Defending the Castle

Rob Landley

Austin, TX (Aug. 21, 1998) -- Today, I want to talk about the real topic of yesterday's article: the relationship between Cash-King companies and commodity products. But first, just past Noon EST today, Tom Gardner flipped heads and then went out to the markets to pick up our shares of Schering-Plough (NYSE: SGP). We purchased 22 shares of Schering-Plough at a total cost of $2,111.70 ($95 5/8 per share plus a $7.95 commission). To read our buy report on Schering-Plough from yesterday, click here: C-K Buying Schering-Plough.

Ok, on to today's topic...

Many companies follow a business model that involves spending a lot of money up front to develop a product, and then selling the fruits of their initial labor over, and over, and over again. This generally fits our ideal Cash-King business model. The huge initial investment forms a very effective "moat" around the business, requiring buckets of cash before you ever see a dime from your first sale. Then the (hopefully extremely cheap) manufacturing phase allows extremely high profit margins, ideally on high volume.

Movie studios try to follow this business model, spending tens of millions of dollars producing a film, and then selling "viewing capacity" by showing the film in front of a bunch of empty seats and charging people to sit in those seats. Its actual costs are about the same whether or not somebody's sitting in that seat, so there's a potential for great profits if all the seats are regularly filled with paying customers.

But movie studios don't break into the ranks of Cash-Kings for one obvious reason. The product they've spent all this money to produce has an extremely limited shelf life. They can't sell it "over and over and over again." With a few notable exceptions, people see a movie once, maybe twice, then rent it once five years later, and that's it. And that's a very good movie there -- two viewings and a rental. That's very rare. Because of that, the studio has to constantly develop new products -- meaning high labor costs, a high cost of creativity, and a short life for the product. That's no Cash-King.

Another type of company that seems to fit this business model, and thus is not in a C-K industry, is the typical communications company. It lays a bunch of fiber optic cable, launches a few satellites, and gets people to pay to use a system that costs just as much to run even if nobody's using it. There is also plenty of competition for data communications bandwidth from many companies, nothing to really distinguish the product between one vendor and another, and thus, price competition.

So what can protect a product from commoditization by competition? Two things that spring to my mind today are legal protection and the brand name.

Pfizer (NYSE: PFE) is a Cash-King because of legal protection. It spends obscene amounts of money developing new drugs, but once developed, the drugs are sold for years under patent protection. If competitors want to sell a competing product, they have to develop their own. They can't simply duplicate Pfizer's original product and run with it. That would violate the patent -- a legal no-no. Pfizer has legal protection for their business.

Coke (NYSE: KO) is a Cash-King because of its brand name. Heck, your local market can sell a cheap, generic imitation of the brown bubbly (and most do), but Coke is still it. Coke didn't patent its formula, since patents eventually expire. Instead, they kept the formula a trade secret. Why? Well, even if someone does duplicate it exactly, they can never prove it. They'll never have the Coke name. And what Coke legally protected was that name and its trademarked logo and its scripts around the planet. If you try selling something that claims to be Coke, anywhere, you'll be sued into the ground.

Intel (Nasdaq: INTC) is fighting to keep its competition from turning its products into a commodity, using every trick imaginable. It starts with "Intel Inside" brand advertising, and then patents anything that looks like a technical advance. But the real moat for Intel is the truly enormous up-front costs to semiconductor manufacturing and design. Companies in this situation can build a natural barrier by spending more on the up-front costs than any upstart. How many semiconductor companies are started out of tinkering in someone's garage? It's too expensive for that.

A company that's in a worse position, in my opinion, is Microsoft (Nasdaq: MSFT). The up-front costs of software design are "a college student with a summer off" or the proverbial "two guys in a garage." (For version one of a product, anyway.) All you need are highly skilled people pressing little buttons on a keyboard, and if they're willing to do it cheaply (or for free), what other costs are there? With the Internet, the costs of marketing and distribution are evaporating -- giving the garage programmers entry into big business.

Legal protection isn't much of an option either. Software has only recently been made patentable, and even then there are fairly strict limits on what can be patented. And those patents are a lot harder to defend than most other patents, since the case law concerning them is too new to be anywhere near comprehensive. Microsoft has benefited from a loose legal structure in software over the past decade, but its own aggressive duplication of competitors' products may put it at risk.

Mr. Softy knows that, and is now attempting to invent its own brand of legal protection by signing exclusive distribution contracts with the various PC companies. I'm sorry, but trying to block all possible distribution channels for competitors forms a very shallow moat at best. (If it was that easy, the Feds would have drug trafficking solved by now.) Worse, the "exclusive" nature of those contracts raises anti-trust issues that will keep dogging Microsoft as long as it persists at trying to build this style of defense.

When it comes to our investments, the question I ask myself is: "If disaster happened and the competition caught up with our Cash-King, could this company survive and even pull out in front again?" Could it survive, even prosper, in a commodity business, while developing new non-commodity product lines? For every company in our portfolio except Microsoft, the answer I come up with is yes. Intel is actually in the process of doing it, and pulling ahead again, as we speak. This is why I can sleep very soundly at night owning several of them, and is part of the reason that I personally just don't like the single most profitable investment in our entire portfolio. Or one of many reasons! Oh, and... I know my fellow C-K managers don't agree. But that's what makes a market!

- Rob Landley (Oak)

Erratum: Yesterday I wrote, "Unfortunately, you still can't walk into a store in the mall and buy a Linux program yet..." Apologies. I meant to write "application software." I picked up my copy of Linux as the CD-ROM in the back of a book I bought at Barnes & Noble, which qualifies as a store. RedHat also distributes versions of Linux in computer stores. Fool on!

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08/21/98 Close

Stock  Change    Bid 
 AXP   -2 1/16  95.06 
 CHV   -  5/16  80.19 
 CSCO  +  1/8   102.75 
 KO    -  1/8   79.31 
 GPS   -  15/16 63.44 
 EK    -1 9/16  84.50 
 XON   -  5/16  71.00 
 GM    -1 1/2   65.00 
 INTC  -1 1/16  84.94 
 MSFT  -1 15/16 110.63 
 PFE   +  1/16  105.75 
 SGP   +2 3/8   98.00 
 TROW  -  25/32 35.50 
                  Day   Month    Year  History 
 C-K         (0.99%)    (0.63%)    14.84%      14.84%  
 S&P 500     (0.95%)   (3.52%)     7.48%       7.48%  
 Nasdaq      (1.95%)   (4.05%)     7.82%       7.82%  
 Cash King Stocks 
 Last Rec'd   Total #  Security    In At    Current    Change 
  05/26/98     18        AXP     $104.067   $95.063   (8.65%) 
  03/12/98     15        CHV      $83.343   $80.188   (3.79%) 
  06/23/98     23        CSCO     $86.346  $102.750   19.00%  
  03/12/98     20        EK       $63.148   $84.500   33.81%  
  03/12/98     17        GM       $72.405   $65.000  (10.23%) 
  05/01/98     37        GPS      $51.090   $63.438   24.17%  
  02/13/98     22        INTC     $84.674   $84.938    0.31%  
  02/27/98     27        KO       $69.107   $79.313   14.77%  
  02/03/98     24        MSFT     $78.269  $110.625   41.34%  
  02/03/98     22        PFE      $82.299  $105.750   28.49%  
  08/21/98     22        SGP      $95.986   $98.000    2.10%  
  02/06/98     56        TROW     $33.673   $35.500    5.43%  
  03/12/98     20        XON      $64.335   $71.000   10.36%  
 Last Rec'd   Total #  Security    In At     Value    Change 
  05/26/98     18        AXP     $1873.20  $1711.13 ($162.08) 
  03/12/98     15        CHV     $1250.14  $1202.81  ($47.33) 
  06/23/98     23        CSCO    $1985.95  $2363.25  $377.30  
  03/12/98     20        EK      $1262.95  $1690.00  $427.05  
  03/12/98     17        GM      $1230.89  $1105.00 ($125.89) 
  05/01/98     37        GPS     $1890.33  $2347.19  $456.86  
  02/13/98     22        INTC    $1862.83  $1868.63    $5.80  
  02/27/98     27        KO      $1865.89  $2141.44  $275.55  
  02/03/98     24        MSFT    $1878.45  $2655.00  $776.55  
  02/03/98     22        PFE     $1810.58  $2326.50  $515.92  
  08/21/98     22        SGP     $2111.70  $2156.00   $44.30  
  02/06/98     56        TROW    $1885.70  $1988.00  $102.30  
  03/12/98     20        XON     $1286.70  $1420.00  $133.30  
 Cash:               $48.06 
 Current Total:  $25,023.00 
 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.

*The year for the S&P and Nasdaq will be as of 02/03/98