GAITHERSBURG, MD (Nov. 26, 1999) -- Since today is the biggest shopping day of the year, it might be a good time to revisit the Merchant-Kings. The name Merchant-King derives from Cash-King, which is what we used to call the type of Rule Makers we usually discuss here in this portfolio. Both types of Kings are the cream of the crop in their respective niches, but they rule in different areas.

Cash-Kings are the manufacturers of high-profit margin items. Ideally, a Cash-King's products are cheap to produce, easy to store and transport, expensive to buy, and highly in demand in the market. Intel's chips, Coke's syrup, Pfizer's pills, the Gap's textiles, and Microsoft's software CDs all fit this model.

Merchant-Kings are distributors that take other people's products and sell them as rapidly as possible. They may repackage or integrate these products, and may even sell services related to them, but primarily their job is to keep the inventory moving so rapidly their competitors can't keep up. Dell (Nasdaq: DELL), (Nasdaq: AMZN), Home Depot (NYSE: HD), Wal-Mart (NYSE: WMT), and eBay (Nasdaq: EBAY) all fit this model.

Not all distributors are Merchant-Kings, just as not all manufacturers are Cash-Kings. This is the mistake Al Levit made in his October 15, 1998 article in which he proposed and then shot down several new companies, and blamed the poor quality of his additions on the Merchant-King model. He didn't focus on the best companies and find what they had in common.

Just as Cash-Kings rely on high margins (as well as financial discipline) to drive their business, Merchant-Kings rely on rapid inventory turnover. Cash-Kings and Merchant-Kings optimize the two different parts of the old saying "time is money." Cash-Kings focus on making more money, Merchant-Kings focus on using less time.

A distributor with faster inventory turnover can thrive with a lower profit margin because they make their profit more often and compound their earnings much more rapidly. Simple math says that a 30% profit compounded four times gives 2.86 times the original amount. A 15% profit compounded eight times is 3.06 times as much. Strange as it seems, a company that makes half the profit twice as often comes out ahead in terms of sheer cash.

A Merchant-King also steals the business from competitors by consistently offering its customers lower prices, the result of accepting a lower profit margin. The Merchant-King simply offers customers a better deal, and customers respond to that. By focusing on trimming costs, reducing inventory, and stocking the most of what sells the fastest, a Merchant-King can dig a moat of low costs and economies of scale around its business to fend off competitors. They can even inspire real customer loyalty, at least compared to an obviously greedy (read "high margin") competitor.

Many of the principles of Cash-King investing apply to Merchant-Kings as well. Advertising to build a brand name doesn't hurt. Debt is simply bad karma. Repeat purchase business inspires customer loyalty, and a company that sells to the same customers more often generates stronger purchasing habits. Once again, rapid inventory turnover has positive side effects.

Merchant-Kings don't just reduce their inventory, but their infrastructure as well. Home Depot and Wal-Mart don't have warehouses. Rather, they let the customers into the warehouse to shop. Borders and Barnes & Noble tried the same approach to book selling, but were themselves undercut shortly afterwards by online bookseller Amazon, which applied the power of the Internet to mail-order shopping in order to run an even tighter ship. Amazon doesn't have to buy more storefronts to expand, just more Web servers.

Dell is another company taking mail-order online, a model which allows the distributor to force their suppliers to carry much of their inventory for them. The distributor (Dell) doesn't even have to order the product until after the customer has paid for it, and thus inventory never has to come to a complete stop within Dell's factory but flows off the assembly line into waiting delivery trucks. And when you consider also that Dell's suppliers are floating the cost of this whole distribution process in the form of high accounts payable, you can see why Dell is able to operate its business so efficiently. For the accounting inclined, Dell's lean, mean ways can be seen in its negative cash conversion cycle.

Probably the most impressive recent development in the Merchant-King world is the online auction model pioneered by eBay. The online auction leader never even sees the products it sells, as the supplier ships product directly to the purchaser, and eBay gets paid a commission for its sales services. This distributor has no inventory, and a purely electronic infrastructure. Outstanding. (Of course eBay's model was copied by divisions of Amazon and Yahoo! before eBay could pull out to a commanding lead. There's a reason we want five years of history before we consider any company to be a Rule Maker.)

A Merchant-King's real strength comes in when they have the opportunity to grow. They do it very rapidly and very cheaply, since they have a relatively lightweight infrastructure requiring minimal investment to expand, and their quick inventory turnover means even small gains can be rapidly compounded. Sheer size and market penetration can deepen the moat around a Merchant-King's business, and help them smother competitors who have nowhere to hide.

In their own way, each Cash-King or Merchant-King company makes the rules by which their respective competitors do business. As far as I'm concerned, Cash-Kings and Merchant-Kings are two different varieties under the Rule Maker umbrella.

- Oak

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