Studying Profit Zones[Fool on the Hill] April 11, 2000

An Investment Opinion

Studying Profit Zones

By Matt Richey (TMF Verve)
April 11, 2000

In considering a company's investment potential, two of the most critical questions to ask yourself are:

1) How does this company make money?

2) How can it make more money than that?

On the surface, these questions might not seem too tough. Take Coca-Cola (NYSE: KO), for example. How does Coke make money? "They sell beverages," you say as you roll your eyes. And how can they make more money next year? "Sell MORE beverages," you say with the same knowing tone.

These questions seem simplistic, but, in fact, they are deceptively probing. Let's look at the moneymaking question in a different light. Does Coke earn the same amount of profit when you pick up a 12-pack at the grocery store as when you deposit a dollar into a vending machine? Obviously not. Carbonated beverage pricing varies as follows: grocery, 2 cents per ounce; fountain, 4 cents per ounce; vending, 6 cents per ounce. This more sophisticated way of thinking about corporate profitability is the study of The Profit Zone, by Adrian J. Slywotzky and David J. Morrison. About Coca-Cola's profitability, the authors go on to conclude:

"The profit zone is in fountain and vending, but, in order to win in those areas, a company needs a strong brand. Brands are developed and maintained through the mass-market, low-profit grocery segment. Even though grocery is low profit, it is an essential part of maintaining position in the profit zone. One fights to maintain share and brand position in low-margin grocery; one maximizes vending penetration to maximize profitability. Coca-Cola learned and applied this brilliantly."

Published in 1997 and aimed primarily at business managers, The Profit Zone introduces an incredibly instructive way of thinking about profitability, and thus the lessons of this book apply just as well to investors as to managers. In reading the book, my eyes were opened to the complexity of how profits arise. Slywotzky and Morrison categorize businesses into 22 distinct profit models, and they fully realize that more models are on the way as value creation evolves. Most useful to investors, these models provide an analytical framework that enables a better understanding of how certain profit models apply to certain companies, and what this means for a company's future profit potential.

What follows is a brief explanation of six of the more interesting profit models described in the book, along with some relevant examples.

1. Customer Solutions Profit -- Think of this as the beyond-the-box model. Companies in this niche may start by selling a basic product, but their profit zone is in selling an array of additional products and services -- things such as financing, consulting, service contracts, and product disposal -- which, as a whole, fulfill a customer's total solution.

Under Jack Welch's leadership, General Electric (NYSE: GE) has become a master in this area, turning a dull assortment of low-profit manufacturing businesses into an integrated portfolio of high-profit customer solutions. Similarly, Dell Computer (Nasdaq: DELL) has moved its profit zone beyond the box -- literally. As Zeke Ashton explains in his Dell Fool Research report, "By adding financial services, Internet retailing, and consulting, Dell has been able to add layers of attractive businesses that offer both higher returns and are logical extensions of the company's core competencies."

2. Product Pyramid Profit -- In this profit assortment structure, the base of the pyramid consists of low-priced, high-volume products, while the apex is made up of high-priced, low-volume products. The bulk of profitability is concentrated at the top of the product pyramid, but the base plays a strategic role -- often through a "firewall" brand -- in protecting the profitability at the top.

There are lots of examples of this model. In Gap Inc.'s (NYSE: GPS) tier of retail apparel chains, Banana Republic is the high-profit, low-volume apex, while Old Navy serves as the low-profit, high-volume firewall brand at the bottom. In the Internet service provider industry, America Online (NYSE: AOL) has created a quasi-product pyramid composed of its flagship AOL service (priced at $22.95 per month) and its value-oriented CompuServe service (priced at $19.95 per month).

3. Multicomponent System Profit -- Businesses in this category have either multiple products and/or sales channels, and only some of these represent the bulk of profitability. But, in order to maximize sales in the high-profitability components, it's necessary to have full presence in the less-profitable components as well.

The variation in Coca-Cola's channel profitability, presented earlier, is an ideal example. Also in the beverage industry, Starbucks (Nasdaq: SBUX) has found it lucrative to sell its beans by the pound in low-profit groceries through a distribution agreement with Kraft. Starbucks doesn't recognize much profit from these grocery sales, but the company deepens its customers' addiction and loyalty in the home coffee market, while also increasing the likelihood that customers will find the craving to drop by a Starbucks cafe during the workday or while out and about on the weekend.

4. Switchboard Profit -- When multiple sellers are communicating with multiple buyers, an intermediary can capture an extraordinary amount of value by providing a single communications medium that reduces the costs to both buyers and sellers.

This profit model is epitomized in the first mover and top dog of online auctions: eBay (Nasdaq: EBAY). As David Gardner wrote in a recent Rule Breaker report, "A new, prospective seller will go where the most buyers are, which is eBay. A new, prospective buyer will go where the biggest selection is (where the most sellers are), which is eBay. Another buyer attracts another seller. Another seller attracts another buyer. To eBay."

5. Time Profit -- This model applies to innovators with a time-limited competitive advantage. When a product is new, it earns premium profits. Then, when a competitor copies the innovation, price competition drives profits to zero. Companies relying on this model make continuous innovation the modus operandi.

Intel's (Nasdaq: INTC) microprocessor profitability is partly explained by this model. (Intel's family of microprocessors also fits in the Product Pyramid model.) Intel earns its highest profits on processors that are fresh out of the gate and unparalleled by the competition.

6. Blockbuster Profit -- The name says it all with this model. Pharmaceutical companies, publishers, film studios, music companies, and software firms all earn their big money from a few mega-sale blockbusters. The economics of this model are such that the costs to produce a big winner don't differ substantially from the costs to produce a flop or sub-par performer. In this fixed-cost environment, profitability is maximized by very high sales volume.

The pharmaceutical industry serves as the best example here since a blockbuster is technically defined as a drug with annual sales in excess of $1 billion. Pfizer (NYSE: PFE), for example, has seven blockbusters in its drug portfolio. Costs for developing and launching a single drug are estimated to exceed $300 million. It's no surprise, then, that investors in the pharma sector focus on product pipelines and potential blockbusters.

That's just six of the models presented for understanding profitability in The Profit Zone. And further, what I've covered here represents only the first 75 pages of the book. Fool, if you're looking for a book that will help you think better as an investor, check this one out.