Customer Solutions Profit Model

“So I set out to find the answer. I interviewed dozens of customers to get a sense of how Factset operated. Piecing together fragments of information from all these conversations, I eventually put together a clear picture of how Factset had designed their business. Here’s what I learned.

“The business information marketplace in which both Factset and my client, Data House, were operating involved close to a thousand major customers. But within that arena, to maintain a strong growth curve, Factset needed to capture only twenty new customers per year. Knowing this, they developed a powerful approach to make that happen.

“Once Factset identified a company as a potential customer for their information services, they’d send a team of two or three people to work there. They would spend two or three months, sometimes longer, learning everything they could about the customer—how they ran their business, how their systems worked (and didn’t work), and what they really cared about. Based on this genuine knowledge of the customer, Factset then developed customized information products and services tailored to the specific characteristics and economics of the account. Once they landed the account, they spent a ton of time integrating their product into the customer’s systems. During this process, Factset’s revenues were tiny and their costs were huge. If you looked at a monthly P&L for a particular account, you’d see they were losing a ton of money. Costs of $10,000 might be charged against revenues of $3,000.”

…“After three or four months, Factset’s products would be woven into the daily flow of the customer’s operations. Their software would be debugged and working fine. Now Factset didn’t need three people working fulltime on the account. One person could maintain the service, probably part-time. And as the word spread among the client’s employees about how powerful Factset’s data was and how effectively Factset’s service had been customized to their specific needs, they began taking more and more advantage of it. Factset’s monthly costs fell from $10K to $8K, while monthly revenues started to grow, from $3K to $5K to $12K.

. ..“What were Factset’s margins?”

“How much do you think?”

…Steve grabbed a pencil and began jotting down numbers. Let’s see, he considered. Twenty-four million dollars in revenue generated by a staff of about forty people. How much would payroll costs be? These folks would probably be well paid. Some might make just sixty or seventy thousand, but a bunch would be in six figures. Steve seemed to recall hearing that benefits usually amounted to about fifty percent of salaries. So even well rewarded, the people would cost no more than, say, $200,000 apiece, counting salary, benefits, the whole nine yards. He multiplied. That makes eight million in payroll.

“How much would overhead be?” Steve wondered aloud.

“Use ten percent,” Zhao suggested.

Okay, figure ten percent of revenue for overhead—$2.4 million. Then there would be licensing fees for the rights to the information being sold.

Those might amount to another ten percent. Throw in a few more points for other costs . . . “I’ll guess forty percent operating margin—about ten million bucks, all told.”

Zhao smiled. “Very, very close.”

“So Data House came nowhere near what Factset accomplished.”

“That’s true.”

“I don’t get it. You laid out the whole plan for them, didn’t you? Are you saying that Data House didn’t choose to follow the winning strategy, even after they knew it would work?”

“About right.”

Steve shook his head. “Wow. I guess that must have been one of the worst organizations you’ve ever encountered. Did you ever work with any other company that simply refused to be successful?”

“Actually, it happens all the time. I can give you the complete recipe for the secret sauce, and the chances are good that you still won’t use it.”

“That’s strange. Why visit the doctor, then ignore his advice?”

“It’s a bit of a mystery. There’s probably no one reason why people seem to prefer failure to success. We know that change can be psychologically threatening—that’s part of the answer. In the case of Data House, they may have realized that following the Factset model would have taken a lot of hard work—much more than they were accustomed to. That’s part of the answer, too. But I think the ultimate explanation is a simple one. To succeed in business, you have to have a genuine, honest-to-goodness interest in profitability. And most people don’t.”

Zhao leaned back and spread his hands wide. “That’s all there is to it.”

Steve frowned. Can that really be true? he wondered. It’s hard to believe.

“That’s all for now. Today’s profit model was a simple one. But what is it, Steve? What’s the idea?”

Steve thought for a moment. Then he said, “Invest time and energy in learning all there is to know about your customers. Then use that knowledge to create specific solutions for them. Lose money for a short time. Make money for a long time.”

From The Art of Profitability by Adrian Slywotzky

What are the distinguishing characteristics of this business model, of this profit model?

(1) Intimate knowledge of the customer; and (2) customization of products and services into (3) integrated solutions that address (4) the customer’s mission-critical problems (5) in such a way that these solutions are woven into the daily fabric of the customer’s business operations.

Once all five components of the model have been locked in, it is very hard to compete against the incumbent, especially in a slow-growing, smallish market. 

It can command very high margins with impunity and earn returns far above its cost of capital. It is a moated enterprise, a franchise. It would take a revolutionary leap of some kind, or sustained bout of self-abuse, to threaten it. You can count on its earnings and you can calculate its earnings power value. 

Despite the everyone-is-special-in-their-own-special-way heterogeneity of business, profit models, like plot lines in fiction or film, recur with surprising regularity. Understanding the elements and structure of a profit model well gives one the opportunity to recognize it where others may not.  If one understands this Customer Solutions Profit model, any company employing it is in one's circle of competence. Isn’t that why Buffett bought IBM? 

Classifying companies by profit model is an effective way of gaining insight into the strengths and weaknesses of an investment case. It is far more useful, in my view, than the headline categorizations of industrial organization popularized by Michael Porter and reformulated somewhat by Bruce Greenwald: “economies of scale”, “brand power”, “switching costs”, and so forth, very easily deteriorate into hollow, vacuous bumper sticker slogans. 

Consider now a business like Howdens Joinery, listed in the UK.  I will quote from the Chairman’s essay at the front of its 2011 Annual Report:

“250,000 local builders hold credit accounts with Howdens because we provide the products and services they require in order to run a successful business of their own. Through our national network of 509 depots we offer the builder a range of well-designed, well-made kitchens and associated joinery and hardware, all of which is available all the time in every depot. We sell to the builder on a trade-only basis, with a confidential discount that allows him to determine his margin and a net monthly account that gives him the ability to manage his cash flow requirements.

Howdens has acquired national scale, but it remains a local business, serving local builders who do not want to waste time travelling long distances or dealing with impersonal, centralised operations. Each depot runs its own customer accounts; employees are engaged locally; and profit-sharing is calculated locally, not centrally. Howdens’ customers expect to see familiar faces in their depot and rely on people they know to offer them sound advice.

A typical Howdens’ depot occupies around 10,000 square feet and employs about a dozen people. The depot is a low-cost operation, located on a trading estate rather than a high street, with convenient access and parking for the builder. Rent averages £5 per square foot and the typical depot fit-out cost is around £170,000.

The depot is able to keep everything in stock, and Howdens is able to refine stock levels, because each depot manager can use local knowledge to tailor re-order requirements to suit the needs of his or her customers...

The results we are reporting for 2011 reflect the inherent profitability of the business, and its capacity to generate cash, which has allowed us to grow and develop as well as meet our legacy obligations…

I’ll start at the beginning, with the Howdens’ model, which is based on a number of well-defined elements.

First, and principally, it is trade only, which means a constant focus on serving one customer – the small builder. We must not forget that we supply builders, who in turn supply people like us. Only Howdens can offer: a well-designed range of rigid cabinets, frontals and joinery that are easy to install, saving the builder time and therefore money; a quality of construction that means our kitchens do not break, look good and work well, saving more time and money (we call it “fitability”); a confidential discount that allows builders to determine their own margin and make a living; and a net monthly account that   allows them to manage their cash flow.

Second, we promise small builders everywhere that all our ranges are available locally, all the time, so they can pick up a complete kitchen when they need it, and they can finish their job and get paid by their customers, which means they can pay us.

Third, Howdens is a local business.  We have 509 local depots, because builders do not want to waste time driving to and fro – they want to get on with the job. Their account is with their local depot. The depot staff know what each account customer needs. And so there are no misunderstandings, and no call centres, which saves everybody a lot of time, as well as money.  “Local” also means that each Howdens’ depot is fully accountable for its own performance. Depot managers hire their own staff, refine their own stock to suit local needs, market it themselves to their own customers, and adjust their own pricing to suit local conditions.  They are wholly responsible for their own sales and their own margin.  Depot managers and staff are all incentivised to drive more sales and more margin, as efficiently as possible. Their bonus is based on a share of their locally generated profit less any stock loss – there is virtually no stock loss.  It is therefore not surprising that depot managers and staff are keen, willing and able to open new accounts and make sure that they trade.

Last year they opened 76,000 new accounts, which equated to 38,000 net new accounts in just one year. The total number of credit accounts now stands at almost 250,000.  On any given day, you can observe  the combination of around  £80 million of stock, spread across  509 depots, with 1,000 kitchen  planners capable of planning up  to 3,000 kitchens per day, 600  depot-based telesales people, 700  sales reps out on the road looking  for new customers, and 250,000  existing customers also out on  the road looking for their next job  to be getting on with – all of which  makes Howdens a business to be  reckoned with. 

Fourth, we run Howdens as a focused and therefore low-cost operation, with high volumes and predictable sales. We have invested in our own manufacturing capability to ensure better service, greater efficiency, and no waste – whether of money, people, process or space.  Our trade depots are typically 10,000 square feet in size, with rent of around £5 per square foot. They are located on trading estates – not retail parks. We do not have glossy showrooms. Our depots open early in the morning and are shut on Saturday afternoons and Sundays.  So altogether, they are not like High Street retailers at all, and their costs are very different too.

As I have remarked before, the Howdens’ model only works if it is implemented as a whole, which  means all of the elements are  non-negotiable [emphasis added].  Our model was designed when the business began in 1995. Its aim is to enable the business to find solutions to complexity efficiently and profitably, because we are engaged in a highly complex activity – that of getting kitchens into homes and making sure they work…

We are seeing an increased level of trust from builders keen to benefit from our knowledge, as well as from the other aspects of our offer, including the attractive terms I have described, and our planning facilities, which are second to none. As we have always said, builders follow the work and right now, proportionately, we are seeing more money spent by the private sector and less by the public sector.

I mentioned at the start of this review that continuing investment had been a critical factor in our ability to outperform the market and to continue to take market share in these challenging times. But what we have invested in? The short answer is that we have invested in serving one customer. That means making sure that we can offer our customer both service and efficiency, which together are the drivers of margin and market share. In order to improve service, we have invested in customer awareness. We provide each of our 250,000 account customers with catalogues, videos, samples and plans of kitchens, worktops, joinery and flooring to support their sales. We have also invested in focused advertising aimed at the end-user or consumer, rather than at our customer, the small builder, because we have observed that this helps the builder to market the whole range of Howdens’ products to an expanding population of aware consumers…

Furthermore, manufacturing supports our reputation with our customers. Builders do not like surprises with product.

They prefer to buy from manufacturers, and feel they know what they are getting, from people with credibility and a track record. By manufacturing product ourselves, we are also investing in supporting the margin of the business as a whole – and growing it, compared to others – because of the inherent efficiencies of not producing for anyone else. There is also the matter of security of supply. This is extremely important to a business that makes over 3.5 million cabinets and 860,000 worktops last year. We have also invested in the systems that control the manufacturing process, and by so doing have supported our ability to increase productivity and reduce waste. For example, we have invested in robots at the end of the production line, which have helped us gain more efficiency in the smooth transition from manufacturing to warehouse. Our investment in systems underpins our sales activity too. For example, we have invested in the latest CAD technology that means we can offer the builder an industry leading design service to support his sale, and he can fit a properly planned kitchen as quickly and efficiently as possible…

We know the importance of vigilance and we monitor everything, all the time – sales, margin, stock, cash, and the performance of every part of the business. In this market, we need to be quick on our feet. The way Howdens is organised means we are very close to where sales happen, and that is a source of competitive advantage. Vigilance also means responsiveness in every area. If a depot has an IT problem, we see it the moment it happens, and will set about fixing it immediately. If a customer account does not trade for 15 months, we close it, so that we keep a clean account base and know that we are tracking only active customers. We control credit by means of our nett monthly account, which is tightly managed, so that our total cost of credit, including debt recovery and bad debts, still remains less than 1.5% of sales.

What this all adds up to is that Howdens outperforms because we are clear about what we are doing. We design and build a professional product, with an up-to-the-minute design, that requires a professional fit, and we sell it to professional fitters who can go and pick it up from local stock day in, day out; and because we give them a truly reliable service, and a confidential discount, they can make a living out of it.

You might recognize the customer solution profit model in that opening essay. (1) Intimate knowledge of the customer; and (2) customization of products and services into (3) integrated solutions that address (4) the customer’s mission-critical problems (5) in such a way that these solutions are woven into the daily fabric of the customer’s business operations. 

It is a conscious, coherent, comprehensive, and sophisticated business model that should allow it to earn returns that are far above its cost of capital and well in excess of that earned by other home and construction supply companies operating in the UK market.

It has much more in common with IBM and Factset Research Systems than it does with Home Retail Group, Kingfisher, or even Travis Perkins.  It would take something special, something other than the hum-drum of daily competition, to knock Howdens down.

And if you recognize Howdens as an effective, successful example of the customer solutions profit model, you will have an insight into the investment case if its shares fall. 

In May of 2012, for example, Howdens’ shares were priced at 109p, or at half its current earnings power, even though it boasts 60% gross margins, 22% after-tax operating margins, and 20% returns on invested capital. Investors looking only at its financial statements would worry that such performance was unsustainable. An intelligent, prepared investor, on the other hand, would be thinking of the quality of the underlying business, as though a businessman considering a private purchase of the whole company. And that investor would have an advantage over the market.

This post is the first of twenty or so in a series. 

If you find this approach interesting and know of any small, listed companies that employ this profit model, go ahead and name them in the comments section below.

Disclosure: No position in FDS, HWDN, or IBM.