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Business Reviews (Click On The Appropriate Link)
July 25, 2006: The blogosphere is full of discussion about customer service issues at Dell. Debbie Weil, of Blogwrite for CEOs, links some of the meaningful articles in the ongoing battle between bloggers and Dell.
With Dell stock trading at levels not seen in the past four years, and non-stop criticism from a small but vocal group of bloggers, I thought it made sense to dig into Dell's most recent 10-Q statement, and learn a little bit about the company's financial performance.
In the first quarter, Dell generated just over $14.2 billion dollars net sales, verses $13.4 billion dollars last year. That's the good news. Gross margin, as a percentage of net sales, decreased from 18.6% last year to 17.4% this year. Dell states that pricing declined faster than decreases in component costs.
Of interest are comments about how Dell plans to reduce costs. One comment states the following: "Cost savings initiatives include providing certain customer technical support and back-office functions from cost-effective locations..." In other words, Dell plans to continue outsourcing various jobs to locations where labor is cheaper, including back-office functions. A lot of us "back-office" folks watched technology jobs move overseas during the past decade. Now jobs in finance or human resources are considered fair game as well. Without a doubt, it is time for the back-office employee to have a career plan, given that leading companies like Dell are publicly stating that back-office jobs are heading elsewhere.
Last year's 10-K statement outlined other issues that Dell faces. The statement indicated that, at the end of fiscal 2005, an amazing 39,900 of 65,200 employees (61%) were located outside the United States, while just 41% of revenue is generated outside the United States.. Dell's third quarter is more dependent upon government contracts than other quarters. Consumer demand is greatest in fourth quarter.
Also of interest is the meteoric growth in top-line sales, since 2001. Sales increased from $32.2 billion in 2001 to $55.9 billion in 2006. This helps explain the hoopla surrounding sales that increased slowly in first quarter. Operating income was 7.8% of revenue in 2005, compared with 8.4% in 2004, illustrating that the profitability trend observed in Q1-2006 continues unabated.
Also interesting is that Dell no longer reports on sales to consumers. At the end of 2005, Dell generated 14% of sales from consumers, verses 15% in 2005, and 16% in 2003. Desktop revenue declined from 45% of sales in 2003 to 38% in 2005. This revenue was offset by small increases in mobility (laptops and mp3 players), software and enhanced services. In other words, Dell has basically maximized their desktop business. As customer behavior shifts to laptops, and as the mix of business further moves to businesses, Dell is highly dependent upon transitioning its desktop business clients to laptops to maintain successful and profitable growth. This transition will largely determine Dell's success over the next 2-3 years.
As I read through Dell's financial records, it becomes obvious that the company is significantly impacted by the transition from desktop machines to laptops, margin pressure, a shift in focus from consumers to businesses, and a shift in focus from a US-based business to a Global-based business. While the blogosphere focuses on customer service problems and a lack of authenticity exhibited by the company, it is clear that Dell has much bigger fish to fry. Dell has to successfully manage four transitions, all happening simultaneously, in order to be successful in the long term. It will be interesting to see how well Dell navigates these tricky waters.
July 23, 2006: Circuit City shares (NYSE: CC) have tumbled by more than twenty percent in the past three months, though some pundits feel Circuit City is in the midst of a financial turnaround.
In the three months ended May 31, 2006, Circuit City posted a pre-tax profit of $7.8 million on net sales of $2.6 billion, yielding an approximate pre-tax profit rate of 3%. A year earlier, Circuit City lost $19.2 million on sales of $2.2 billion. This helps defend pundit opinions that Circuit City is improving their business.
Circuit Cirty SEC filings indicate that their US-based business is performing better than their international business. International business, primarily in Canada, generated an after-tax loss of $4.3 million, whereas the US-based business generated an after-tax profit of $9.3 million.
Multichannel statistics are interesting. Comp-store sales in the first quarter grew by 14.5%. However, online sales are included in comp store sales. Therefore, retail comps were greatly influenced by an 85% increase in web-originated sales verses last year. This should make multichannel pundits happy. Circuit City is continually lauded for its "buy online, pickup in store" program. The increases should also make Circuit City executives happy. Given that Internet Retailer estimated that online sales were 7% of total Circuit City sales in 2005, an 85% increase in online sales contributes about five of the 14.5% point increase in comp store sales. Reporting online sales in comp store sales overstates overall comp store productivity.
Circuit City operates four divisions. Video represented 44% of first quarter sales, and produced double-digit increases in the first quarter. Information Technology, representing 29% of first quarter sales, experienced a low-double-digit increase, led by notebook computers and printers. Audio, representing 16% of the business, experienced a double-digit comp store sales increase. The entertainment division, 11% of the business in first quarter, experienced a single digit comp store sales increase. The company expects continued growth in flat-panel televisions, portable digital audio, and notebook computers.
Circuit City offered guidance that it expects to achieve net sales growth of between seven and eleven percent, and earnings before taxes of between 2.0% and 2.4%. The company also states that it will continue to invest in multichannel activities.
The results indicate that Circuit City is very dependent upon driving comp store sales increases to achieve profitability. Had comp store sales been below ten percent last quarter, it is unlikely that Circuit City would have generated a quarterly profit. The online channel is clearly contributing to the success of the business, in the first quarter.
July 6, 2006: eBay announced a shakeup within its management staff this week, signaling continued change in their business. A review of their most recent SEC quarterly filing illustrates some of the issues facing the company.
During the first quarter of 2006, sales increased a healthy 35%, from $1,031,724 last year to $1,390,419. Gross Margin decreased from 81.9% last year to 80.0% this year. This metric was partially influenced by changes in stock option expensing.
Expenses, after accounting for changes in how stock options are expensed, have increased at a faster rate than sales have increased. Sales and Marketing expense increased by 39% verses last year. Product Development increased by 33%. General and Administrative expenses increased by 40%.
As a result, income from operations decreased by 4% after accounting for stock options. Income from operations, on a comp basis with last year, only increased by 20% on the 35% increase in sales. In other words, eBay is not generating sales fast enough to cover rising expenses.
Their filing indicates other interesting tidbits. PayPal is the fastest growing of the three mature business units at eBay, growing by 44% over last year. However, only 26% of PayPal dollars flow-through to profit. US Sales increased by 30%, and these sales flow-through to profit at a much more impressive 40%. The most profitable unit, International Sales, only increased by 25%, though these sales can be influenced by exchange rates. International Sales flow-through to profit at a whopping 48%. In other words, the fastest growing business areas at eBay generate the lowest rate of profit. This is not good for the future of eBay. Couple that with their purchase of Skype, which lost more than eight million dollars on sales of $35 million, and the profit story isn't great.
Further compounding eBay's growth problems are subscribers. Although net sales increased by 35%, the number of active users, those active over the past year, only increased by 25% verses last year. This may indicate a future problem for eBay. PayPal accounts, measured as active users over the past three months, increased by 32% verses last year, a rate that is less than the rate which net sales are growing.
The data may indicate that eBay is reaching maturity, as a business. Obviously, I don't know the inside workings of eBay, so any comments about eBay reaching maturity are purely speculative. It will be interesting to see if eBay can find additional ways to grow.
In their 10-Q statement, management states that they may need to increase marketing and brand expenses. One of their quotes states that "Brand promotion activities may not yield increased revenues, and even if they do, any increased revenues may not offset the expenses incurred in building our brands. If we do attract new users to our services, they may not conduct transactions using our services on a regular basis. If we fail to promote and maintain our brands, or if we incur substantial expenses in an unsuccessful attempt to promote and maintain our brands, our business would be harmed." In other words, eBay may spend marketing dollars to promote business units, and those marketing dollars may not have a corresponding return on investment, limiting future growth.
eBay's PayPal unit is facing increased competition from Google. And reports indicate that Microsoft has an interest in merging their MSN unit with eBay. The next few months could prove to be very interesting for a previous stock darling that has lost more than fifty percent of its market capitalization over the past eighteen months.
June 23, 2006: Several years ago, my wife and I sold a home we had purchased forty-five months earlier. At closing, we were surprised to learn that we had to pay a $5,000 pre-payment penalty, because the loan had been paid off before four years elapsed.
We paid the penalty. We did ask Bank of America to forgive the penalty, given that we had just taken out a mortgage that would generate far more interest in a short period of time than the penalty we were assessed. Naturally, Bank of America declined our appeal.
Two short years later, we refinanced with Wells Fargo. To-date, Bank of America lost $100,000 of interest income, but gained the $5,000 pre-payment penalty. Try calculating the lifetime value of that decision!
Bank of America makes their 10-K statements available on their website, www.bankofamerica.com. These financial documents tell a fascinating tale of the money-making machine that is Bank of America.
In 2005, Bank of America received $34.8 billion dollars (yes, billion dollars) in interest and fees on loans and leases. For instance, when you make your $1,500 payment on your mortgage, the majority of that payment goes to interest, not to the principal on your home. Across all interest income categories, Bank of America generated $58.6 billion dollars of revenue. Amazingly, Bank of America only generated $27.9 billion dollars of interest expense, yielding $30.7 billion dollars of income.
Bank of America also earns $25.4 billion dollars of non-interest income, including $7.7 billion dollars in service charges, things like ATM fees or annual fees on your credit card. Another $5.8 billion is earned on credit card income.
So, in total, Bank of America earned $56.1 billion dollars of income. Non-interest expense was $28.7 billion dollars, yielding $24.5 billion dollars of pre-tax profit. $24.5 billion dollars of pre-tax profit.
Bank of America then paid $8.0 billion dollars of income tax expense. And we wonder why big business is so influential in governmental issues?! After subtracting taxes, Bank of America took home $16.5 billion dollars of after-tax profit.
It is amazing that we Americans don't raise more of a stink about how much money we give to banks, like Bank of America. We grumble over paying $3.50 for a gallon of gas, and feel frustrated when our annual gasoline bill is $3,000. We feel like the oil industry is gouging us.
Yet, homeowners deal with a situation that is much more severe on their checkbook. A family with a $200,000 mortgage at a 6% interest rate pays as much as $8,700 a year in interest expense. If this family earns $50,000 per year, as much as a quarter of take-home pay goes to the bank servicing the mortgage. Add to that home equity loan interest, credit card interest, car loan interest, service charges and annual fees, ATM charges, and any other expense, and it becomes obvious that your local bank has control over your checkbook.
June 17, 2006: Have you ever wondered why your popcorn and diet soda cost $9 when you visit the movie theater? It is probably because that is the only way that a movie theater can stay in business. A simple review of Regal Cinemas SEC filing for 2005 illustrates the problems facing movie theaters these days. Let's MineThatData, and understand how expensive concessions contribute to the profitability of this organization.
Regal Cinemas operates 6,463 screens in 555 theaters across 40 states, representing a significant portion of the movie industry. During 2005, here is how their financials break down:
Revenue (Sales Numbers in Millions):
Other Operating Revenue $194.7
Total Revenue $2,516.7
Two-thirds of their revenue comes from ticket sales. The average ticket sold at a Regal Cinemas is $6.80.
Twenty-six percent of their revenue comes from concessions, with the average customer spending $2.70.
The fastest growing source of revenue is in other operating revenue. This category represents the advertising you see before a movie, as well as business meetings held in the theatre during off-hours.
A movie theater is expensive to run. Let's break down some of the expenses at Regal Cinemas.
Fifty-three percent of admissions revenue is gobbled up in film rental and advertising costs. This means $3.62 of your movie ticket are gobbled up by the movie industry.
Of the $2.70 you spent on concessions, Regal Cinemas pays $0.39 for the product, pocketing $2.31 of your expenditure. The product you purchase at the concession stands costs about seven times as much for you to purchase as it cost Regal Cinemas to purchase. Wow.
The remainder of your movie ticket is gobbled up by other expenses. Remember that $3.62 of your movie ticket goes to cover film rental and advertising costs. Another $1.27 goes to cover the rental expenses of the actual theater. Another $3.90 cover general and administrative expenses, depreciation, and an assortment of other costs.
So, you spend $6.80 on your movie ticket. Regal Cinemas pays $3.62 + $1.27 + $3.90 = $8.79 per ticket to cover their expenses. See the problem? The theater has already lost $1.99 on you, the customer, the minute you purchase your ticket.
This explains why the theater needs the $2.31 profit generated by concessions, and why the theater needs an average of $0.80 advertising revenue per customer, in order to survive.
With movie traffic decreasing year-over-year, Regal Cinemas generates all of its profit from concessions and advertising. And as traffic continues to decrease, Regal Cinemas continues to ask its most loyal customers, the ones still going to theaters, to pay more and more money on food, and to watch more and more advertisements. This is the way Regal Cinemas is trying to remain profitable.
It should also be noted that almost half of the profit Regal Cinemas generates is gobbled up by interest expense. $0.19 of your $6.80 ticket go to cover the interest on debt that Regal Cinemas has.
This is a business model that is tough to profitably manage. The next time you decide to boycott the $9 you will be charged for popcorn and a diet soda, consider the alternative --- that one day in the not-so-distant future, the theater industry just won't exist.
July 29, 2006: See this article for a recent update of Netflix performance, and increasing customer acquisition rates.
June 9, 2006: Paul forwards this article about Netflix. The article discusses how Netflix took advantage of a gaping marketing hole, by providing a catalog of 60,000+ movies via mail to customers with interests that go beyond the most popular, most recent 1,000 movies.
Netflix dramatically grew its subscriber base over the past three years. At the end of fiscal 2003, Netflix had 1,487,000 subscribers. This number grew to 2,610,000 at the end of fiscal 2004, and an amazing 4,179,000 subscribers at the end of fiscal 2005.
Rapid growth of this nature requires an enormous investment in Customer Acquisition. Customer Retention is also important. Let's explore these two dynamics.
Netflix states that their churn rate, the percentage of customers who end their subscriptions, is 4.1 percent per month. Netflix also states that the churn rate is greater for new customers than for existing customers. I infer that Netflix keeps, at best, fifty percent of its subscribers on an annual basis, keeping 1.3 million of the 2.6 million subscribers from the start of fiscal 2005.
Netflix must add 2.8 million subscribers to get to the stated total of 4,179,000 at the end of fiscal 2005. Netflix states they added 3,729,000 new subscriptions, so several (1/3) of the new subscribers also ended their relationship with Netflix.
Netflix allocates marketing expense to new customer acquisition. Given this allocation, we can make an educated guess as to the lifetime value of Netflix customers, and compare lifetime value against the cost per acquisition.
In 2005, Netflix paid $38.08 for each new subscriber. By looking at the profit and loss statements provided by Netflix, we can see that most of their expenses appear to be "variable". This means that most expenses increase at a rate similar to net sales. Expenses that are "fixed", like salaries of management, corporate office expense, and the like, are often not counted in lifetime value calculations.
Ok, Netflix states the following expenses, as a percentage of net sales:
Subscription Fees (shipping disks) = 57.7% of Net Sales.
Fulfillment Expense (Netflix buys movies) = 10.4% of Net Sales.
Technology Development = 4.5% of Net Sales.
General / Administrative Expenses = 4.3% of Net Sales.
Resale of Old DVDs = -0.3% of Net Sales.
Total = 57.7 + 10.4 + 4.5 + 4.3 - 0.3 = 76.6% of Net Sales.
Let's assume that half of Technology Development and General / Administrative Expenses are fixed. This yields 72.2% of Net Sales that are variable.
We're making progress, now. Netflix states that they receive $17.06 of revenue per subscriber per month.
We also know that about four percent of these subscribers leave the company each month. Therefore, on an annual basis, the average customer is expected to spend ($17.06*0.96*0.083 + $17.06*0.92*0.083 + $17.06*0.88*0.083 + ... + $17.06*0.52*0.083) = $154 of revenue per year.
Multiplying this number by 72.2% expense yields $42.11 profit. Subtract $38.08 of marketing expense, and we finally get to our magic number. $4.03 is the approximate amount of twelve-month profit generated by a new customer.
In other words, within twelve months, Netflix recoups its customer acquisition expenses. As long as Netflix keeps its churn rate below 4%, keeps its revenue per subscriber at $17.06 or higher, and manages expenses properly, it has the potential to be a very profitable business. Remember, many of these customers will continue to maintain their subscription into future years, driving lifetime value even greater, driving even more future profit.
Challenges will occur once Netflix exhausts the potential number of customers who are willing to receive rentals via the mail. At that point, customer acquisition costs will become very expensive, and Netflix faces the potential of becoming unprofitable, should it continue to spend so much on marketing. The data indicate that Netflix isn't close to that ceiling of customers, yet.
Challenges can also occur if Netflix continues to acquire customers at lower subscription fees ($9.99). I'm sure Netflix staff have "run-the-numbers" on these subscribers, and have measured short-term costs verses long-term profit. Management will need to identify the churn rate of these subscribers, and will need to evaluate lifetime value against a much lower revenue base.
Netflix receives a "thumbs-up" from MineThatData for good financial management of the business model, in today's business climate. At some point in the future, Netflix will have to deal with the inevitable shift in movies from DVDs to digital downloads. With luck, they will get through this and all other challenges in a profitable manner.
June 1, 2006: If a tree fell in a Sharper Image store, would any customers or employees hear it fall?
The story of Sharper Image, and their quick fall from grace, illustrates the razor-thin margin of error businesses have. Mis-steps in just one or two items can lead to the collapse of a 2,500 employee company that spent three decades building its reputation/brand.
This MSN article, from a little over a year ago, outlines problems Consumer Reports found with an air purifier sold by Sharper Image.
All of the facts listed in this discussion are from the Sharper Image 2006 10-K filing.
In 2003, Sharper Image operated 149 stores, a catalog division, and a website. Combined, these channels drove $648 million in net sales, and $39 million in pre-tax profit. At a six percent pre-tax profit, Sharper Image posted average, if not spectacular, results.
Just two years later, Sharper Image operated 190 stores, a catalog division, and a website. Combined, these channels drove $669 million in net sales, and an amazing pre-tax loss of $27 million.
Along the way, a perfect storm of problems confounded Sharper Image management. Negative press about the failure of air purifiers to purify the air caused a dramatic drop in sales of these items. In addition, a significant portion of sales came from massage chairs. The vendor responsible for producing the massage chairs elected to sell cheaper versions to Sharper Image competitors, undercutting Sharper Image. Air purifier and massage chair sales plummeted by an amazing $126 million.
Sales of other items increased by $35 million, providing hope for Sharper Image. However, sales increased in product lines like branded MP3 players, which carry low margins, reducing profitability. In fact, cost of goods sold were nearly identical in 2005, compared with 2004.
Given the dire conditions at Sharper Image, management undertook several cost-cutting measures. Between 2004 and 2006, advertising expense will be reduced from $150 million to about $80 million. Reductions are across the board, with the notable exception of online marketing, which will be increased in 2006. Catalog page counts are being reduced from 88-96 pages to 52-76 pages. The catalog business decreased, from $131 million in 2004 to $87 million in 2005, in part to lower demand, and advertising reductions. Even the online channel, growing by 20% to 40% at most companies, failed to grow in 2005, decreasing from $116 million in 2004 to $107 million in 2005.
At the corporate office, headcount was cut by twenty percent. In stores, staffing was reduced from 8-12 employees per store to 7-10 employees per store. In addition, employees lost their sales commissions. Instead, management instituted bonuses based on achieving sales goals and expense management. Executive pay was reduced by fifteen to fifty percent, though executives somehow got to keep their jobs.
The bad news continues for Sharper Image. May same store sales are down an amazing thirty-six percent. A first quarter investor conference call is scheduled for June 8. Disenchanted investors forced a change on the Board of Directors, hoping to increase future sales and profit.
This business review clearly illustrates the razor-thin line that separates success from failure. Two years ago, the sky appeared to be the limit for Sharper Image. Impressive sales per square foot of more than $600, and huge comp-store sales gains, resulted in an aggressive expansion plan.
Mis-steps on only two items paved the way to collapse. I would be curious to hear what branding experts have to say about Sharper Image. If this company had a 'strong brand', then why would customers leave in droves when just a few mistakes were made? If this company had a 'weak brand', then why was it driving sales per square foot figures that were industry-leading, at over $600? What would a branding expert recommend to save this business?
Ultimately, no amount of branding, CRM implementation, target marketing, word-of-mouth marketing, return-on-customer studies, leadership blogging or other window-dressing can save a business when the fundamentals are messed up. In this case, customers did not forgive Sharper Image for making one mistake. In addition, customers did not exhibit any customer loyalty when competitors offered similar massage chairs at lower prices. An apparently healthy and profitable businesses quickly descended into chaos.
I believe the lesson to be learned from Sharper Image is one of managing the fundamentals of your business. Dependence upon a breadth of quality products helps a company ride out storms like this. In retrospect, the company expanded so quickly that, when everything turned bad, the added expense and lower sales-per-square foot of new stores caused the profitability of the company to suffer. In the rush to grow sales, the company relied upon products with low margins, making profitability even more challenging.
Unfortunately, the employees, the very same employees who did the same level of work two years ago when the business was successful, bore the brunt of this downturn. The importance of quality merchandising cannot be under-stated.