What are Bad Profits?

Yesterday, I had a lengthy conversation with the Vice President of Finance of a major company. He was immersed in the capital budgeting process, and wanted to discuss ways to evaluate investment proposals.

Our conversation started with a discussion of the cost of capital, which is an important ingredient in evaluating investments. After all, what could be more logical than ranking investment opportunities by their projected returns, taking into account the cost of capital, and putting money into the most lucrative opportunities?

In my writing, I argue that all revenues are not equally desirable – some produce high profits, and some actually produce losses. Profitability management is all about figuring out which is which, and how to get more profits from an existing business.

But are all profits equally desirable?

The answer is no – and the key to understanding the difference between “good profits” and “bad profits” is the Investment Decision Matrix, pictured below.

Investment Decision Matrix

The desirability of an investment is not just a function of the likely returns, but also and more importantly, the strategic relevance (whether the investment moves the company’s strategy forward).

Two quadrants of the matrix are easy, the other two take some thought. Let’s start with the easy ones. The upper right, high returns and high strategic relevance, is an obvious winner. The lower left, low returns and low strategic relevance, is a pretty poor bet.

Think about the upper left, high returns but low strategic relevance. This quadrant is quicksand. These investments look very attractive, but take the company’s capital and focus away from its main line of business. All too many companies have unclear and unproductive positioning because they lack the discipline to say no to attractive-looking investments that don’t fit. Ultimately, companies that do this get picked off by highly-focused competitors. These are the investments that produce “bad profits.”

Let’s look at the lower right, low returns but high strategic relevance. These are investments that would show up at the bottom of a simple capital budgeting ranking, but are essential to moving the company forward. Here, the watchword is “courage.”

For example, I remember meeting with the top officers of a major telecom company several years ago when telecom companies first began to develop video capabilities that could compete with cable TV. The company had a study that showed that an early investment in video would not pass the company’s investment hurdle rate. The question was whether to invest.

After discussion, the officers saw that the real question was not whether this initial video investment produced high enough returns. Rather the right question was whether the company was willing to remain the dominant communications channel into millions of customers, or whether it was willing to open the door for a host of competitors to get a foothold in all of their customers. Fortunately, the management team made the right decision.

The moral of the story: If investments in the upper left quadrant produce “bad profits,” investments in the lower right produce “good losses.”

How is this possible? Investments are virtually always part of larger business or strategic initiatives. The correct frame of analysis is the overall initiative, not just the component investment.

Within this strategic context, capital budgeting is a useful way to evaluate alternative ways to accomplish a strategic goal (e.g. which machine to choose), but you can’t use capital budgeting to determine strategy.

This is why it is so important that CFOs and other top finance managers be broad-gauge strategic thinkers, as well as disciplined business managers. Their company’s future depends on it.

Sustainable Profitability

In yesterday’s commentary, I talked about our economic dilemma, summed up in this quote from Sunday’s NYT:

“This seeming contradiction – falling sales and rising profits – is one reason the mood on Wall Street is so much more buoyant than in households, where pessimism runs deep and joblessness shows few signs of easing.”

Yesterday’s WSJ ran an article, “Investors Say No to ‘Let’s Expand’ Companies” that expanded this view.

What’s wrong with this picture?

What’s missing is the concept of sustainable profitability. Managers and analysts today make the huge hidden assumption that in a stagnant economy, growth diminishes profitability, unless through some mysterious mechanism the whole economy strengthens and all ships rise on the incoming tide. Picture the airlines where all carriers chase business and add capacity until they run out of money.

This assumption is completely false.

In my research and consulting in over a dozen industries, I’ve found that even in the best-known leading companies, 30-40% of the business is unprofitable by any measure, and 20-30% provides all the reported profits and subsidizes the losses. In years of my writing about this, no one has disagreed.

What this means is that every company has a core portion of its business that generates high, sustainable profitability, and that even leading companies look like islands of profit in a sea of red ink. The islands can be identified, secured, and grown rapidly, yielding high sustainable profitability even in a weak economy. Moreover, a lot of the marginal business can be turned around in a surprisingly easy way, and can become sustainably profitable.

What keeps managers from doing this? Three key factors stand out:

(1) our historical accounting systems were developed in a prior business era, and they fail to show managers where their core sustainable profitability resides;

(2) sales compensation is not aligned with the need to grow business that has high sustainable profitability – in most companies, all sales or gross margin dollars are equally desirable;

(3) most companies have a blind spot when it comes to creating compelling new value for the customers that are capable of giving them high sustained profitability – instead they spread their efforts across their whole customer base, or focus mostly on large accounts, without regard to which do, and which do not, yield sustainable profitability.

Sustainable profitability is within the reach of every manager. It does not require capital, but it does require insightful management and leadership.

Picture Southwest Airlines, the exception to the airline industry portrayed above. Southwest has prospered and grown in good times and bad because it clearly understands what business fits and yields high sustainable profitability, and, more importantly, it understands and avoids the business that does not.

Sustainable profitability is the key to lasting success. With it, companies can both proper and grow, and in the process, play a vital role in reversing our economic malaise.

Who Needs Customers?

The July 25 NYT ran an article, “Industries Find Surging Profits in Deeper Cuts.”

The essence was that our economy is in a unique situation: profits are soaring – not because sales are rising, but because costs have been cut to the bone and are staying that way. Meanwhile, unemployment is terrible, and may well stay that way for 3–5 years (David Gergen’s view).

Here’s a quote:

“This seeming contradiction – falling sales and rising profits – is one reason the mood on Wall Street is so much more buoyant than in households, where pessimism runs deep and joblessness shows few signs of easing.”

It reminds me of a story my father used to tell about an elderly couple in a small New England town. The husband had been employed by the town for 30 years to polish the Civil War cannons on the village green. One day he came home and announced to his wife, “I’m going into business for myself – I bought a cannon.”

Think about it.

The Early Days of Facebook

This morning, I noticed that the Harvard Crimson website featured a link to the original February 9, 2004 Crimson story reporting the creation of what is now Facebook. Note the quaint headline, “Hundreds Register for New Facebook Website“.

Remember, this was 2004 and Mark Zuckerberg was a sophomore in college. Today, just six years later, Facebook announced that it had reached 500 million members, and Mark Zuckerberg is a billionaire.

The article is very interesting reading. Here are a few quotes:

“After about a week of coding, Zuckerberg launched thefacebook.com last Wednesday afternoon.” “‘Everyone’s been talking a lot about a universal face book within Harvard,’ Zuckerberg said. ‘I think it’s kind of silly that it would take the University a couple of years to get around to it. I can do it better than they can, and I can do it in a week.’” [A Harvard official responded that the creation of a University facebook was not that far off.]

The story of Facebook’s origin is reasonably well known. However, the article mentions a little-known fiasco that preceded it.

“Zuckerberg said that he hoped the privacy options would help restore his reputation following student outrage over facemash.com, a website he created in the fall semester.” “Using without permission photos from House facebooks, Facemash juxtaposed the pictures of two random Harvard undergraduates and asked users to judge their physical attractiveness.”

Facemash landed Zuckerberg before Harvard’s Ad Board (the disciplinary committee), but he learned from his mistake. “‘Facemash was a joke, it was funny, but at its root it had problems – not only the idea but the implementation. It was distributing materials that were Harvard’s. I was very careful with [thefacebook.com] to make sure that people don’t upload copyrighted material,’ he said.”

The rest is history. What does this tell managers and entrepreneurs? Here’s my short list.

(1) There is a tremendous power to showcase projects – just trying things and learning by doing. Thefacebook.com never would have stood the test of a formal business case because its market could not have been measured at the time it was developed.

(2) Don’t be deterred by an early stumble. Facemash certainly was ill-advised, but Mark Zuckerberg managed to learn from this experience and move on to do something that really endured.

(3) As Nike would say, “Just Do It.” Almost everyone has some good ideas in mind, but few have the resolve to put them into action – either within your company or on your own. This is one of the essential things that separates leaders from followers.