for company sales growth. In Step 1 you forecast Strategic Group Revenues.

In Step 2 you calculate each company's maximum earnings market share using incremental analysis. This is a sophisticated form of strategic benchmarking.  It equates the incremental cost of a market share point with incremental earnings after enterprise marketing expenses.  This is the point where earnings are maximized. For details see my audio slide show on "The Rule of Maximum Earnings." This Adobe Connect presentation runs about 14 minutes. [Click to enlarge the graphics]

In Step 3 you calculate each company's earnings residual at that share of revenue where they are maximized.  This is important. You don't begin with forecast company sales. Rather you begin with forecast strategic group sales and estimate company sales as a product of its maximum earnings market share.

In Step 4 you calculate each company’s Risk-Adjusted Differential (RAD) and Relative Earnings Productivity (REP) for the most recent period. RAD is the difference between a company's share of market value and share of sales revenue, adjusted for volatility. See "Y'all Buckle That Seatbelt." This slide show runs 18 minutes. REP is the difference between a company's actual and maximum earnings. For details see "Competitive Stock Valuation." It runs 13 minutes.

Step 5 you forecast of the strategic group’s combined shareholder value and each company’s share of that value. Finally, given the number of shares outstanding at the end of the forecast period, the present value of lowball, most likely and highball stock prices are calculated.

ICEBOT's PRICE JUNE 2008
On the last day of trading in March, 2007 the common stocks of BOT, CME and ICE closed at $181.50, $532.46 and $122.21 respectively. Assuming investors built into these prices their expectations on the value of a merger, the price of ICEBOT was $303.71. The market cap of ICEBOT was $18.0 billion. The number of shares outstanding, adjusted for the merger, was 59.32 million.

If ICEBOT maximized earnings and its rejected suitor responded as I hypothesize below, my lowball forecast (minus 2 sigma) of the present value of its stock in June 2008 is $335. The present value of the expected price is $384 and my highball estimate (plus 2 sigma) has a present value of $430 per share ... assuming no changes in the shares outstanding. The next graphic shows the details in the five step competitive stock valuation process.

Step 1. Strategic group revenues were $729 million on March 31, 2007. That's the sum of each company's sales in Q1-07. I applied a rolling same-quarter year-on growth rate to forecast group revenues. Using the historical rate of 38%, the result in Q2-08 is $1,008 million in group revenues. Note, in this graphic the historical numbers are green and the forecast numbers are yellow.

Step 2. Sales revenues of ICEBOT divided by group revenues gives the merged companies a market share of 51.2% in March, 2007. If ICEBOT maximized earnings over the ensuing five quarters, its market share in June, 2008 would be 56.2%. Achieving this share would require doubling enterprise marketing expenses from $121 to $248 million. This would generate ICEBOT revenues of $567 million: a 52% increase over March, 2007 revenues of $373 million.

Built into this forecast is this assumption: if CME lost its bid management would not take it lying down. Rather, they would attempt to minimize their loss of market share by increasing enterprise marketing expenses at an historical rate equal to that of ICEBOT: about 42%. This move significantly reduces ICEBOT's maximum earnings market share by 360 basis points.

Step 3. ICEBOT's maximum EBITDA reaches $319 million in June, 2008 – a 65% increase over March, 2007 earnings of $194 million.

Step 4. ICEBOT's risk-adjusted differential (RAD) was -0.45 in Q1-07. To put this in perspective, the long run expectation for RAD was zero in a sample of 347 companies in 29 industries over the ten years form 1991 through 2000. See "Marketing's Impact on Firm Value. " Since its RAD was just slightly below the expectation, the ICEBOT merger seemingly did not excite investors all that much. ICEBOT's relative earnings productivity, however, was extraordinary: REP was -2%. What does this mean? ICEBOT produced actual earnings that were only 2% shy of maximum earnings in March, 2007. The historical RAD and REP numbers were assumed be the same in June, 2008.

Step 5. The combined market cap of all three companies was $36.6 billion in Q1-07. A power function (y = 5988.8*Q#^0.8005) fit the 9 quarters of historical data well (R^2 = 0.97). This produced a forecast of the strategic group's market cap in June, 2008 (Q=14) of $49.5 billion.

At the bottom end of the 95% confidence interval, my theory predicts ICEBOT would create 46% of the group's future market value, leading to lowball stock price forecast of $335. At the upper end of the interval ICEBOT would create 63% of the group's market value, leading to a highball price forecast of $430. Since ICE had an historical Beta of 3.2 compared with BOT's Beta of 0.8, I considered this a more risky combination. So I discounted the forecast June, 2008 stock prices at a rate of 3.3% per quarter.

CMEBOT's PRICE JUNE 2008
On the last day of trading in March, 2007 the common stocks of BOT, CME and ICE closed at $181.50, $532.46 and $122.21 respectively. Assuming investors built into these prices their expectations on the value of a merger, the price of CMEBOT was $713.96. The market cap of CMEBOT was $28.1 billion. The number of shares outstanding, adjusted for the merger, was 39.42 million.

If CMEBOT maximized earnings, and its rejected suitor responded as I hypothesize below, my lowball forecast (minus 2 sigma) of the present value of its stock is $713 in June 2008. The present value of the expected price is $809 and my highball estimate (plus 2 sigma) has present value of $886 per share ... assuming no changes in the shares outstanding. The next graphic shows the details following the five step competitive stock valuation process.

Step 1. Strategic group revenues were $729 million on March 31, 2007. That's the sum of each company's sales in Q1-07. As in the case of ICEBOT, I applied a rolling same-quarter year-on growth rate to forecast group revenues. Using the historical rate of 38%, the result is $1,008 million group revenues in Q2-08. Note, in this graphic the historical numbers are green and the forecast numbers are yellow.

Step 2. Sales revenues of CMEBOT divided by group revenues gave the merged enterprises a market share of 79.4% in March, 2007. If CMEBOT management maximized earnings over the ensuing five quarters, its June, 2008 market share would fall to 69.7%. Theoretically, the merged companies already were over-sized for the expected revenues in this strategic group. As a result, the enterprise marketing expenses required to maximize earnings barely increase by 4%, from $204 to $213 million. This would generate CMEBOT revenues of $703 million: a 21% increase over March, 2007 revenues of $579 million. Built into this forecast is the assumption that if ICE lost its bid for BOT, management would not take it lying down. Rather they would continue their aggressive pursuit of market position by increasing enterprise marketing expenses at their historical rate of 47%. Compared with a more growth neutral increase of 22%, this move by ICE significantly reduces (by nearly 700 basis points) CMEBOT's maximum earning market share in June, 2008.

Step 3. CMEBOT maximum EBITDA reaches $490 million in June, 2008 – a 73% increase over March, 2007 earnings of $283 million.

Step 4. CMEBOT's risk-adjusted differential (RAD) was -0.61. To put this in perspective, the long run expectation for RAD was zero in a sample of 347 companies in 29 industries over the ten years form 1991 through 2000. See "Marketing's Impact on Firm Value." The CMEBOT merger prospect it seems did not excite investors any more than did ICEBOT's, since its RAD also was slightly below the expectation. CMEBOT's relative earnings productivity, however, was quite extraordinary too: REP was just -8%. What does this mean? CMEBOT produced actual earnings that were only 8% less than maximum earnings in March, 2007. These historical RAD and REP numbers were assumed be the same in June, 2008.

Step 5. The combined market cap of all three companies was $36.6 billion in Q1-07. A power function (y = 5988.8*Q#^0.8005) fit the 9 quarters of historical data well (R^2 = 0.97). This produced a forecast of the strategic group's market cap in June, 2008 (Q=14) of $49.5 billion.

At the bottom end of the 95% confidence interval, my theory predicts CMEBOT would create 59% of the group's future market value, leading to lowball stock price forecasts of $713. At the upper end of the interval CMEBOT would create 75% of the group's market value, leading to a highball price of $886.  Since CME had an historical Beta of 1.4 compared with BOT's Beta of 0.8, I considered this a much less risky combination. So I discounted the June, 2008 stock prices at a rate of 1.1% per quarter.

IT'S THE PROCESS -- NOT THE PRICE
What's the probability the actual prices of the winning bidder will be bracketed by the nominal lowball and highball prices I forecast for June, 2008? It's non-zero. But I wouldn't say I'm 95% confident in these limits. There's a big difference between statistical confidence and practical confidence. The difference is reflected in the actions management of the winning bidder takes over the next four quarters as well as market devlopments. For example, can you be confident management will maximize earnings? How will investors assess their performance? What might happend to demand for futures exchange services in the next year? How will the rejected suitor respond? And, of course, there's always the possibility that the BOT shareholders will reject both bids on July 9, 2007.

Here’s what I am confident of: the utility of this pricing process. Competitive stock valuation is a valuable supplement to the company cash flow analysis used by the M&A guys. For one simple reason: valuing a stock in the context of a company's simultaneous competition for customers and capital provides a richer perspective on the future. What do you think?

~V