“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.
