Thursday, February 19, 2015

Market Share versus Profitability

General Motors, Volkswagen, Facebook.  What do they all have in common?  They chased after market share instead of profitability.

When I was a lad of 18 and working for GM, they told us, at their little school, that it made no difference if they could sell one car and make a Billion dollars from it, or sell a million cars and make a thousand dollars each.  Profit was profit, and market share meant nothing.

GM seemed to forget its own advice for the next three decades.   Partly this was due to the fact that the UAW contract required that they keep plants open and people employed, whether there was demand for cars or not.  So GM went after market share, selling cars for cheap, and plowing excess inventory into rental car fleets.  It all came crashing down in 2009.

Today, GM is leaner and meaner, and again has the largest market share of any automaker on the planet - for the time being.  Toyota, recovering from its tsunami setback, is poised to take over the #1 spot.   But I think both companies have learned a painful lesson - being "Number One" means nothing, if it means you make less money.

After all, the most profitable car company on the planet is BMW, and they hardly sell 1/10th the output of GM.   They took that "if we could make a Billion dollars selling one car" idea to heart in Bavaria (and their prices prove it!).

Volkswagen decided, a couple of years back, to set its sights on being the largest carmaker on the planet.  And so, following in the footsteps of GM, they built a new factory and then de-contented their cars so they could sell on price point, as opposed to quality and features.   And it seems to be working, as sales are up.  But whether this means increased profitability, remains to be seen.

Why do companies want to be "Number One" in the market?  Part of it is ego rush, I guess.  I once worked for a silicon valley company that was approaching $1 Billion in sales.  They got so excited by this prospect that they decided that this $1 Billion number was their next corporate goal.  In a year, they were nearly bankrupt.  By concentrating on overall sales volume, they forgot to pay attention to what was really important - and that was net profit.  And when they started worrying more about mass sales and less about product quality, well, sales sagged.

Going after volume is not always the answer.  In my personal life, I learned this lesson, too.   When I started my practice, I tried to get more and more work, hire more people, and build up a small empire of my own.   But I forgot two things.  First, I wanted to start my own practice to get away from empire-building.  I wanted to work, not manage.  And I was going in the wrong direction.

Second, volume does not equate to profitability.  In order to make a law firm really profitable, you have to have a huge amount of work and an army of underpaid associates to do the work.  You will spend all day stroking and cajoling your associates to work - with implied threats of termination and implied rewards of eventual partnership (not that you really mean either).   You do this, you can make millions a year.  Few do.  And the few that do have sold their soul to the Devil to do it.

For a smaller firm, more work does not equate to more profit - and many Patent Attorneys discover this only after trying to grow.    If you work solo, you can bill $250,000 a year if you work hard, and keep $200,000 of it.  However, if you hire another associate, well, you are not going to bill $500,000 a year and keep $400,000 of it.   Two things work against you.   First, you must spend time reviewing the work of the associate and also managing increased office overhead for him.   Second, he wants to be paid - likely as much as you, so you are lucky if you end up taking home $350,000, if that.  For each additional associate you hire, there is a diminishing return on investment, until you reach a tipping point, at which time you are just supervising all the time, doing no real work of your own, and are riding this herd of other people to make money, as illustrated above.

But in some instances, you can work harder and harder and actually make less money, particularly if you are not effectively managing your associates, or the associates you hire don't have the work ethic you do - which is going to be typical for the types of associates you can attract, as a small business.

So, sometimes small is better - and less hassle.  Sometimes.  Growth for growth's sake is not always a good idea.

But in addition to ego rush, growing a business is also useful for other reasons.  You grow big enough, you can afford to push other people around, pay lobbyists, influence politics, and generally be the 600-lb Gorilla.   GM realized this when it went bankrupt.   While it may have been a humiliating experience, GM was literally "too big to fail" and as such, the government bailed them out.   Whether they would have done this for Ford, well, we'll never know.

So sometimes, being huge has business advantages beyond simple profitability - particularly in an industry that is consolidating and growing quickly - provided you don't leverage yourself too much.  Recall that in the early days, GM nearly went bankrupt twice, when it tried to grow too fast.

During the boom times of the dot com era, the mantra was growth - with profitability sorting itself out later on.  It never did.  The companies that survived, made profits - and could afford to buy their money-losing growth competitors.  The idea was, if you could establish a web site, get a lot of traffic and users, you could establish yourself online and then have the leverage to consolidate smaller companies into your business.

It didn't work out that way.  Cars and Internet Users are not the same thing.   While being "too big to fail" might be true in the car business or banking business, on the Internet, there is no such thing.   The playing field is awfully level on the Internet, and small companies can grow big, overnight - not by being an established presence or by buying superbowl ads, but by providing better prices and better service.

So went belly-up, as it was losing money on each sale and spending massive amounts on advertising.  But other pet sites, like 1-800-PetMeds (better prices than Amazon, but that's not saying much these days) soldier on.

Facebook has had "growth" as its mantra, and has made little in the way of profits - at least compared to what its current stock price should support.   They tout having a Billion users, and many folks look upon that as prima facie evidence that the company has worth.  After all, if they have captured the eyeballs of a Billion people - that is worth a lot of money, right?

Perhaps.  But we are not told whether of those Billion people, how many log on once a day, once a week, once a month, or once a year.  And how many click on the sidebar ads?   A lot, compared to other sites, I am told.  But still  not enough to attract quality advertisers and extract higher ad revenue.

The problem Facebook is facing is that its volume doesn't equate to profits - and by focusing on volume, they sacrifice profits.   Efforts to extract more profit from current users - by adding more sidebar ads, more banner ads, or by charging users for services - have met with resistance from users.

If they try to monetize the site more and more, they lose customers and the vaunted One Billion Users.   However, if they don't extract more money from their base, they never will make the increased profits necessary to justify the current stock price.  Catch-22.

And as I noted before, internet users are not like cars.  They can evaporate in a nanosecond.  No one "owns" a user to a website, and when you change a website, some people leave because they no longer like it.  When you don't change a website, some people leave because there is nothing new.  Catch-22 again.

And there are a staggering number of websites out there for people to waste their time on.   And what becomes popular is more a matter of social engineering than anything else.

Of course, for a social networking site, Volume does have one advantage:  If "everyone" seems to be on it, then people find more utility in the site, as it has links to people they know.   A social networking site that is just starting out, on the other hand, has to reach that critical "tipping point" in order to be successful.  And Google's "Plus" has yet to reach that, just yet.

I am not very bullish on Apple, but their market model for Smart Phones illustrates the concept.   Apple has less than half the market for smart phones - with Android having well over half.   But Apple makes more money, per phone and overall as they don't chase "market share" so much as profit-per-phone.

The problem for Apple, of course, is that it is highly leveraged on this one product.  Samsung makes other things besides smart phones.   Google makes money on a lot of things, not just the Droid O/S.  Apple has all its apples in one basket, and that basket is "iPhone".

But so long as Apple can convince people to pay nearly double for their phones, they will continue to make profits, despite having a smaller market share.   Market share really doesn't mean anything - if it comes at the expense of profits.