RULE MAKER PORTFOLIO

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The Customer is Right

by Rob Landley (TMF Oak)

AUSTIN, TX (April 14, 1999) -- The first question a company should ask when developing a new product or service is, "What's in it for the customer?" Unfortunately, the first question many companies ask is, "What's in it for me?" Believe it or not, entire product lines are sometimes based on that second question without ever answering the first.

Last month, I commented on the MP3 (Motion Picture Experts Group, Audio Layer 3) digital music format. It provides exactly what consumers want: the ability to take music from existing sources such as CDs and easily compress the songs into compact, portable computer files with little or no loss of sound quality. Other than your computer, no expensive additional hardware is required (although portable MP3 players and CD players that understand the MP3 format are already entering the market). Just download any free MP3 player and a CD-to-MP3 conversion program, plug your sound card's output into your amplifier, and suddenly your computer becomes your own personal jukebox capable of storing thousands of songs and playing any of them at the click of a mouse. For more on recommended MP3 players, music download sites, and more, check out CNET's excellent special on MP3.

Dozens of companies, including big names like Sony, IBM, Microsoft, and RealNetworks have come up with various competing formats which they hope will unseat MP3. Why not simply support MP3? Most cite "security," by which they mean that MP3 files are too easily copied and shared, resulting in MP3 music download sites all over the Internet. That this offends companies trying to profit from music sales is obvious, but why any consumer would consider this a bad thing ("I have too much freedom, this has to stop") is never addressed. Each company hopes that its competing music format will replace MP3 because that's what they would prefer to sell. They fail to consider, however, whether that's what their customers would prefer to buy. This does not strike me as a sound business strategy.

Here's a story about Sony's proprietary digital Walkman.

Another impending disaster is Circuit City's (NYSE: CC) proprietary DIVX video player, a variation of the VCR replacement technology known as DVD. Digital Video Disks (DVDs) have seven times the storage capacity of CDs, which is enough to store full-length movies. DVD is on the market now, and consumers with DVD players can purchase or rent DVD movies as easily as VHS videotapes. Playing a DVD disk is like playing a CD -- you put it in the machine and it does its thing.

Playing a DIVX disk is quite a bit more complex. DIVX involves buying the rights to watch the movie each time it's played. This scheme is implemented by hooking the DIVX player up to the phone and giving DIVX Customer Service your credit card number. Follow the logic here: you buy a player, and you buy a disk, but you don't own the movie. The disk is only good for 48 hours after you first play it. After that, it's pay-per-view. By paying $19.95, your disk can be upgraded to unlimited use, but only on your player. If you take the disk over to a friend's house to watch, you'll have to pay an additional $3.25. The only "new problem" that DIVX solves is the ability to charge the customer for each viewing of the movie. Why would a customer want that? Here's a full, albeit biased, comparison of DIVX vs DVD. Also, Fool analyst Louis Corrigan discussed Circuit City and DIVX in yesterday's Foolish Workshop.

Sometimes companies try to use a superior proprietary product or technology to gain exclusive control of an otherwise competitive market niche. Looking back at the 1980s, Sony's (NYSE: SNE) BetaMax videotapes provided better sound and picture than Matsushita's (NYSE: MC) VHS, but Matsushita (parent company of Panasonic) recruited many other companies as manufacturing partners and was willing to share the wealth. In the end, technically inferior VHS squeezed BetaMax completely out of the market. Now, a decade later, Sony and Matsushita may be squaring off for a rematch, this time over competing DVD audio format standards.

The same drive for proprietary control doomed IBM's PS/2 line of personal computers. Big Blue missteped in choosing the technically superior but incompatible micro-channel bus. Third parties like Creative Labs (the Sound Blaster company) had to pay royalties to IBM for the right to make expansion cards for micro-channel computers. Meanwhile, the standard ISA expansion cards (which the rest of the PC world had copied from IBM's older computers) involved no permission or royalties. Today, technically pathetic ISA is still in use, while micro-channel has gone the way of the dodo.

By nature, capitalism pushes and pushes and pushes for free competition. An example from history is how the interstate highway system bypassed the railroads and their "robber barons." Today, Linux is experiencing strong growth vs. Microsoft's NT in the Internet server market.

Corporate executives can be as greedy and shortsighted as any other group of people. As consumers, we automatically judge whether a company's offerings are what we want and act accordingly. As long-term investors, we need to make similarly independent judgments. As Rule-Maker investors, we look for companies that serve their customers and business partners, and create sustainable relationships with them that hopefully last a lifetime.

Tomorrow, I'll discuss a company that does just that.

- TMFOak

News Update

Last night, Intel (Nasdaq: INTC) reported earnings per share of $0.57, beating the First Call estimate of $0.55. The company broadcast its conference call live from its website (where the replay is still available). I covered the call and posted a summary on our Companies board. Also of note, Intel is opening its April 22 Spring "Analyst" Meeting to the public. Bravo, Intel! The chipmaker is setting a wonderful example of appropriate corporate disclosure.

Fool on!

Matt (TMF Verve)

04/14/99 Close
Stock  Change    Bid
AXP   +1 1/16  136.50
CHV   -4 3/8   91.13
CSCO  -7       110.75
KO    +1 1/2   63.38
GPS   -4 1/16  72.56
EK    +1 1/4   64.25
XON   -1 1/4   74.19
GM    +1 5/8   89.75
INTC  -4 1/8   57.13
MSFT  -7 1/8   85.88
PFE   -5 7/8   144.25
SGP   -5 9/16  55.19
TROW  +  13/16 32.94
YHOO  -11 15/16191.00

                    Day   Month    Year  History
        R-MAKER  -4.07%   2.94%  14.66%  45.09%
        S&P:     -1.58%   3.28%   8.39%  34.09%
        NASDAQ:  -2.94%   1.86%  14.36%  51.70%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     85.88   119.44%
    5/1/98   55 Gap Inc.      34.37     72.56   111.12%
   6/23/98   34 Cisco Syst    58.41    110.75    89.61%
    2/3/98   22 Pfizer        82.30    144.25    75.28%
   2/17/99   16 Yahoo Inc.   126.31    191.00    51.22%
   2/13/98   44 Intel         42.34     57.13    34.93%
   5/26/98   18 AmExpress    104.07    136.50    31.17%
   8/21/98   44 Schering-P    47.99     55.19    14.99%
    2/6/98   56 T. Rowe Pr    33.67     32.94    -2.18%
   2/27/98   27 Coca-Cola     69.11     63.38    -8.29%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     89.75    23.96%
   3/12/98   20 Exxon         64.34     74.19    15.31%
   3/12/98   15 Chevron       83.34     91.13     9.34%
   3/12/98   20 Eastman Ko    63.15     64.25     1.75%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4122.00  $2243.55
    5/1/98   55 Gap Inc.    1890.33   3990.94  $2100.61
   6/23/98   34 Cisco Syst  1985.95   3765.50  $1779.55
    2/3/98   22 Pfizer      1810.58   3173.50  $1362.92
   2/17/99   16 Yahoo Inc.  2020.95   3056.00  $1035.05
   2/13/98   44 Intel       1862.83   2513.50   $650.67
   5/26/98   18 AmExpress   1873.20   2457.00   $583.80
   8/21/98   44 Schering-P   2111.7   2428.25   $316.55
    2/6/98   56 T. Rowe Pr  1885.70   1844.50   -$41.20
   2/27/98   27 Coca-Cola   1865.89   1711.13  -$154.77

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1525.75   $294.86
   3/12/98   20 Exxon       1286.70   1483.75   $197.05
   3/12/98   15 Chevron     1250.14   1366.88   $116.74
   3/12/98   20 Eastman Ko  1262.95   1285.00    $22.05

                              CASH    $185.03
                             TOTAL  $34908.72

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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