Calibrating Your Value Model

The holiday break provides us an ideal time to calibrate and refocus our efforts and build for the year ahead.  Given the dynamic nature of the business environment, I recommend you consider these two simple questions:  If I were starting my enterprise today, what would I be doing different from what I am doing now?  And what (other than inertia) is holding me back from doing those things now?

The changes we don’t see

Changes in the competitive business environment come slowly.  In the heat of battle — producing and selling what we produce and sell — we often don’t see change…until it has already passed us by.  We tend to do the same things we did last year — maybe a little faster, a little better, a little more efficiently.

But we forget that the market, the competition, the entire business environment is different from what it was a year ago, or even a quarter ago.  Ever so slightly different, perhaps — but then, big changes typically begin life as small changes.

Consequently, the value model that is central to our product or service offering may not be as, well, valuable as it once was.

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The Pharmaceutical Innovation Crisis

I used to read a lot of management books.  Or rather, buy a lot of them, then take a quick look — and promise myself to get around to reading them someday.  When (and if) I finally did, I’d often find the information dated and the advice stale.

Not so with most of Peter Drucker’s work.  In Drucker I find things that sound timely — sometime prophetic — even today.

The productivity of knowledge

Drucker spoke of the productivity of knowledge, and how firms, industries, and even countries who managed to excel at it would over time come to dominate their respective sectors.

When I first heard him use that term, it sounded abstract — and not immediately relevant to my work in business strategy. That changed recently when I conducted a study of the innovation crisis in the US pharmaceutical industry (which represents 80%  of the industry’s R&D worldwide.)  This is widely known in the press as the patent cliff that affects most major pharma manufacturers to some extent.

How pharma creates value

pillsIn a nutshell, a significant portion of the industry’s revenues and profits depends on branded drugs — the more successful of which you see advertised on TV.  Most of these are discovered by rapidly scanning lots of molecules, or computer models of the molecules, for potentially beneficial properties.  The most promising of these are first matched with diseases for which they might be useful, then registered under patents.  Then they are developed by being rigorously tested, first on animals, then on humans in a range of clinical trials.

The data from all these tests are presented to the Food and Drug Administration (FDA) for approval.  Drugs that are approved, and that are added to the ‘formularies’ of insurance companies and government payers who will reimburse patients for their use, can becomes wildly successful.  Lipitor, the statin used to control cholesterol in the blood, is the most successful drug to date, with total sales over $125 billion.

These blockbuster drugs (generally defined as those with annual sales over $1 billion) command prices in the marketplace much higher than their cost to manufacture.  Their gross margins can be as high as 75-80 percent.

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Competitive Dynamics: Understanding the ‘Even-Newer Normal’

I’m a lucky guy.  Nearly every day I walk between home and office along the Hudson River, just north of where it widens out into New York Harbor.  As an amateur photographer, I have begun to pay closer attention to — and often photograph — the scene (as below).

Each day the sky as the sun sets over New Jersey is different.  Sometime clear, sometimes cloudy, often mixed — with many variations in cloud types, formations, heights, and so on.  Each day the river water is different — sometimes calm and almost glassy, sometimes choppy and almost ocean-like, with thousands of variations in between.

The tides create a 4-5 foot variation in river height on a typical day, as well as variation in the direction and interactions of the channel flow and the surface texture.  Sometimes the air is still, sometimes pleasantly breezy, sometimes downright windy.  Each day of the year, the sun sets in a slightly different place.

Harbor 3In the five years I’ve been doing this, I do not recall seeing the identical sky-water combination more than once.  There are simply too many factors that change over too wide a range, and that interact in complex ways to see much repetition.  The building and piers are the only relative constants — and sometimes those change too.

New York Harbor is an open, dynamic, complex system, with an innumerable number of factors interacting continually.

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Avoid the Biggest Mistake in Market Intelligence

The late Ted Levitt, professor at Harvard Business School, used to tell this apocryphal story:  The CEO of a tool manufacturer gathers his executives into a meeting and says, “People, I have bad news.  I’ve discovered our customers don’t want quarter-inch drill bits — they want quarter-inch holes.”

What we sell vs. what they buy

In my view, that would count that as good news — since the executive has figured out that there is an important distinction between what our customer buys and what we make.  Your company makes and sells a product or service; your customer buys value – a benefit as he defines it.  They may be the same thing — your product may completely (or at least sufficiently) satisfy the customer’s need.  But when they diverge, you’re in trouble if you don’t realize it and adjust quickly.  Some companies never catch up when such a value shift occurs.

To play out Levitt’s example:  You make and sell a ¼” drill. What your customer needs and buys is ¼” hole.  Hypothetically there are other ways to get that ¼” hole:

  • hire a handyman who has a drill;
  • buy a pre-drilled piece of lumber; or
  • buy something that can be assembled with clamps instead of holes, thereby doing away with the need for holes altogether.

The point is that, on a value basis, these are also your competition (in addition, of course, to the other drill makers.)  You should keep them on your radar, and maybe even borrow from what they do to compete with yourself — and thereby pre-empt them from doing so.

A current example:  the PC industry

Companies and whole industries make this mistake over and over.  A textbook example is currently playing out in the personal computer industry.  Personal computers as we know them became common business tools in the 1980s.  The growth figures roared along, and with them star companies like Dell and Hewlett-Packard.  Both of these companies now seem to have lost their bearings, and could now be seen as fallen angels — largely due to the shifts in technology that went on around them.

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Value Starts at the Top

My colleague Robert Reiss studies CEOs — especially their successes and failures — in order that others might benefit from them.  His Internet show The CEO Show produces interviews from these CEOs on leadership, and how they make their organizations ‘tick’.  His book (with Jeffrey J. Fox) The Transformative CEO (McGraw-Hill, 2012) gathers some of their stories, principles, and accomplishments.CEO Show

Robert characterizes the CEO’s primary job as getting the organization from here to there.  Whatever resources are required to do that, it’s his or her job to make sure they’re in place — fully resourced, focused, and firing on all cylinders.

Robert sensed intuitively that the CEOs he interviewed on his show were adding substantial value to their organizations.   But was what seemed subjectively true also objectively verifiable?  When Robert wanted an independent test of his hypothesis, he turned to The Knowledge Agency®.

The TKA test

TKA devised a test using a widely-accepted benchmark — the change in the stock price during their respective tenures as CEO.  But market conditions were very different over the differing time frames we tested — even staying flat in a down market like that of 2008-09 would be judged superior. To adjust for such variations, we gauged the results against the return from the overall market, as measured by the return on the S&P 500.

So our benchmark metric was stock price return in excess of the return from the S&P 500.  We tested the eleven of Robert’s ‘transformative’ public companies having market capitalizations over $1 billion.

The envelope, please

The results were astonishing.   As shown in the table, the median gain was 44 percent over the benchmark, with the range from a slight loss against the benchmark to an excess gain of more than 5400 percentage points.  These results were for periods of time ranging from 5-23 years.

CEO chart shadows

Only one company (Xerox) did not beat the market over the CEO’s tenure — and on further examination we found that in fact it did for most of that CEO’s tenure, until the sharp recession of 2008-09.

Click here to download a short article from The CEO Forum magazine based on TKA’s Transformative CEO study.

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Value for Dummeze

There’s so much talk around here about value that I’ve been accused of being obsessed by it.  I plead no contest.

Bang buck CROPParticularly in these stressed economic times in which we seem mired for the foreseeable future, the quest for value is a search that most of us pursue, in both our personal and professional lives, almost continually.

But what is value?  Most of us realize it’s not the same as cost or price.  It’s what you get for that cost — the ‘bang for the buck’.  Economists would say it’s the benefit/cost ratio.

My two bucks not to Chuck

I like wine.  One of my hobbies is discovering really good wines that sell for less than $10 — but taste like they’re worth several times that.  To me, it wouldn’t be nearly as much fun discovering a great bottle for $100 — too easy — besides which my Scottish heritage would never stand for it.

I’ll never forget our trip to Languedoc-Roussillon in the south of France, where we got delicious local wines in the supermarket — for $2 a bottle. That cured me forever of wine price snobbery — but made me forever a wine value snob.

“Value” implies getting more (of something) for a given amount of money.  A value investor is one who likes to buy low, then sell high.  A value stock is one that seems underpriced relative to its fundamentals and earnings potential.

Thinking like an MBA

Value creation is the fundamental keystone of our competitive economy — and one of the genuine Mysteries of the Universe.  For me one of the best things about business school was the opportunity to think and talk about value for two intense years — both in an abstract theoretical sense, and in an applied sense as it relates to producing value in live enterprise situations.

As an MBA, you learn not only not to take value for granted, but even to have a certain reverence for it — that value is transient, not to be treated carelessly — it can come and go.  Much like other living organisms, products, business models, companies, even whole industries have life cycles — they are born, they grow, they thrive, they ebb, they die.  The value life-cycle is an entirely natural process — even predictable, once you understand it.

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What’s a Record Store, Grandpa?

When I first moved to New York in the mid-70s, I was working downtown for New York State’s Emergency Financial Control Board.  Yes, Virginia, we’ve had financial crises before, and that was a pretty bad one.  My job was conducting ‘financial intelligence’ about the city subway system.

A guy I worked with shared my interest in music, and told me about this great new record store just down the street — J&R.  It was for years my first stop when I wanted to find something unusual.  As many of you know, in the interim they expanded from that one store to now occupy many of the storefronts opposite City Hall.  They now carry cameras, computers, TV and other electronics, small appliances, and on and on.J&R

‘This could be the last time’

These days, whenever I’m downtown, I’ve taken to stopping in — because I’m always afraid it will be the last time.  Tower Records, Virgin, Sam Goody’s, and HMV, formerly the other biggies in town, have long since left the market for vinyl records and CDs — because obviously the markets for these products are increasingly niche-based, and the major (legal) markets for recorded music are for MP3 downloads and streaming à la Pandora and Spotify.  I still buy CDs to get the best quality sound, but do it almost exclusively now from Amazon.

Even while they were around, records changed a lot.  My first memories of buying music are of going to the record store with my dad and having the clerk take out the record you were interested in so you could listen to it in a listening booth before committing to it.

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Competitive dynamics: a basic typology

“I love you, you’re perfect…now CHANGE.”  That’s what the market in effect continually tells high-achieving companies—because the world always changes around them.

Companies tend to do best today what they did best yesterday…not what they’ll need to do best tomorrow.

In working with companies of various sizes, in various industries, I’ve noticed that the most significant strategic challenges are those brought on by some fundamental type of industry change.  Anticipating and adapting to industry change is at the heart of what competitive strategy is.

I’ve also noticed that not all industry changes are of the same magnitude or carry the same degree of strategic implications.  I’ve begun informally categorizing these changes with regard to their impact on industry players.  We’ll call these—in ascending order of how difficult they are to manage successfully—Levels 1, 2, and 3.

Level 1 industry change – “New kid in town”

In a Level 1 industry change, a major player enters or leaves the industry.  This could be a major buyer, a major competitor, or a major supplier for the industry.

WB recardsExamples of Level 1 change abound, and you can usually pick up a financial journal at random and find one.  I just now did exactly that, and find two pages into my search an article reporting that Warner Music Group is selling its music publishing business (leaving one less player there), in hopes of clearing anti-trust to be able to buy the foundering EMI (leaving one less player there as well).  EMI owns, among other assets, the master recordings by my all-time favorites, the Beatles.

Level 1 changes can require significant adjustments in any industry.  However, relative to other types of industry change, the impact of a Level 1 change on existing other players is low.

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iPad math: a consumer looks at value

In a recent post Surfing the value waves I mentioned having purchased an iPad. Here’s the value calculation that drove me to buy it.  Of course it’s cool and fun—but does it make economic sense?

It first occurred to me in discussions with my wife—who wants a big, flat, thin TV like all our friends have—that we could EACH get an iPad, skip the TV, and pocket the change.  The iPad is not quite “there” in terms of programming, but for what I mainly watch (movies and sports), it’s halfway there (the movies half.)  TVs have gotten so cheap, this was actually about break-even—so there wasn’t a lot of change to pocket.

In this sense the iPad (and the Internet in general) is a textbook example of a disruptive rival to the TV—not as good in many respects, definitely cheaper—but with the future potential to knock the whole competitive game into a different orbit.

But then I started adding up the other gadgets that an iPad could replace.  I should mention that while I do not own all of these, as a “weekend warrior” musician and photographer, I own more than most people.  Your mileage will probably vary.

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Surfing the value waves

Picture in your mind your organization’s typical customer or client.  Now picture the moment that customer purchases your product (or service).  Each transaction with that customer is preceded by some calculation—whether rigorous or informal— that your product is “worth it” compared to alternative solutions.  This worth-it-ness is called your product’s value proposition.

The sum of each of those value calculations over time is essentially your customer relationship with that customer.  In turn, the sum of all your customer relationships is pretty close to the value of your whole enterprise.  Each happy (successful) company starts with a happy (satisfied) customer—and the ability to scale that happiness across many customers.

Let me illustrate.   Apple (AAPL), in the waning days of a prolonged economic downturn, reported selling 3 million iPads (at $500+) in its first three months, and that same number of iPhone 4s (at $200+) in its first one month.  Millions of people (including me) made a decision to part with their hard-earned money, and possibly forego other purchases, to have one of these tools/toys (tooys?)

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