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Archive for December, 2013

Advertising Where There Are No Customers?

Tuesday, December 31st, 2013

Here’s a conundrum: What does it mean when a company advertises for customers… in a place where almost none of its customers exist? Better yet, what if that location is particularly expensive?

A friend of mine recently told me that he was diagnosed years ago with hypothyroidism. He took the medication Synthroid for several years.

One day, he was reading the New York Times Sports section, and saw an as for a law firm that had a class action lawsuit against Abbott Laboratories, the manufacturer of Synthroid.

These types of lawsuits happen all the time, so that wasn’t strange at all. In the end, my friend did get a whopping $72 out of it, although I am sure several attorneys became quite wealthy.

What was strange is that over 90% of those with hypothyroidism – and hence over 90% of Synthroid users – are female. But the overwhelming majority of Sports section readers are… male. Why in the world would you advertise where your customers are not?

As always, it pays to look at the incentives. It appears that once the suit was class-action certified and then settled in 2000, to the tune of about $137MM, the law firm really had no interest in finding more claimants. They already have their millions in attorneys’ fees, which was the real purpose behind the lawsuit in the first place, and so the nuisance post-suit claimants, who will get $72-111 each, are a lot of overhead and paperwork for the law firm.

And yet, the settlement (and the judge) requires them to notify the public about the settlement over a period of time.

So, they advertise… where they least expect customers to show up.

As Deep Throat / Mark Felt said in Watergate, follow the money. The most irrational behaviour will always make sense; you just need to understand how.

It Is Always About the Profit… but Depends on the Currency

Monday, December 30th, 2013

In my last article, I looked at how the attempt to increase profits motivates people. Sometimes it leads to the wrong behaviour, but most of the time, especially in a competitive environment where customers have real choices, it leads to the right behaviour. This is the reason why I so rarely have worked with non-profits; they so often have a strong disincentive to improve.

Jeffrey L. Minch, a longtime entrepreneur, CEO, and professional executive coach, pointed out in an extremely insightful comment:

“Profit motives make the world go round.  You just have to figure out what currency you’re trading in.”

I am a lifelong student of incentives and motivations. I constantly use them in my practice to help clients figure out:

  • How to encourage desired behaviours and outcomes from employees;
  • Why customers behave a certain way;
  • How to align sales with the rest of the company;
  • Just about everything people do inside, outside and in relation to the company.

But as a consultant mostly to for-profit businesses, I am used to looking at financial incentives as a key part of the picture: price for customers; salary and bonus for employees; benefits. Sure, I always look at intrinsic motivators like pride, promotion, recognition, emotional needs, but these are part of the picture. The primary currency is, well, cash.

Jeff correctly points out that in places where cash is by definition not a primary currency, like non-profits and government, where the “non-profitness” is imbued in the very DNA and culture of the place, the lack of cash profit motive creates an absence, and nature abhors a vacuum. The gap will be filled, but by a currency other than cash. Once you understand what that currency is, you can understand the incentives and motivators of the employees, customers and other stakeholders.

 

The Profit Motive… Motivates

Thursday, December 26th, 2013

It is finally happening. American universities and colleges, long an upward funnel of spending, are cutting back. The WSJ reports in its Boxing Day edition that many institutions, facing the inability to raise prices any more – well, they could, but would lose many students – and the decline in state funding, have decide they actually have to make choices.

The reason they operated this way was simple: marketing.

  1. They convinced customers (students and parents) that their products (degrees) are indispensable, allowing them to raise prices indefinitely (price inelasticity).
  2. They convinced influencers (the public) that their products are an unquestionable social good, thus pressuring governmental authorities to pay more via direct (state and federal funding) and indirect (student loans) subsidies.

The very definition of economics is the allocation of scarce resources. As long as schools could increase revenues from both sides, they could increase expenses ever more on professors, administrators, paper, cars, buildings, and whatever else they wanted, while demanding ever less from those employees. With no constraints on revenue, and no profits to be paid to owners or create efficiency incentives for managers, there became no need for constraints on expenses. Resources were never truly scarce.

Marketing actually works! Until it doesn’t. Even brilliant marketing has its limits; after all, the iPhone never sold for $2,000 each, even the unlocked, contract-free top model.

Granted, these cuts are just playing at the edges. University of Kansas cut $5MM in 2013, a meagre 0.88% savings from an operating budget of $569MM in 2013 for its Lawrence Campus alone. State University of New York saved $48MM over 2 years, or $24MM per year (although the article isn’t clear if it is one-time or recurring)… out of a “Core Operating Budget” of $2.3BN, a savings of just 1%. The real savings and cutbacks are yet to come.

In 2008, I needed to visit a well-known university office in New York, to take care of some paperwork on behalf of a family member. The process was incredibly inefficient. When I commented upon it, many of the people involved in the process begged me to engage with the university to improve their processes. After all, I am a business consultant.

I didn’t even try. I knew what the results would be.

Let’s say you are the head of a group or division or an entire company. Your annual revenues are $20MM and your expenses are $19MM. If I can help you shave another $1MM off your expenses at current revenues, your annual budget goes down to $18MM, but your profit margin just went up from 10% to 20%. You are about to get a very nice bonus!

On the other hand, if you are running a university division with a $19MM budget, and I help you shave the same $1MM off your budget just went down to $18MM. Did you get some bonus? Probably not. What happened is your empire – defined at these places by the size of your budget, for which you fought tenaciously – just shrank. Unless you are the head of the entire system, you have a negative incentive to work with me to improve yourself.

I have done very little work as a consultant with universities and non-profits in general, precisely because of these negative incentives. Where I have, it has been when there was a genuine interest in improvement and the right incentives already in place.

In the end, the profit motive… actually motivates.

It’s a Matter of Trust

Monday, December 23rd, 2013

With due respect to Billy Joel, this article is not about music, but about buying music – or anything else – without getting your credit card information stolen.

Over a period of more than two weeks, data thieves stole more than 40 million credit and debit cards from Target stores. Unlike most well-publicized cyberthefts of cards, the thieves apparently did not break into the back-end IT systems and databases of the company and take a big dump of the cards. Rather, they managed to infect tens of thousands of point of sale systems – those red card-swipe machines at every Target store – so that as you swiped your card or entered your PIN, it transmitted the information simultaneously both to Target’s own systems (and on to the payment processors for validation) and to the thieves. Kudos to Brian Krebs’s Krebs on Security for breaking the story and following up. In many ways, this is very similar to the infamous TJ Maxx breach a few years back, where they hacked in using improperly secured store WiFi.

This incident highlights, yet again, the fundamental weaknesses of the credit card system, and what we need to do to repair it.

Since the early years of credit cards, your card number has been the approval to draw from your account. Since cards were physical items, the most one had to worry about was the card itself being stolen. Sure, thieves stole carbon copies of the card imprint machine slips, but as a matter of scale, it was quite small, and all you really had to do was shred those. These were losses both people and the industry could absorb.

The real question became, “how do I verify that the person giving me the card is the real owner?”

The idea that the merchant was fraudulent or irresponsible was simply a non-issue. You trust the merchant, the merchant verifies you.

Over time, as the credit card industry enabled catalog sales and then Internet sales, the scale of card usage has grown. But so have the opportunities for fraud. The card industry’s answer has been:

  1. Magnetic strip encoding
  2. Risk evaluation – if you purchase an item with a physical card present, the risk is lower, and so are the fees charged the merchant
  3. IT – use algorithms to identify suspicious purchases and block them
  4. Security code – the code on the front (AmEx) or back (others) of cards that is neither encoded on a magnetic strip nor raised in the imprinted number of the card.
  5. Processes – lay down rules for merchants as to what data they can store and how. Your name can be kept, the card number must be encrypted, the security code must never be kept

All of these, however, follow the same fundamental assumption: the merchant’s job is to collect enough information to allow the credit card industry to validate the user of the card, while the cardholder’s job is to hand all of that information over to the merchant. We must trust the merchant, but we must question the cardholder.

To their credit, these actions have reduced the valid lifetime of a stolen card before it is blocked, which reduces each card’s value; according to the latest information on the Target thefts, the card numbers were being sold for ~$40/card. However, with the massive growth of the number of merchants, and hence points of sale, network transits and storage databases, the volume of theft will more than compensate for the drop in value of a stolen card.

This game of cat and mouse will go on… until the industry realizes – and merchants and cardholders insist – that the best way to prevent credit card fraud is not to prevent fraudulent card usage, but to prevent credit card theft in the first place!

We must challenge our assumptions about merchants. We need to begin to trust the merchants about as much as we trust the cardholders: very little. Lest anyone become offended on behalf of the merchants, they themselves would far prefer not to have to worry about card storage. I have evaluated and managed a goodly number of PCI implementations; they would far prefer to get out of the business entirely.

What does this mean practically?

What I as a cardholder really need is a system that gives me the ability to give my merchant enough information for them to verify this one sale at this one moment, but not enough information for them to make even a single additional sale!

There are two ways to do this. It is much to my surprise that no provider has done this yet.

  1. Push instead of pull: Giving Target my card number is nothing more or less than an authorization to post a charge, i.e. pull funds from, my account. It is this very “pull” nature that allows thieves to reuse that number and pull more from the same account. Instead of pull, I should be able to push. Target should give me a unique transaction number on checkout. I then go into my account, to which only I have access, and push funds (perhaps via smartphone) to that transaction. Target neither needs to know nor care if I am a legitimate cardholder, just as they neither know nor care when I pay them in cash. They have gotten paid; move on.
  2. One-Time Numbers: If we continue to insist on pulling funds rather than pushing them, then we create one-time credit card numbers. Similar to those RSA keychain fobs, or the now-popular Google Auth iPhone/Android App, credit card numbers would have a base of 16 numbers that is unchanging, and 4 digits that change every thirty seconds. You need the entire 20 digits to make a transaction, can only use it within a short window, say 5 minutes, after it appears, and each one can only be used once. The 20 digits are more than enough for Hertz to identify me, far more reliably than in the current manner, but even if a thief broke into Hertz and stole that number, it would be useless, as it had already been used.

Most of us may not care, since the card companies and banks cover fraud on our behalf, as they should. Nonetheless, there is a large inconvenience factor, and the card issues must cover their expenses by charging more to merchants, who must cover their costs by increased prices. It may only total 1% of the total card usage in a year, but with almost $3TN in credit card purchases in 2012 in the US alone, 1% is $30BN out of the hands of thieves and into the economy.

What could the economy do with $30BN…

AT&T Doth Protest Too Much, Methinks

Wednesday, December 11th, 2013

For years – since the dawn of the American mobile industry – carriers have sold subsidized phones in exchange for multiyear contracts. Instead of paying $500 for a phone, you pay $100 or $200, and commit to staying on their network 2 years.

Now, out comes Randall Stephenson, AT&T CEO, and whines, “we cannot afford to subsidize those phones anymore!” Is it possible? Could AT&T be losing money (or at least potential profit) by subsidizing phones? Let’s take a look.

The latest 16GB iPhone 5S costs $649 to buy outright from Apple, but only $200 upfront from AT&T with a 2-year contract. AT&T is subsidizing the phone to the tune of $449. In exchange, the customer commits to two years of paying at least $60/month for the base plan, which includes unlimited nationwide talk and text and 300MB of monthly data. If you bring your own device AT&T will shave $15 off your bill.

So how much is that phone costing AT&T vs profit for them? After all, it is highly unlikely AT&T would be doing the subsidy for two decades, if they did not make a nice profit on it.

AT&T’s Weighted Average Cost of Capital (WACC) is 4.22% (see the end of this article for the calculations). So the monthly financing cost to AT&T over two years is $19.54. Out of the $60/month you pay AT&T, just under $20 goes to finance the phone; the remaining $40 is pure plan revenue.

Does it cost AT&T $40 to provide that basic plan? Not even close. AT&T’s company-wide cost of services (it doesn’t give information by division) is about 43%. Of the $60 you paid, $25 is a cost to them to provide you with service… including the cost of the phone! So of the additional $40, a grand total of $5 is the cost to provide you with service. All of the rest is pure profit.

Subsidizing phones is a very good business for AT&T! The last thing they want is for customers to bring their own devices. If the do:

  1. They will be much more willing to jump carriers with regularity, as the Europeans do.
  2. They will be much more aggressive in demanding no-contract, post-pay, lower-price plans. For example, my Israeli carrier (I have one for every country in which I operate) charges me 100 NIS (~$29 USD) for unlimited voice, text and data, with no commitments and including all taxes and fees, as long as I bring my own device. These numbers would give AT&T serious heartache.
  3. They will lose the device sale relationship touch point, when they do much of their new customer sale. There is a reason that you had to activate your 2007-2008 iPhone with AT&T, even when you purchased it in an Apple store.

What AT&T is really saying is, “We really want to raise rates. We know if we do, you will get angry and jump to other carriers. So we need to do two things: prepare you for a rate raise, and convince other carriers to raise rates as well.”

The first is psychology; the second is constrained by antitrust law. Mr. Stephenson wants to kill two birds with one stone:

  1. By complaining about how much they are subsidizing phones, he wants to paint his company as a do-gooder from its own pockets, reluctantly forced to raise rates to keep phone subsidies in place.
  2. By signalling publicly about the need – even if the reason is false – he hopes to legally signal to other carriers to raise rates as well, since he cannot collude with them directly.

Unfortunately, both efforts are likely to fail. AT&T is hated by most of its customers; a few years back, when the moniker for it was “The Evil Empire”, someone photoshopped the AT&T logo into the Death Star. I have no personal opinion, but customers very much do. They feel that the customer service is terrible, the prices are far too high and the company exists to mistreat them.

Second, there may be fewer carriers, but they all want to eat AT&T’s lunch. T-Mobile, in particular, has been aggressive about finding ways to make customers feel at home. As uber-VC Fred Wilson said, “T-Mobile is customer friendly.” Or, as he quoted T-Mobile’s COO, “We sit around and say, ‘What can we get away with not charging the customer’?” Even with a few competitors, competition works.

AT&T is making, not losing, money on subsidies; it is making a lot more on wireless services; and it is unlikely to succeed in convincing customers to allow it to raise rates or competitors to do so with it.

WACC Calculation

All data is taken from Morningstar and Yahoo Finance, as well as AT&T’s own filed 10Ks, and the official yields on the US Department of Treasury Web site.

  • Equity/Value: 52.9%
  • Debt/Value: 47.1%
  • Risk Free Rate (given by yield on 10-year Treasuries): 2.81%
  • AT&T Beta: 0.33
  • Market Risk Premium: 8% (historical)
  • AT&T average debt yield: 4%
  • AT&T effective tax rate: 29%
  • After tax debt yield: 4%*(1-29%) = 2.84%
  • Cost of equity: RFR + Beta*MRP = 2.81% + 0.33*8% = 5.45%

WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt = 52.9%*5.45% + 47.1%*2.84% = 4.22%

Feedback is Only Good If You Use It

Tuesday, December 10th, 2013

Why do companies that are good at getting feedback often fail at actually improving?

Yesterday, Harvard Business Review published a great article by Rob Markey, where he pointed out five top reasons why companies fail to make good use of the data. The article is short and a good read.

Their very first listed reason is a classic scientific method mistake: discover what, ignore why.

Here’s the problem. If you put in effort to find out how your company is doing, what the customer satisfaction or market acquisition or return customer metrics are, but don’t dig deep enough to find why they are that way, you are only halfway there, and arguably worse off. Just as security by obscurity is worse than insecurity – because at least you know you are insecure as opposed to deluding yourself into a false sense of, well, security, thinking you understand your customers’ behaviours when you actually don’t can lead you to confidently drive right off the cliff, and suppress any dissenting voice that says, “Hold on; why are we doing this? Are we sure?”

It is for this reason that I, as a consultant, always spend face to face time with the employees, especially more junior ones, when doing internal analysis, and always speak directly with customers – current, potential and lost – when doing a market analysis.

Here are two examples:

Why Do My Sales Hurt?

A client asked me to figure out why every sale was so very difficult. They were hitting their numbers, but it was like pulling teeth for each deal. I spent a lot of time with their sales staff, professional services, marketing, sales engineering, customer support – including those who were still with the company and many who had left – but I spent an equal amount of time having honest conversations with current, potential and former customers, as well as those who had declined to do business with the firm.

Unsurprisingly, they were more than willing to share openly. They were even more open with a third-party consultant, knowing they could be brutally honest and their specific comments would never be shared directly and identifiably with executive management.

We already knew and were tracking our cost of sales; we didn’t yet know the why.

Why Is My NOC So Expensive?

A different client asked me to determine why his operations centre cost was so high, yet performance – in terms of ticket turnaround time – was so low, leading to lower customer satisfaction, higher costs, and unhappy staff, which led to higher employee turnover, leading to even higher turnaround time, and onwards down the spiral.

Once again, I spent a very large amount of time with each and every line employee – network engineers, customer support associates, human resources interns. Once again, the employees had many of the answers. All they needed was:

  1. An open ear to listen.
  2. A third-party ear to whom they could speak without fear of upsetting their managers and executives.
  3. Someone smart enough to put it all together, and distill the cruft from the cream, the cranks from the stars.

It is amazing what you can do if you are willing to listen, get someone who can, and avoid hiding the real feedback under piles of statistics.

Making the Right Amount of Investment in Technology

Wednesday, December 4th, 2013

So it happened again. A company underinvested in technology, the numbers looked great for years, and then it came back and bit them in the rear…. hard!

RBS (Royal Bank of Scotland), the British bank, had a major failure that left customers unable to access accounts and withdraw cash, and this was less than 18 months after their last such glitch.

Unlike most cases, the (newly installed) CEO of RBS, Ross McEwan, came out and openly apologized. They had underinvested in technology for decades, and it was their fault. I do not know if that sort of apology would occur in the US; the lawyer- and litigation-heavy climate takes any such apology as an excuse to sue the company on behalf of customers and management on behalf of shareholders.

Nonetheless, one must give credit to Mr. McEwan for openly admitting the problem and working to fix it. Personally, I would love to be involved with the team that fixes it. I have spent most of my career fixing business and technology processes and investments; the challenges in a turnaround are great fun.

So if RBS underinvested, how does any company know how much to spend?

The simplest way is to look at peers – RBS can look at NatWest or even JPMChase – but peers may be at different stages in technology lifecycle development, may be able to cut back on investment due to heavy investment in previous years, or may be overinvesting due to low earlier investment, new market opportunities or different segments. If RBS suddenly decides to focus more heavily on servicing the hedge fund industry (prime brokerage), it would need to invest significant capital in technology that an otherwise similar firm not servicing prime brokerage or already there for years would not need to invest.

Part of the answer is to ask your IT team. The problem, of course, is that the IT team never says it has enough. I have consulted with and worked at literally dozens of companies over the last 20 years, and I have never ever seen the software engineers, operators or infrastructure people say that they have enough budget (capex or opex), people or time. For the most part they are correct, for the most part to a lesser degree than they say.

The real challenge, then, is hiring the right technology executives.

Budgeting for technology is, fundamentally, no different than budgeting for marketing; it just requires a different skill set to translate those needs into financial numbers.

When the CEO asks the VP Marketing for her needs, the experienced head of marketing says, “tell me what you need to get done, I will tell you what it takes.” The marketing department never has enough money, but the marketing department’s job is to translate business requirements and targets into marketing actions and budgets to achieve those.

The job of the CIO, CTO or VP Technology is fundamentally the same. The head of technology should be saying, “tell me what you need to get done, I will tell you what it takes.” However, for a few reasons, this sort of interaction does not take place with technology:

  1. Technology is viewed as voodoo. CEOs – even those of technology companies – are either overconfident or underconfident in their abilities to understand the technology and ask relevant but not micromanaging questions.
  2. Heads of technology lack financial and sales skills. For some reason, companies follow the Peter Principle and promote technologists to their level of incompetence, rather than first training them in hard-core business skills, and only then promoting them to executive roles.
  3. CEOs believe technologists are more supermen/women than other departments. When the head of technology actually does say, “given the budget and your needs, here is what we can do, please prioritize,” the CEO often will say, “I’ll take all of that and raise you 50%.”

There are rules of thumb to follow, but every single company is different: a different stage in the lifecycle, a different size, a different culture, different markets, different needs to change.

The right amount of investment in technology and systems is the amount that a trusted and experienced technology executive with hands-on technology experience coupled with financial and business knowledge and acumen tells the CEO s/he needs to achieve the business goals.

I don’t know what McEwan’s definition of “underinvestment” is, but chances are very good that the real issue is lack of solid relationship, and possibly leadership, between the CIO and CEO over the years.

CEOs Must Know Their Products (or, It Isn’t Just About Numbers)

Monday, December 2nd, 2013

Last week, HP announced its fourth-quarter results. Apparently, they were better than expected, but revenue still fell. It says a lot that a company can have falling revenue, and still beat expectations. What does it say about HP when analysts expect revenue to fall even worse than it did??

I particularly liked a quote in Australia’s “The Age” on the HP results.

HP, one of the oldest companies in Silicon Valley, was blindsided by advances like smartphones, tablets and cloud computing, all of which have hammered its core businesses…

Blindsided?

  • Simon Wardley, one of the top macro strategy technology consultants, has been writing about cloud’s inevitability for years.
  • The iPhone has been around since 2007, but the Handspring Treo was launched in 2002, the Blackberry years earlier.
  • At least the iPad (and follow-on tablets) were quick out of the gate; HP has some excuse.

I used to do quite a bit of business with HP when I worked as an executive in IT, and especially after their 2001 acquisition of Compaq, who made excellent data centre servers. One of the things I noticed over and over was that HP were, in some ways, like Oracle: aggressive and successful sales staff. But in other ways, they were not: their executives (and their Board) never got or even cared about the core product. I first noticed it during Carly Fiorina’s days, but it was strong during the tenure of Mark Hurd as well as Leo Apotheker; I cannot comment from first-hand experience during Meg Whitman’s two years (so far) at the helm.

Metrics, numbers, financials… they help you report on the state of your business and run it. But your strategy, your future, your ability to do something positive with those numbersmust come from the product! If you don’t get the product, then you don’t get what your customers are doing, why they are doing it, how to respond to or get ahead of your competition, and what fundamental changes threaten your entire business model.

HP is actually getting into the cloud – they are even taking over healthcare.gov, although that is probably a bad bet for HP – but don’t understand how it works and what to offer. They are using the same sales methodology without a fundamental understanding. I am aware of several cases in the last few weeks where they tried to sell customers on add-ons that would have adversely affected their security or manageability… and they want customers to trust them to operate it??

Much ink has been spilled (can we use that phrase if it is all digital?) on Tim Cook’s not being a product visionary the way Jobs was. It may or may not be true that he is not a product visionary, but he does fundamentally get Apple’s products, how and why they are used and by whom.

Yes, HP needed to replace Apotheker with Whitman, and probably Hurd as well. But what they really needed was a change in Board-level and then executive-level mindset, that the numbers are nothing more than a tool to get insight into the performance of the business, but understanding customers and product are the key to using that tool to build the business.