Strategic Logic and Kodak Part 2

Happy Thanksgiving to all

Part 2: Kodak Case Study

The book that discusses this case:

Most new technologies do not create a new business, but rather a substitute for the old way of doing things. Thus, the strategic impact of a new technology will depend on how it affects the market imperfections that protected the older way of doing things. And this impact can be important. Take the case of photography, which turned to digital. You do not have to be a genius (written in 2003) to realize that the traditional business of Kodak is in danger, since every time someone buys a digital photographic camera, he or she is renouncing the future purchase of photographic paper and the products necessary for development, products on which Kodak has a high margin supported by its patents and economies of scale. There are only two important competitors in the world, Kodak and Fuji, along with a few secondary actors.

Facing this ‘announced death’ of its main business by the invasion of a new technology, Kodak seems to have a straightforward strategic solution: enter into digital photography. Kodak has been investing the important cash flow produced by its traditional operations in the new digital technologies. However, profits are not arriving and never will. The reason is that the competitive structure of traditional (chemical) photography and that of digital photography (electronic) are very different, the second being much less attractive than the first.

Traditional photography is based on a fairly specific chemical technology, on which Kodak has an important number of patents and specialized knowledge, accumulated over more than 100 years. Moreover, not only research but also most production processes are subject to important economies of scale. In addition, Kodak’s brand, advertised for a century, and its worldwide distribution reach are two more barriers that protect the company’s profits. A further positive for the manufacturers is that the price of the cameras is relatively unimportant compared with that of the consumables, such as photographic paper and developing products. Each person who buys a camera, no matter how inexpensive, ends up leaving a lot of money in Kodak’s till. For all these reasons, the business has traditionally been very profitable, with very little competition. Kodak has been able to push the rest (Agfa, Ilford) that did not have its competitive advantages from the market.  The only exception has been Fuji, which shares the market with Kodak.

This competitive structure, however, has nothing to do with the business of digital photography. To start with, there are no significant consumables: digital photos are taken with a digital camera, which does not use rolls of film, and are seen on the computer screen, without consuming film. Some, perhaps, are printed on the printer, on paper that is more normal than photographic paper and is not protected by entry barriers.

The technology of the cameras is also different, based on electronic light sensors, produced by several companies: all those that have significant capability in photo-electronics can manufacture them, and there are many. Finally, because we are dealing with a digital product, company brands such as Sony, Panasonic, HP and so on come into play, as they have credibility with consumers in this area. In short, we find a business that will be structurally less profitable than that of traditional photography, since its entry barriers are lower and the degree of competition, logically, is higher.

That is why Kodak’s effort to transform itself into a digital photography company is headed for failure. Even if it succeeds, it will find that the business is not as profitable as the traditional one. And there is not much that it can do about it: The shift from chemistry to electronics is a technological change that destroys the profitability of the traditional photography business, just as the microcomputer destroyed the profitability of large computers. If IBM has become profitable today, it is not by selling PCs, but by doing other different activities. It is a question of accepting strategic logic: the profitability of a company depends in the first place on the possibilities of singularization[1] that exist in its business, and if these change to become higher or lower, then profitability will change to become better or worse.

[1] Singularization means that the company can charge a higher price or produce at a lower cost or some combination thereof than its competitors or potential entrants.

5 responses to “Strategic Logic and Kodak Part 2

  1. To state the obvious, a similar analysis could be done on information publishing business being substituted by the Internet. The Internet has made information easily distributed and created. Arguably, we are facing an oversupply of information vs our attention to consume the information thanks to the Internet. Oversupply implies that the value of information will drop and activities associated with information creation and distribution is likely to drop too. Traditional information publishing or distribution companies like newspapers, magazines, books, book stores are facing an uphill battle to switch into digital publishing since margins are not as good.

    I’ll like to challenge readers to find more non-obvious examples of industries facing such issues. Investing in these industries is tricky unless the assets could be bought at a low price, sold for another use (for example land & building).

  2. Dear Selau:
    Thanks for your thoughtful post. I believe competitive analysis is crucial when investing or analyzing a company like GroupOn that trades at a premium to its asset value. If there are no barriers to entry (I don’t see any) then growth will hurt the company and investors will be hurt in the long run.

    • I kinda owe you one for the lecture notes by a famous investor you posted. So here is a my shot at Groupon.

      For a bearish analysis on GroupOn I suggest Rocky Agrawal’s blog here: , I don’t know him personally, just happen to find him via Quora & Techcrunch. But I’ve got to say his ideas make sense.

      But I’m going to give an alternative view on the competitive analysis for Groupon.

      On barriers to entry for Groupon, I suspect the email subscription list is to a certain extend a moat if the moat is built correctly. Take a look at Daily Candy or Thrillist to gain a sense of the defensiveness of email subscription lists. The main argument goes like that, email is a very private place and a high volume of spam makes users unwilling to let businesses gain access to their email addresses. So, to get a user to give a business the permission to email the user needs a certain level of trust. Furthermore, a user will not easily trust other similar websites thus creating some captivity to the business if the user trusts the business. When a business manage to built that goodwill with customers, it is hard to duplicate even with money. But the goodwill must be built correctly so that trust is optimal to the extend people keep opening the email and the churn from the subscription is low. So a few important metric to measure is email open rate, email subscription churn rate, average life of a subscriber, and finally life time value of a subcriber. With these metrics, Groupon can be valued quite reliably. I remember Groupon doesn’t give the email open rate which is really suspicious because if its really good, why not publish it?

      A subscription list is somewhat limited to a city so its rather local like newspapers. Thus the list is very difficult to scale beyond a city besides via an acquisition. Now with this in mind I’m going to explain what I guess is Groupon’s strategy. Groupon bought up many many local clones in other cities, especially in overseas market. This is because Groupon is trying to buy up the subscription list before the local clones becomes too hard to overcome and closing Groupon from the market.

      So why Groupon is not contended to stay in USA and dominate the US market since Groupon has a moat and US is big? The reason is because Groupon wants to average out the online advertising fixed costs on a very large number of internet audience worldwide. When Groupon has enough local sites to offer a variety of deals to internet users all around the world(economies of scope), Groupon gains economies of scale in advertising costs. So an Internet surfer anywhere in the world, sees an Groupon advertisement, clicks and goes to Groupon’s local version for the user. This can be done because Groupon can detect user’s browser’s location in the world. A combination of subscription list (captive customers) and economies of scale is a classic Bruce Greenwald competitive advantage argument. Once this optimal strategy is revealed, the strategy have to be executed quickly(or so Groupon believes) to ensure no other daily deal website will achieve the same scale. So Groupon raises money, and more money, and more money to buy other websites and advertise like crazy.

      Every strategy has it’s risks. First, Groupon has to ensure they don’t overpay for quality of the local clone. The quality of a foreign Groupon clone will depend on the variables I’ve describe above for a subscription list. Additionally, the clone need to be able to ultimately dominate the local market by grabbing up all subscribers and merchants via network effects and not lose to other competitors. Next, Groupon have to ensure that the marketing costs spent to maintain a huge subscriber list worldwide(just like maintenance CapEx for brick and mortar companies) is worth the money. However, some argue that a good subscriber list needs little marketing expenses to maintain because churn rate is low.

      Now Groupon might have forcefully grown big too fast and thus it is not likely that all their acquisitions are bought at the right price(below intrinsic value). An optimal strategy should be like Wallmart to slowly grow at the edges of the main market(US) worldwide and not overpaying for companies. Besides, the quality of Groupon’s subscriber list is not known due to the short time span. You don’t know how long the subscribers will stay before they churn simply because the model is young. Goodwill takes some time to build which I guess is not yet build in Groupon’s case or Groupon’s subsidiaries’ case. Quality of service and reliability for a reasonable time(10 years) builds goodwill. Additionally, gaining subscribers by advertising “Cheap deal, buy now!” is not a good way to built goodwill because it attracts cheap subscribers.

      Thus, for now, it is best to sit on the sideline to watch what happen because Groupon might fail or might not fail depending on whether the subscriber list is high quality and the advertising costs spent to acquire customers is lower than a customer’s life time value. Rocky argues that the subscriber list is in decline. Yipit also has data showing that the list is in decline.

      If you believe in Groupon, wait a while more for goodwill to be really built and try to test the goodwill by surveying your friends. Or wait until profits and positive cash flow show that Groupon’s strategy work. It’s not too late to invest when the cloud clears because Europe, China and the US will keep the markets scared for awhile. Additionally given the large bearish calls on the stock, and potential sell out by employees the stock might get cheaper.

      Or else, if Groupon fails, I guess there will be some strong foreign subsidiary daily deals website spin offs at a cheap price for the private equity people. Additionally, Living Social will gain or other foreign competitors will gain when Groupon exits the market. Look out for competitors.

      Or if Groupon fails moderately, without going into Chapter 11, Groupon might close some foreign sites and maintain presence in US markets. In this case if the stock is cheap enough it might be a good investment. Again test for quality of subscriber list.

      Hope you guys enjoy this, thank you.

  3. Good post. You are thinking strategically.

    I wonder if the email list is exclusive since I am bombarded with so much spam. The email list would imply either lower customer acquistion costs or customer captivity.

    Would there be network effects because businesses would have the largest group of customers to advertise to while customers would have the greatest choice of deals? Perhaps this is where to look. But if so, their international strategy will fail. The bigger the market the less chance for economies of scale and more entrants would or could create niches within this global market. A grand strategy is most likely to fail lkie Hitler entering Russia or the US in Afghanistan.

    The competitive advantage won’t come from patents, licenses, or proprietary

    When in doubt, the burden is on whether there are any barriers to entry. 95% of the time a business will have NO competitive advantage whatsoever.

  4. Very interesting discussion on Groupon… However, even if it has some kind of moat, how would you value it “conservatively” if it does not generate any cash?

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