Retail – Bates Creek Consulting

We love our Guru’s but they aren’t helping

I have been saying for many years that we are using the word ‘guru’ only because ‘charlatan’ is too long to fit into a headline. Peter F. Drucker.

There is comfort knowing that someone knows what is going on and can help us by giving us their opinions about politics, stocks, how to live better and what to wear. All we have to do is to find the right guru – the right advice. We think we are reducing risk by following a guru, but we aren’t. But, at least we won’t look foolish alone.

There are not many physics guru’s because one important part of guru-ness is that the subject matter should be indeterminate, that is that it cannot have a single right answer. The stock market is prone to guru’s. There are no simple answers and what works one day, won’t work another. Investment shows on TV are about entertainment, not education.

By now hopefully you know that there are no stock market guru’s. It is simply not possible to forecast where the stock market is going in the short term. Most of what passes as forecasts are 20/20 hindsight or deal with relative valuation of the market. I think relative valuation is useful, you can buy the market at a discount. I know you will pay less for Christmas/Holiday cards in January (11 months early) than November. However, buying something at a discount doesn’t stop the chance that there will be a bigger discount later.

“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. ” Lao Tzu

Politics is similar to the stock market. The guru’s in politics are no more accurate, and offer no more clarity than the stock market guru’s. Political forecast accuracy has been the subject of quite a few good books. Tetlock’s book “Expert Political Judgement” outlines his thoughts on why so many political forecasts go poorly. Philip Tetlock’s suggests that foxes are better than hedgehogs at forecasting. The fox knows many different things, hedgehogs know a few things well. His more recent book with Dan Gardner “SuperForecasting” offers examples of good and bad forecasts and includes some suggestions on how to do it better.

Forecasts are effected by circumstances and human behavior that in the short term can be identified, but in the long term (more than a year or so) have too many interactions to be of any use in forecasting. Like the weather forecasts which fall apart the further out you forecast, the longer the time frame the more human behavior and chance result in different outcomes.

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.” – J. Scott Armstrong

There are a lot of guru’s in the business world. Harvard seems to grow them like tomatoes. The history of management includes a lot of ideas that turned out to be stinkers. Scientific management wasn’t a very good idea even when it came out. Re-engineering turned out to be another way of saying lay-off. I’ve spent hours debating core competencies which in the end, couldn’t be defined or implemented. Theories that can’t be tested are especially prone to guru-ness.

Trying to implement guru’s advice can be frustrating. I loved “In Search of Excellence” but the advice was general like “stay close to the customer”, which is almost perfect guru advice since you can always say you weren’t close enough. I call it Zott’s Law of Business Books. The more general, the easier to read, the less useful the advice. Kahneman’s “Thinking Fast and Slow” was a top business book of 2015 and is interesting and a good read. Again, not much useful advice.

J. Scott Armstrong also said, “If you can’t convince them, confuse them.” A lot of business guru’s wrap pretty simple ideas in complicated language.

The Principal Agent problem states that there are differences between principals and agents (owners and managers) and that making agents more like owners will solve the problem. I like Agency Theory, it explains a lot of behavior. We sought to fix this problem by giving executives stock options. Since then we’ve spent millions on stock options and it doesn’t appear that management is any more aligned now than before. The cure I think is worse than the disease.

We listen to these guru’s because we want an answer. The answers given aren’t necessarily right nor particular useful, but they are confident and we value that certainty. Guru’s use our need for certainty to sell us their opinions (and via advertisements, dish soap). In today’s world of fake facts, alternative news, spin and TV personalities who are selected and paid for their ability to speak confidently (without knowledge), our main defense is a healthy skepticism . Skepticism and an understanding that we live in an uncertain world.

Quidquid latine dictum sit altum videtur – Anything said in Latin sounds profound.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

Paying a Price for Certainty

We all want certainty. We want our investments to average 5% return a year (7.375% if you are in the state of California), our children to grow up strong and healthy and it to only rain at night. However, life is uncertain.

Insurance is about creating certainty. A small cost is paid, instead of a small chance at a large loss. Health insurance is part pre-paid services (check-ups) and part joining a purchasing cooperative (in-network pricing is a lot cheaper than out-of-network) and part real insurance. Car insurance doesn’t include oil changes, although they do control where certain repairs are made. Not just insurance companies make money on reducing uncertainty.

I once had a competitor that sold a tuning service for radios and electronics. This advantage was a significant part of his marketing and brand value. At some time in the past, there might have been some value in swapping out vacuum tubes but since the 1960s most marine electronics were solid state. By the 1990’s there was nothing to be done to a solid state radio, and if they didn’t work out of the box, they had to go back to the manufacturer. He sold fear, uncertainty and doubt or FUD.

FUD was made famous by IBM, who would meet every new competitor in the computer industry with comments about reliability, threats of the loss of warranty coverage, rumors of financial difficulty and vague hints about losing purchasing status. For the longest time I’d hear the comment “no one got fired for buying IBM”. FUD works.

People will pay for security – even if the math suggests it is a bad bet. My firm started selling extended warranties on our products. This was a big money maker for Circuit City as electronics extended warranties had a 90-95% margin. For a while the staff wouldn’t sell them, they thought the extended warranties were a rip-off of the customers, and we had a no-hassle money back guarantee. Buying an extended warranty is not a good bet, but people appreciated the certainty and paid for it.

Eating at McDonald’s is not normally a “treat”. We select fast food because of the consistent product, price and convenience. We know what we are getting – uncertainty is reduced. Retailers who reduce uncertainty increase sales. Zappo’s can sell you shoes because they agree to take all returns. I doubt Zappo’s makes much profit on its shoes, the freight has to be killing them (see here) but given that Amazon owns them and Amazon is the worlds largest capital destroyer it is ok.

I see the problems with seeking certainty as a function of information asymmetry, competition and add-ons. The retailer that offers a money back guarantee knows how often goods are returned and when they sell you an extended warranty, the likelihood of your using the warranty. You can’t judge if it is a good deal or not. Those situations are referred to as information asymmetry, where one side knows more than the other. Learning more about failure rates can give you confidence to skip paying an extra 15% for a product, knowing the chance of fault might be 0.02%. A phone with a one year warranty and a three year overall life doesn’t present much time for a failure.

Your car insurance company knows more than you do about the likeliness of an accident and they price the insurance so that they make a profit. The car insurance company is kept honest by a competitive market place and regulators. Competitors push prices towards an equilibrium, which is lower in price than an un-competitive market.

The least competitive market is one where you have little time and no access to competitive prices or data about risk. This happens while standing in line, or in the midst of a transaction when an add-on is offered. Rental car companies are good at offering you several levels of insurance-like services (one full priced for 100% coverage, a second with a deductible, a third with a collision damage waiver) while all levels of coverage are priced extremely high. It is not unusual to pay $5-6 a day for coverage for your new car, and $40 a day for insurance for a rental car. The extended warranty is pitched to you at the register without any time to calculate the costs, benefits or risks.

Seeking security isn’t a problem, and reducing uncertainty isn’t bad. One consequence of a population that doesn’t understand probability is that we will be taken advantage of by providers of certainty. Be a smart consumer, do your research before you buy.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Three Thoughts on Balancing Profit and Uncertainty

Life is uncertain. Any entrepreneur knows that to start a business, you have to take a chance. You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk. Frank H. Knight defined risk as events that have a probability and a severity and are calculatable. Uncertainty is defined as those events without a probability and a severity. We face both uncertain outcomes and risk in our lives.

As a professional CFO, I’ve worked to limit uncertainty and manage risk. Eliminating risk and uncertainty however is impossible and will kill a business. The very nature of profit comes from taking a chance and offering a solution for a customer. A risk-free (and low uncertainty) business doesn’t exist. The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%. If you want to make more than 2.2% you are going to have to take on risk.

Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.

Profit comes from risk taking. The risk taking must be commensurate with the return, or it is foolish. Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers. Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.

Managing risk (and opportunity) sometimes means thinking about what could change. What assumptions are foundational to the business model which if changed would result in a serious impact to the firm? Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.

Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers. Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.

Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy. Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety. If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show. When a great deal of income depends on the health of one man, then there is a big assumption of risk.

Business decisions can increase or decrease risk and uncertainty.

Every decision we make creates new risks and uncertainty. Selecting a new ERP system? Hiring a new executive? Changing a key purchase policy? All will create both a primary effect and secondary effects that are unknown. Not making a decision, often called strategic dithering, creates additional uncertainties. Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here). I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product. But either way is uncertain.

Too often executive teams ignore risk and uncertainty factors in making their decisions. Anecdotes are easy to understand and are compelling although they are often sample sizes of 1. In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story. Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.

Invert the decision making model – think about increasing risk.

Risk is necessary for profit, but risk as I’ve noted is calculable. Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk. That is what insurance companies do. Offering a money back guarantee on products for a retailer is simple. If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product. The highest margin item I’ve ever sold was warranties on electronics. Most are never used.

If you are a SaaS business, how can you lower the customer uncertainty and increase your payout? Most firms find buying a new system a major endeavor. They’d like to be married, without the process of getting married (which is a hassle). The risks are centered in the conversion, implementation, training and the first 90 days of the new system. Firms will pay to have implementation risk decreased.

Playing safe isn’t always a good option (see here). My local community has half a dozen businesses that are clever, deliver great value and could have a national presence. They don’t because the owners are happy enough with a small local business. Every couple of years change comes to the community or one of the owners and one of these businesses dies. I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”

Conclusion

I think a lot about balancing risk and returns. If you bet the long shot that is undervalued, you may win big, but you will most likely lose. Losing isn’t bad in this case, it is just one iteration of a process that brings a profit. Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.

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Retail Apocalypse or Just Another Cycle?

Bricks & Mortar retail is suffering. People are shifting their shopping habits from in person to on-line. The on-line selection is greater, the prices are better and the shopping experience is relatively easy (in comparison to parking at the mall). Peter Drucker said that “What customers – at least a good many of them – want is not shopping that is enjoyable, but shopping that is painless.”

Although e-commerce will continue to grow, I suspect that on-line shopping will top out in the 20-30% range of total retail sales. The drawbacks of e-commerce (freight, timeliness, inability to touch or try-on) will limit sales to only a portion (although a very significant portion) of total sales. However, just losing another 10-15% of market share to e-commerce will make bricks & mortar returns even less attractive. It doesn’t matter if your retail chain is cannibalizing itself with a web site or it is Amazon, stores will continue to generate worse returns on investment. With lower returns, there will be less capital invested, fewer stores and fewer malls. The New York Times calls them Zombie Malls, the escalators are running but no customers.

There have been many, many articles on how the US is overstored. In 1990 the ICSC reported (Billboard 6/2/90) shopping central growth was dropping due to the country being overstored. ICSC reports the millions of net square feet added to U.S. Shopping Center space in their report “America Marketplace”. You can easily see the post 1980 recession slow down and the post 2008 recession collapse of growth. The dot.com era of 1999-2001 didn’t appear to matter. One conclusion is that the overstored retail space has gotten less overstored in the last seven years.

I don’t know what the right amount of retail space is in the US, but given this trajectory we will eventually reach an equilibrium where demand closer matches supply. However, when equilibrium is reached, a lot of today’s retailers will be gone.

Life Cycle

The usual life cycle for retail bankruptcies is a recession which weakens the retailer, a recovery which allows some breathing room and then another recession which puts the retailer out of business. This is the retailers’ version of the Eldredge & Gould “punctuated equilibrium”, where a significant event creates the opportunity for species growth (or death) followed by a long period of relative calm. Eventually another significant event punctuates the equilibrium and the game changes. This cycle is only slightly different from the normal recession/recovery/recession, as the punctuation now is the on-going loss of market share to e-commerce. If we get another recession, then we should expect even greater industry turnover.

The total profit of a transaction is split between the manufacturers (the product), real estate (the space), staff (the labor) and the retailer (the operator & the capital). This is an uneasy relationship, as total profitability is limited by the market. Each player takes the steps that create the most long-term value for their portion. The losers in the movement online so far have been staff and retailers. Next the cycle will impact real estate prices.

Tim Harford, who wrote “The Undercover Economist” suggests that over time, the landlord obtains most the profits of the relationship due to lack of substitution. Retailers combat this by negotiating long leases with renewals to lock in the lease costs. If business slows, those long leases can burden the parent company enough to cause bankruptcy. When retailers stop making money, they close stores, vacancies rise, the real estate centers stop making money and the price of retail space falls. Stores are closing at a record pace, and rents are beginning to drop (see here). Lower rents allow retailers a chance to recover and begin growth. However, things are a little different this time as e-commerce will still gobble up market share and retailers have loaded up on debt.

Debt!

One factor that is worsening the crisis is debt. Low interest rates and high equity valuations have caused growth companies to borrow funds to drive growth. When I was a student, we were told that carrying debt would lower the cost of capital as interest on debt is deductible and interest rates are usually lower than the cost of equity. This is an accepted part of finance theory and is used extensively by CFO’s to generate equity returns. Whenever you can invest at a rate of return that is higher than borrowed funds, you create a return to equity (see WACC). So if you can open units that generate a 40% return and are limited to 3 outlets due to limited equity capital versus opening 6 outlets with a mix of equity and debt you generate almost twice as much cash return. The only drawback is a subtle increase in risk and interest costs that comes with additional debt.

The risks aren’t always apparent. Low interest rates are great, but they don’t always stay low. When interest rates normalize, payouts will squeeze profits and options. Most loan agreements are based on covenants that call for enough earnings to pay a multiple of the interest and principal payments. Earnings in a growth company can be volatile as expansion, even if investment oriented, is accounted as expenses by GAAP. Banks use GAAP, not “reported” earnings.

Theoretically financing should not matter. Modigliani-Miller came up with a concept of capital structure irrelevance. They believed outside the tax effects of interest (vs. dividends which are rare), how you financed the company shouldn’t affect the intrinsic value. M-M’s insight was that you could imagine an investment pool that is half debt and half equity buying a company with no debt. The total investment would be leveraged, 50/50. If you bought the stock of a company that was half debt/half equity with a fund that was all equity, the pool together will still be 50/50 leveraged. Whether debt is held at the company level or at the portfolio level is irrelevant. However, the relative amount of debt in the system remains.

CFO’s that leverage their firms (as I did) find themselves taking on risk that may be better placed at the portfolio level. If the investors want leverage, they should borrow to make their investments. I’ve come full circle and consider debt a serious problem for growth companies. Yes, there are some instances when it makes sense, but in general it should be avoided.

The other big debt factor that will grow is lease debt. The great lease debate is now settled for the next decade. The FASB agrees that leases are debt. The new rules further muddy the financials as the value of the liability won’t represent the true value of the asset, and it will put another confusing and inaccurate calculation on the balance sheet. Retailers are readying to put trillions of debt on their balance sheets, drawing further attention to the risk.

Fear is the mind killer – Frank Herbert. Debt is the company killer – The Market.

Conclusion

The future is clear, malls are going to struggle and they are not going to turn into apartments (sorry Sears). The e-commerce story is only half over. Further retail consolidation is likely and we should be looking for new concepts that will be able to use that (now lower cost) space to deliver a product/service package that will compete with the convenience and prices of e-commerce.

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