Atomic Energy

A colleague of mine in Israel, Yishai Boasson, recently wrote an article analyzing the perceived and actual value of a “special promotion.” This article, available here, is only in Hebrew. As it is an interesting analysis and an excellent example of the importance of distinguishing between sales and profits, it is worth translating here for the larger English-speaking audience. It is also, in itself, an example of how numbers can trip you up.

Original Analysis

In honour of Israel’s Independence Day, which this year was on Wednesday, April 29, 2009, the large supermarket chain Rami-Levy decided to have a special promotion of a half-kilogram (about 1 pound) of Kebab plus one kilogram (about 2 pounds) of hummous for just one New Israeli Shekel (NIS). The exchange rate has been fluctuating, but we can roughly estimate it at 4NIS=1USD, which means you could but a pound of meat and two pounds of hummous for $0.25. The apparent value of the kebab plus hummous special is around 30NIS. It is unclear from the original article Yishai quotes whether this is the retail price, i.e. the value of the gift includes foregone profit, or if this is just the variable cost, i.e. the value is just the direct cost to Rami-Levy. Either way, the supermarket chain is believed to have brought in 100,000 customers, each of whom spend about 200NIS, for total revenues of 20MM NIS.

As a general rule, supermarket chains run on very thin margins. Yishai decided to be very generous and assume they are operating at 10% margins. If so, then the profit from this little promotion was 10%*20MM NIS = 2MM NIS. Of course, Rami-Levy also gave up 100,000 customers * 30NIS per special package = 3MM NIS. The net result is that this little promotion brought in 2MM NIS in profit, at a cost of 3MM in marketing.

First rule of thumb in marketing: if your marketing costs exceed the profit generated by that marketing, it was a bad idea. Spending 3MM NIS to get 2MM NIS in profit is a good way to go out of business fast. Let’s only hope they don’t decide to “make it up in volume.”

Digging even deeper, the picture gets worse:

1. It is not at all clear that the 100,000 customers are actually new. How many of them would have come to Rami-Levy anyways, even without the promotion?
2. How many customers did Rami-Levy lose? While many people do come in for special promotions, many others are unwilling to deal with the mob, and are just fine paying the extra 30NIS (or $7.50) for their kebab and hummous, rather than fight the madhouse. Worse, those people who are willing to forgo the special to avoid the lines are precisely the customers that are most likely to spend more money at the supermarket.
3. Rami-Levy’s margins are undoubtedly below 10%, with some analyses putting them at around 6.5% or lower.

This analysis correctly highlights that the value of any investment is not the sales return from the investment but the profit return from it. Spending 1MM to get 10MM in sales may or may not be a good idea… depending on the gross margins of those 10MM, and alternative uses of cash.

Other Benefits

Several commenters on the original article pointed out that Rami-Levy may have had larger goals, that may have justified the net 1MM (or more) loss. These include: savings on general marketing or growth of a certain department. Additional values may have been: savings on launching costs for a new store or series of stores, and clearing out inventory. Although margins are low, inventory that might have been close to end of shelf life are worthless unless they can be cleared. A 5NIS loaf of bread is worth 0.5NIS to the bottom line at 10% gross margins… but it is worth a full 5NIS if the alternative is to completely discard it.

The Flaw in the Numbers

Last, but not least, there is one strong flaw in the analysis: the low margins are operating, not gross. While supermarkets do not normally have very high gross margins either, they tend to be much higher than 5% or 6%. We can analyze Publix, a large US-based supermarket chain, Publix, which is a public company and therefore has a publicly available 10K. In 2008, it had $24MM in revenue and $17.5MM in COGS, for an operating margin of 27%, over 4 times the 6.5% operating margins of Rami-Levy. Publix operates on even thinner operating margins than Rami-Levy, despite being a much larger chain, and thus likely has lower gross margins as well. Thus, it is not impossible that Rami-Levy actually lost quite a bit less, or broke even on the promotion, depending on what its gross margins are.

Conclusion

In sum, we see that numbers are very powerful but seductive. In our case study, we needed to watch for two things:

1. Don’t confuse revenues with profits when calculating return on investment.
2. Don’t confuse operating margins with gross margins when calculating profitability.

As any manager of a (successful) business will tell you, the two most important factors are:

• Cash – as in “cash is king”. You need cash to pay your payables. If you do not have enough cash, you cannot meet basic obligations, let alone invest in expansion. Cash generally comes from sales, particularly from converting receivables to cash. Never confuse the accounts receivable asset with the cash asset. Although there are receivable-based financing options, most of which are quite expensive, you normally cannot pay your bills with a receivable. Try telling your engineer that, this week, instead of direct deposit of her paycheck, she will receive a receivable from customer X! Additionally, cash can come from investors, to support expansion or growth in a time of negative profitability, until profitability is reached.
• Gross margins – gross margins provide the excess over costs of sales (for services) or costs of goods sold (for products) to cover fixed costs, not to mention create operating profit for the owner(s).

Norm Brodsky, in his columns in Inc magazine as well as his book “The Knack” hammers home, again and again, how important gross margins are. As an aside, one of my favourite lines is the story of the manager who, upon being told that each product is being sold at a loss, i.e. negative gross margins, says, “no problem, we will make it up in volume!”

The two major factors that go into COGS (in the rest of this article, we will use COGS and COS interchangeably) are:

• Product costs – materials, labour, transportation, etc.
• Sales – commissions, channel costs, etc.

Assume Linksys sells a router for $100. If the cost of materials (plastic, chips, antenna, power supply, shipping, manufacturing) is $50, and they pay a 30% channel commission, i.e. $30, then gross margins are $20. Obviously, besides increasing prices, the two primary methods of increasing gross margins are:

1. Reduce manufacturing costs, through one or more of: more efficient processes, lower-cost materials, better economies of scale, etc.
2. Reduce sales costs, either through having each sales unit (e.g. salesperson) on a fixed cost sell more product, or reduce commissions to sales units, i.e. reduce the commission rates.

Clearly, the choice of sales channel, and its costs, has a significant impact on gross margins and, hence profitability.

This insight is very important when analyzing how to structure a new business. We will analyze two potential similar businesses, both based on actual business plan case studies, to see how these costs impact the choice of channel.

Business Overviews

Both of our businesses sell security software. To protect their privacy, we cannot disclose exactly what are of security, but suffice it to say that it is software that is usable only to businesses. The software is very similar, except that company S sells to small-to-midsize businesses (SMB), while company E sells to enterprises. S’s SMB targets have average revenues of $20-100MM; E’s targets have average revenues of $250MM to $BN+. SMB businesses are likely to have, at most, 1,000 employees. Enterprises will have, at minimum, twice that, and most will have 10,000 or more. Given the value of security at the larger scales, the minimum price point of E’s sales at an enterprise is at least $100k, and maximum sale price of $250k. By contrast, S’s minimum price point is $10k, and maximum sale price of $25k. Given the different market sizes and complexity of usage, it is not surprising that S’s minimum and maximum sales are 10% that of E. Both S and E wish to follow the traditional salesperson model. A salesperson, in both cases, makes direct sales calls, and closes each deal.

Enterprise

Given the complexity of E’s customers – both organizationally and in terms of deployment – it is unsurprising that E prefers the inside sales model. This model actually works quite well for them. Following our assumption of the minimum price point of $100k, our salesperson is earning a 20% commission. In the real world, some earn more, some earn less, but this number works for our purposes, and is close to the average assumed in the actual business studied. Our salesperson, being a star, wishes to earn at least $200k per year. Given that his commission is 20%, that means he needs to bring in $1MM per year in sales. Since the minimum sale size is $100k, he needs to make 10 minimum size sales per year, or just under one per month. For a good salesperson, this is eminently reasonable. 160 hours (4 weeks * 40 hours per week), is a reasonable amount of time to spend on closing a large deal. Additionally, since the maximum sale size is $250k, this salesperson likely will earn significantly more.

Enterprise Summary: Required minimum of $1MM per year in sales, for 10 sales per year.

SMB

S actually would prefer to avoid using a salesperson. S seriously investigated using distributors and other channels. However, these channels generally take 30% (sometimes more), and, more importantly, tend not to stock a product until there is significant customer demand. Given the higher COS (and hence lower gross margins and profitability), as well as the chicken-and-egg problem of distributors not taking product until there is demand, but no ability to generate demand without some sales and reasonable cash flow for marketing, S falls back on the same strategy as E: sales staff.

We follow our above assumption that the minimum price point is $10k. As with E, our salesperson earns a commission of 20%. Our salesperson, of course, also wants to earn at least $200k per year, which means at least $1MM per sales each year. However, since the minimum price point is $10k, our salesperson must make not 10 but 100 sales per year. With 52 weeks in the year, she must sell two products every single week. This gives her 20 hours to sell each product. This is extremely difficult, if not impossible, to do as a salesperson reaching out to customers. Even with the maximum sale at $25k, she would have to make just under a sale a week, if every single sale were at the maximum.

SMB Summary: Required minimum of $1MM per year in sales, for 100 sales per year, an unachievable target.

Alternate Paths

Clearly, our SMB is in a bind. If it uses distributors, it has no viable channel until customers demand the products. If it uses sales staff, it can either (a) increase commission rates to retain staff, thus killing gross margins and profitability or (b) expect to lose sales the staff, with a high turnover rate and an inability to attract savvy salespersons, as a quick analysis shows it to be physically impossible to make enough sales to earn the desired amount of income.

What does the SMB do, then? It has several possibilities:

• Raise investment funds, which will allow it to unprofitably invest heavily in marketing and inside sales for the first one to two years, at a loss. At that point, sufficient demand should exist in the marketplace to allow it to use other channels that will be more profitable than a dedicated sales staff.
• Increase prices significantly, essentially moving into E’s turf, or somewhere around the top of its market and the bottom of E’s.
• Use Web distribution channels. This idea was raised by Mike Baird, author of “Engineering You Start-Up“. Mike’s argument is that in order to reach SMBs, you need to engineer and simplify your product sufficiently that it can be explained – value and installation – on the Web, and thus marketed and sold through Internet channels.

Assuming the SMB does not want to change markets because, for example, it has identified a large enough and strong enough niche, or the E space is already too competitive, and it does not want to or cannot raise investment funds, then the third choice is the best. Additionally, from a market product perspective, this is the best choice. Enterprises have large and complex environments, with advanced and highly-paid IT staff. Enterprises are the ones that need and can use complex products. SMBs rarely have such large staff, and normally have a fairly simple environment. The product from S must meet all of the needs of the customers, but must do so as simply as possible. Thus, not just for sales and distribution reasons, but also for core market reasons, Mike’s point is accurate.

Conclusion

Inside sales is rarely the best choice for a sales channel, unless all of the following are true:

1. The price-point is at least $100k per sales, and preferably more.
2. The organization to which you are selling is complex and requires a lot of handholding to get the deal done.
3. The environment into which your product will be installed is complex technically, with advanced staff, and requires customization and/or advanced features for proper installation.

No, this article will definitely not be a Bible sermon. However, it will look at the success levels of two fairly well to-do Israeli companies, and try to get a bit of understanding as to why the land of the Jewish Prophets is not as successful as it might be with Israeli Profits.

Before we begin, it is important to note that this article will not delve into macroeconomic policy. Policy leads to politics, which is absolutely necessary, but writing about it, in this context, is not good for business. We will focus solely on two public Israeli companies, as well as certain macroeconomic data about the State of Israel.

First, the overall view.

• Israel has a population, as of the end of 2008, of 7.4MM people (Israel Central Bureau of Statistics).
• Israel has a GDP of $202BN in 2008 (IMF).
• Israel has a GDP per capita of $28,365 (IMF). Yes, these numbers don’t quite add up, due to a slight variance in how the IMF calculates population, and its averages over the year, as opposed to point-in-time census.

By comparison, the United States has a GDP per capita of $46,859, and the UK has a GDP per capita of $43,785. On the other hand, Israel far exceeds its neighbours’ GDP per capita, with Egypt at $2,161, Syria at $2,757, Jordan at $3,421, and only Saudi Arabia coming somewhat closer, largely due to oil revenues, at $19,345.

The interesting question is why Israel, with its highly educated workforce, intense innovation and entrepreneurial drive, and multilingual and multicultural workforce, as well as a network of expats around the world, has a GDP of only slightly more than half that of the US and the UK. Interestingly, even in highly educated industries and roles, for example C-level executives, engineers and top academics, the income scales are also normally one third to one half of those for comparable roles in the United States, ignoring the very highly paid executives of American multinationals, the equivalent of which largely does not exist in Israel, due to its small population size, approximately 1/28th that of the United States or the Euro zone.

Rather than delving into macroeconomic management (or mismanagement), although much of that does exist here, we will take the microeconomic view. Many of the larger Israeli conglomerates, like Koor and Klal, are vestiges of the statist/socialist days of the Israeli economy, prior to the economic liberalizations of the 1980s and 1990s. Much of the growth engine of Israel in the last two decades has been due to innovative firms in what is called “high-tech” in Israel, the software, security, hardware, Web, biotechnology and energy sectors. As such, let us investigate two firms that are distinctly “high-tech”, have been successful enough to live on their own revenues and even go public, analyze their results, and determine what insights are available.

The two companies we will explore are AudioCodes, manufacturer of Voice over IP, or VoIP, hardware and software, and NICE, manufacturer of enterprise and security information technology products.

For the years 2005 through 2007, the last year for which publicly released financial information is available, AudioCodes had revenues that grew from $116M through $147MM to $158MM, an annual growth rate of 26% in 2006 and 7.5% in 2007. These are undoubtedly respectable growth numbers, especially in a sector that has major players in the market, such as Cisco, Nortel and other technology behemoths. Now, let us turn to operating profit. In 2005, operating income was $12.5MM, or 11%. In 2006, operating income was $4.3MM, or 2.9%. In 2007, operating income was ($4.2MM), or -2.7%. Immediately, we can see that even before the recession, as AudioCodes grew its revenue impressively, its operating margins shrunk and then turned to a loss. Further, even before the shrinkage, in 2005, operating margins were at 11%. By contrast, in 2005, competitor Cisco had operating margins of $5.7BN on $21BN in revenues, or 27%. While one can argue that VoIP products are a small subset of Cisco’s business, it is highly unlikely that Cisco would go into any business where it could not foresee maintaining its margins.

If we look at NICE, we see a similar pattern. NICE is much larger than AudioCodes, with 2005 through 2007 sales of $311MM, $410MM and $517MM, respectively. Once again, however, its net income is $32.1MM (10.3%), $17.1MM (4.2%) or, excluding a one-time in-process R&D write-off, $30MM (7.3%), and $33MM (6.4%). Like AudioCodes, despite healthy and growing revenues, and a scale that is sufficient to be solidly profitable, NICE is stuck in low operating margin territory.

Two questions arise from this analysis:

1. Why are these two companies operating with such terribly low margins?
2. What impact does this state of affairs have on the health and robustness of the Israeli economy and GDP per capita?

The answer to the first question, of course, is that it takes some real time on the inside of the company – top-down financial and operations analysis and bottom-up walking the floor, talking to staff and customers, and seeing what is going on inside – to understand why. Nonetheless, there is no reason for these companies to be operating at such a low-level of profitability.

The answer to the second question is, “a lot.”

• GDP is defined as the total income of the economy. If these businesses, engines of economic growth in the most dynamic sector, are having such low income, then GDP is directly reduced. With a constant population base, GDP per capita is reduced.
• With such anemic returns from even successful companies, investors will be hesitant to invest in them, or other similar companies. This reduction in investment directly leads to lost growth opportunities and reduced GDP. With the same population base, GDP per capita, again, is reduced.
• With very low returns for the same staff size, company profitability per employee (i.e. productivity) is much lower. The employees themselves may or may not be less productive than their US counterparts. However, for the company as a whole, profit per employee is low, and hence both the willingness to invest in more employees and the desire to pay them more, is reduced, directly reducing the human component of GDP and GDP per capita.

As we can see, despite the miracle of Israeli growth over the last two decades, and the brilliance of its entrepreneurs, many of its more mature companies are focused too intensely on revenues, at the direct expense of profitability. This is not a shortcoming unique to Israeli managers; most entrepreneurs, owners and CEOs are top-line driven rather than bottom-line focused. It is for this purpose that COOs exist. However, the pattern is likely having a negative impact on Israeli GDP, GDP per capita, investment and salary levels. Improving these numbers using real operations expertise is crucial.

In the years 2006-2008, Google earned, respectively, $10.5BN, $16.4BN and $21.1BN in advertising revenues. With net income of $3-4BN each of those three years, it is hardly surprising that “free supported by advertising” became the model of choice for many an aspiring startup, as well as many non-startup businesses. During the latest mini-bubble of venture investing, it was nearly impossible for an online company to get an investor’s meeting if your business plan was not based on the presumption that your services would be free and paid for by advertising.

In the 12-18 months since the investing bubble collapsed, and investors went into a deep freeze not that different from what occurred in 2001-2002, the value of the advertising model has been severely questioned. Whether using CPC (cost per click) or CPM (cost per thousand impressions), the rate for each of these has gone down. In some cases it actually has gone down; in others, the assumptions of CPMs and impressions (or CPC and click-rates) was dramatically overstated. In January, AdAge reported that a study from the Interactive Advertising Bureau and Bain Capital was showing CPM rates on ad networks of $0.60 to $1.10, with their own direct sales of $6-10. The report indicated that (a) those 10x multiples for direct sales were likely overstated and (b) online publishers were only able to unload around 1/3 of their ad space inventory directly anyways.

Assuming the high CPM of even $1.00, an online services company that wants, say, a small $1MM in revenue, needs to have 1BN impressions per year ($1.00 CPM means 1,000 impressions makes $1.00, times 1MM to make 1BN impressions). Over 12 months, that is 83MM impressions per month. If we assume that each unique visitor visits once per week, and sees 10 pages, and each page has 3 ads, then each unique visitor sees 120 impressions. For 83MM impressions per month, this company needs nearly 700,000 unique visitors each and every month, just to clear $1MM per year in sales. Of course, these numbers change if:

• Like most sites, visitors see fewer pages per visit, reducing revenue.
• Visitors visit more or less frequently than weekly.
• The site has some strong unique niche, like ClubMom, that can command higher CPMs.
• The site does not have a strong unique niche, and thus gets much lower CPMs.
• The site does not have 700,000 unique visitors per month, a fairly high number.

Essentially, just to clear $1MM in annual revenues, the site needs to have many regular, loyal, high-usage visitors.

Conversely, if the site managed to sell to each of these unique visitors at just $5 per month (the model used by backup services, like Mozy), then it would generate $3.5MM per month in sales with the same number of visitors. Those kinds of numbers could even attract professional investors. Clearly, if you can sell instead of using a three-way (service provider, user, advertiser) model, it is far more revenue-intense and, likely, profitable. Of course, paying customers demand a whole different level of service, but $42MM per year can pay for a lot of customer service.

Two interesting case studies came out in the last several months that illustrate this concept.

• YouTube vs. iPhone vs. Kindle: On June 15, 2009, Business Insider published a report by Goldman Sachs analyst James Mitchell. In it, he showed how YouTube revenues were essentially on par with iPhone App Store and Amazon Kindle eBook sales in 2008, while eBooks should double YouTube revenues by 2010, while iPhone App Store revenues will be quadruple YouTube revenues in the same year. It is important to note that YouTube has 71MM unique monthly visitors, according to its own information, and has been around for over 4 years. The iPhone, by contrast, has been around for 2 years, with the App Store somewhat less, and certainly nowhere near open enough to encourage heavy usage until into 2008. The Kindle launched a few months after the iPhone, and is thus even younger. Essentially, one of the hottest properties on the Internet, with an enormous number of visitors, cannot match direct e-sales products half its age. Interestingly, both iPhone Apps and Kindle eBooks are of the same essential format as YouTube videos: 3rd-party content. In the case of YouTube, it is user-generated videos; in the case of the App Store, it is overwhelmingly 3rd-party developers; in the case of the Kindle, it is 100% publisher-author provided books. If we compare users, as stated, YouTube has 71MM unique monthly visitors, while the total number of iPhones sold by Apple is slightly over 20MM, and the number of Kindles is almost certainly below 1MM. With fewer than 1/3 the users, and half the life, iPhone App Store and Kindle eBooks are handily putting YouTube in its place. Finally, notice that we are discussing revenues, not profits. Video is notoriously expensive. It requires a lot of bandwidth, even with advanced encoding such as mp4, and a lot of processing and memory. There is no doubt that the fixed and variable costs for YouTube far exceed those of the App Store and Kindle eBooks.
• iPhone App advertising: A great company, based in New York, is Pinchmedia. Pinchmedia is one of several companies (another excellent one is Medialets) that provide in-application advertising and metrics (akin to analytics such as Google’s Analytics) for iPhone applications. Earlier this year, Greg Yardley, the founder and CEO of Pinchmedia released a fascinating study based on the analytics his service has provided in 30MM downloaded applications. The report is available here, and is worth reading. It is a masterpiece of data analysis. The net result of his analysis is the following. Free applications, on average, are used 6.6 times more than paid ones. Since the minimum price is $0.99, and Apple keeps 30%, at minimum a paid application returns $0.70 per user. But since free applications are used at most 80 times per user, based on Pinchmedia’s analytics, then to make advertising worth it, 80 usages would have to generate at least $0.70 per user. $0.70 in 80 sessions is an equivalent of $8.75 CPM, if one ad is shown per session. Yet, Pinchmedia is seeing CPMs more on the order of $0.50 to, at the most, $2.00. Essentially, unless you have a very high usage application, one in which there are lots of advertising opportunities, i.e. users stay in the application a lot and return to the application far in excess of the average 80 usages, or, if the application has a much stronger than 6.6:1 ratio of free:paid, because of the inherent nature of the application, you are unlikely to recoup anything near the revenue of selling the application.

Summarizing, selling directly to the end-user beneficiary is far normally much better for your revenue than advertising, Google’s search business notwithstanding. There are instances in which advertising-supported free services do, indeed, make a lot of sense, and need to be examined on a case-by-case basis. This brings back to mind the late 90s Internet bubble, when revenues did not matter, all that investors and managers looked at were “new economy” metrics, primarily “eyeballs.” Once again, the market has reasserted itself. There are businesses wherein advertising-based works on the Internet, just as it does in the real world. Clearly, however, in most cases, free can be very expensive indeed.

On Tuesday, 2009.06.24, Oracle posted its fiscal fourth quarter results for the period ending 2009.05.31, as well as the “guidance” for future earnings. We won’t get into the value of this guidance, and the impact it has on running the business. However, an interesting nugget – perhaps a daydream – was buried in the announcement. Oracle stated that the current guidance does not include expected revenues from its pending acquisition of Sun Microsystems. It does expect the deal to close in the current quarter, i.e. before the end of August 2009; Sun shareholders are scheduled to vote on the deal on 2009.07.16. However, Oracle did state that it expects Sun to contribute $1.5BN in operating profit to Oracle in the first year after the deal closes.

Of course, when a company executive predicts the value of an acquisition, especially in the short-term (one year), it is always worth looking at the numbers.

Sun Profits

According to Sun’s SEC filings, in the three years 2006-2008, it had total revenues of $13.1BN, $13.9BN and $13.9BN. It also had costs of sales of $7.4BN, $7.6BN and $7.4BN, respectively, for gross margins of $5.6BN (43%), $6.3BN (46%) and $6.5BN (47%). However, its “operating expenses”, primarily R&D and SG&A, were $6.5BN, $6.0BN and $6.1BN.

Over the three years, that left Sun with an operating profit (loss) of ($870MM -6.6%), $309MM 2.2%  and $372MM 2.7%.

A number of observations stand out:

1. Sun’s gross margins are too low. Although reasonably respectable in most businesses, in the tech business, margins in excess of 50% or even 60% are common and expected. This is largely because the tech business is very R&D intensive, but R&D is written off as a current year expense. By contrast, in the same period, Oracle had gross margins of 56%, 55.5% and 56.9%.
2. Sun’s operating costs – R&D and SG&A – are too high. In the last three years, Sun had costs, as a percentage of revenue, of 49.6, 43.8% and 44.3%. Again, comparing to Sun’s new partner in Oracle, we see costs of 23%, 22.5% and 22.1%.
3. As a result, Sun’s operating profit has been pitiful.

However, the absolute numbers tell the strongest story. Sun’s best year in terms of operating profit, over the last 3 years, was 2008, with $372MM in operating income. To add $1.5BN to Oracle’s bottom line, Sun’s operating profit would have to quadruple in just one year. Even assuming Oracle could massively cut costs at Sun – whether on the gross margins side or on the operating costs side – there is an enormous uplift required. Additionally, Sun’s revenue has been essentially flat over the three years.

Let us take it one step further, however, let us assume that Oracle can, with a quick wave of the wand, get Sun, at its same revenue levels, of around $13.9BN, to Oracle’s margins. Reprising 2008, that would mean Sun would have gross margins of around 56%, for gross profits of $7.8BN, and fixed costs of around 22%, or $3.1BN, for operating profit of $4.7BN. If Oracle could, indeed, get Sun to its same margin ratios, its profitability could be very high indeed. The problem is getting Sun to the right level.

1. Oracle is notorious for overpriced products and services. Sun was in the same position for many years, but had to switch in order to stave off the threat of Linux plus commodity hardware that nearly sunk it. It is entirely possible that Sun may not be able to improve its gross margins, because pricing may be lower, relative to variable costs, than Oracle can get away with.
2. Sun has a significant investment in the open-source business. This business is of great value to many customers, but may not be as profitable as Oracle would like, and may need lower margins.
3. Sun is very much a hardware company. Margins in hardware are known to be notoriously thin. Without internal information, we do not know what its per-product-line margins are. However, if Sun is playing its cards right, then high-value products like its Thumper arrays have greater margins than its commodity servers.
4. Sun has a significant investment in Java. This is a very valuable commodity to many other players, but few more so than Oracle. To some extent, Oracle reaps the benefits of Sun’s investments. Oracle is not likely to kill that source of value for itself.
5. Sun revenues may suffer. Oracle is often reviled among the open-source community, not that differently than Microsoft, which is ironic, given the years of intense rivalry between Bill Gates on the one hand and Scott McNealy & Larry Ellison on the other. Sun, on the other hand, tends to get positive reviews. Many companies who currently do business with Sun may shy away from Oracle-Sun.

Finally, it often takes a long time to get to these levels. Let us assume that Oracle gets Sun halfway there in 12 months, and that the improvement is linear over those 12 months. This is highly unlikely, as there will be an enormous investment in organizational transition, not to mention merging HR, closing the books, SEC requirements and the rest. Nevertheless, if Oracle gets Sun halfway there, then its annualized profit at the end of the year would be improved from $372MM to $2.3BN, an improvement of $2BN, which is not bad. However, Oracle claimed that the contribution to the bottom line would be $1.5BN. Using this model, the total annual contribution would be $1.3BN (average of $372MM at beginning of year and $2.3BN at end of year), close but still 13.3% below target.

Of course, all of the above is terribly optimistic. Nonetheless, it appears that this is the approach Oracle is likely to take. I do not believe Oracle will be able to execute anywhere near as quickly, and will spend far more time digesting the acquisition than it predicts. Further, the turmoil within Sun, especially among the engineers and sales staff who have a very different culture from that of Oracle, is likely to have a significant drag on integration and extracting value. It is more likely to add around $500MM, barely more than its current profitability, and at most $1BN. If Oracle manages the acquisition correctly, it is likely to see better profitability in future years.

The photo-sharing site Flickr, owned by Yahoo, is one of the top online photo-sharing sites. It hosts at least 3BN images, and has over 24MM unique visitors. One of the interesting elements about Flickr is that it tracks the cameras from which each image is uploaded. Thus, it has important insight into the camera market. It is important to note that this is a subset of the camera market – those that use Flickr. Nonetheless, the data is revealing. The key data are available here.

Note that the iPhone camera is growing steadily in usage, and, according to the graph, appears to be in usage by nearly 50% of Flickr members. Among cameraphones, the 3rd graph on the page, iPhones are taking off rapidly. Clearly, the iPhone is very popular, and becoming more so, among those using Flickr. This is unsurprising, as the target audience for Flickr – the “digiterati” – are also the primary audience of the iPhone. The two align very closely. Additionally, with its always-on connectedness, it is easier to take a picture with an iPhone camera and then immediately upload it, rather than taking one with a standalone camera, then get back to the home or office, sync with the laptop/desktop, and then upload it. As such, the growth in iPhone usage is to be expected.

Business Insider has a different take on it. On the basis of the same data, Business Insider believes that the iPhone poses a real threat (clear and present danger?) to the point and shoot cameras from major manufacturers like Nikon, Canon, Sony, etc. Although Business Insider writers often have good insight, in this case, their reading of the data is flawed. We will look at this from two angles: the data from Flickr itself, and the market as a whole.

Flickr Data

The Flickr data has several features that make their data presentation questionable, especially for the purpose of drawing any conclusions.

• The charts have no scales. This is graphing and charting 101, and even my grade school children know it from watching the CyberChase show on PBS. Without scales, we do not know if the iPhone has climbed from 10% to just over 50%, of 42% to just over 44%. Similarly, the decline in usage of the Canon EOS Digital Rebel XTi may be from 95% to 75%, or 45% to 44%, a statistical blip.
• The charts are not exclusive. Any member may be (and probably is) using more than one camera. The charts simply show the percentage of users who have, at one time or another during the period, uploaded a picture from that camera.
• The charts separate high-end cameras – Canon EOS Digital Rebel and iPhone – from point-and-shoot – Nikon Coolpix and Canon PowerShot. As these are not on the same graph, we do not know what the impact of one on the other is. Yet, the Business Insider writers attempt to draw conclusions about the future of point-and-shoot cameras from a graph that includes only high-end cameras. The people who buy and use a Canon SureShot are not the same ones, at least not for the same purpose, as those who buy a Canon EOS Digital Rebel.
• The charts reflect percentage of members, not percentage of photographs. A single iPhone camera shot would have the same impact on the charts as 100 Coolpix photographs, but someone who takes 100 Coolpix photos is likely to continue using one for his or her basic photography needs.
• The charts are “normalized” by Flickr to reflect a change in users. While a good idea, and works similarly in, for example, seasonally adjusting sales, it is highly susceptible to errors and unintentional manipulations, and cannot be relied upon without knowing the method of normalization.
• The charts rely on limited data. Flickr explicitly states that it can only determine the source camera type in about 2/3 of the photos and/or videos.
• The charts reflect only Flickr users, who are highly advanced technology users, usually younger and more comfortable with online usage.

There may or may not be a story in the charts. Whatever it is, the charts do not provide anywhere near enough information for anyone to determine if the iPhone does indeed pose a threat to point-and-shoot manufacturers. There definitely is a story in how (not) to use statistics.

Market Information

According to Apple, in the two years since launch, it has sold about 21MM iPhones. Every single one of these sales either involved a very expensive unlocked iPhone, or a monthly commitment for 2 years to some carrier. The entire cost to any one purchaser will run at least $1,500 (2 years of $30/month data and $30/month voice = $1,420 plus $99 for the cheapest iPhone), or perhaps $1,000 if an unlocked phone is bought. According to Gartner, 36MM smartphones of some kind or another were sold in 3Q2008. Assuming four times that number for the entire year (which is not fair because of seasonal adjustments and certain model launches, like the iPhone), the annual market is, at most, 144MM phones. While that is a fairly sizable market, there are several factors that reduce the impact:

• Included in this market are 15.4MM Nokia phones, many of which do not fully qualify as smartphones.
• Many, if not most, of the smartphones do not include cameras, due to lack of market need, cost factors, or corporate preferences. Many companies do not want to purchase phones with cameras for employees for liability and/or security reasons. Corporations are the majority purchaser of smartphones for employees, although that may be shifting.

By contrast Canon alone sold $11BN in cameras in 2008 alone. Assuming an average price of $200 (some cameras are more expensive, some are less), that is 55MM cameras. Add in Nikon, Sony, Kodak and the others, and the total digital camera market, excluding smartphones, is at least 5 times that of the smartphone market.

Finally, even the new iPhone 3G S camera cannot approach the basic simplicity of usage and quality of a simple SureShot. Although the convenience of having the iPhone camera available will count for something with its users, an average of 10MM per year over the two years since launch, the lack of basic flash, zoom and other features that a compact smartphone simply cannot handle will limit its functionality.

Summary

Yes, the iPhone is a great smartphone, especially for Apple and its stock price. The camera is significantly improved in the new iPhone 3G S. Nonetheless, it is unlikely to threaten the point-and-shoot market – let alone the high-end camera market – for years to come.

In Part I of this article, we analyzed Ticketmaster’s operations, particularly over the last several years. The conclusions we came to were:

1. Ticketmaster appears to be increasing its staff at a rate that is too fast for its growth, and thus causing its gross margins to drop.
2. Ticketmaster is acquiring businesses with a lower gross profit than its own, making inefficient use of its capital.

Now, it is entirely possible that both of these are actually acceptable, each for its own reason.

1. Ticketmaster may be investing in personnel for rapid future growth, i.e. taking hits now for future profitability.
2. Ticketmaster may be acquiring businesses that currently have a lower gross profit, but can be made profitable, either through integration cost reductions (that lovely word, synergies), or through better cross-selling, thus reducing the cost per sale.

So what does all of this have to do with scalpers?

There are many players along the value-chain of an event of the kind Ticketmaster handles. Once Ticketmaster has sold a pair of tickets for the Stanley Cup Finals to John and Jane Doe, they are largely out of the picture. Ticketmaster has brokered a transaction between the Does and the NHL. Ticketmaster, having sold and delivered the ticket, no longer has any value to the Does or, for that matter, the NHL. Let us assume that the Does paid $100 per ticket. From their perspective, it was worth right about $100 each to go watch the Pittsburgh Penguins beat the Detroit Red Wings. Now, it is entirely possible that, at some point, that value will change. For example, if John and Jane fall ill, hopefully only with a cold, it is now worth $0 for them to go, so they would rather sell the tickets at nearly any price. There is someone out there for whome it is worth, say $50 each to go, but clearly less than $100 (else they would have bought directly from Ticketmaster at the same time as the Does),  and thus it is a win-win situation. Conversely, if the Does could not buy the ticket from Ticketmaster because it was not worth $100 for them, but, rather, $150. Of course, by now, Ticketmaster is completely sold out, and in any case, Ticketmaster has set the price at $100. In this case, the only option for John and Jane is to find some other John and Jane who are willing to pay $100 but not $150 to go. They buy the tickets from them, the sellers clear a $50 profit per ticket, and the Does get their tickets for their desired price.

So what, then, is scalping? It is defined differently in different places, but, roughly, it is individuals (be they persons or companies) selling tickets for more than their face value, usually in some organized fashion. Thus, although technically one person privately selling to another for some price, whether above or below, is scalping, it is usually not treated as such unless it is at the event venue, or sold in a public manner like on Craigslist or another resale site.

In an open market, prices for most items are set by supply and demand, whether it is the price of milk, gas or a single share of Microsoft (GM, on the other hand, is basically worthless). For some people, it is worth $10 a share, for others $100. As of this writing, it is worth just over $23 per share. Now, when Microsoft goes public, it sells them at what it thinks is the best price. Let us assume it is $20 per share. Some people will buy at that price, others will think it is too high, while some will think it is too low and buy many to resell higher. While Microsoft does prefer to maximize the revenue from its share offering, it is also interested in an active post-offering market for a number of reasons. It understands that the more the market is active, at various prices, the more value it brings to Microsoft, in terms of potential investors for future debt or equity offerings, coverage for the company in the financial media (a.k.a. free marketing), and other benefits.

In order to pull the last pieces together, we need to understand the concept of “price discrimination.” In price discrimination, a seller recognizes that the apple is worth $1 to you and $3 to someone else. Ideally, the seller will find a way to sell $1 to you and $3 to the other person, maximizing his profit. He recognizes that selling it for $1 means getting 2 sales but giving up on an additional $2 in profit (assuming costs are the same), but selling it for $3 means getting one high-margin sale, but losing the second sale. In price discrimination, the seller finds a way to sell it to the first person for $1 and the second for $3. Microsoft, in its share offering, would far prefer to sell one share to the first person for $10, the second for $20 and the third for $100. This would absolutely maximize the net proceeds of the offering to Microsoft. However, Microsoft recognizes that it cannot do so, and must set a fixed offering price for everyone. It relies on the secondary market – all of those who buy it from the offering and then sell to others – to further set the share price. The entire set of businesses who have ever had a share offering, as well as the entire financial services industry, understands this dynamic, and recognizes that although Microsoft gives up on quite a bit of potential proceeds, it is in its long-run benefit to have an active market. As a matter of fact, many of the participants who do buy at a particular price, do so with the expectation of reselling soon (flipping the stock) for a higher price. Microsoft is thus constrained from performing price discrimination in its offering by three factors:

• Legal and regulatory requirements
• The need for an active market, with a set market price at any one moment
• The understanding that doing so would cut out short-term investors, and thus eliminating many of its own direct purchasers

Let us return to Ticketmaster. In many ways, the tickets it sells are like shares. It can set different prices for different ticket types – two rows back as opposed to fifth-level mostly obstructed – but the prices of each class of ticket are largely set to the number the event organizers believe will maximize its profits. While many people do simply buy the tickets at those prices for themselves, or as gifts, there are many, possibly more, who buy them as an investment, to resell at a higher price as the date of the event gets closer. Of those who do buy it for themselves, there is always a partial investment incentive: “if I cannot use it, I can always resell it for a profit.” Thus, scalpers make an active secondary market in a valuable commodity, event tickets. Without the active secondary market, several things are likely to happen:

• Investor purchasers will pull back, leading to reduced upfront ticket sales. This will appear to be good to Ticketmaster initially, as they feel they are gaining control, but will ultimately hurt their bottom line.
• Secondary purchasers, like those who want to buy from the Does at $50, or those who decide to go after the event is sold out and are willing to pay a 50% premium at $150, will not only be unable to sell tickets, but they will quickly sour on the whole concept of getting any. The reality is that most people cannot plan concerts or sporting events months in advance, and many are willing to pay a premium for last-minute flexibility.
• Non-investor purchasers, like the original Does, will be far more reluctant to pay $100 per ticket if they are concerned they will be unable to unload the tickets in a secondary market, if they are unable to go.

All of the above will have the following effects:

1. Reduced ticket sales, both initially and leading up to the event.
2. Reduced ticket sale prices, as people are more reluctant to buy, whether primary purchasers concerned about the ability to resell, or investor purchasers who have been banned from the market.
3. Reduced overall attendance.

Of course, Ticketmaster will be hurt by this behaviour, but event organizers, to whom goes the lion’s share of the face price of the ticket, and who bear the risk of not getting sufficient positive return, or even a loss, on their concert investment, will suffer far more. It is unlikely that these organizers will suffer this state of affairs for long, and will quickly shift their business of ticket brokerage to other venues.

All of this begs the question, why is Ticketmaster so laser-focused on scalpers? Note: the last well-known company to use “laser-focused” in its annual reports (Ticketmaster does not, I am giving it to them) was Enron.

Ticketmaster appears to be bedeviled by two very human factors, which are blinding them:

1. Broken Windows: Referring back to Frederic Bastiat’s “parable of the broken window,” Ticketmaster management only sees what it sees, and cannot see what it does not. All it understands is that there is lots of secondary market activity going on, profitable for everyone except for itself, at least directly. It does not see how this secondary market is actually benefitting them and their clients, the event organizers. To be fair, Microsoft has the benefit of lots of other companies going public, and thus it sees first hand the benefits of an active secondary market. Ticketmaster has become a virtual monopoly on direct ticket brokerage, and thus has, to some extent, locked itself into its own insular world, lacking the ability to see how others in the same space far.
2. Fear of (Admitting) Failure: As we saw, Ticketmaster’s revenues are growing by double-digit percentages, but its strategy of growth and acquisition is leading to lower profitability. It cannot fathom that its own strategic and operational mistakes might be making these problems (a very human condition), and thus must look for outside factors. It must be the scalpers who are “stealing” Ticketmaster’s revenues.

Looking at these two factors, the parallels to the entertainment (music and movie) industry are eerie. In the entertainment world, prices kept rising, as the quality of entertainment fare, in most cases, kept dropping. At the same time, the Internet created new venues of distributing music, both copyrighted to major studios or labels as well as independents. The combination led to a drop in revenues and profitability that management found frightening. Once again, with a largely insular oligopoly structure preventing an ability to see how others in a similar industry succeed using varying business models, combined with a fear of admitting failure (in entertainment, more correctly straight hubris), led them to believe that it could anything, but not their own strategies. Thus, it must be the evil pirates who are doing it. Many pirates are illegal and damaging, but the memorable cases of the MPAA and RIAA suing grandmothers for millions of dollars simply showed their desperation to avoid admitting their own failures.

Ticketmaster has an enviable position of a well-known brand-name, solid infrastructure and operations, and relationships with just about every event organizer/producer in the United States, if not the world. They can and will easily destroy this if they cannot see where their own weaknesses are, and thank rather than attack the scalpers.

For the last several years, data privacy and security has received a significant amount of press coverage. To be fair, this is for a good reason: most entities – private, non-profit, governmental or otherwise – due an absolutely abysmal job protecting data. In this case, data refers to all types, hardcopy and digital. However, in most cases, it is the digital that is the primary focus. This is for several reasons:

1. Digital does not require physical access to steal. A talented digital thief can break into a business’s Internet servers and steal credit card information from across the world.
2. Digital does not require originals. When a physician’s practice is broken into and paper records are stolen, the very fact that the records are missing, and the telltale signs of a break-in, are often strong indicators of a theft. On the other hand, since digital can be instantly duplicated, theft can occur without anyone being aware.

On the other hand, digital has significant advantages, which are the direct corollaries of the security shortcomings:

1. Because digital does not require physical access, records can be accessed for good from anywhere. A radiologist can look at emergency MRIs from anywhere, thus saving a patient’s life.
2. Because digital does not require originals, records can be used in many ways simultaneously, thus providing all of the benefits of digital records. This property also allows for easy backup and recovery.

For the above reasons, many if not most sensitive records have become digital in the last decade. At the same time, the weaknesses inherent in the digital domain have made data and identity theft much easier, and have thus led to the high-profile coverage, from the infamous credit card theft at TJX Cos. to the Oklahoma laptop with over 1MM Social Security stolen just this past April.

In response to the heightened concerns over data theft, several organizations have promulgated binding data security standards. The most prominent are the Health Insurance Portability and Accountability Act (HIPAA) privacy standards and the Payment Card Industry Data Security Standards (PCI-DSS). HIPAA covers all health care providers who have access to and store sensitive medical data; PCI-DSS (PCI for short) covers anyone who processes and stores credit card information. Atomic has been involved and lead implementations of both PCI-DSS and HIPAA.

The rest of this article compares and contrasts HIPAA and PCI, and attempts to understand some of the risks involved in implementation and motivations of the drafters.

First, a few key pieces of information:

• PCI has tiers for those covered by the requirements. The tier of a covered entity is determined primarily by the amount of sensitive data covered. This makes sense, as a company with 3 credit card numbers, or PANs, is a much less enticing target than one that has 3MM PANs. HIPAA has no such concept. Rather, the standards are “scalable”, meaning they apply, in its own words, “from the very largest of health plans to the very smallest of provider practices.”
• PCI has 73 pages of requirements in one document, including all introductions, workflow charts, samples, appendices and other material. The actual standards themselves cover 46 pages. HIPAA covers at least 9 separate documents, covering 125 to 237 pages, depending on how they are counted.
• PCI requires certain actions; HIPAA sets a distinction between “Required” (R) and “Addressable” (A).
• PCI has very specific requirements; HIPAA has general rules.

Let us give a very specific example. Assume you are the network administrator of a hospital billing system that contains both credit card information, and thus is subject to PCI-DSS, and medical information, and thus is subject to HIPAA. Because you are the network administrator, you have access to the entire system. Thus, your access is extremely powerful and sensitive. Let us see what each standard requires:

• PCI: Standard 8.3 requires that if you have remote system-level access, you must use two-factor authentication, e.g. a password plus something else physical, e.g. a one-time token, like those sold by RSA and CryptoCARD, or a smart card or biometrics. Conversely, someone with application-only level access is not mandated to use strong two-factor authentication.
• HIPAA: Section 4.17 requires you to take 3 steps: determine authentication applicability, evaluate your options, and select and implement the option. This rule holds for someone with access to one record or the entire system.

Unfortunately, due to the brilliance of hackers on the Internet, your system is breached, and personal information is stolen. Let us examine what happens under each of the two standards:

• PCI: A quick audit of your records and systems demonstrates that you complied with the PCI standards. You did, indeed, implement two-factor authentication where the PCI-DSS clearly required it. Thus, you may get a slap on the wrist, largely to protect the PCI group, and it is highly likely that the PCI data standards setting group will use your breach as a case study to determine if its standards need to be updated.
• HIPAA: An audit determines that you did, indeed, determine authentication applicability, evaluated your options, and selected and implemented an option. In your case, you decided the same two-factor that was good enough for PCI-DSS would also be strong enough for HIPAA. Of course, HIPAA never actually said that two-factor was required, or sufficient. It simply asked you to evaluate. If you are a public hospital with a public breach, it is fair to estimate that your executives are soon to face a very upset state or Congressional committee hearing. Additionally, the patients whose data have been stolen are likely to file a lawsuit, claiming that you did not take sufficient action to protect their data. You will, of course, claim your compliance with federally-issued HIPAA privacy and security standards as a defense. However, opposing lawyers will argue that you did not comply, that your subjective assessment in 4.17 was erroneous and even grossly negligent.

Differences like these abound throughout the HIPAA vs. PCI comparison. PCI-DSS is largely very specific, with rules and regulations defining your minimum, but never your maximum. By contrast, HIPAA, in somewhere between 3x and 6x as many pages and 9x the number of documents, gives processes to follow to determine what you should do, but never sets the standard explicitly.

In my experience in dealing with HIPAA and PCI, from the perspectives of covered entities, regulators and auditors, I have found very different motivations. As always, incentives matter greatly.

• PCI-DSS is promulgated by a private entity, the Payment Card Industry, which itself is an association of private card issuers, such as Visa, American Express, and others. These companies have one driving incentive: increase adoption and usage of payment cards. Security breaches simultaneously drive down card usage and adoption, and cost the industry significant sums in repairing the breaches and paying damages, either voluntarily or as required by a court settlement or order. PCI drives towards constant minimizing of breaches. At the same time, it does not want to penalize those who follow the standards and are nonetheless breached in an unduly harsh manner, as it will provide a disincentive towards others expending the often significant sums in compliance. At the same time, those who do not follow the standards open the entire industry up to risk, and thus are penalized heavily.
• HIPAA is promulgated by the US federal government, largely driven by political requirements. Although in theory they also prefer to minimize breaches, in practice the politicians and civil servants who stand behind HIPAA have one overriding goal: reelection/reappointment. HIPAA was first enacted in 1996, almost 13 years ago. No Congressperson will be reelected in 2010 on the basis of some legislative action they took a decade and a half prior. Similarly, the head of Centers for Medicare and Medicaid and other administrators at the Department of Health and Human Services will not be receiving any promotions on the basis of an event that long ago. People subject to the public require headlines for reappointment or reelection. These headlines will come primarily from “doing something” about a breach event. Thus, the incentives for those behind HIPAA are to ensure that every breach, no matter how minor or severe, can become a major event requiring high-level involvement, as opposed to a routine audit and acquittal.

When implementing PCI or HIPAA, it is important to keep in mind these incentives and driving behaviours. Of course, lack of execution of either is guaranteed to bring significant trouble to any entity. However, it is important to understand that these are merely risk-reducing strategies, with HIPAA serving as much as a tool with which to bludgeon entities that are compliance as guidelines for data protection.

Despite the title of this post, we will not be discussing the current or previous administration’s involvement in the financial sector, the federal reserve bank, or any of a myriad of acronyms from TARP to TALF to PIPP. Rather, we will examine the pitfalls of successful initiatives within organizations due to politics. This article could have been titled, snatching defeat from the jaws of victory.

I recently had the pleasure of lunching with a colleague, who has a great idea for a way to significantly increase business in his division. While I am not expert on his company’s particular sales process and funnel, I trust that he is, and the 50-100x return on investment will indeed pay off. Additionally, the sales initiative he has is perfectly in line with the culture and mission of his company. Nonetheless, he has concerns about approval, despite the piddling sums (under $20,000 per month for a large public company), and has seen attempts to slow it down.

There is an old saying that success has many patrons, and failure is lonesome. While I believe the original phrase meant that many people working together are likely to succeed, and a lone initiative is more likely to fail (see Ecclesiastes, “two are better than one”), in the corporate world, it could just as well refer to the fact that everyone wants credit for and a piece of a success, while failure will be pushed off onto the one individual who cannot send it anywhere else. Who was actually was responsible in either case is, of course, irrelevant.

The Challenge

Within a corporate environment – whether for-profit or non-profit, private or governmental – it is important to understand the financial return to the organization of an initiative. It is important, but insufficient. Let us assume that John has an idea to spend $15k per month on special advertising that will generate $150k in new business. If gross margins are 30%, then the new business generates $45k in profits, for a 3x return on his investment. All told, this is a great idea. However, John works in sales. He may even spend this $15k in concert with the business development group. Thus, the CEO is thrilled with John, and the business development department gets a nice gold star. However, the marketing department is not as happy. Sure, the business makes more money, but the head of marketing is more than a little concerned. At some point, the CEO is likely to see the $5MM annual marketing budget, the $1MM increase request, and ask, “well, how much increase in market share will this generate?” The head of marketing answers honestly, “$6MM in new business.” This sounds great. However, with the 30% gross margin, the new business is worth only $2MM in profit, or a 2x ROI. The marketing head must be nervously aware that John’s idea, along with the business development group, is generating profits 50% faster with their little direct marketing campaign than marketing is. The marketing head will likely take one of two paths:

1. Torpedo the $15k spend before it gets off the ground.
2. Torpedo John the next time around

Either way, John is in trouble. Sure. he is a hero… for now. But is it worth creating this enemy for half a million dollars in new annual profits? If he could generate many millions, and get a big percentage of it, sure it is worth it, because he can retire before getting torpedoed. Since this is unlikely to happen, and even then the head of marketing can torpedo the initiative, mostly by a stealth campaign, John is better off getting the head of marketing on his side first. Additionally, he had better identify who else wins, and who loses, from his initiative. Unless his initiative is crucial to the survival of the business, or going to make so much money so fast that there will be plenty to spread around to salve wounds, and perhaps walk away with enough to retire on his own, some relationship planning and politics are crucial.

Incentives

In order to properly manage his initiative to success, John needs to isolate and understand the incentives of every party involved, and even those uninvolved. Specifically, he needs to understand:

• Financial: Who has a budget that may look better or worse through this initiative? What about compensation? Is there a way to change the measurement of the results such that everyone wins? Continuing our example above, if the marketing department becomes a participant, providing half the budget while measuring market share as part of the initiative, the same net results to the company can lead to direct rewards to both John and marketing. In one instance of which I am aware, changes in budget would have exposed how one group was carrying an inordinately large amount of the fixed costs for another group. If the changes had gone through, the second group’s true costs would have come to light, directly and dramatically dropping the compensation of the second group’s divisional president. Changes in incentive structures can be crucial to gaining support.
• Political: Who else within the company has been angling for private initiatives? Who is doing what are nominally termed “skunkworks” projects, waiting for the light of day? Who else has promised returns on small initiatives and not delivered? Sharing credit in the right method is crucial. As is so often the case, who gets public credit together is less important than who the true enabler is, a fact normally known by the board and top management. In John’s case, if he is known as the guy who brought the 3x investment, he will be known as a star, for a time, until the next star comes along. However, if he is the guy who brought everyone on board to the 3x investment, he is not only the star, sharing his light; he is the guy who can manage everyone. Which one do you think will next be considered for an executive seat?

Opening Up

The crucial challenge, then, is for John to open people up and discover:

1. Who the real players are;
2. What the political drivers of each player are;
3. What the financial incentives of each player are;

John then needs to determine how to get everyone on board given the above drivers and incentives. The problem is that (a) John has a day job and (b) people can be suspicious of him and less likely to open up. After all, John, too, is a player, and they are all aware of it. These are the challenges. Oftentimes, an outsider can get in and gain trust in the way insiders, even senior insiders, cannot. Once I had a client looking to revamp a major operational area. Unfortunately, the one person who was most dead-set against the initiative had 50% of the information necessary to understand the current structure, finances and culture, either directly or in his organization. This person was 6′3″ tall, ruddy, a big beard, and quite intimidating. No one managed to get him on board. As an outsider, it took me one hour to get him to warm up, and I had all we needed when we were done. This was something only an outsider, with no vested agenda, no promotion battles, no budget concerns, no political history, only the best solution at hand could achieve. In addition to allaying his fears, this person had serious, valid concerns about the initiative that I promised to include in my final recommendations, and did so. Coming from “the obstructionist”, no one gave them credibility; filtered through the outsider, they were credible, and I was even able to give him credit, which renewed the internal working relationships.

Summary

Every initiative must make financial sense for the organization, but that is insufficient. The organization has many perspectives, not just that of the income statement and the individual/group/division making the recommendation. It will impact many other areas, some positively, some negatively. In order to succeed now and the future, an initiator must be able to discover all of the players, drivers and incentives, whether himself or through others he brings in, and move every single one either to support or neutrally abstain. Only then can his initiative be successful and the start of many more.

Business Insider had a fascinating short article on the inverse relationship between Craigslist and newspaper classified advertising revenues. The primary image is shown below.

It is well-known that the newspaper industry, which exists largely based on advertising revenue, with a supplement from circulation, including newsstand and subscription sales. For example, in 2008, the New York Times Co. earned $910MM in circulation, and nearly double that amount, $1.78BN, from advertising. If one goes back two years, the differential is even more dramatic, with $890MM from circulation and $2.15BN from advertising. The Wall Street Journal, a subsidiary of Dow Jones & Co., has a similar approximately two-to-one ratio of advertising to circulation, for 2006, its last posted year as an independent entity prior to its acquisition by News Corp.

Clearly, the loss of advertising revenues, including classified, has been incredibly destructive to the newspaper industry, and lies at the heart of its financial troubles. From the perspective of the newspapers, this wealth has evaporated, disappeared. Many have lamented this situation, and there have even been discussions of federal bailouts, similar in style, if not scale, to the bailouts of the financial and auto industries under TARP and its variants. However, from the perspective of advertisers, those who have what to sell, this has been an unmitigated success. Look at the numbers above. We will assume, for argument’s sake, that more or less the same amount of goods have been sold in 2004 as in 2008. We will also assume that 2004 and 2008 dollars are relatively constant, i.e. we are ignoring inflation. Given that the consumer price index has increased by 14% from 2004 to 2008, according to the Bureau of Labor Statistics, this is somewhat erroneous, but not terribly so. If we add up the total cost of selling goods and services in newspaper classifieds in 2004 was just over $17BN from newspapers and a negligible amount, under $10MM from Craigslist, the total remains approximately $17BN. To be fair, we can also add eBay auctions to round out the numbers, a total of $1.4BN (US-only auctions), the total cost is $18.4BN. Assuming the same number of goods and services were sold via classified ads and auctions in 2008, and we add up the same elements – $12BN in newspaper classifieds, $70MM in Craigslist, and eBay earned $5.6BN from marketplaces, of which approximately half is in the US, then the total is $14.9BN. This is a reduction in costs of 19%. Quite simply, for those doing the selling, this has been an incredible boon.

The above somewhat understates the impact for two reasons.

1. Much of the eBay sales are not those that would normally go through newspaper advertising, thus making the reduction more on the order of $5BN out of $17BN, a savings of over 29%, or just under 1/3.
2. The trend is accelerating dramatically, with forecasts in 2009 of newspaper classified advertising revenues of $8BN, or less than half of 5 years prior, with the Craigslist replacement costs at approximately $90MM.

Ignoring eBay for the moment, in just 5 years, $17BN in costs was replaced with $8.1BN in costs. While the regional monopoly / oligopoly that sold these services (a.k.a. the newspapers) are suffering terribly, for the sellers (a.k.a. the advertisers), and the economy as a whole, this is an incredible boon. In many ways, this is akin to the replacement of manual farm labour with tractors in the early 20th century. Although it was terribly rough for farm hands, the reduction in costs to food purchases (a.k.a. everybody), and the resultant increase in health and welfare, not to mention reduction in poverty and economic growth, cannot be overstated. Although this is on a much smaller scale, the analogy holds nicely.

Sorry, New York Times Company; your loss is everyone else’s gain.