Large competitive moats play an important roll in determining the current and future success of a business. Moats are barriers to entry that protect the economic castle—from both new entrants, or expansion by current competitors. So the bigger the moat, the better the business, right? For the current and very near future, yes. But huge competitive advantages can become disadvantages when they lead companies to become complacent about their customers and potential alternatives to their product.

On the one hand, you have Wal-Mart and Coca-Cola—companies where consumer preference plays a large role. Wal-Mart has economies of scale that result in lower costs—probably the biggest competitive advantage in all of retail. But as the old saying goes, “retail is detail” and they still have to work hard to get the customer experience right (at least for their price point). If they don’t, competitors like Target and the dollar stores are more than willing to pick up new business.

Coca-Cola also has seemingly large advantages: a powerful brand name due to strong consumer habit and share of mind, plus large economies of scale in global marketing and distribution. Coca-Cola-owned brands account for 3% of every beverage consumed in the world today. But consumer preference still drives this market share, and a single slip-up (like this) can drive customers to the also-dominate #2 in the market, Pepsi.

On the other hand, you have companies with extremely wide moats like Microsoft and Ebay. They essentially have a lock on most of their customers because of high switching costs or strong network effects. Ten years ago, if you used their products and wanted to switch, it would be very difficult. Among other reasons, I think that led them to skimp on product quality and customer experience. There were product updates and improvements, but little innovation compared to alternatives. Why upset the apple cart when people are essentially forced to use your product?

The details matter!

Having a powerful lock on customers can lull companies into complacency. By the time they realize customers  have a good alternative or their business model is being disrupted, it may be too late. For companies who have big competitors or have to constantly cater to customers, it’s easier not to fall into that trap. So if you have the luxury of running or investing in a business with a strong lock on its customer base, remember to sweat the details. Customers will always eventually have an alternative.

The gist of the article is that managers of public companies focus too much on the expectations behind their stock price, and in turn “maximizing shareholder value.” [1] According to Martin, the causes stem from misaligned incentives and the business culture that has developed over the past 30 years. This focus on shareholders usually comes at the expense of customers and employees. “If you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either.” When managers are working in the expectations market, they’re much more likely to make short term decisions that benefit only themselves and a (vocal) subset of shareholders—traders. This includes seemingly harmless activities like giving quarterly or annual earnings guidance, or for retailers reporting monthly same-store sales figures.

Martin proposes a few remedies to the problem, like improving board governance and eliminating both safe harbor provisions and stock-based compensation. These would go a long way to nudge corporate behavior in the right direction. But for managers who want to take it upon themselves, here’s my proposal: think of your company as a Dynamic Pie.

If you didn’t notice from the picture above, in this part of the post I’ll be discussing pie—the dessert, not the mathematical constant. The Dynamic Pie represents the value of a company to its customers—or in financial terms, its revenue. The size of the pie grows or shrinks over time depending on the amount of value received from customers. It then gets divided into three groups of stakeholders: Providers, Employees, and Owners.

The job of managers is twofold:

1. to grow the pie by delighting and growing the current base of customers; and
2. to divide the pie in a way that’s fair to all three groups.

Of course, the size of each group’s slice isn’t completely determined by managers. Each business is different—in some Providers will take the biggest slice (Wal-Mart), in others it’s Employees (Goldman Sachs) or Owners (Microsoft). The key is not that they are equal, but fair. Or, to be more precise, each group should be satisfied with their share given market circumstances.

Every stakeholder works to increase the size of the pie, because in most cases it’s in their best interest. If one group is being shortchanged in favor of another, they’ll end up focusing only on getting a bigger share, and not on customers. By taking care of customers and being fair to all stakeholders, the pie will grow and shareholder return should take care of itself.

Sears Holdings: Division of a Shrinking Pie

Sears Holdings is the company that owns Sears, Kmart, Land’s End, and other brands like Kenmore and Craftsman. It’s a good example of a business where the size of the pie is shrinking over time, primarily due to customers switching to competitors from under-maintained Sears or Kmart stores.[2] This is a difficult situation, as each group of stakeholders wants to maintain their share. If the pie’s getting smaller overall, it will come only at the cost of other stakeholders.

Although individually they don’t have much of a choice, employees don’t want to be laid off. Sears has 300,000+ associates, and you can’t meaningfully decrease their slice of the pie without consequences. There is value left in the huge amount of real estate that Sears leases, but again, you have to muscle it away from the lessors that provide it.[3]

Because it’s hard to maintain value for all share owners, Chairman Eddie Lampert has been focusing on a subdivision of the Owners slice: that of long-term shareholders. By buying-back a massive amount of shares over the past 6 years, the pie has shrunk further as some investors exit with their fixed slice, leaving remaining owners with a bigger share of a smaller pie.

For dying retailers, the decline is never linear—less customers, less employees, and poorer quality operations are all part of a negative feedback loop that accelerates over time. This is what has been happening to Sears recently. Now, all the investors who exited and “ate” their pie are looking much better off than those who stayed.

Getting it Right

In the article, Denning cites Johnson & Johnson, Proctor & Gamble, and Apple as exemplars. Costco and Starbucks are two more examples of companies that do a fantastic job of dividing and growing their value.

In Starbucks’ case, the Providers take the biggest slice by contributing the coffee beans, milk, paper products, real estate, etc. Though I’m not sure about the rest of their suppliers, I do know that Starbucks treats their coffee suppliers very well. Despite the fact that coffee is a commodity and can be had for the lowest possible price, Starbucks spends a little extra to ensure good working conditions for the farmers and good relationships with the communities involved. Baristas and other Starbucks partners receive full healthcare coverage, including part-time workers. Is this really necessary? Short-term, Starbucks could probably get away with cutting benefits (this was suggested to CEO Howard Shultz during the recession) to increase Owner’s share of the pie. But in the long run giving even the lowliest of partners a fair share will grow the pie for everyone involved.

Costco is a similar example. Despite operating on razor-thin margins (stores aren’t allowed to mark merchandise up more than 14% above cost), Costco pays their employees above-average wages and insures 85% of them compared to less than 50% for other major retailers. “It’s not altruistic,” Costco founder Jim Sinegal said in a recent interview. “This is good business, hiring good people and paying them good wages and providing good jobs for them and opportunities for a career.”

Let’s look back at the Sears example for a moment—what if declining value is the only possibility? Even if Sears plowed money into improving their stores, they would be unlikely to out-compete the Wal-Marts and Targets of the world. An historic example of this can be seen in Berkshire Hathaway.

When Warren Buffett took control of Berkshire in the late 1960s, it was a declining textile mill with no hope for revival. Instead of trying to divide the shrinking pie amongst current stakeholders, Buffett decided to grow the pie by allocating cash to better businesses. Over time, this added new employees and providers to the overall company while the textile mill faded away. Owners were not forced to fight over a smaller and smaller piece, nor were they taking an unfair share from employees or providers.

Some situations are harder than others to fairly split the pie. Companies with competitive advantages have more leeway in how stakeholders are treated. But by making sure everyone “wins” by receiving a fair share, every contributor is more incentivized to grow the pie and delight customers. Now onto finding me some real pie… (My favorites—because I know you’re wondering—are apple, cherry, peach and pumpkin.)

[1] Listening to the comments of current business leaders and reading histories of past leaders, I’ve always been perplexed by the misguided focus on stock price and market expectations. Part of me thinks that they don’t have a fundamental understanding of the way the market and its participants work. With very few exceptions (for companies that require constant short-term financing, or those issuing or buying back stock), businesses and their leaders shouldn’t give a damn about the market price of their company.

As an investor and entrepreneur, my advice to all leaders is this: If the market or analysts “expect” you to grow sales by 20% next year, that’s their business—not yours. If you miss expectations by 2% or by 2 cents a share, they’re the ones to blame for missing estimates. Your job should be to focus on improving the long term value of the business for everyone involved. Most share “owners” these days are short-term holders or mindless algorithms anyway.

[2] Other Sears Holding’s brands and their online division are doing much better, but due to the relative size of the Sears/Kmart retail operations it drags the rest down with it.

[3] Yes, it’s true that lease agreements lock lessors in and give them little options. But this is just another example that shows the only way to extract value in a situation like this: by taking it from the other stakeholders. Real estate Providers aren’t getting their fair share because Sears pays much lower than market rent for their properties.

After reading Walter Isaacson’s biography and the last few months worth of articles on Steve Jobs, I put together a collection of my favorite quotes about and related to him:

At the company he founded after being ousted from Apple, Jobs was able to indulge all of his instincts, both good and bad. He was unbound. The result was a series of spectacular products that were dazzling market flops. This was the true learning experience. What prepared him for the great success he would have in Act III was not his ouster from his Act I at Apple but his brilliant failures in Act II. – Isaacson (page 219)

It was yet another example of Jobs consciously positioning himself at the intersection of the arts and technology. In all of his products, technology would be married to great design, elegance, human touches, and even romance. – Isaacson (page 41)

Jobs’s interest in Eastern spirituality, Hinduism, Zen Buddhism, and the search for enlightenment was not merely the passing phase of a nineteen-year-old. Throughout his life he would seek to follow many of the basic precepts of Eastern religions, such as the emphasis on experiential prajñā, wisdom or cognitive understanding that is intuitively experienced through concentration of the mind. – Isaacson (page 48)

[Jobs's] reality distortion field was a confounding melange of a charismatic rhetorical style, indomitable will, and eagerness to bend any fact to fit the purpose at hand.  – Andy Hertzfeld 

The unified field theory that ties together Jobs’s personality and products begins with his most salient trait: his intensity. . . . This intensity encouraged a binary view of the world. Colleagues referred to the hero/shithead dichotomy. You were either one or the other, sometimes on the same day. The same was true of products, ideas, even food: Something was either “the best thing ever,” or it was shitty, brain-dead, inedible. — Isaacson (page 561)

What makes Steve’s methodology different from everyone else’s is that he always believed the most important decisions you make are not the things you do, but the things you decide not to do. He’s a minimalist. – John Sculley

Jobs’s sensibility was editorial, not inventive. His gift lay in taking what was in front of him—the tablet with stylus—and ruthlessly refining it. – Malcolm Gladwell (The Tweaker)

A genius is a genius, [Dean] Simonton maintains, because he can put together such a staggering number of insights, ideas, theories, random observations, and unexpected connections that he almost inevitably ends up with something great. “Quality,” Simonton writes, is “a probabilistic function of quantity.” — Malcolm Gladwell (Creation Myth)

He was, indeed, an example of what the mathematician Mark Kac called a magician genius, someone whose insights come out of the blue and require intuition more than mere mental processing power. Like a pathfinder, he could absorb information, sniff the winds, and sense what lay ahead. — Isaacson (page 566)

Steve Jobs’s natural talent is to imagine not only what consumers want now but also what they will want in the future — and pay a premium price for. He searches for discontinuities in the external landscape. He figures out trajectories of new opportunities. . . . He figures out precisely what problems need to be solved, however impossible they may seem, and searches for the best people to solve them, regardless of their status. — Fortune (How Steve Jobs gets things done)

Steve Jobs was an enemy of nostalgia. He believed that the future required sacrifice and boldness. He bet on new technologies to fill gaps even when the way was unclear. — Mike Daisey (Against Nostalgia)

That emphasis on consilience, even if it came at the expense of convenience, has always been a defining trait of Steve Jobs. In an age of intellectual fragmentation, Jobs insisted that the best creations occurred when people from disparate fields were connected together, when our distinct ways of seeing the world were brought to bear on a singular problem. — Jonah Lehrer (Technology Alone is Not Enough)

The nasty edge to his personality was not necessary. It hindered him more than it helped him. But it did, at times, serve a purpose. Polite and velvety leaders, who take care to avoid bruising others, are generally not as effective at forcing change. — Isaacson (page 565)

(* I put together the above image as a compilation of WSJ hedcuts of Jobs, mostly from this blog.)

Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.

There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.

Duration of the arbitrage spread depends on the size of the imbalance and the nature of competitive advantages. The imbalance size is the difference between what the market demands (total size of the “job” and the level of performance demanded) and what is currently offered.  Competitive advantages can affect the duration because very low barriers to entry can cause a gap/imbalance to be filled much more quickly by the many entrants who seek any remaining excess profit.

Startups usually start in niche markets but can expand based on a number of factors. For example, durable moats don’t exist at first but can be developed over time while the arbitrage gap is closed. According to Mohnish Pabrai, “these events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority of startups.” Only certain kinds of innovations lend themselves to strong competitive advantages, and hence large operations. (I.e. Standard Oil, US Steel and Nabisco succeeded while National Wallpaper, Standard Rope & Twine, and US Button failed.)

Examples:

• Ford—combined assembly line & interchangeable parts with gas-powered auto production. Most consumers already had the need for a car but couldn’t afford high-end models. Size of the need was huge, achieved strong economies of scale at first but after ~15 years competitors caught up and the gap closed.
• Starbucks—there was a gap between low-end convenience coffee and high-end coffee shops. Combined chain restaurant with coffee shop experience, market was very large & performance demand wasn’t too high at first. Entrants couldn’t match the reach and brand trust of Starbucks (which emerges from the habitual nature and consistently good experience across locations.)
• Facebook—there was demand for a way to connect to others on the internet that was being poorly met. Copied the “social network” concept but implemented it much better, gaining a foothold in the niche school market first then expanding based on advantages in network effects. Size of imbalance was huge and entry barriers prevented entrants from closing gap ahead of them.

Sources: Innovation and Entrepreneurship, The Origin and Evolution of New Businesses, The Dhando Investor

Animal species reside on a scale with “generalist” on one end and “specialist” on the other. Specialists can live only in a narrow range of conditions: diet, climate, camouflage, etc. Generalists are able to survive a wide variety of conditions and changes in the environment: food, climate, predators, etc.

Specialists thrive when conditions are just right. They fulfill a niche and are very effective at competing with other organisms. They have good mechanisms for coping with “known” risks. But when the specific conditions change, they are much more likely to go extinct. Generalists respond much better to changes/uncertainty. These species usually survive for very long periods because they deal with unanticipated risks better. They have very coarse behavior: eat any food available, survive in many climates, use a simple mechanism to defend a wide range of predators, etc. But unlike specialists they don’t maximize their current environment, because they don’t fill a niche where they could be more successful. It’s tough being a generalist—there’s more competition.

An environment with more competition breeds more specialists. Rainforests have huge diversity and competition, and therefore many specialist species.

Specialist examples: Orchid mantis (colorful mantis with appendages like leaves, thrives only on orchids and in tropics), sword-billed hummingbird (beak longer than body, co-evolved with flowers having very long corollas and difficult getting food elsewhere), koala (lives almost entirely on eucalyptus filling a niche that is toxic to most animals).

Generalist examples: Cockroach (survives in most climates, only needs water/moisture and a food source, only defense is responding to puffs of air), raccoon (wide diet, omnivore, lives in any area with trees, brush, or structures), rat (found everywhere in the world but the Artic, not picky eaters), horseshoe crab (wide diet on floor of sea bed, tolerates wide range of water temperature, can survive in low oxygen waters and out of water for extended periods; species over 360MYO).

Specialists & Generalists in Business

This model can be applied to many different areas.

Investors themselves can be put on the specialist/generalist scale. The most specialized investors focus only on narrow segments of the market or certain types of securities. They can be very successful during certain time periods but in the long run are usually disrupted by a changing investment landscape or black-swan-like event. The most generalized investors use very coarse, unchanging rules and are truly “go anywhere”, willing to buy or sell any type of security around the world. They may underperform or lag behind their specialized brethren in the short term but will likely do well in the long run when averaged out over many different environments. Most investors (including Warren Buffett) lie somewhere in between these two extremes. Specialists include investors in certain industries like Sam Zell (real estate) and Ron Burkle (retail), or in certain situations like Jim Chanos (shorting) and David Tepper (distressed). True generalists are more rare, but include great investors like Ben Graham and Seth Klarman.

A more interesting application is to the competitive business world. Like in the animal kingdom, generalists are rare and are usually much bigger than the specialists. They include big multinationals like Johnson & Johnson, Wal-Mart, Coca-Cola, and Proctor & Gamble. Also included are conglomerates that may hold many diversified specialists like General Electric or Berkshire Hathaway. Specialists are businesses that focus on a local niche whether in geography or product space. Because many specialists can dominate their niche, they’re usually protected by moats and thus have high returns.

This is what I call the Specialist’s Dilemma. The stronger your competitive position, the more vulnerable you are to eventually being disrupted and replaced.

Let me explain further. Out of the universe of companies that have strong competitive moats, many of them have advantages originating from the niches they occupy. (Which can lead to barriers like economies of scale, brand attachment driven by habit, and being ahead on the learning curve.) These advantages are durable only as long as the niche itself remains viable. In other words, the more specialized a company’s dominance is, the stronger its advantages are — but the higher the odds of the niche itself eventually disappearing. Not disappearing due to competitors within the industry, but due to the niche being completely destroyed and replaced by something else. The timing of when this happens partially depends on the “clockspeed” of innovation within the industry (more on that in my last post).

Just something to think about if you’re a long term investor or business manager.

The following is a simplified chart/timeline of innovations in the computer industry:

Consumers purchase computer systems, with new innovations or shifts in one component (processors or operating systems) driving innovation in computer design and vice versa. Other components like storage and display also drove innovation but were less important in this context. Most of the above innovations are technical, with the exception of the commodity PC makers (Dell, Compaq, etc.) which were an innovation in business model.

After money was transferred from consumers to computer makers, it went primarily to chip makers and OS developers. Because suppliers like Intel and Microsoft had strong competitive advantages, they had strong bargaining power, and therefore received and kept most of the value.

Retail Industry

The progression of innovation doesn’t just apply to industries as technical and complex as computers. Below is another timeline (dates are approximate) of the progression of the retail industry:

As you can see, the speed of innovation in retail is much slower than the computer industry (but still faster than other businesses, like consumer staples). Innovations and shifts in the retail industry were driven by both (1) prior retail innovations, like discount retailers combining the variety store model with the grocery model of low margin/high turnover; and (2) outside-industry innovations, like railroad transportation leading to nationwide chains, free rural postal delivery leading to mail-order catalogues, and the internet leading to online retail.

If you’ve got any suggestions or critiques of the above charts, let me know in the comments or through email. I tried to get all the facts right for a simplified version of the timelines, but may have missed something.

The hefty valuation, along with the youth of the company (2.5 years) and the reported operating loss may lead observers and the media to cry “bubble.” While I think that $25 billion is a very rich valuation and wouldn’t pay that amount if it went public today, I think people in general underestimate the potential of Groupon’s business model. In other words, they were probably right to turn down Google’s offer of $6 billion (even if they don’t cash out during the offering).

Before going into Groupon’s business model and competitive advantages, here’s a quick run down of some of their customer statistics from the S-1:

In the above equation, those 5 metrics are multiplied to arrive at Groupon’s net revenue amount (the amount Groupon gets to keep after giving merchants their cut). So in the first quarter they made $270 million before expenses.

First the market, then the moat

Before Groupon and all the other deal sites began, local businesses had many lackluster options for advertising their product. They could send coupons in the mail; pay for ads in a local newspaper; pay for outdoor advertising; or pay for online advertising via Google, local news sites, etc. Most of these options (Google less so) are what Seth Godin calls interruption marketing. They are made to interrupt what you are normally trying to do. And because of that, people usually don’t like them, and they have a very low hit-rate in acquiring customers.

Groupon sells what Godin calls permission marketing. People want Groupon to send them daily emails, even if they don’t bother with 95% of them. This “permission” asset that Groupon owns is very valuable. It is not only the huge email list alone that is valuable, but the fact that the people on the other end look forward to Groupon offers (even if they don’t come in the form of daily deals in the future).

Felix Salmon has a good article going into more detail on the value of the “collective buying” model to consumers.

The absence of a well-run permission marketer in the local advertising space (a HUGE market) was an enormous opportunity. It was a form of entrepreneurial arbitrage — find the gap, and close the spread before everyone else catches on. But filling an unmet market opportunity, even if you’re the first mover, doesn’t necessarily mean your profits are protected from assault by competitors.

No company, outside of one with government contracts, has a competitive moat right off the bat. But as Groupon grew to fill-in the market opportunity, it grew its barriers to entry along the way:

• Trust & habit — similar, though not as strong, is why people continue to use Google despite many low-barrier alternatives. This is the initial, fundamental reason for Groupon’s success. As long as they keep their customers happy (and don’t screw anything up), people will keep using what their familiar with and trust. That will also be the one they tell their friends about.
• Initial network effects – the more people that use the service, the better discounts Groupon can get because they can better guarantee a certain amount of people will buy. The group buying aspect provides a kind of mini-economies-of-scale for local businesses. If they have a certain amount of fixed costs, the more customers they can bring in the door (even at little or no variable profit) the better.
• Long-run network effects – local businesses want to sell/advertise their product with the company with the biggest customer base (email distribution, popularity, trust). This is the key advantage. Because Groupon already has a dominant market share, local businesses will seek them more than anyone else. This also leads to a feedback loop—the bigger and better quality Groupon’s “deal” base is, the better they can serve their customers. Combined with trust/habit, these network effects allow Groupon to capture a significant amount of consumer’s attention and time. That attention is obviously very valuable to local businesses around the world. It is much more valuable than say an ad in the newspaper, yellow pages, or on the side of the road.

Groupon also has a funding source in the form of float. It receives the cash from selling a Groupon in an average of 8 days, but waits an average of 79 days to pay merchants their share. This is mainly due to a policy of paying merchants 1/3 five days after their debut, 1/3 thirty after, and the remainder in 60 days. As of March, this amounted to total float of $268mm (payables – receivables). This float has funded most of their recent cash needs in excess of non-growth profit.

All the above also applies to LivingSocial, Groupon’s largest competitor. Past a certain point, customers will get “deal fatigue”. No one wants to receive and sort through 20 daily email offers, or to browse 20 different deal sites. People have a limited amount of “mindshare” to devote to things like this. But at the same time, despite the above competitive advantages, people will still subscribe and solicit other deal sites. This business model is well designed for an oligopoly between Groupon, LivingSocial, and maybe a few other smaller players (Gilt, Travelzoo, etc.).

Not all growth is free

Here is a quote from a blog post today on Forbes: “…investors would be wise to mind the gap between dazzling revenues what it costs to get them.” These are probably the thoughts, at first glance, of many observers.

But if Groupon cut its advertising to nothing, there wouldn’t be a mass customer exodus. In fact, I would guess that growth wouldn’t even slow that much — at this point, it seems that a good portion of obtaining new subscribers would be organic (spread by word-of-mouth). It was certainly smart to spend as much on marketing as possible at first in order to grow market share, for the reasons stated in the above section.

So a certain percentage of marketing spend could be classified as “maintenance expenditures”, which would be the amount they would have to spend to maintain the current customer base. I have no guess as to what that number is, but it’s a lot smaller than their total marketing spend in the 1st quarter of $208mm. To arrive at an adjusted figure (they call it “Adjusted CSOI”) Groupon adds back $180mm of that amount. This would mean it costs them $28mm a quarter to maintain the current customer base. Seems reasonable to me.

Using $28mm in maintenance marketing, Groupon’s first quarter steady-state operating income was $63mm.

There’s always a “but”…

Groupon’s model and growth story aren’t a perfect fairy tale. There is certainly a “fad” element to Groupon (but the same could be said for Facebook, and Facebook has a more difficult job of converting attention to money). As Andrew Mason mentioned is his S-1 letter to investors, there will be bumps along the way. That’s inevitable for a company only 30 months old, no matter what its size.

Groupon is not unassailable. Although they have a moat, it’s definitely not as big as the moat around Google, Apple, or Facebook. In going back to the “oligopoly” argument — even if this is the case, LivingSocial has similar advantages and could potentially outdo Groupon in terms of service and efficiently acquiring customers. I’ve been a customer of both for a while now and recently it seems LivingSocial has done an excellent job. Regardless of whether it’s Groupon or LivingSocial on top — and LivingSocial has a long way to go at ~10% market share vs. 70-80% for Groupon — the business model is a powerful one that will continue to produce large amounts of profit for years to come (until it is inevitably disrupted at some point in time by another business model).

In this week’s New Yorker, Malcolm Gladwell writes about innovation and how Xerox PARC failed to profit from the many incredible inventions that came out of its lab. (You can read the summary here.)

PARC (Palo Alto Research Center), located on the Stanford University campus, was founded in 1970 as a division of Xerox Corporation. They were an R&D lab that Xerox planned to use to both create new products and augment their current ones. They were tasked with creating “the office of the future.” In the mid-1970s, almost half of the world’s top 100 computer scientists were working at PARC. Within five years of its founding, PARC had developed a wide array of important computer technologies, including the following:

• Xerox “Alto”– the first personal computer with a mouse and graphical user interface (GUI) that included windows, icons, and pull-down menus.
• A WYSIWYG (what you see is what you get) text editor.
• Computer generated graphics.
• An Ethernet local-area-network.
• Laser printing.

In Everett Roger’s book Diffusion of Innovations, he uses Xerox PARC as a case study in the “commercialization” phase of the innovation-development process. What led the engineers and scientists at PARC to such an amazing track record? Rogers breaks it down as follows:

1. Outstanding R&D personnel. Several key R&D employees moved to PARC from nearby SRI International, where they had been working under visionary computer scientist Douglas Engelbart. It was around that time that funding to SRI from DARPA, NASA, and the Air Force began to diminish.
2. Management style that was conductive to creating technological innovation. Led by Dr. Robert Taylor, PARC encouraged the free exchange of technical information among the research workers. Their regular meeting room was equipped with beanbags, and the walls were lined with white boards. There was little hierarchy in PARC, and resources were plentiful.
3. R&D employees used the innovations that they created in their daily work.
4. Timing. The time was ripe for technological innovation in personal computing. A crucial prior innovation, the microprocessor, had recently been invented at nearby Intel Corp. Rapid advances in miniaturizing semiconductor functions, with a corresponding decrease in price per unit of computer memory, occurred in the early 1970s.

For anyone not familiar with the history of the computer, the question is obvious — if the above is true, why don’t we all have Xerox computers and Xerox operating systems in our homes right now? The simple answer is that although Xerox PARC invented them, they failed to commercialize and market most of their best discoveries.

In Gladwell’s article, he makes the distinction between the inventions created at PARC and the adaptations of those inventions by Steve Jobs and his team at Apple. The mouse that the PARC engineers designed cost $300 to build and would only work for two weeks of use. The mouse that Jobs contracted to design and eventually distribute with the Macintosh cost less than $15 to build and was much more functional and durable for a typical user. This difference, Gladwell claims, is not trivial. “It is the difference between something intended for experts, which is what Xerox PARC had in mind, and something that’s appropriate for a mass audience, which is what Apple had in mind.” In other words, Xerox created a breakthrough sustaining innovation and Apple adapted and packaged that technology into a disruptive innovation.

Gladwell concluded that although PARC was a great place to research and design cutting-edge innovations, it was indeed a bad place to commercialize them. “For an actual product, you need threat and constraint — and the improvisation and creativity necessary to turn a gold-plated three-hundred-dollar mouse into something that works on Formica and costs fifteen dollars.”

In his case study, Rogers lists the following reasons that Xerox ultimately failed to take the final step of commercializing the technologies developed at PARC: (Adapted from the book Fumbling the Future by Douglas Smith and Robert Alexander.)

1. Xerox was the leading company in the paper copier business, and it perceived itself as only in the office copier business, not in the personal computer business. In Gladwell’s words, “Xerox was a multinational corporation, with shareholders, a huge sales force, and a vast corporate customer face, and it needed to consider every new idea within the context of what it already had.” This is why one of the only innovations it did end up using was the laser printer.
2. No effective mechanisms were created for technology transfer from Xerox PARC to the manufacturing and marketing/sales divisions of Xerox.
3. The button-down organizational culture at Xerox’s Stamford, Connecticut headquarters clashed with PARC’s freewheeling hippie culture.

This is another classic case of the innovator’s dilemma for big corporations. Clayton Christensen names the following attributes as their downfall: (1) Current customers aren’t served by new market; (2)New market is too small for large companies; (3) Use of new technology isn’t fully known yet; (4) Processes that help them with current business hurt them with new business; and (5) New technology isn’t good enough yet to meet higher-end market demand.

Almost all of these attributes can be applied to Xerox and their PARC subsidiary. PARC, in essence, had too much resources at its disposal. Apple was serving a different customer base and was very nimble. They had no choice but to deliver a ship-ready product that they can make a profit on under their current cost structure. Xerox was devoted to their current money-makers and had little incentive to focus on the small, untested personal computer market. “Maybe the only lesson of the legend of Xerox PARC,” concludes Gladwell, “is that what happened there happens, in way way or another, everywhere.”

It was a very good letter overall, with Buffett providing his usual wisdom and wit. This year, he didn’t have to review the basics as he did in 2009 for the new Burlington Northern shareholders, so there was even more wisdom about Buffett’s methodologies and Berkshire’s businesses than usual.

He spends some time in the letter talking about Berkshire’s culture, which is an extremely important yet overlooked part of their past and future success. It is this culture that will allow Buffett to continue to “run” the company for many years after his death. That’s what Berkshire shareholders and the media should focus on instead of worrying so much about succession.

One thing is clear: Buffett may not run the companies that Berkshire owns, but he knows the numbers cold. Of course, that’s always been the case. For every kind of business, he knows the metrics that matter most and the determinants that drive success over time. Sometimes, he even knows it better than the managers themselves (and he’s a much better manager than he’d like to admit in his letters).

For investors, one of the most insightful parts of both Buffett’s letters and annual meetings is how he thinks about and evaluates businesses. In this letter, he didn’t disappoint by providing more insight on how he evaluates Berkshire’s holdings. GEICO was one specific example. The value of policyholders for many insurance companies is zero or even less than zero — these companies are worth tangible book value and no more. But GEICO, according to Buffett’s evaluation, has an extremely valuable base of policyholders: worth about $14 billion, or 97% of annual premium volume.

Number-wise, Buffett provided his estimate of the normalized earnings power of Berkshire’s operations — which at $17 billion, is higher than the reported amount in 2010. These earnings alone would give Berkshire a current pre-tax yield of over 8%, and that doesn’t include any new investments or future gains on their $158 billion in investments.

This valuation compares very favorably to many large-caps in the S&P 500. I think Berkshire is worth at least $100 per “B” share, if not more if Buffett can continue to deploy capital into good, growing businesses.

You can see the above comments in addition to commentary from other Berkshire shareholders in this WSJ blog post: “Here is What People Are Saying About Buffett’s Letter“

Braewick Holdings LP owns shares in Berkshire Hathaway. We reserve the right to buy or sell them at any time.

• +8,524% (37.7% annualized): Stock performance since Steve Jobs’ return to Apple in 1997.
• +821% (18.6% annualized): Revenue growth since Jobs’ return.
• +5,093% (66.4% annualized): Stock performance since the launch of the iTunes Store in April, 2003. (A disruptive innovation.)
• +951% (39.9% annualized): Revenue growth since iTunes Store launch.
• In the last 8 years, revenue has grown by $60 billion (1,000%). 73% of that growth came from newly launched products.
• In the last 3 years, revenue has grown by $40 billion (165%). 60% of that growth came from iPhone sales.
• $220 billion: Amount of products sold since the release of the first iPod.
• $19 billion: Apple’s cut of all sales through the iTunes Store, plus Apple iPod accessories (currently $5 billion a year).
• 298 million: Total number of iPod units sold.
• 90 million: Total number of iPhone units sold.
• If the cash and securities on Apple’s balance sheet (~$60 billion) was turned into a hedge fund, it would be the biggest in the world.

Apple Sales/Income Timeline

Apple’s unit volume for non-Mac products: