One Strategy, One P&L

How should a business be measured?

For a long time, the answer has been “more.” Ever since Frederick W. Taylor did time studies of steelworkers with a stopwatch in 1900, the measurement of business activity – called “Greater Taylorism” by Walter Keichel in his business history “The Lords of Strategy” - has grown ever more central to management. One result of this drive to quantify and analyze has been that senior executives often create numerous profit centers, or isolated groupings of both revenues and expenses nested within large businesses.

The two benefits are obvious. First, profit centers allow these executives to make better decisions. In organizations whose various revenue and cost accounts are not linked, poor economic performance can be hidden by positive results elsewhere, and decision-making is clouded. Second, profit centers help make accountability clear. By giving managers direct profit and loss responsibility, companies can incentivize activity that measurably contributes to the bottom line.

So in most large companies, different business divisions and geographic regions are organized as distinct profit centers. Increasingly, product lines, key customer accounts, or brands are treated as mini-businesses as well, like at Procter & Gamble, where global brand managers have P&L responsibility. For that matter, why not functions too? Some organizations are establishing transfer prices for supplies and services between business departments (such as manufacturing and sales), and then measuring, and rewarding based on, the income of each.

There’s just one problem. We optimize what we measure. And the entire logic of profit centers rests on the assumption that maximizing the pieces will maximize the whole.

Unfortunately, this shortcut often isn’t true. Exceptional, sustainable results derive from great strategy, and great strategy isn’t additive – it relies on the way individual pieces fit together in a system, so that the whole is greater than the sum of the parts.

Decision scientists know this – in their models, it’s the difference between finding the local optima (the best result within each “neighborhood”) and the “global optimum” of the whole system. For that matter, football coaches know it too; no professional coach would argue that the best way to win a championship is to focus on maximizing each individual player’s performance statistics.

Yet this is exactly how many businesses are run. Rather than sacrificing certain parts for the good of the whole, companies essentially force each division to stand on its own. This approach undermines strategic fit, which, as Michael Porter put it, “requires the integration of decisions and actions across many independent subunits.”

For a coherent strategy to work, then, the organization executing it must be measured as a whole, rather than as parts. In other words, if a company is to have a single strategy, it must be driven by a single P&L.

This may sound like an extreme position. Yet some of the world’s most successful companies operate this way. Apple famously has only one P&L, for which its CFO, Peter Oppenheimer, has direct responsibility. And while each of its major hardware product lines is priced to make a significant profit, it bundles in all its key software upgrades, products, services, and platforms for free. CEO Tim Cook explains the logic:

“We manage the company at the top and just have one P&L, and don’t worry about the iCloud team making money and the Siri team making money. We want to have a great customer experience, and we think measuring all these things at that level would never achieve such a thing.”

It’s Apple’s single-company mindset that lets it give away industry-leading software and cannibalize its own products, which in turn has led to its unprecedented success. But that’s not to say a single P&L is always the right answer. Instead, a company should have as many P&Ls as it does distinct strategies. P&G’s Gillette shaving brand has a very different strategy from its Bounty paper towel brand, and Gillette has a different strategy in India than in North America. But although Gillette sells its razors and blade cartridges separately, these products fall under a single strategy. P&G’s profit centers reflect these boundaries.

Of course, companies should still measure a division, product, or function’s profitability (to the extent it can be done accurately) – that’s just good management. But this shouldn’t be the primary basis upon which managers are held accountable for their decisions, or they won’t enact a strategy that looks beyond their narrow interests. Amazon wouldn’t be able to underprice and over-market the Kindle to achieve their larger strategic objective of selling content if the Kindle product manager’s main objective was to maximize hardware profits. Nor would “free” look like such a great price point for Google’s Android unit.

So measure carefully – because if you reward each area of your business for acting in its own best interest, you just might get what you wish for.

Amazon vs. Apple: the Gathering Storm

Two weeks ago the Wall Street Journal confirmed earlier reports that Amazon plans to launch a tablet this fall. It’s rumored that it will have a 9-inch screen and run an Android operating system.

On the surface this looks like a terrible idea. Since the launch of Apple’s iPad last year, tech titans including Samsung, HP, Motorola, and Research in Motion have all fast-followed with their own tablets, but the outcomes have been uniformly disappointing – John Gruber at Daring Fireball estimated that, even including Nook Color e-readers, the iPad’s share of the category is in the ~95% range. As Marco Arment put it, “[t]here really isn’t much of a tablet market. There’s an iPad market.” It’s widely agreed that Apple has the best tablet OS, form factor, and specs, plus the most apps and the strongest brand. It’s believed that Apple also has a cost advantage (due to early investments in suppliers’ production facilities), enabling entry level iPad pricing that none of the other major players have been able to beat.

So trying to enter this market as the 14th or so player doesn’t sound like a smart move for Amazon. Unlike the aforementioned hardware makers, it could easily sit this game out. Or could it?

Crazy Like a Fox

Amazon is a retailer that, despite its ever-growing “A to Z” product offering, still makes 40% of its revenue - and even more of its profit – by selling software and content, like books, movies, music, and games. This media, not physical goods, is still Amazon’s selling focus. Don’t believe me? Check out the department list at the left side of its home page – right now it reads:

  • Unlimited Instant Videos
  • MP3s & Cloud Player
  • Amazon Cloud Drive
  • Kindle
  • Appstore for Android
  • Digital Games & Software
  • Audible Audiobooks
  • Books
  • Movies, Music & Games
  • Electronics & Computers <- Finally, ten items down, the actual physical stuff!
  • Home, Garden & Tools
  • Grocery, Health & Beauty
  • Toys, Kids & Baby
  • Clothing, Shoes & Jewelry
  • Sports & Outdoors
  • Automotive & Industrial

It’s often been said that Apple makes money selling devices, and uses its software and content (e.g., iTunes) to drive those sales. Amazon does the reverse. Being the content-retailer of choice is so important to them that they designed and marketed an intuitive e-reader, the Kindle, just to ensure they’d own the e-book space. (A side note: crucial to Amazon’s success here was the realization that, in the digital media retailing world, “purchasing” and “consuming” activities would converge in a single device.) Even with a beautiful piece of hardware, Amazon was clearly tempted to view it as a mere complement for their true aim (selling digital media) in a razor-and-blade strategy. Which is exactly what Amazon’s been doing: rapidly dropping Kindle prices to get devices in the hands of as many users as possible (the ad-supported version is now only $114 and, in a sense, the Kindle app in every mobile store is essentially a free version of the device). This strategy shares elements with the idea of commoditizing your complements – in both cases, a cheaper complement (e-reader) helps you sell your money-maker (e-books).

In the meantime, of course, Apple has launched its own iBooks app and store on its iOS devices, a credible second-runner to Kindle. In theory, Apple doesn’t need to have its own content stores on its devices – if customers decide they like using the Kindle app for e-books (or, say, the Netflix app for movies), that would still help Apple sell iPads and iPhones. But Apple knows that providing its own proprietary, well designed content stores and formats will increase user stickiness and earn them a nice pile of cash on the side. So Amazon built a device to help them sell e-books and Apple built an e-bookstore to help them sell devices.

In an alternate universe, a fragile peace could have emerged between Apple and Amazon, with each holding a knife against the other (a strategic phenomenon known as spheres of influence). But unfortunately for Amazon, the Kindle was only a minor threat to Apple’s ability to use e-reading to sell devices, while Apple’s “knife” was and is much bigger. Apple recently announced it has sold 222 million iOS devices, all of which have iTunes (movies and songs), the App Store (software and games), and now the iBookstore. In other words, the sheer speed of Apple’s success in selling devices has made its threat a reality: it’s already become a dominant software and content retailer.

This position has emboldened Apple to muscle Amazon around a bit. This week, Apple began enforcing an earlier threat to take a 30% cut of every publisher sale made through an iOS app (like Kindle), as well as disallowing in-app buttons that took readers out of the App Store to make a duty-free purchase. Unable to cope with such a burden, Amazon – as well as Barnes & Noble, Borders, Google, and purveyors of other types of content like Rhapsody – removed the stores from their apps on Monday.

While users can still use Apple’s mobile browser Safari to access the Kindle store and download content, this is obviously a huge blow to Amazon’s ability to retail content. Controversy aside, Apple clearly knew that most digital retailers would choose to close up shop rather than pay such huge fees. A lot of pundits have missed this point – Apple isn’t trying to make money by taxing iOS users’ purchases in other companies’ stores. It’s trying to be the only good store in town (a la iTunes), and it’s doing it by crippling Amazon’s ability to have a store on the turf Apple owns. Amazon and the other companies aren’t revolting, they’re getting run out of town.

This is why Amazon can’t sit the tablet game out. To sum up, they’re basically looking at four facts that, combined, spell big trouble for them:

  1. Selling digital content and software is extremely important to Amazon.
  2. People want to buy (and consume) digital media on highly functional mobile devices (i.e., smartphones and tablets).
  3. Apple reigns supreme in those product categories.
  4. Apple’s aggressively preventing Amazon from selling digital media on Apple devices.

The only link in that chain that Amazon feels it can attack with any chance of success is #3.

And in This Corner…

The good news for Amazon is that, because it’s aiming to put devices in people’s hands primarily to enable selling them content and software, it doesn’t have to adopt the same “me-too” strategy that’s so dismally failed the other hardware manufacturers. One big key to success is a low price: a Retrovo study indicated that this was a huge selling point to potential tablet customers, and that a price in the $250-400 range could garner significant share relative to iPads at $500-830.

Is a price that low even possible? That depends on two things – first, Amazon would have to keep costs to a bare minimum. There’s plenty of signs that’s exactly what it’s doing – from outsourcing manufacturing to a large, experienced Asian producer (possibly Samsung), to using a simpler, smaller touchscreen, to forgoing cameras. It could also save money by using lower-cost processors and chips and having less flash memory storage. But another part of keeping the price down is relinquishing device profitability. Unlike the huge margins sought by Apple, Amazon can adopt the razor-and-blade strategy (possibly even accepting a loss on each tablet sale) and try to make it up on subsequent revenue from the digital media users buy on the device. Through a combination of these two tactics, I bet Amazon could price a tablet below $300.

The second big key to success, however, is the right user experience and capabilities. Some, such as MG Siegler, doubt whether customers would even want a stripped-down tablet from Amazon. But I believe it has an opportunity here to capitalize on its strengths and create the ideal content discovery and consumption device, rather than the ultra-flexible machine Apple’s designed. Imagine a tablet perfectly designed to find, buy, and consume books, newspapers and magazines (via the Kindle app), audiobooks (via Audible), music (via a rebranded Amazon MP3 and Cloud Player), movies and shows (via Amazon Instant), games, and other software (via the Appstore for Android). Running the Android Honeycomb OS, the tablet could tightly integrate these features in a simple interface with Amazon’s Cloud Drive for storage and syncing, Amazon’s excellent loyalty program Prime (with perhaps a free year’s membership), and an improved recommendation engine for discovery. General tablet functionality like web browsing, email, and social media would be key secondary features, while more advanced apps and capabilities – perhaps including 3G service – might be absent altogether. In many ways it might resemble a better-packaged Nook Color.

Could Amazon pull this off? Despite not yet having a tablet, Amazon’s brand is strong enough that a majority of potential tablet customers would consider buying it based on name alone. If Amazon nailed the pricing and user experience described above and added some brilliant marketing, I think it could be the first non-iPad tablet to sell in the multi-millions. That’s not the whole battle, though – Amazon would still have to convert enough digital media purchases to make it all worthwhile. Here’s where Amazon’s strengths in retail, pricing, and loyalty could really pay off. Amazon also just signed up 100 newspapers and magazines to deliver full-color issues to subscribers in the Kindle app, a sign that content creators still have faith in Amazon’s experience in selling and delivering digital media.

Ready for War

Any way you slice it, Amazon is making a huge bet by entering the tablet market. I don’t think anyone realizes how high the stakes are for them, and thus for Apple too. On the one hand, Amazon’s success with the Kindle, combined with CEO Jeff Bezos’ strategic direction (and the inevitable feeling of having one’s back against the wall) bodes well for an Amazon tablet. On the other hand, selling an Amazon tablet means convincing consumers not to buy the most successful consumer product ever. The last thing I would tell a company that spends half its energy battling Walmart would be that it should start spending the other half going toe-to-toe with Apple.

But Amazon is gritting its teeth and marching onto the field. The clouds have gathered. Get ready for a rumble.

What Should I Watch? The Evolution of Recommendation

One of the great promises of the Digital Age is a better way to figure out the answer to the question above. People love great writing, artwork, film, and music, but no one is going to experience, in their lifetime, more than a fraction of all the content in existence. That’s why we try hard to find the stuff we’ll probably enjoy.

But that’s always been really difficult – as the saying goes, you can’t judge a book by its cover. Even if you could, no one wants to waste time searching through every title ever written to find the ones they’ll like. So for ages we’ve relied on poor solutions for discovery of new content (not to mention food, fashion, software, etc.). The three main ways we’ve done this are:

Curation: Experts decide what the best content is, and we listen to them. That’s why everyone read To Kill A Mockingbird in high school, and why movie critics put out Top 10 lists. Of course, there’s much to be said for being exposed to high culture and different viewpoints, whether we want to be or not. But the nature of art is subjectivity – everyone has different interpretations and tastes, so I might not like the experts’ picks. And who decides who’s an expert anyways – have you ever bought a book from the Staff Favorites rack at a bookstore?

Popularity: TV channels, radio stations, movie theaters, and bookstores offer an array of the most popular content, and we pick from the available options. Pretty simple – they modify their offering based on what sells, and everyone wins, right? But again, there’s no personalization here, and we don’t all have statistically average tastes. Worse, picking based on popularity creates a feedback loop that might misrepresent reality (did anyone actually like Rebecca Black’s Friday video?).

Word of Mouth: The old standby. Our friends and family probably have a better idea of what we’ll like than anyone else, and we’re more inclined to trust them (I’ll read anything my dad or my buddy Tom sends me). But unfortunately their experiences probably overlap significantly with ours (as Mark Granovetter pointed out decades ago), so while you might get fewer false positives (bad recs), you’ll also have more false negatives (missed content). It’s also tedious to poll your friends every time you’re looking for a movie to watch.

Enter the recommendation engine. Of course, in the Digital Age of plentiful data, a lot of companies can get more mileage out of the same basic methods listed above – for instance, the New York Times can now easily measure and display its most popular articles. But technology can also do a much better job of helping us discover new content when our tastes take us beyond the Top Ten (this has also created a revolutionary paradigm for content sellers, which Chris Anderson of Wired termed the Long Tail). Although I’m not an expert in the field, it seems like there are at least three entirely new ways to use consumer data to recommend new content:

Intrinsic algorithms use the actual attributes of the content and combine them with individual user feedback. The best example of this is probably online radio Pandora, which uses the Music Genome Project’s 400 attributes to tag every song in its database. If you say you like a song, it cues up more songs with similar traits (e.g., beat, vocal pitch, etc.). While this approach is widely praised for helping discover good music, it’s probably harder to apply to other types of content. There are also certain things we love about great art (like a metaphor in a song’s lyrics) that can’t be reduced to digitized attributes.

Preference algorithms rely on both our own and others’ ratings. Amazon was a pioneer in using its massive scoring database to shift from just popularity-based discovery (“X is highly rated”) to adding a preference-based algorithm, too (“you liked X, and most people who like X also like Y, so we recommend Y”). But while the logic is simple, the algorithms get incredibly complex. The gold standard is Netflix, whose Cinematch recommendation engine is so critical to their success they offered a $1 million prize to researchers that could improve it by 10%. But this approach has limits too, many of which have been described by Eli Pariser (example: preference algorithms tend to be risk-averse, so restaurant recommendation engines keep sending people to decent, inoffensive places like Chipotle).

Social algorithms – right now, social networks’ role in recommendation is just word of mouth on steroids, but their use for discovery is only just beginning. You could talk about Game of Thrones (or “like” it) on Facebook today, and your friends may be intrigued. But far more powerful would be an automatically generated recommendation if a significant percentage of your closest ties liked or mentioned something.

So which approach is best? The more interesting question is how these approaches can be combined to produce exponentially better discovery. That’s why Facebook’s announcement last week that Reed Hastings, Netflix’s founder and CEO, was joining its board was exciting. Sure, it may signal Facebook’s preparations for an IPO, or its future addition of streaming video, but it might also pave the way for Netflix to integrate a social element into its recommendations. What if curation and/or intrinsic factors were added too? Google might also be well positioned to offer a killer recommendation engine in the future if Google+ takes off. And at the very least, a better recommendation system could help Amazon win the retail war against Walmart – or vice versa.

Going further, recommendation engines have been mostly add-ons for content sellers so far (stand-alone recommendation platforms haven’t been widely adopted), but imagine how powerful a universal recommendation engine across all types of content (and other choices we make) could be. Again, there are legitimate concerns about a world of excessively personalized discovery, as Pariser argues in The Filter Bubble - ideally, we’d always be quite conscious of recommendation and decide when to switch it on and off. But at the very least, I bet we’d watch a lot less bad TV.

As always, your feedback is welcome.

Apple’s Absurdly Low P/E Ratio

Fortune has a short post by @philiped today that calculates Apple’s PEG ratio (price / earnings / earnings growth, a favorite measure of Peter Lynch) to be below 1.0, and far below companies such as Dell, Amazon, and Cisco, implying that it’s undervalued (same for Google and IBM).

In other words, Apple’s profit growth is explosive, but as I write this, its P/E is still in the mid-teens (currently 15.0). Google’s is 18.8. The S&P 500 overall is 22.6. Amazon’s is 81.3.

This means either the market is expecting Apple’s growth to slow dramatically, or it believes Apple’s future earnings to be highly risky – or both. Whatever the case, Apple’s stock is down 10% in the past four months.

This is absurd. Would anyone in his right mind actually bet against Apple’s earnings growth right now, given the sales it’s posting for iPads, iPhones, and iMacs? If this is a Steve Jobs story, it’s hugely overblown.

Prediction: Apple will continue to outperform the S&P and tech peers like Amazon over the next 6, 12, and 24 months. I’m putting reminders to check back into my calendar.

Buy now.