Atomic Energy

This article is a short follow-up to our discussion of the low profitability of Israeli firms. I recently had the pleasure of sitting with the Chairman of a very well-established Israeli firm, not one of those discussed explicitly in the previous article. I raised the issue of Israeli profitability with him. His perception was that Israel, being a small country, is subject to an excess of information. You could almost name it the “too-efficient market” hypothesis. Because each customer knows how the costs of each supplier, including salaries and margins, customer squeeze suppliers down to bare-minimum gross margins. As he put it, “we have a pricing problem.”

I take issue with these comments for several reasons, but specifically note the insight it provides into at least part of the Israeli business mentality.

1. There is no such thing as too much information. Buying Dell servers in Israel is no more transparent than buying consulting services in Palo Alto. Any good executive knows, or can quickly find out, the variable and overhead costs of each and every supplier. If anything, the US market is actually more transparent than the Israeli one, since the size of it provides many more opportunities and a broader data set. Outliers are less likely to dominate or skew.
2. Many of the companies that have higher margins – and the only ones I can directly analyze without inside information – are publicly traded. These companies issue annual reports, and thus have all of their costs, at least at a high level, publicly available.
3. Many of the Israeli companies with poor margins actually do the majority of their business internationally. Thus, their customers are the exact same customers, with the same pricing negotiations, as their US or European competitors with higher margins.

What I find most notable, however, is the insight this provides into the mentality of at least part of the Israeli business market. Many Israelis, due to their culture, are natural salesmen, doers, dealmakers. As such, they focus on constantly making a sale, and have the salesman’s mentality. This is great for volume and top-line revenues. Unfortunately, if unrestrained by a CEO with an eye on profits, can lead to many low gross-margin deals. This focus on sales at the (possibly unconscious) expense of profits leads to higher revenues, low profitability, and poor return on investment for investors.

Israeli companies appear to be trapped in the mindset of “deal at any price.” In order to grow into profitably, Israeli firms need to learn the investor’s profit mantra, how to measure deals based not on their revenue but their margin, and learn to differentiate their products and services sufficiently, at least in their customers’ views, so that they can charge rates with sufficiently high gross margins. Their problem is one of both marketing and sales.

In the prior article, we analyzed the likelihood of Oracle meeting their comment, at their fourth quarter 2008 results conference, of having Sun add $1.5BN in operating profit to their bottom line within one year of closing the acquisition, essentially in fiscal 2009. The conclusion we reached was that it was a highly aggressive target, and unlikely to be reached by half. Nonetheless, if Oracle could get Sun halfway to Oracle’s gross margins and fixed costs as a percentage of revenues by 12 months from acquisition, they would get fairly close.

In this short follow-up, we will look at the political drivers behind Oracle’s $1.5BN announcement.

According to the April 20, 2009, announcement, Oracle agreed to pay $9.50 per share for Sun’s stock. As of this writing, the total number of shares issued and outstanding for Sun is 746.25MM, for a total value of the transaction as $7.1BN, which differs slightly from Sun’s announcement that the value is $7.4BN. We will ignore that discrepancy, as it is not material to this article. After accounting for Sun’s debt and cash, the net cost to Oracle is $5.6BN.

Sun, like Oracle, is in a fairly risky business. In its latest annual report, Sun ranges the estimated weighted average cost of capital, and hence discount rate for in-process R&D (IPRD) for its acquisitions, as between 12% and 22%. As some of these are much riskier projects than Sun as a whole, we will stay in the middle and assume a discount rate of 17%. Using a basic perpetuity schedule, for Oracle to break even on its $5.6BN investment in Sun, and ignoring the actual cost of closing the deal – legal fees, filing/regulatory fees, investment banker fees – all of which can add up to well in excess of 10%, as well as the operational costs of merging the businesses, Sun will need to add almost $1.0BN ($952MM to be precise) to Oracle’s bottom line.

Now, let us add 10% for closing costs, and another 10% for operational costs, for a total deal cost of $7.1BN: 10% of the transaction cost of $7.4BN (not the net cost of $5.6BN – those investment bankers are in a very good place), another 10% for operational costs, gives about $1.5BN in additional costs. Add that to the net costs of $5.6BN for $7.1BN in total cost to Oracle in the first year. Returning to our 17% discount rate calculation, and the Sun acquisition needs to $1.2BN to Oracle’s bottom line. Of course, Oracle’s managers do not want to have taken all of this risk in the deal, just to get the same return as if they had done nothing. This is especially true during an earnings report where they did not do quite as well as they would like. As we recall, the headlines indicated that Oracle was “not immune” to the recession. Clearly, many had expected it to be. Thus, it was critically important that Oracle’s managers show not only that the Sun deal would break even, and in one year, no less, but that it would actually do 25% ($300MM on top of the $1.2BN break even is 3/12 = 25%) better than break even, and thus return higher than its cost of capital.

To be fair, it would be reasonable to also use Oracle’s weighted average cost of capital and discount rate, and those that apply to the company as a whole, or perhaps its internal projects, rather than its acquisitions. The only discount rates provided in Oracle’s latest annual report is for its BEA acquisition, where it uses discount rates of 7% to 17%. For a tech company, this is quite low. The Corporate Executive Board, in its November 17, 2008, report, indicated that the typical company expects to see WACC rise to between 9% and 12%. A tech company such as Oracle or Sun should expect a good few percentage points higher, given the volatility and riskiness of the business; anyone remember DEC? when Dell was the undisputed leader? when Yahoo ran search and there was nothing new in that space? Thus, our 17% rate will suffice.

Conclusions

Oracle should, and possibly could, achieve significant improvements in Sun Microsystems’ bottom line, by bringing its margins more in line with Oracle’s. This is in addition to any reductions in cost due to redundant activities, as well as additional revenue due to cross-selling opportunities. Its $1.5BN is challenging but not absurd. However, it is highly likely that its selection of this number target was driven as much by public/investor/political relations incentives as actual financial benefits.

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.