Wednesday, September 14, 2011

Understanding a Business; It’s Business Model and Business Strategy

“The Scarce Resource is not Information; it is Processing Capacity to Attend to Information”
Herb Simon, 1973

In a previous blog, we highlighted how the SEC’s interactive disclosure standards have leveled the investment playing field between professionals and individuals.  By sitting on top of the SEC’s interactive data, Valuation Tutor is designed to provide the required processing capacity for understanding a stock’s business model and business strategy.
Source:  Chapter 1, Valuation Tutor
In figure 1 understanding the business starts with the business model.  The business model is described in Item 1, The Business, in a standard 10-K.  You can access Item 1 of a 10-K in Valuation Tutor by entering the stock ticker, selecting the desired form and then clicking on the hyperlink beside the 10-K.  For IBM this brings up the following screen. 

From the dropdown labeled “Select Statement” you can select the appropriate form for IBM.  In IBM’s 10-K,  Item 1 “The Business” provides a concise description of the business model immediately followed by a section titled “Strategy.”    Similarly, for Wal-Mart:
IBM (2011 10-K):  Item 1. Business:
        International Business Machines Corporation (IBM or the company) was incorporated in the State of New York on June 16, 1911, as the Computing-Tabulating-Recording Co. (C-T-R), a consolidation of the Computing Scale Co. of America, the Tabulating Machine Co. and The International Time Recording Co. of New York. Since that time, IBM has focused on the intersection of business insight and technological invention, and its operations and aims have been international in nature. This was signaled over 80 years ago, in 1924, when C-T-R changed its name to International Business Machines Corporation. And it continues today: The company creates business value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes. IBM solutions typically create value by reducing a client's operational costs or by enabling new capabilities that generate revenue. These solutions draw from an industry leading portfolio of consulting, delivery and implementation services, enterprise software, systems and financing.
WMT (2011 10-K):  Item 1:  Business
Wal-Mart Stores, Inc. (“Walmart,” the “company” or “we”) operates retail stores in various formats around the world and is committed to saving people money so they can live better. We earn the trust of our customers every day by providing a broad assortment of quality merchandise and services at every day low prices (“EDLP”) while fostering a culture that rewards and embraces mutual respect, integrity and diversity. EDLP is our pricing philosophy under which we price items at a low price every day so our customers trust that our prices will not change under frequent promotional activity. Our fiscal year ends on January 31 for our U.S., Canada and Puerto Rico operations. Our fiscal year ends on December 31 for all other operations. During the fiscal year ended January 31, 2010, we had net sales of $405.0 billion.

Now consider how you can translate the above business model descriptions into a useful practical representation that lets you understand the business?
Working with Item 1:  Understanding the Business Model
A Business Model describes what a company does to create shareholder value.  Our starting point for understanding the business model is to identify exactly how shareholder value is created.  This requires that we start by identifying and decomposing the business model into a sequence of value adding activities.  This decomposition is referred to as the Value Chain.
In Porter’s original formulation he stressed five primary activities:  Inbound logistics, Operations, Outbound Logistics, Sales & Marketing.  This original formulation is applicable to Wal-Mart along with some additions.
Step 1:  For Wal-Mart Porter’s original representation nearly immediately applies.  

For Wal-Mart, management emphasizes stable every-day low prices.  This implies that Supply Chain Management (SCM) is critical for Wal-Mart to ensure price stability, starting with Procurement.  This was a support activity in Porter’s original formulation but it is a value adding activity for Wal-Mart.   The abundance of information also guarantees that this is a chain with information flowing around in virtual real time.
For the case of IBM, Procurement is not a primary activity.  Instead Customer Relationship Management (CRM) is critical to ensure that IBM’s chain feeds back repeat business.

Figure 3:  A Value Chain for IBM
Source Chapter 1, Valuation Tutor.
Breaking down the business model into a set of value adding activities, that may or may not, be completed by the firm is the first important step required for understanding a business.    However, what really matters is the allocation processing capacity to attend to information.  In other words, from a business strategy perspective the second important step is to understand the relative weightings:
Step 2:  Understanding Business Strategy
Once an analyst has identified the company’s value chain it is feasible to identify the company’s business strategy by assessing which value adding activities the company is currently emphasizing when implementing their business model.  Getting business strategy right can add large amounts of shareholder value and similarly getting it wrong will destroy large amounts of shareholder value.  As a result, identifying and assessing a stock’s business strategy is of primary importance to an analyst.  Again Valuation Tutor is designed to provide the processing capacity that will let you attend to this information.
Porter describes business strategy for a company relative to their competitors in these terms.  In particular:
a business performs different activities,
a business performs similar activities in different ways,
or a business chooses not to perform certain activities. 
In other words, the business strategy is described by comparing the weights placed on ones own value chain relative to the weights placed on competitors’ value chains.
For example, IBM emphasize the “enabling of new capabilities that generate revenue.”  That is, Research and Development including new patents is an important component of IBM’s business model.  IBM anticipate the relevance of this to investors’ in their Item 1 as follows which describes how IBM is performing both similar activities in different ways as well as different activities to their competitors in their approach to Research and Development:
“Research, Development and Intellectual Property
       IBM's R&D operations differentiate the company from its competitors. IBM annually invests approximately $6 billion for R&D, focusing on high-growth, high-value opportunities. As a result of innovations in these and other areas, IBM was once again awarded more U.S. patents in 2009 than any other company, the 17th consecutive year IBM has been the patent leader. IBM's 4,914 patents in 2009 were the most U.S. patents ever awarded to one company in a single year. Consistent with the shift in the company's business mix, approximately 70 percent of these patents were for software and services. The company will continue to actively seek intellectual property protection for its innovations, while increasing emphasis on other initiatives designed to leverage its intellectual property leadership and promote innovation. “
Similarly, in their Strategy section IBM further describe how they have chosen to not to perform certain activities (Item 1, 10-K):
“The company has shifted its business mix, exiting commoditized segments while increasing its presence in higher-value areas such as services, software and integrated solutions. As part of this shift, the company has acquired over 100 companies this past decade, complementing and scaling its portfolio of products and offerings.”
In other words, IBM shifted away from highly commoditized (low margin) products (e.g., laptops and PC’s) to higher margin team projects.  Observe that this strategy exploits IBM’s value chain especially it’s strong positive record for patents and development of cutting edge “know how.”  As a result, this strategy has worked well for IBM and shareholders have been duly rewarded with additional shareholder value.
IBM Attracts Imitators of it’s Business Strategy
HP was anticipated to and now has moved towards imitating IBM’s business strategy.  Earlier this year the following interview was published in the Financial Times (source FT.COM)
“IBM lays down challenge to rival
By Richard Waters in San Francisco
Published: March 13 2011 21:48
“IBM is years ahead of rival Hewlett-Packard in building the integrated software and services business needed in a modern IT company, according to one of the top lieutenants to Sam Palmisano, IBM chief executive.
Mike Daniels, head of IBM’s services division and a leading contender to succeed Mr Palmisano, threw down the challenge ahead of a key HP strategy session on Monday in which Léo Apotheker, HP’s new chief, is due to lay out his plans for the company. While Mr Apotheker has made it clear that he plans to boost HP’s presence in software, the IBM executive suggested that focusing on building individual divisions would not be enough to put HP level.
It’s not like we have a company that has a software strategy and then a services strategy or a hardware strategy,” Mr Daniels said.
By tying its software and services businesses more closely together, IBM has been able to boost its profit margins ahead of HP and is on track to maintain its lead with further expansion over the next five years, he added.
“’I think it would take a long time for anybody to accumulate the kind of capability that we have,” the IBM executive said.’”
The article went on to observe that Wall Street performance over the past year had IBM stock up by 27% and HP stock down by 20%.  It also reported that IBM was working on further tightening their business strategy by spending $14bn on software acquisitions and another $2bn on hiring and training consultants to build business in analytics that are designed to help customers make better use of their data. 
That is, the observation that the Nobel prize winning Herb Simon made nearly 40 years ago has become the center stage of business strategy for  technology firms today:
“…. The scarce resource is not information; it is processing capacity to attend to information.”
In a future blog we will explore what the implications from understanding a business model and business strategy are for Financial Statement Analysis.


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