“The Bear” on Business

I led a buyout of ICG in 2004. We spent less than $9M of our investors’ money. Two years later, investors and management enjoyed an exit for more than $225M. That is approximately a 25 times return.

As you can imagine, I am often asked how we did this. There were a lot of reasons, but in this blog entry, I will focus on one. ICG, circa 2004, was an example (among many) of a company that didn’t understand its franchise. Worse, it thought its franchise was something else–and this led to them re-directing their precious resources on investments that detracted from their core franchise. Although their franchise was interesting, it was in desperate need of fortification. However, management’s attention, and the pursebook, was elsewhere.

Their franchise was deep fiber networks in certain geographies of the country. In a world where companies and individuals of all types need more bandwidth, this is a pretty good franchise. In ICG’s case, the Colorado network, in particular, was special. It was the most extensive network in the front range. Moreover, the Colorado business community is skewed toward companies that need lots of bandwidth. If you had to pick a region to have a robust and unique fiber network, Colorado would be a good choice.

Fortunately for my team, ICG’s management convinced themselves that the real opportunity was the small and medium enterprise market. Further, a well oiled sales engine (not a deep fiber network) was the most important franchise for this market. First alarm bell: that doesn’t sound like much of a differentiator. In ICG executives’ mind, this was good because they saw sales as a strong skill of their (circular logic perhaps?). However, to be safe, they decided to be a pioneer in an advanced area of VoIP called IP Centrex.

ICG, as you might know, had only recently emerged from a disastrous bankruptcy. Their post-bankruptcy CEO was from outside the telecom industry. How does a company that had recently emerged from bankruptcy decide to re-direct their efforts on being a pioneer in a brand new technology?

To recap the strategic thinking: (1) Fiber doesn’t matter because the opportunity is with smaller enterprises; (2) Sales is the company’s competency; (3) The company will be a pioneer at VoIP; (4) We will be successful at VoIP because of our unmatched ability to sell. This led to the following conclusions. New York and Chicago (where ICG didn’t have networks) should be the focus, as there are more businesses there than where ICG owned fiber networks. The more sales people they’d hire, the more value they’d create, so add a lot of them is what they did. Finally, the most valued technical resources were concentrated on VoIP, with the hope that this would give them something unique to sell.

Those outside of telecom will probably chuckle and assume this story is unique to ICG and, perhaps, I am embellishing. Those who were in the middle of the great boom and bust will probably cringe as they reflect on close-to-home situations that sound a bit too familiar. For those still in telecom, the real question is how does this reflect on your company’s existing strategic activities?

The prior three blogs focused on franchise. Appreciate its importance. Know your franchise. Make strategy fortification the focal point of strategic decisions.

Though I don’t know its history, Microsoft Office strikes me as a great positive example. DOS/Windows was Microsoft’s franchise, and they certainly have maintained sufficient focus on the protection of this franchise. Microsoft Office was one of their major business expansions. At the time of Office’s emergence, Lotus 123 and Wordperfect were emerging as the best spreadsheet and word processing platforms.

DOS/Windows made it materially more likely it would succeed with its Office applications (despite the headstart of 123 and Wordperfect). Moreover, success would further strengthen its DOS/Windows franchise, as the prevalence of Office makes DOS/Windows platform harder to displace. A sustainable advantage of Office was its preferential access to future DOS/Windows development. The result: Office wins. 123 and Wordperfect lose. Microsoft sued for engaging in monopoly practices.

Had DOS/Windows not been a very strong foundation in itself and had it not given Microsoft an advantage relative to 123 and Word, the Excel and Word initiatives might have been huge failures.

This entry is the third consecutive entry on the topic of franchise. In the first, I emphasized how important a sustainable competitive advantage (or franchise in Buffett lingo) is in creating long term value for shareholders. The second of the series covered the criticality of developing a thorough, honest, and appropriate understanding of the franchise, and ensuring this is clearly communicated throughout the enterprise. This third installment emphasizing that the strategic focus of all companies needs to be on how to strengthen its franchise.

The title of this blog might suggest too narrow of a definition of strategy. Nonetheless, I think it is helpful to equate a company’s strategy with the development of its franchise. Said differently, nearly every strategic analysis and initiative should pertain to answering the question of “how will we strengthen our franchise”.

Businesses that are funded by professional VCs are typically good at this. That is, the entire focus of their expenditures is driven by the question of “what unique competitive position do we think we can create for ourselves”. The question is grounded in the company’s brief and clear history–to get funded, the company almost certainly had a well-thought out answer to “what is unique about us”. Since the company is early-stage, the strategic premises is both backwards-looking (what do we already have that is unique?) and forward looking (what execution is required to parlay this uniqueness into long term value creation?). The VCs, if the are doing their job, ensure that the company stays narrowly focused on these two questions. Unfortunately, in the telecom boom, many VCs got sloppy.

Larger companies, though, often lose their way. As discussed in the previous blog entry, part of their meandering might be due to a misconception of what the nature of their franchise really is (and isn’t). The other culprit is that a company’s strategy isn’t laser focused on franchise fortification.

“Our franchise isn’t as strong as it needs to be. Our strategic priority must be on making in stronger.” How many times have you heard an executive say these words? More times than not, especially in a developing industry like telecom, this should be the mindset. Quite often, executives don’t acknowledge this. I suppose they fear it sounds weak. Instead, many companies spend their scarce strategy cycles on exciting new areas. This results in the enterprise’s resources being directed to distractions (relative to the priority of ensuring the franchise is sufficiently strong), such as new features, new products, new geographies, or whole new lines of business.

As we discussed in the prior blog entry, company’s sometimes are too casual in describing the nature of their advantage. Let’s consider a company that convinces itself: “Our advantage is that we are great at sales.” Many telecom companies, including a large one that I took private in 2004, developed this notion. “The network is a commodity, but we are successful because of the relationships we have with our customers.” Well, if this is believed, it follows that a company can sell most any product in most any geography. It suggests the act of hiring more sales people is the key to earning unfair returns.

Many telecom companies marched down this path. Not only did they waste a lot of other people’s money, they also missed the opportunity to use their precious resources to strengthen their competitive position. The telecom meltdown provided a nasty and hasty correction. When left with no choice but to retreat to their “franchise”, most companies realized it wasn’t sufficiently strong to support the collapse of everything else.

Companies with strong franchises can branch off into new areas. However, the question of franchise strengthening should remain at the core of expansion decisions. The following questions need to be the focus of the evaluation. “Does our existing franchise make it materially more likely we will be successful at the extension?” “If we are successful, does this materially help fortify our current franchise?” “For the new initiative, what franchise must we successfully develop to achieve a sustainable advantage?”

Though I don’t know its history, Microsoft Office strikes me as a great example. DOS/Windows certainly represented both a strong existing franchise and it made it materially more likely it would succeed with its Office suite. Moreover, success would further strengthen its DOS/Windows franchise, as the prevalence of Office makes DOS/Windows platform harder to displace. A sustainable advantage of Office was its preferential access to future DOS/Windows development. The result: Monopoly.

The expression “sustainable competitive advantage” is commonly used in business. It is a section title somewhere in most business plans. It is talked about in the hallway of most large companies. I believe it has becomes so commonplace that it isn’t treated seriously enough. Not even close!

“Our advantage is our people.” I’ve heard this so many times. “Our people are better than their people.” Really? I’ll take Google’s search engine. You take their best dozen people. Let’s see who wins. It might be laudable to want to credit “our people” as a company’s key advantage but this strikes me as a feel-good distraction from zeroing in on true advantages and disadvantages.

“We are great at execution.” Slightly more specific words might substitute for execution, such as “marketing”, “operations”, “customer service”or “engineering”. There are certain companies who have developed a franchise in one of these areas, such as HP for technical innovation, but for the most part, these are generic expressions that speak to execution ability. Most companies believe they are good at execution. Most engineering departments believe they are exceptional at engineering. However “we execute well” is not a suitable franchise. Said slightly differently, strong execution, in a general sense, is not an adequate substitute for having a true franchise. If it is, your company has a potential problem. If competitors have a strong franchise, a company that relies primarily on execution has a much steeper hill to climb. Oakland A’s did very well in baseball for a number of years, despite having a payroll that was a fraction of the Yankees. At the end of the day, however, the Yank’s franchise proved too powerful to overcome.

Does your company have a strong franchise? What is it? How well does your company understand its franchise? On a relative basis, how well does it understand the strength and weaknesses of its franchise relative to those of its competitors? Does this understanding get shared with all employees? Is there a passion about what is special about the company?

I will emphasize the importance of not kidding oneself in this area. If your franchise is strong, you have a foundation to build on. Good business decisions are underpinned with a clear understanding of what specifically is the company’s pillar of strength. If your franchise is weak, it is extremely important to acknowledge this and use this understanding to make responsible decisions. Bad outcomes result when a company has a mis-understanding of either the nature of its franchise or its relative strength. Poor decisions are made. Years often go by before the implications are fully understood.

Know your franchise. Be honest about its strength. Use this information to improve your decision making.

In MBA lingo, consultants use the expression of “sustainable competitive advantage”. The less polished (like me) substitutes “unfair” for “sustainable”. Warren Buffett emphasizes the word “franchise”. When used in the context of Microsoft and Buffett’s billionaire best buddy, “monopoly” is used. The business expression “barriers to entry” conjures up a structural blockade, such as the walls of a castle, that keep the less advantaged from enjoying what the favored are trying to protect. The concept has many powerful descriptors because it is one of the most important keys to long term value creation.

Out of respect for Mr. Buffett (and because it is easier to write one word instead of three), franchise is the expression I will use. Franchise refers to the unique attributes and capabilities that a particular business enjoys which improves the likelihood it will generate better returns than its competitors. All things being equal, the company with a stronger franchise will prevail. They are more likely to find opportunities to earn excess returns for their investors. A strong franchise, Buffett stresses, also makes future cash flow streams more predictable. As we discussed in an earlier blog entry, predictable cash flows lead to making investment, rather than speculative, decisions.

A franchise can take many forms. A power brand identity, like Nike or Kraft, is one. Everyone know what a Kit Kat bar is and most people see it as a tasty treat. Feb Ex and UPS have vast distribution networks. ADT = security. Comcast has a coax cable attached to millions of homes. DOS/Windows made Gates a billionaire and earned his company the reputation of a monopolist. Wireless spectrum is a limited commodity—if you have a lot of it, you can pursue business opportunities that very few others can even contemplate. Warren Buffett places great importance in maintaining Berkshire’s reputation as a much better buyer of your business than a strategic buyer (who will gobble you up) or a private equity firm (who will chew you up alive).

Franchises provide an unfair edge. Nearly all businesses that do well for their investors over the long term have a strong franchise. It is much more likely that a business will have predictable cash flows if it has a franchise. In the next blog, we will continue the discussion of franchises.