Tag Archives: Case Study

CASE STUDY of Perception vs. Reality (Old Republic Insurance, “ORI”)

Perception vs. Reality

Old Republic (ORI) pulled their spin-off and looked what happened

What changed? I would advise you to listen to the current conference call: http://ir.oldrepublic.com/phoenix.zhtml?p=irol-eventDetails&c=80148&eventID=4797341 which will be available until July 3, 2012. It is a classic of how analysts view the stock price and the owner/operator/management views the reality of their business.  Old Republic (“ORI”) announced a spin-off of their money-losing Mortgage Guaranty Insurance business (“MGI”) but then on Friday decided not to go through with the spin-off for various reasons.

As you can see above in the short-term chart of ORI, the stock moved up upon announcement of the spin-off and the price neared $11 before plunging to below the pre-announcement price.

No matter what your assessment of intrinsic value was or is now, the mathematics of future cash flows has never changed. Actual risk hasn’t changed, but the PERCEPTION of risk has. If you read through the conference call transcript, you will see that several analysts/investors do not understand how run-off insurance operates. Run-off means that no new insurance is underwritten while claims of the old (past) insurance are paid down from stated reserves.  ORI will pay claims initially at 50 cents on the dollar as per the orders of their insurance regulators.

Ironically, management (Aldo Zucaro – Chairman of the Board, Chief Executive Officer) bought shares last month around $9 to $10 per share probably never guessing that shareholders would respond to the announcement as they did. Note his exasperation in having to repeat over and over that the economics of the business have not changed. Note the gap between perception and reality. I have highlighted certain passages of the transcript for emphasis. Markets are efficient?

See the case study here:

Case Study of reality vs perception for Property Insurer Old Republic_

Review of Old Republic here: ORI_VL, ORI_May 2012, 1Q12 FINAL Financial Supplement, and ORI_Morn_Spin

Mortgage Indemnity Business in Run-Off

Details of Old Republic’s Mortgage Guaranty and Consumer Credit Indemnity Businesses renamed Republic Financial Indemnity Group, Inc. (RFIG). This will help you understand ORI’s deferred payment obligation (“DPO”) for the run-off of its MGI business.  The DPO keeps the Mortgage Indemnity Insurance unit SOLVENT via the orders of the insurance regulators and in terms of STATUTORY ACCOUNTING.

The Statutory Accounting Principles are a set of accounting rules for insurance companies set forth by the National Association of Insurance Commissioners. They are used to prepare the statutory financial statements of insurance companies. With minor state-by-state variations, they are the basis for state regulation of insurance company solvency throughout the United States.

You will then understand the lack of risk to the rest of Old Republic. Statutory accounting is the reality not GAAP. financial_supp_stat_exhibit_032112 and the Press Release of Old Republic’s Partial Leveraged Buyout and planned spin-off of its RFIG subsidiary’s stock to ORI shareholders: may_21_2012_ori_press_release

Some say the market is efficient. What do YOU think? Who are the sellers?

Post Script: I am backed up this week so I might be light on the posting. Be well and keep learning every day.

UPDATE 1#

Moody’s lowers debt ratings on Old Republic

NEW YORK (AP) — Moody’s Investors Service on Wednesday lowered its senior unsecured debt ratings for Old Republic International Corp., citing the company’s decision to withdraw plans to spin off a subsidiary.

The Chicago-based insurance underwriter announced last week it changed plans to spin off Republic Financial Indemnity Group Inc. The move came after stakeholders raised concerns that the spinoff would not be in their benefit.

The reversal prompted Moody’s to downgrade Old Republic’s senior unsecured debt ratings one notch to “Baa3” from “Baa2.” That’s the lowest possible investment-grade rating on Moody’s scale.

The ratings firm also lowered the insurance financial strength ratings of Old Republic subsidiaries Old Republic General and Old Republic Title by one notch to “A2” from “A1.”

Moody’s has a negative outlook on the ratings for Old Republic and its principal subsidiaries, which means there’s a 40 percent chance that the ratings could be lowered in the next 18 months.

The ratings firm said its outlook reflects continued risk of liquidity strain at Old Republic International, should regulators find that capital levels its subsidiary, Republic Mortgage Insurance Co., falls short of requirements, triggering an early redemption of the parent company’s senior notes.

Moody’s believes liquidity options exist in such a scenario but said such an event would still place pressure on Old Republic International.

“The intended spinoff would have helped protect Old Republic’s bondholders and insurance policyholders from further deterioration at the troubled mortgage insurance operation,” Moody’s analyst Paul Bauer said.

The risk of financial strain at Old Republic International could strain its subsidiaries’ financial flexibility, Moody’s noted.

Moody’s affirmed Old Republic subsidiary Manufacturers Alliance Insurance Co.’s insurance financial strength rating of “A3.”

It also maintained an “A3” rating on Pennsylvania Manufacturers’ Association Insurance Co. and Pennsylvania Manufacturers Indemnity Co.

Old Republic shares ended regular trading down 4 cents at $8.29. The stock added 5 cents to $8.34 after hours.

Liquidity fears ebb at Old Republic

By Jochelle Mendonca and Sharanya Hrishikesh

(Reuters) – Old Republic International reassured investors that scrapping plans to spin off its money-losing mortgage insurance business would not lead to a liquidity crisis as regulators were unlikely to seize the unit.

The insurer had planned to separate the unit and had even entered into a deal to sell a fifth of the business in a leveraged buyout but shelved the plan following stakeholders’ objections.

The company’s stakeholders include its regulators, the government-backed Fannie Mae and Freddie Mac and bank customers.

Regulators in North Carolina have already placed the unit under supervision. It is now only allowed to pay claims at 50 cents on the dollar to preserve capital, leading to investor fears that the unit would be seized, triggering a default under the company’s debt covenants.

Old Republic eased those concerns on a conference call to discuss the canceled spinoff.

“We’re comfortable, based on our discussions (with our regulators), that receivership is not in play,” Chief Executive Aldo Zucaro said.

He expressed confidence that the company would be able to either refinance its debt or amend the terms, should a default occur.

Old Republic said the mortgage insurance (MI) unit, which stopped writing new business when its capital levels cratered last year, would continue to lose money for the next two years.

“By (2014), our total loss since 2007 will have been $1.7 billion, versus the total accumulated profit of $1.8 billion booked in the first 26 years … of our mortgage insurance journey,” Zucaro said.

The company said almost all its statutory capital – the standard claims-paying metric – comes from deferred claim payments ordered by regulators. Deferred payments count as a liability under generally accepted accounting principles.

On a reported basis, the company said its mortgage insurance unit has no capital and that it does not have the funds to add to the business.

“To just keep the company solvent, you’d have to come up with $250 million, which we are not committed to doing,” a company executive said.

UNHAPPY INVESTORS

But even as the MI unit’s stakeholders got their way with the scuttled spinoff, many Old Republic shareholders are unhappy at the prospect of being saddled with the business for the foreseeable future.

Investors from hedge funds SAC Capital, Anchor Capital, Divine Capital and others grilled company executives on options for the unit, including voluntarily placing it into receivership.

“Why is it not better to simply spin this out and go out to your bondholders and amend the covenants if necessary or to go in receivership?,” Darius Brawn from SAC Capital asked on the conference call.

Even a sale of the business to investors specializing in run-off situations, where they just manage the existing book till the policies are exhausted, seems unlikely.

“I think the possibility of a runoff (investor) buying a mortgage guarantee business with regulatory approval is remote,” an Old Republic executive said on the call.

The company said it sees no need to amend its debt covenants in advance of a seizure, something shareholders asked it to consider, because it does not believe the default will occur.

“One of our sayings around here is that you don’t just jump off the roof because you’re afraid you’re going to fall off,” CEO Zucaro said.

“We don’t think we’re falling off the roof. So we’re not jumping.”

(Reporting by Jochelle Mendonca and Sharanya Hrishikesh in Bangalore; Editing by Viraj Nair, Anil D’Silva and Supriya Kurane)

 

Barnes & Noble Valuation Case Study

There are opportunities to learn all around us.  The recent announcement of Microsoft’s $300 million investment in the Nook–Barnes & Noble’s eReader provides a reference point for valuation.

Barnes & Noble (BKS) Case Study Materials

BKS and MSFT Agreement 8K April 27 2012 What valuation can you derive from MSFT’s purchase price?

BKS 10Q March 8 2012 The most recent 10-Q. Combine with the 10-K to value BKS on your own.  BKS 10K April 30 2011

The Amazon Letter discusses the Kindle: Amazon Letter to Shareholders 2011

Try to think about how you would value BKS. If you struggle, then look at the case study materials below, then return to the financial statements. Don’t become discouraged.  The research report below isn’t perfect (lacks a full competitive analysis of the different businesses), but the report does do a good job in showing you how the author reached a valuation. You may disagree with the assumptions, but you know what they are.

When you read of a public transaction for a company or part of a company, you have a reference point to test your valuation skills. Good luck!

Valuation of Barnes & Noble

Barnes & Noble Case Study

Chapter 10: Fox Becomes a Network (Into the Henhouse)

In my house there’s this light switch that doesn’t do anything. Every so often I would flick it on and off just to check. Yesterday, I got a call from a woman in Madagascar. She said, “Cut it out.” — Steven Wright

Chapter 10 in Competition Demystified: Into the Hen House

HBR Case Study on Fox News Network: https://rcpt.yousendit.com/1427965236/6c910671770adc188996bd7639688499

QUESTION 1: Describe how the three networks (ABC, NBC, and CBS) played the prisoner’s dilemma game in the 1960s and 1970s in regarding advertising pricing, advertising inventory, purchasing of shows, and hiring of talent.

QUESTION 2: How did Fox influence the other networks’ responses to its efforts to get behind their barriers to enter their market?

QUESTION 3: How effective was Fox’s strategy of having synergistic media business?

The analysis will be posted next Friday. Good luck!

STep Lightly

Have a good weekend and step lightly: http://www.youtube.com/watch?v=spv1a5NMyvw&feature=related

Coke and Pepsi’s Uncivil Cola Wars-Case Study Analysis

Money is better than poverty, if only for financial reasons–Woody Allen

Besides understanding economies of scale, the next area you need to master is understanding the prisoner’s dilemma and how companies coexist or compete within barriers to entry.

The case readings were presented here:http://wp.me/p1PgpH-yl

Remember that if the links do not work, then the materials are in a folder in the VALUE VAULT. Simply email Aldridge56@aol.com and request a key.

CASE STUDY ANALYSIS

The case study discussion in a PDF because of financial tables. Go here: http://www.yousendit.com/download/M3BsM25ITmFsMHhESjlVag

 Pepsi and Coke’s Uncivil Wars

Chapter 9 in Competition Demystified: Uncivil Cola Wars: Coke and Pepsi Confront the Prisoner’s Dilemma

What are the sources of competitive advantages in the soda industry?

First we should look at industry structure. The cola companies buy raw materials of sugar, sweeteners and flavorings from many suppliers then they turn the commodities into a branded product which consists of syrup/concentrated combined with water and bottles. The companies are joined at the hip with their bottlers/distributors who then sell to many retail outlets.  Selling bulky and heavy beverages lends itself to regional economies of scale advantages.

The soda companies cannot operate successfully unless their bottlers and distributors are profitable and content whether company-owned or franchised.

The existence of barriers to entry indicates that the incumbents enjoy competitive advantages that potential entrants cannot match. In the soft drink world, the sources of these advantages are easy to identify. First, on the demand side, there is the kind of customer loyalty that network executives, beer brewers and car manufacturers only dream about. People who drink sodas drink them frequently (habit formation), and they relish a constancy of experience that keeps them ordering the same brand, no matter the circumstances.

Both Coke and Pepsi exhibit the presence of barriers to entry and competitive advantage—stable *ROE can be influenced by whether bottlers’ assets are off or on the balance sheet

Second, there are large economies of scale in the soda business both at the concentrate maker and bottler levels. Developing new products and advertising existing ones are fixed costs, unrelated to the number of cases sold. Equally important, the distribution of soda to the consumer benefits from regional scale economies. The more customers there are in a given region, the more economical the distribution. A bottler of Coke, selling the product to 40% to 50% of the soda drinkers in the market area, is going to have lower costs than someone peddling Dr. Pepper to 5% to 56% of the drinkers.

During the “statesmen” era of Pepsi and Coke, what actions did each of the companies take? Why did they help raise profitability?

Note the stability of market share and ROE. ROE dipped in 1980 and 1982 as Pepsi and Coke waged a price war. Yet, market shares did not change as a result of the price war—both companies were worse off. Pepsi gained market share in the late 1970s versus Coke. Coke was slow and clumsy to respond.

Price wars between two elephants in an industry with barriers to entry tend to flatten a lot of grass and make customers happy. They hardly ever result in a dead elephant. Still, there are better and worse ways of initiating a price contest. Coke chose the worst. Coke chose to lower concentrate prices on those regions where its share of the cola market was high (80%) and Pepsi’s low (20 percent). This tactic ensured that for every dollar of revenue Pepsi gave up, Coke would surrender four dollars.

Coke luckily developed New Coke which allowed it to attack Pepsi in its dominant markets in a precise way—minimizing damage to Coke’s profits–and force a truce in the price wars.

They made visible moves to signal the other side that they intended to cooperate. Coca-Cola initiated the new era with a major corporate reorganization. After buying up many of the bottlers and reorganizing the bottler network, it spun off 51% of the company owned bottlers to shareholders in a new entity, Coca-Cola Enterprises, and it loaded up on debt for this corporation. With so much debt to service, Coca-Cola Enterprises had to concentrate on the tangible requirements of cash flow rather than the chimera of gaining great hunks of market share from Pepsi. PepsiCo responded by dropping the Pepsi Challenge, toning down its aggressive advertising and thus signaling that it accepted the truce. Profit margins improved. Operating profit margins went from 10% to 20% for Coca-Cola. Pepsi gain was less dramatic but also substantial.

Both companies focused on ROE rather than market share and sales growth.

The urge to grow, to hammer competitors and drive them out of business, or at least reduce their market share by a meaningful amount, had been a continual source of poor performance for companies that do have competitive advantages and a franchise, but are not content with it.

Competition Demystified Continued: Coors Case Study Analysis From Readers

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.–Warren Buffett

Coors Case Study Analysis

My short write-up: http://www.scribd.com/doc/80155636/Coors-Case-Study

But readers’ comments are even better. These contributors posted here: http://wp.me/s1PgpH-1302. I reposted below. Good work.

Dave

  1. These were the numbers that jumped out at me:
    In the 3 largest areas that they operated, Coors had almost 50% market share in 1977. By 1985 they had only 14% in that region, however they expanded to almost all the states and sold 16% more barrels.
  2. Also in 1977 Coors had a 20% operating margin, far ahead of any competitor. By 1985 it was down to 8%. Marketing expenses were the cause of this, jumping from 2.6% of revenues to 15%, far more than any major competitor.
  3. While Coors was expanding, all of their competitors (mostly AB and Miller) were taking a major chunk of their market share in the markets they previously dominated.
  4. It seems that the marketing expenses are what killed Coors’ margins. If Coors expanded its local market share in 1977 instead of jumping around their marketing expenses would’ve been much lower per barrel than all of their competitors.

Herman | February 1, 2012 at 8:12 am | Reply | Edit

I fully agree with Dave’s analysis. Although there was advertising expenses were on an industry-wide rise since the late 70s (probably driven by PM’s takeover of Miller), Coors’ advertising expenses made up 15% of sales vs. an industry average of 10%. On a per-barrel basis, Coors spent $11/barrel on advertising in ’85, whilst AB spent $7/barrel.

Reason for these high expenses was that the advertising expenses are primarily regional, and Coors had lost market share in its heart land (Mountain, Pacific, WSC) – 25% in ’77 to 15% in ’85 against AB and Miller, and had insufficient foothold in other states (in all non-heartland areas except for NE Coors had <10% market share).

A crucial mistake Coors management made was to allow Miller and AB to fill the capacity gap in its heart-land (10 states west of Colorado), thereby losing market share and thereby weakening the EoS it had. It seems like Coors’ management was focused on its nation-wide roll and lost sight of defending its local market share.  EXCELLENT POINT.

It seems like AB enjoys EoS now.

It’s easy to play Monday morning quarterback, but if I were in Coors shoes, and saw the decline in market share I would have taken the following steps:

Step 1) Map out profitability per state to understand which states create a drag on Coors margin. My guess would be that this would be a combination of distance from its brewery and low ( <10%) market share) but this would require some further analysis.

Step 2) Cut fat – there seems to be fat everywhere in the value chain, which translates into lower margins. By cutting out this fat, more cash can be generated. Examples of potential areas of fat:

a) Coors strategy of maintaining full integration of its supply chain (e.g. owning its own transport company, generating its own power, etc). This may not be the best strategy in a mature market like beer. Other service-providers may have an cost-advantage, e.g. in transportation. Coors own transport company led to 10%-15% higher trucking costs thanks to low back haulage compared to independent transporters.

b) Maintaining so many brands – Coors ran 4 different super premium brands vs. an industry average of 1. Even though super premium brands generated cash to fund advertising campaigns, the costs were pretty high ($20 – $ 35 Mln launch costs, $10 M annually advertising maintenance costs, and costs associated with running so different many packages on its production lines).

Step 3) Abandon the ‘bleeder’ states, and focus on the strong states (its heartland). Defend market share aggressively by cutting prices, using the excess cash generated by having cut the fat as laid out in step 2 .

I of course completely agree with you but do you have any insight on why they may have pursued the strategy that they did at the time?

Coors Case Study that is Not Helpful

There is interesting information and background here on the beer industry, but this 64-page reports lacks logic and analysis.  On what basis does the author suggest that Coors go international? That advice is equivalent to giving a drowning man a drink from a firehose. Coors would only be worsening its position—further growth without profit. The readers above who contributed their analysis in a few paragraphs grasped the essence of Coors errors. Don’t be fooled by fancy terms like SWOT analysis–get at the nub of the problem like Hannibal Lechter http://richraths.com/files/CoorsCaseStudyAnalysis2004.pdf

Part 2: A Professor Provides a Different Perspective on WMT

I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. 26 times, I’ve been trusted to take the game winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.–Michael Jordan

What is a Moat?

Moats are structural characteristics of a business that are likely to persist for a number of years, and that would be very hard for a competitor to replicate.  Management is not a moat. The best poker player with a pair of deuces can’t beat a beginner with a straight flush.

Moats are not great products, strong market share, great execution and good management.

Part Two: A Professor discusses WMT Case Study

See Part 1: http://wp.me/p1PgpH-j0

Part Two: The Professor continues his talk on Wal-Mart’s success.

First used in grocery supermarkets, bar-code scanners at retail checkout stations are now ubiquitous. Mass merchandisers began to use them in the early 1980s. Most retailers saw the bar-code scanner as a way of eliminating the cost of constantly changing the price stickers on times. But Wal-Mart went further, developing its own satellite-based information systems. Then it used this data to manage its inbound logistics system and traded it with suppliers in return for discounts.

Susan, a human resources executive, suddenly perks up. Isolating one small policy has triggered a thought. I gave a talk the day before on “complementary” policies and she sees the connection. “By itself,” she says, “it doesn’t help that much. Kmart would have to move the data to distribution centers and suppliers. It would have to operate an integrated inbound logistics system.”

Good,” I say, and point out to everyone that Wal-Mart’s policies fit together—the bar codes, the integrated logistics, the frequent just-in-time deliveries, the large stores with low inventory—they are complements to one another, forming an integrated design. This whole design—structure, policies, and actions—is coherent. Each part of the design is shaped specialized to the others. The pieces are not interchangeable parts. Many competitors do not have much of a design, shaping each of their elements around some imagined “best practice” form. Others will have more coherence but will have aimed their designs at different purposes. In either case, such competitors will have difficulty in dealing with Wal-Mart. Copying elements of its strategy piecemeal, there will be little benefit. A competitor would have to adopt the whole design, not just a part of it.

The professor suggests that WMT incorporated the bar-code scanners into an integrated process that a competitor couldn’t copy at least in the short run. When a company invents a process advantage, competitors can eventually copy that. I see WMT using a technology to lower costs within the company’s regional economies of scale advantage. Even if Kmart could lower its costs with the same technology, it was still at a disadvantage in terms of cost structure versus WMT.

There is much more to be discussed: first-mover advantages, quantifying its cost advantage, the issue of competence and learning developed over time, the function of leadership, and whether this design can work in cities. We proceed.

With fifteen minutes to go, I let the discussion wind down. They have done a good job analyzing Wal-Mart’s business, and I say so. But, I tell them, there is one more thing. Something I barely understand but that seems important. It has to do with the “conventional wisdom”—the phrase from the case I put on the whiteboard at the beginning of the class: “A full-line discount store needs a population base of at least 100,000.”

I turn to Bill and say: “You started us out by arguing that Walton broke the conventional wisdom. But the conventional wisdom was based on the straightforward logic of fixed and variable cost. It takes a lot of customers to spread the overhead and keep costs and prices low. Exactly how did Walton break the iron logic of cost?”

I push ahead, putting Bill into a role: “I want you to imagine that you are a Wal-Mart store manager. It’s 1985 and you are unhappy with the whole company. You feel that they don’t understand your town. You complain to your dad, and he says, ‘Why don’t we just buy them out” We can run the store ourselves.’ Assuming Dad has the resources, what do you think of his proposal?”

Bill blinks, surprised at being put on the spot for a second time. He thinks a bit, then says, “No it is not a good idea. We couldn’t make a go of it alone. The Wal-Mart store needed to be part of the network.”

I turn back the whiteboard and stand right next to the boxed principle: “A full-line discount store needs a population base of at least 100,000.” I repeat his phrase, “The Wal-Mart store needs to be part of the network,” while drawing a circle around the word “store.” Then I wait.

With luck, someone will get it. As one student tries to articulate the discovery, others get it, and I sense a small avalanche of “Ahas,” like a pot of corn kernels suddenly popping. It isn’t the store; it is the network of 150 stores. And the data flows and the management flows and a distribution hub. The network replaced the store. A regional network of 150 stores serves a population of millions! Walton didn’t break the conventional wisdom; he broke the old definition of a store. If no one gets it right away, I drop hints until they do.

When you understand that Walton redefined the notion of “store,” your view of how Wal-Mart’s policies fit together undergoes a subtle shift. You begin to see the interdependencies among location decisions. Store locations express the economics of the network, not just the pull of demand. You also see the balance of power at Wal-Mart. The individual store has little negotiation power—its options are limited. Most crucially, the network, not the store, became Wal-Mart’s basic unit of management.

In making an integrated network into the operating unit of the company, instead of the individual store, Walton broke with an even deeper conventional wisdom of his era: the doctrine of decentralization that each kettle should sit on its own bottom. Kmart had long adhered to this doctrine, giving each store manager authority to choose product lines, pick vendors, and set prices. After all, we are told that decentralization is a good thing. But the oft-forgotten cost of decentralization is lost coordination across units. Stores that do not choose the same vendors or negotiate the same terms cannot benefit from an integrated network of data and transport. Stores that do not share detailed information about what works and what doesn’t can’t benefit from one another’s learning.

If your competitors also operate this kind of decentralized system, little may be lost. But once Walton’s insights made the decentralized structure a disadvantage, Kmart had a severe problem. A large organization may balk at adopting a new technique, but such change is manageable. But breaking with doctrine—with one’s basic philosophy—is rare absent a near-death experience.

The hidden power of Wal-Mart’s strategy came from a shift in perspective. Lacking that perspective, Kmart saw Wal-Mart like Goliath saw David—smaller and less experienced in the big leagues. But Wal-Mart’s advantages were not inherent in its history or size. They grew out of a subtle shift in how to think about discount retailing. Tradition saw discounting as tied to urban densities, whereas Sam Walton saw a way to build efficiency by embedding each store in a network of computing and logistics. Today we call this supply chain management, but in 1984 it was as an unexpected shift in viewpoint. And it had the impact of David’s slung stone.

Compare this discussion with Greenwald’s analysis of WMT in Ch. 5 of Competition Demystified. Do you agree with the professor that WMT has a network effect?

Hint: You are most likely to find the network effect in businesses based on sharing information (Amex), or connecting users together (Ebay, CME), rather than in businesses that deal in rival (physical goods). Of networks there will be few.

Cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria.

WMT 2003 and Coors Case Studies; Items of Interest

I got my driver’s license photo taken out of focus on purpose. Now when I get pulled over the cop looks at it (moving it nearer and farther, trying to see it clearly)…and says,” Here, you can go.” — Steven Wright

The Wal-Mart Stores in 2003 and the Adolph Coors in the Brewing Industry Case Studies are in the Value Vault.  If you just want me to email you the cases just write to aldridge56@aol.com with CASES in the Subject line–you will have them by tomorrow.

Other Items of Interest

Should we re-write the constitution every 20 years as Thomas Jefferson suggested? Check out: http://www.constitutioncafe.org/

How to strengthen willpower. http://artofmanliness.com/2012/01/15/how-to-strengthen-willpower/

Nassim Taleb’s New Book

Talk about Nassim Taleb’s new book, Antifragility, go here www.cafehayek.com and click on podcasts on left of blog.  Other interesting podcasts available.

Keynesian Economics is a Failure

Interesting lecture on classical economic theory: http://mises.org/resources/5278/Why-Your-Grandfathers-Economics-Was-Better-Than-Yours

  • A participant: “I really enjoyed this talk. Most of it is about Say’s Law and how Keynes was wrong. Keynes, in fact, got his idea from Thomas Malthus who was a contemporary of JB Say.”Here are some notes:Recessions are never due to demand deficiency.
    An economy can never produce more than its members are willing or able to buy.
    High levels of savings do not cause recessions.What causes recessions?
    – Structure of supply doesn’t fit the structure of demandGeneral Glut
    – Could you produce too much of everything? No.
    – Overproduction of particular goods can lead to a general downturnMen err in their production there is no deficiency in demand – David Ricardo

A Different Analysis of Wal-Mart Part 1

I bought a self-learning record to learn Spanish. I turned it on and went to sleep; the record got stuck. The next day I could only stutter in Spanish.                 — Steven Wright

A Different Professor’s Analysis of the Wal-Mart Case Study  (Part 1)

Try to jot down answers to the professor’s discussion. Part two of his lecture will be posted tomorrow.

A Professor Discusses Wal-Mart with his MBA class. The purpose of this analysis is to give you another approach of analyzing a case. Do you find Greenwald’s approach “better” or more thorough, precise and analytical or this professor’s approach? Can you answer his question at the end of this post?

The Professor: Much of my work with MBA students and companies involves helping them uncover the hidden power in situations. As part of this process often teach a case about Wal-Mart’s founding and rise, ending in 1986 with Sam Walton as the richest person in the US. In a subsequent session I will follow-upby discussing the modern Wal-Mart, pushing into urban areas, stretching out to Europe, and becoming the largest corporation on the planet in terms of revenue. But the older case portrays a simpler, leaner Wal-Mart—a youthful challenger rather than the behemoth it has become. Hard as it is to believe today, Wal-Mart was once David, not Goliath.

I write this on the Black-Board: CONVENTIONAL WISDOM: A Full-line discount store needs a population base of at least 100,000. The question for the group is simple: Why has Wal-Mart been so successful? To start, I call on Bill, who had some experience in sales during the earlier part of his career. He begins with the ritual invocation of founder Sam Walton’s leadership. Neither agreeing nor disagreeing, I write “Sam Walton” on the board and press him further. “What did Walton do that made a difference?”

Bill looks at my labeled box on the board and says, “Walton broke the conventional wisdom. He put big stores in small towns. Wal-Mart had everyday low prices. Wal-Mart ran a computerized warehousing and trucking system to manage the movement of stock into stores. It was non-union. It had low administrative expenses.” It takes about thirty minutes for six other participants to flesh out this list. They are willing to throw anything into the bin, and I don’t stop them. I prod for detail and context, asking, “How big were the stores?” “How small were the towns?” “How did the computerized logistics system work?” And “What did Wal-Mart do to keep its administrative expenses so low?”

As the responses flood in, three diagrams take shape on the white-board. A circle appears, representing a small town of ten thousand persons. A large box drawn in the circle represents a forty-five thousand square foot store. A second diagram of the logistical system emerges. A square box represents a regional distribution center. From the box, a line marks the path of a truck, swooping out to pass by some of the 150 stores served by the distribution center. On the return path, the line passes vendors, picking up pallets of goods. The line plunges back to the square, where an “X” denotes cross-docking to an outgoing truck. Lines of a different color depict the data flows, from the store to a central computer, and then out to vendors and the distribution center.

Finally, as we discuss the management system, I draw the path of the regional managers as they follow a weekly circuit: Fly out from Bentonville, Ark., on Monday, visit stores, pick up and distribute information, and return to Bentonville on Thursday for group meeting on Friday and Saturday. The last two diagrams are eerily similar—both revealing the hub structure of efficient distribution.

The discussion slows. We have gotten most of the facts out; I look around the room, trying to include them all, and say, “If the policies you have listed are the reasons for Wal-Mart’s success, and if this case was published—let’s see—in 1986, then why was the company able to run rampant over Kmart for the next decade? Wasn’t the formula obvious? Where was the competition?”

Silence….This question breaks the pleasant five-and take of reciting case facts. The case actually says almost nothing about competition, referring broadly to the discounting industry. But surely executives and MBA students would have thought about this in preparing for this discussion. Yet it is totally predictable that they will not. Because the case does not focus on competition, neither do they. I know it will turn out this way—it always does.

Half of what alert participants learn in a strategy exercise is to consider the competition even when no one tells you to do it in advance. Looking just at the actions of a winning firm, you see only part of the picture. Whenever an organization succeeds greatly, there is also at the same time, either blocked or failed competition. Sometimes competition is blocked because an innovator holds a patent or some other legal claim to a temporary monopoly. But there may also be a natural reason imitation is difficult or very costly. Wal-Mart’s advantage must stem from something that competitors cannot easily copy, or do not comply because of inertia and incompetence.

In the case of Wal-Mart, the principal competitive failure was Kmart. Originally named the S.S. Kresge Corporation, Kmart was once the leader in low-cost variety retailing It spent much of the 1970s and 1980s expanding internationally ignoring Wal-Mart’s innovations in logistics and its growing dominance of small—tow2n discount. It filed for bankruptcy in 2002. After some moments I ask a more pointed question: Both Wal-Mart and Kmart began to install bar-code scanners at cash registers in the early 1980s. Why did Wal-Mart seem to benefit from this more than Kmart?

Wal-Mart Discount Stores’ Operations 1985 Case Study Analysis

 Capital isn’t scarce; vision is.

Each Wal-Mart store should reflect the values of its customers and support the vision they hold for their community.
High expectations are the key to everything.
I had to pick myself up and get on with it, do it all over again, only even better this time.
I have always been driven to buck the system, to innovate, to take things beyond where they’ve been.
Outstanding leaders go out of their way to boost the self-esteem of their personnel. If people believe in themselves, it’s amazing what they can accomplish.
There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else.
We let folks know we’re interested in them and that they’re vital to us. cause they are.
We’re all working together; that’s the secret.
               — All quotes are from Sam Walton

Wal-Mart Case Study 1986

Analysis of Wal-Mart http://www.scribd.com/doc/78543427/WMT-Case-Study-1-Analysis

See: http://www.scribd.com/doc/78527294/Wmt-50-Year-Chart

Who wants to move deeper into analyzing WMT and see the HBS Case on WMT for 2003? …………or

Ready to move onto to the Coors Beer Case Study which is a lesson on what happens if a company loses its regional economies of scale advantage?

Lessons learned so far?

If you had read this case study when it was published in 1986 would you have bought WMT and held on for five or seven years?  What analysis would you need to do?

Tomorrow I will post another strategic view of Wal-Mart so you can see other perspectives.

Economics and QE2 Explained with Cartoons; A Future Case Study: Amazon

The First Economist

Hayek’s Road to Serfdom

A Reader’s Digest Version–thirty pages–of Hayek’s Road to Serfdom, plus cartoons.  Hayek and Mises both predicted the inevitable collapse of socialism and fascism. http://www.cblpi.org/ftp/Econ/RoadtoSerfdom

_ReadersDigest_and_Cartoon_Versions.pdf

Quantitative Easing explained in a cartoon video. http://www.youtube.com/watch?v=PTUY16CkS-k  About five million viewers have watched this video of two bears (dogs?) asking simple questions about monetary policy.  The theory at issue here is Keynesianism  which assumes that stimuli from government, a category that includes QE2 (Quant. Easing for the second time), are beneficial. Really? Why?  If economics can neither be explained in plain English nor understood then it’s probably bunk.

For a Future Case Study on Moats

http://www.nytimes.com/2011/12/17/business/at-amazon-jeff-bezos-talks-long-term-and-means-it.html?_r=2&ref=jamesbstewart&pagewanted=print

Amazon Says Long Term And Means It By

In 1997, the year Amazon.com went public, its chief executive, Jeff Bezos, issued a manifesto: “It’s all about the long term,” he said. He warned shareholders “we may make decisions and weigh tradeoffs differently than some companies” and urged them to make sure that a long-term approach “is consistent with your investment policy.” Amazon’s management and employees “are working to build something important, something that matters to our customers, something that we can tell our grandchildren about,” he added.

But shareholders seem never to have gotten the message. In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. This week they were trading even lower, at $181.

Over the years, Amazon shares have been periodically buffeted by short-term results that seem to have disappointed investors. “The stock has been bumpy,” a Morgan Stanley analyst, Scott Devitt, told me this week. “Investor trust seems to go in cycles.”

The notion that public companies should maximize shareholder value by managing for the long term is pretty much gospel among good-governance proponents and management experts. Jack Welch advanced the concept in a seminal 1981 speech at the Pierre Hotel in New York and elaborated on it in subsequent books and articles while running General Electric, when G.E. was widely lauded as the best-managed company in the country. It has been especially championed in Silicon Valley, where technology companies like Google have openly scorned Wall Street analysts and their obsession with quarterly estimates and results by refusing to issue earnings guidance.

Amazon, in particular, has been true to its word to manage for the long term. It remains one of the world’s leading growth companies and its stock has soared 12,200 percent since its public offering. In late October it reported quarterly revenue growth of 44 percent to almost $11 billion, which came on the heels of 80 percent growth a year ago. “We’re seeing the best growth which we’ve seen since 2000, meaning in 2010 and so far over the past 12 months ending September,” the chief financial officer, Thomas Szkutak, told investors in October. But operating earnings fell sharply to $79 million. While that was in line with most estimates, Amazon offered a forecast for the fourth quarter in which it said it might lose as much as $200 million or earn as much as $250 million, and even the high end would represent a 47 percent drop.

The reason Amazon is earning so little while selling so much is that it is spending so much on long-term growth. It’s opening 17 new fulfillment centers — airport hangar-size storage and shipping facilities — this year and aggressively cutting prices. Its profit margin for the quarter was just 2.4 percent, and it said it might be zero for the fourth quarter. (By comparison, Wal-Mart’s margins are 6 percent on revenue of $440 billion. )

Amazon seems to be taking customer focus to new levels, willing to run its ever-bigger global business while earning little or nothing in return. To the dismay of some, Mr. Bezos even takes a long-term view of price cuts. “With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease,” he told shareholders in 2005. But that kind of thinking, he added, is “short term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or 10 years or more.” Selling at low prices may undercut profits, but they create “a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com,” Mr. Bezos said.

Amazon has done little to dampen speculation that it is selling its revamped Kindle e-reader devices and its recently introduced Fire tablet at a loss. Amazon simply doesn’t think like most other companies. When “we think about the economics of the Kindle business, we think about the totality,” Mr. Szkutak said. “We think of the lifetime value of those devices. So we’re not just thinking about the economics of the device and the accessories. We’re thinking about the content.” In other words, profits will come down the road when Kindle users buy content through Amazon.

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people,” Mr. Bezos told reporter Steve Levy last month in an interview in Wired. “But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn.”

Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.”

For Amazon, long-term growth confers two major benefits: the kind of economies of scale enjoyed by Wal-Mart and eliminating or weakening competitors. The book retailer Borders has been forced out of business and a rival, Barnes & Noble, is struggling. Best Buy, the electronics retailer, reported this week that earnings plunged 29 percent, despite higher revenue and a surge of Black Friday sales, because the chain had to cut prices and offer free shipping to compete with Amazon. Amazon inflamed many competitors this holiday season by offering extra discounts to shoppers who took mobile devices into stores and then used them to compare prices and order from Amazon.

The revamped Kindle line and especially the new Fire tablet illustrate Amazon’s long-term strategy. “Amazon has much greater ambitions than near-term profits or margins,” Ken Sena, an Evercore analyst, said.

“Some people are griping that the Fire is sub-par,” Mr. Sena continued. “It’s not an iPad. And some investors are confused. Why would they give it away, even lose money on it? But getting it into as many hands as possible is important to them. They’ll use it to drive higher physical and digital good sales on their site. And these devices also bring Amazon deeper into the local retail opportunity, not to mention the app marketplace potential that exists. Media sales on the device are just the beginning. I think Amazon understands all these components.”

The Fire “isn’t meant to be another iPad,” Mr. Devitt noted. “It’s a device to sell Amazon content. All indications are it’s a success. It’s the most gifted item on Amazon. It’s too soon to tell, but it seems more promising than it’s getting credit for.” This week Amazon said it had sold more than a million Kindles a week for the last three weeks.

Nearly 15 years after Amazon’s public offering, it’s safe to say that Mr. Bezos and his colleagues have realized their goal of creating a company to tell their grandchildren about. But one of these days Amazon has to deliver on its promise of higher margins and profits, however long term that may turn out to be. “To many investors, long term is a year,” Mr. Devitt said. “For Bezos, he’s looking at a 10- to 20-year time line. When he says long term, he means 2020 or 2030.”

Now from http://ycharts.com/  Amazon: Free Shipping and Low Prices Don’t Add Up To a Moat By Jeff Bailey

The smartest guy in financial journalism, James B. Stewart, earlier this month in his Saturday New York Times column, praised Amazon (AMZN) for taking the long view in building its business and criticized the company’s critics for failing to appreciate the company’s steadfastness. (See above.)

Amazon revenue continues to rise spectacularly. Its profits, however, have fallen, as margins are squeezed by aggressive product pricing and surging use of the company’s popular free-shipping option. So, the question seems to be, will those strategies help Amazon build what Warren Buffett would call a moat – a protective fortress around its business that long-term allows it to reap substantial profits and build value?

Stewart, author of several fabulous business books, including “Den of Thieves,” about the late-1980s Wall Street scandals, and a Pulitzer Prize winner for his work at the Wall Street Journal, is such a well-regarded thinker about companies that we at YCharts were forced to stop and consider his point of view; he’s not just another pro-Amazon tout.

We have regularly written that we view Amazon as overvalued and have marveled at how its recent growth has made it less profitable, not more so.

The critics have certainly influenced Amazon’s share price in recent months.

Amazon.com Stock Chart by YCharts

Yet the PE remains in the 90s, and this for a company with a plunging and razor-thin profit margin.

Amazon.com PE Ratio Chart by YCharts

Stewart’s admiration of Amazon certainly makes sense if you’re an Amazon customer. The service is wonderful, and like so many American shoppers during this holiday season we have ventured into actual stores very few times because shopping online – from Amazon and its many imitators – is so much easier. That change in consumer behavior seems to suggest a moat is forming. But does the moat encircle Amazon protectively, or is it instead a moat encircling bricks-and-mortar retailers into a market-share-losing ghetto?

The brutal price-comparison ethic Amazon unleashed on the book business years ago helped it take huge market share. But it also rendered the book business less profitable for all players. And as that ethic unfolds across product categories – aided most recently by Amazon’s Price Check app – results at Amazon and Best Buy (BBY) would suggest the greater transparency on pricing is helping consumers, but not so much retailers.

Running Borders out of business, sadly for Amazon and other booksellers, didn’t make the book business more profitable again. Rather, the pricing model Amazon brought to the market seems to have rendered book retailing a crummier business. And it’s also unlikely that consumer electronics and the other categories Amazon is transforming will, once a few large competitors go bust, miraculously become more profitable. There isn’t a shortage of players in any of these markets and the consumer behavior Amazon helped spur – constant price shopping, demanding free or reduced-priced shipping – would seem impossible to reverse.

The Wall Street Journal recently noted the toll free shipping is taking on retailers’ profits. The Journal, noting Amazon’s shrinking margins, said, “Free shipping has likely played a meaningful role in this, although the company hasn’t detailed the cost.”

Actually, Amazon does detail the cost in its 10-K filings (page 26). Its net shipping costs – total shipping costs minus what Amazon collects from customers for shipping – totaled $1.39 billion in 2010, up 63% from $849 million the prior year. Total sales were only growing by 40%. So net shipping costs were equal to 4% of sales in 2010, versus 3.4% in 2009. That trend may have accelerated during 2011, and could largely explain why profits have fallen.

The strategy Stewart lauds is doing a bang-up job of boosting revenue. And consumers love Amazon’s service. But it’s hard to see how the company is going to fatten its margins when competition remains fierce; consumers have been taught to demand low-low prices (and free shipping); and beyond elegant technology, Amazon’s main tools for attracting consumers are both margin killers — low-low prices and free shipping.

Certainly the Kindle is an attempt to build a moat around Amazon’s book business. Selling the devices at what has been reported as a loss suggests the company sees future payoff from Kindle-owning consumers downloading their reading (no shipping expense here) exclusively from Amazon. But in the more general merchandise categories that increasingly make up Amazon’s sales, it’s hard to see how to insert such a loyalty device.

Stewart’s argument seems in part based on the notion that, forgoing current profits, Amazon must be managing for the long term. But if your very pricey stock is reliant on spectacular revenue growth, a cynic might reason that a strategy of adding sales — even if they’re increasingly less profitable (or money-losing) – appears short-term and somewhat desperate.

Amazon management is smart, as is Jim Stewart, and investors could be inviting ruin by shorting Amazon shares. But to us, the company hasn’t made a persuasive case that it’s building a moat – just that it’s delivering great service and selling stuff cheaper than the next guy.   End.

Let’s revisit our study of whether Amazon has a competitive advantage or not after we finish our study of Competition Demystified (in the VALUE VAULT).