Where did Sports Authority go wrong in their failing efforts to survive?

In March 2016, Sports Authority applied for bankruptcy protection. The CEO, Michael Foss, is quoted to have said: “We are taking this action so that we can continue to adapt our business to meet the changing dynamics in the retail industry. We intend to use the Chapter 11 process to streamline and strengthen our business both operationally and financially.”

So what has changed? Management claims that internet sales has had the most negative impact, but that doesn’t tell the whole story. When Sports Authority was purchased by Leonard Green & Partners LP in 2003, it was on par with Dick’s Sporting Goods in terms of same store sales. Over time Dick’s Sporting Goods steadily improved its business performance to the point where today Dick’s Sporting Goods generates $10 million per store per year against Sports Authority at $5.75 million per store per year. To have sales at approximately half of the competitor’s is not due to internet sales cannibalizing brick and mortar store sales.

Management claims outdated information systems, bad mergers and leadership turnover to be responsible for the slow and relentless decline in sales. However, anyone who has visited a Sports Authority store and a Dick’s Sporting Goods store, knows that the reason is much simpler.

Both Dick’s Sporting Goods and Sports Authority stock premier brands like Nike and Under Armour, are located in the same shopping concentration areas, are exposed to the same internet sales bleed from Amazon and others and sell pretty much the same range of products. Even more disconcerting is that sports apparel and equipment is one of the few retail areas where demand is increasing.

However, Dick’s Sporting Goods is better merchandized, has more staff on hand to help out, and generally offers a much more pleasant shopping experience. In contrast, Sports Authority is badly understaffed, feels cavernous and gloomy and generally offers an unsatisfactory shopping experience. It is not internet sales, systems or mergers that is the reason for the remarkable difference in store sales performance – we contend it is a cost minimization strategy that is the culprit.

We have seen this play out in particular where private equity or hedge funds have a big say in the way companies are managed. Their focus is frequently to load up acquisitions with debt, extract as much as possible and not reinvest with long-term growth in mind. Once in the downward spiral of excessive cost minimization, driving lower customer satisfaction, driving less foot traffic, driving more cost minimization takes hold, bankruptcy is extremely likely.

We agree with other industry analysts’ stated position that the probability of Sports Authority still being in business five years on is pretty remote. Shutting down 140 stores out of 465 while the competitor has 737 stores in its fleet is not a confidence inspiring strategy. Getting traffic through the doors is what is needed. Sports Authority and its owners need to abandon its cost minimization strategy and creatively think about how it can create a high-value destination shopping experience – it is worth as much as the actual merchandise sold. That will require truly out-of-the box thinking.

Stopping the bleeding in the remaining stores will come from the simple stuff – better store design, better merchandizing, better staff availability and competence. Profits will come from leveraging the larger asset base that Dick’s Sporting Goods does not have. For example – we would expect Leonard Green to carefully consider leveraging synergy between companies. It owns LA Fitness as well as Sports Authority. We think there are opportunities to co-locate stores and fitness centers, creating virtual coaching that goes with Sports Authority equipment and integrating home gyms with the LA Fitness brand through creative web traffic.

If Sports Authority does not come up with an orbit-shifting strategy that goes outside the traditional constraints of retail thinking, it may lose the support of its halo brand suppliers. That will be the death knell for Sports Authority.

What should Valeant do now after their company’s stock plummets?

Valeant Pharmaceuticals International
Once in a while, the investment community finds out that one of its darling companies touted as a star investment turns out to be a disaster. In 2015, Forbes Magazine sang the praises of Valeant, describing it as one of the world’s most innovative companies with a market capitalization of $67.5 billion. Even though it was ranked no. 1147 in terms of sales, it was ranked no.133 in market value. In the light of our assertion that corporate strategy is the major driver of market capitalization, the investment community clearly thought Valeant had a stellar and sustainable future. Fast forward nine months later and Valeant is the polecat of the very same investment community. Market capitalization plummeted to $9.5 billion – 14% of its 2015 value.

Much like Lehman Brothers, the massive amount of debt – some $31 billion on annual sales of $11 billion – was what spooked the investment community and brought the stock price crashing down from $257.00 per share in August 2015 to $28.10 in April 2016.

What was the strategy in play that brought the company down?

With significant hedge-fund investment, the strategy was to grow market capitalization as fast as possible, then exit with alacrity. The goal was to achieve the five-fold growth by buying companies, repricing their product range and re-launching the products under the Valeant banner.

In January 2014, Valeant’s now departed CEO, Michael Pearson, was quoted as saying “We did set an aspirational target of being a top five pharma company by the end of 2016… that would be a market cap of $150 billion roughly.” Since the top five pharma companies average $41.1 billion per year in prescription sales only, that would require a five-fold increase in sales in two years.

The problem with a highly leveraged growth strategy is that it requires larger and more profitable acquisitions to keep the momentum going, if the acquisitions in and of themselves are not massively profitable. When Valeant tried to buy Allergan, that company compared Valeant to Tyco, a company that deployed a similar growth through acquisition strategy that spectacularly crashed 2002. Allergan successfully resisted the takeover bid, and vindicated their position.

The question the board under the chairmanship of Robert Ingram needs to answer is this:
“What strategy will restore investor confidence in Valeant?”

The investor community bases its valuation on future earnings potential, and a new strategic direction would have to doubly reassure stockholders that Valeant could profitably do so. Clearly, the sophisticated buy-reprice-relaunch model won’t do, and given that 50% of the current directors list an affiliation with hedge funds, we would be surprised to see a robust long-term growth strategy.

Remarkably, management seems to be at a complete loss as to a new strategic direction. In the March 15, 2016 quarterly investor stockholder conference call, the company listed the following key activities:

  • Restructuring smaller businesses: Solta, Sprout, Obagi, Commonwealth.
  • Beginning to address SG&A cost reductions given revenue shortfalls: (but… partially offset by investment in key functions – Financial reporting, Public relations, Government affairs, Managed care and Compliance, which means the gain will be marginal.)
  • Exploring targeted divestitures of non-core assets.

This lackluster list of managerial interventions should make the last investors head for the exits, especially in the light of the strategy outlined at the JP Morgan Healthcare Conference in January 2016. There the interim CEO stated that Valeant remains “committed to our strategy with a relentless focus on execution.” He highlighted the following (we assume) as strategy components:

  • Collection of great healthcare franchises and brands around the world
  • Deep bench of talented people
  • Exciting pipeline of new products
  • Relentless focus on providing easy and affordable access for physicians and patients

We contend that this is not a strategy, but simply the necessary conditions to survive – have product that the market wants, have competent people, new products in development and getting the products to the market at low cost to the consumer. Every pharmaceutical company needs to satisfy the same requirements.

In the long term, there is only one strategy that works – bring new blockbuster drugs and devices to market faster than the products become available as generics. Of the four strategy items, we consider the last two statements fit this model – exiting pipeline of new products and affordable access to products.

How well is Valeant positioned to turn these two strategy items into a sustainable long-term advantage?

At the same JP Morgan Healthcare conference, Dr. Ari Kellen EVP and Company Group Chairman shared this information on the state of the R&D pipeline:

Firstly, pharma companies tend to have more early stage developments than late stage developments. The low level of early stage developments may be the result of the minimal amount spent on R&D. Valeant spent some $260 million on R&D in 2014, which is 5% of its prescription income. The top ten companies spent on average 18% of its prescription income on R&D. Compared to its total sales, Valeant spends 2.8% on R&D. That is not what the top pharma companies do. Considering the R&D pipeline itself, the situation may be even less attractive.

Our research indicates that, in pharmaceutical R&D, the accepted rule of thumb is that:

  • Stage 1 to 2 = 30% survival rate
  • Stage 2 to 3 = 14% survival rate
  • Stage 3 to NDA = 9% survival rate
  • NDA to commercialization = 8% survival rate

Applying this to the Valeant late stage pipeline where its long-term growth must come from, only one drug or device out of the 72 products in development may make it to the commercialization stage. This is not a problem for blockbuster drugs like cox2 inhibitors that provided decades of massive cash inflow in the billions of dollars. However, looking at the performance of the existing Valeant top 30 bestseller products, the average annual sales is $48.23 million per product with the top earner contributing $210 million per year. That is less than the company’s total annual R&D expenditure.

It is reasonable to assume that the probability of that single successful product being in the billion dollar earning range in the near future is near zero. It seems there is nothing there to reassure investors of long-term growth.

We have also considered the second strategy element, of providing easy and affordable access to physicians and patients, to Valeant products. Will this bring long-term growth?

For Valeant, the top 30 products account for 52% of sales income. Since the company indicated in its 2014 filing that it has 1600 products it sells, the top earners represent 1.9% of its product portfolio. There must be a gigantic number of unprofitable products in the portfolio all requiring sales effort, supply chain and manufacturing cost and effort. It may also explain the anomaly that, in December 2014, there were 6,200 employees in sales and marketing and 1,600 in general and administrative positions out of 16,800 people.

That is 47% of the workforce.

Secondly, the biggest buyer of pharmaceutical products are the US and Canadian government procurement programs. These are supplied by the large wholesale pharma supply companies, which Valeant is actively pursuing. It describes the new Walgreens Booth Alliance agreement as a significant gain in order to “take cost out of the healthcare system.” We interpret that to mean lower prices on Valeant’s products. Add this to the existing contractual relationships with the wholesale providers:

  • McKesson with $179 billion in 2015 sales. It accounts for 17% of Valeant sales.
  • Amerisource Bergen with $ 135.9 billion in 2015 sales. It accounts for 10% of Valeant sales.
  • Walgreen Booths Alliance with $103.4 billion in sales. Valeant now has a 20-year supply agreement with a 10% price reduction commitment. It is reasonable to assume that it would account for at least 10% of sales.

These three large entities alone represent 37% of Valeant’s sales, in turn however Valeant only makes up approximately 2.6% of McKesson, Amerisource and Walgreens Booth Alliance’s sales. Not a strong negotiation position. We interpret that to mean that Valeant prices and margins will continue to be under pressure.

To bring the observations together:

  • Very low probability of significant new products coming from late-stage R&D.
  • A huge product range requiring massive sales and admin support.
  • A significant increase in exposure to price and margin erosion from large wholesale buyers.

There is not much left to reassure investors of a strong, profitable long-term growth strategy.

The last question then remains: “What can Valeant do to rebuild its market valuation?” The answer is not rosy. We would advise the board to:

  • Dramatically reduce the product range down to profitable products. Sell off what can be sold.
  • Retire debt by liquidating as many assets as possible.
  • Take a hatchet to the R&D pipeline and focusing all effort on the candidate products with the highest probability of delivering significant sales volume. Implement high-velocity project management tools and skills.
  • Upgrade supply chain management infrastructure to effectively manage inventory using 24-hr. replenishment optimization algorithms and tools.
  • Dramatically reduce headcount and fixed expenses.
  • Appoint a board that truly has the long-term interest of the company at heart.
  • Be the best and most responsive service provider outside of the large wholesale chains using supply chain technology again.

However, bold and significant strategy changes like these may convince the investor community that Valeant has a future.

Restoring Restoration Hardware

Following the spectacular meltdown in the stock value of Restoration Hardware this week after the release of the Q4 2015 operating results, CEO Gary Friedman gained significant investor attention for two things – his all-caps internal memo to his employees for fiddling while Rome (read RH) burns, and that investors are starting to believe the RH growth strategy may not be as good as what management purported it to be.

Both of these are sobering insights and the stock market – the most honest of all institutions – promptly discounted the stock down 60% to close near its IPO price. This is a wake-up call to management that the current strategy is not inspiring confidence in the long-term growth prospective of RH.

Although the company attributed the less-than-stellar performance to short-term factors such as wealth effect and market jitters, the larger investment community looks past those to evaluate the feasibility of the longer term growth opportunities. No one can argue that Gary Friedman and the RH management team have done great things, but the market thinks it is not sustainable in the long term.

At risk of over-simplification, RH revenues represent 1.14% of the total annual US home furnishings market. That is either a sad reality of what it can secure or a huge indictment against RH management for fiddling with the trivial while a huge market opportunity goes to waste. Here is our take on the RH strategy and why we think it inspires investors to bolt for the exits:

  • Market Perception: Every company has at its core a singular identity that it projects to the market. McDonalds equals burgers, for example. So RH equals what? Neutral-toned, distressed-finished, robust retro-industrial style merchandise – serving the tastes of a very narrow segment of the market. Granted, the RH Modern brand is aimed at changing that, but the essence is still the same, just designed differently. That singular identity immediately excludes a large portion of potential customers.
  • Sustainable Competitive Advantage: Investors place immense value on companies that have a sustainable advantage, like for example, Apple in design and technology. Does RH have a sustainable competitive advantage? It has most of the same things as its competitors – easy credit, design consultants, cool websites and brick & mortar stores. With RH sales nearly equally divided between store sales and direct sales, the focus on more expensive gallery-style emporiums may seem like a larger fixed cost burden. No sustainable competitive advantage there.
  • Customer Needs: In the light of today’s dominant drivers of consumer behavior – Forward Customization, Transaction Freedom, Independent Work and Agile Systems, the RH membership card model is diametrically opposite to what the market wants – fewer constraints, easier decisions, faster need satisfaction.

To summarize: A narrow market segment, unclear sustainable competitive advantage and incentives misaligned with key consumer behavior drivers, does not make for an attractive long-term investment thesis.

If we were to write a hypothetical internal memo from a prospective investor to RH management, it may read:

“Don’t beat up on your people. They operate within the constraints management created. Rather look at building systems that create hard-to-emulate customer delight – predictive, agile supply chain models for the right product in the right place at the right time, effective assortment management, profound immersive virtual experience, design at purchase, for example. There is HUGE market to be had out there. Go get it.”

How did Lego rebuild itself and deliver massive growth?

In our strategy work, we ask our clients a simple question: If I woke you up at 2am and asked you to immediately tell me “What is the one thing your business must be extraordinarily good at?” what will you say? In most cases there is no clear answer.

That is the most telling and disturbing indicator that management has not created, defined and internalized the essence of its core strategy. For most companies, it is a surprisingly difficult question to answer, let alone internalize at management level and embed throughout the organization.

There is one company that illustrates the value of this concept better than any other. It is a household name in nearly every part of the world – LEGO. The Danish company that manufactures and sells the ubiquitous plastic toy bricks is now the world’s most recognized brand. It was not always a joyful tale, though. In 2003, LEGO was on the verge of bankruptcy, deeply in debt and bleeding cash. The generations-old business was mired in theme parks it didn’t know how to run well and was invested in non-core businesses that diverted management attention.

In 2004, it appointed the fist non-family chief executive – Jorgen Vig Knutstorp. The parlous state of the business made the first strategy pretty obvious – tight fiscal control to stop the cash bleed. Once stabilized, Jorgen could afford to devolve management control and move to the one thing that, throughout its existence, had carried LEGO – the creative pleasure its products provides.

When Jorgen and the management team asked themselves “what is the one thing that secures the existence of LEGO?” the answer was: “Uniquely designed products that help children learn systematic, creative problem solving.”

This clear statement of the one thing was the springboard that launched the company on a stellar growth path. It caused LEGO to focus on both adult and children markets, tapping into a huge 120,000 strong volunteer product designer corps. It caused them to research to extraordinary depth the experience children have with their product, as do their parents.

By having a crystal-clear picture of the one thing, LEGO devised and deployed a strategy that resulted in exceptional growth and profitability while building a huge global fan base for their simple, colorful bricks that everybody loves.

What is the one thing your company should do better than anyone else?  If you have difficulty answering, you should consider talking to us. We can help.

Cost Reduction is not a Strategy – it is a Cop-Out.

Wall Street analysts were nonplussed to hear the new CEO of Procter & Gamble declare in his first public meeting with investors that another $10billion in cost reduction is the major strategy for restoring profitability. After deciding to sell off a raft of companies and brands, analysts are hard pressed to determine the strategic direction the company will take.

The same dynamic also appeared recently with the announcement by Nordstrom that it plans to generate $150 million in savings. “Expense rigor is a key component of our plan” the CFO announced. Investors did not like that, as the stock chart illustrates:

The two-thirds drop in earnings per share contributed to the decline in stock value. Management blames the disappointing performance on consumers preferring to shop at Amazon rather than at the company’s brick and mortar stores.

However, both Macy’s and Kohl’s reported similar substantial declines in sales in the first quarter of 2016, while the embattled Sears announced the closure of another 78 stores. Investors did not like that either, with the stock losing nearly 80% of its value:

Macy’sannounced that it is “digging deeper to find expense reduction opportunities.” Investors didn’t like that either:

Kohl’s CEO announced in the last investor call that “We managed our expenses effectively throughout the quarter as every area contributed to our savings versus our plan.” Investors did not like that either:

There is too much of a coincidence here not to ask the question: “Do retailers realize that cost cutting is not a successful strategy?”

Investors reward companies that demonstrate growth and profitability and mercilessly punish the cost-reduction, store-closing, “batten-down-the-hatches” management teams. Prudent cost control is expected of all management teams as a matter of course, but presenting it to the world as a strategy in and of itself is inexcusable.

Our contention is that cost cutting is the easy way out. It takes no effort not to spend money, but it takes a highly competent management team to figure out how to develop a growing, profitable business despite adversarial business trends.

Proof of our hypothesis of the suspect quality of management strategy in the above-mentioned companies is to be found in the performance of a retail chain in Brazil. In a country known for its shaky economy, Riachuelo is one of the largest clothing retail chains with 223 stores, some 40,000 employees and 23 million store cards in the hands of its shoppers.

Its business results are way more impressive than its North American counterparts:

  • It is strongly profitable
  • It has been opening 20 – 45 new stores per year over the past five years – a 20% annual expansion.
  • Product prices are increasing by 3.8% per year while their competitor’s prices are declining by 2.7%.
  • Sales increase by 30% year-on-year.
  • Slow moving inventory is 30% less discounted, compared to its competitors.
  • Total inventory continues to decrease by 15-20% across the entire company while increasing the variety of SKU’s available.
  • In-store inventory is 50% of what would be normally expected.
  • It is opening smaller stores with equivalent sales as larger stores– 1,800 m2 compared to 6,000 m2 average store size.

I’m sure you would agree that this sounds like a great retail business with a very effective strategy that would make investors very happy.

So what makes the difference?

In a nutshell – Riachuelo focuses on providing an extraordinary client experience where it counts.

Inventory management at the SKU level versus the Grid level guarantees the correct size in the correct color whenever the client wants it. With only two items of every SKU on display, shoppers no longer dig through piles of inventory hoping to find the right size. That is what brings customers back.

An insanely fast inventory deployment system insuring every size of every range is available every day in every store, thereby driving higher sales through their much reduced store size.
Disproportionate focus on fast movers and big sellers in order to maximize sales while a particular design is in vogue. They offer very few markdowns and sale items. This negates the tendency for shoppers to wait for the sale event rather than shopping throughout the year.

Also, by leveraging just one sustainable competitive edge – that of insuring their customers will get what they want at all times, the company reduces the reason for shopping on the internet. Riachuelo has no shortage of internet-based competitors in Brazil, but still outperforms even those.

What drives this management paradigm?

An appreciation for just how much change is required to stay ahead of the game.

While USA retailers are trying to cost-cut back to profitability, Riachuelo has been reconfiguring its systems, processes and competence based on customer service models and supporting software tools that are orders of magnitude more responsive and precise than the systems the USA companies are still using.

As an analogy, imagine yourself driving cross-country thirty years ago. You would do so with a map in hand but with no idea of traffic density, optimized route options or construction delays.

Fast forward to the era of GPS navigation. Now Google Maps will tell you the best route, taking into consideration a myriad of variables while guiding you to your destination quickly and accurately. It will even re-calculate your route if you veer off the planned route.

New inventory systems treat every item of apparel in the same way, guiding each individual item to the store where it is needed, tracking all sales volumes to avoid parking the item in a congested store.

While the USA retailers are still holding their paper maps, companies like Riachuelo are building a competitive advantage at the GPS level that is nearly impossible to equal.

Strategy Lesson:

The Riachuelo strategy is in line with our assessment of the four major strategy drivers that top management should be considering in their strategy formulation, namely that of final assembly of goods and services as close to the final customer as possible.
Look for the one variable that offers disproportionate value to your customer base and then go build the most effective capability to reliably serve that need beyond their expectations.

If you wish to learn more about our analysis of the major business megatrends, email us at info@akzeon.com

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