by Bob Andelman

When C. Steven McMillan took over as the new CEO of Sara Lee in July 2000, he ordered a review of every operation. When that was completed, he boldly announced (paraphrasing), "This is the direction of Sara Lee and these are the business segments we will focus on. We will dispose of those assets that don't fit or are not making money. Then we will buy things that do fit into these segments."

In January 2001, McMillan followed through. He announced that the company was unloading eight divisions: Champion Europe, Sara Lee Apparel Australasia and several international bakery operations, including its U.K. bakery, Ozark Salad Co. and the Spanish processed meats company, Argal. These were in addition to previous divestitures of PYA/Monarch, a leading food distribution company, Lyle & Scott, Georges Rech and Well Hosiery. Sara Lee will use the proceeds generated from these divestitures, estimated to be between $2.5 billion and $3 billion, to repurchase stock, retire debt and fund future acquisitions.

Analysts such as Ann Gurkin, who follows Sara Lee for Davenport & Co. LLC, find it enlightening for management to state a realizable objective and set an easily understandable way of achieving it.

"They had too many different businesses and too many different directions," Gurkin says of life before McMillan. "It was hard to follow them because you didn't know which direction was the most important and how to value the company, where they were making acquisitions or what might or might not be making money."

In an eat-or-be-eaten environment, Sara Lee took the kind of action that many established brands too entrenched in the past are afraid to try. By remodeling its business design, Sara Lee lives to bake another day as predator, not prey.

A Business With No Model
Is a Model of No Business

Every company has a business model. It's the way it does business, whether it's selling computers exclusively via the Internet (Dell), "everyday low prices" (Wal-Mart), or manufacturing products without owning manufacturing plants (Cisco). Some fly high; some are so dense they fall to earth and shatter in a million pieces.

Finding the right business design is no easy task, and too many people underestimate its importance. CEOs and top management can spend years designing and building ownership of their model, staying consistent and aligned in everything they do, whether it's deciding what to buy, what to sell, how to pay people or what markets to move into. The ones who are consistent and aligned do well.

"Business model" can mean many things.

It can be how a company is positioned in the market. We often start with the basics. What does the income statement look like? So many people, even some with MBAs, don't know how to read a financial statement, so it is important that the average investor understand the basics of cost versus expenses. The most important thing we look at nowadays is the balance sheet, how the company uses its assets, which is directly related to cash flow, how well it collects on bills, and how it manages assets ranging from plants and equipment to inventories.

Most investors hear talk about a company's business model and it bores them. That's too bad.

The great thing about the democratization of capitalism is that good companies normally write great annual reports. All you need to do is read the letter from the chairman or the president. Because in the body of that letter, the company will tell you what to expect financially. It will tell you about its R & D budgets. And in the body of that letter, it should tell you about potential commercial innovations that it expects. The president's letter is nothing more than a verbal business model. Then the other thing you should do is pay attention to the company's quarterly reports, which should do a reasonable job of pointing out problems along the way to its annual goals.

Investors are more sensitive to business design today; the rate at which CEOs change is one indication of this. CEOs change because they don't execute an effective model.

Learn what's supporting the model. How will management reach its stated goals? Is it too conservative? Too aggressive? Will a new model require a change of the company's strategy beyond your level of comfort?

Does the company have the right strategy? Is it going in the right direction? Has it identified a profitable direction, a growth direction? Is it a reasonable strategy? Many companies don't have a good strategy; they are lost, trying to reposition, restructure and come back to life. Does the company have the ability to execute a new strategy? What are its objectives, its strengths and weaknesses?

Start with the basics of the business model, meaning income statement, balance sheet and cash flow. Link that to the corporate strategic objectives, and how that funnel drips down to the functional objectives, meaning marketing, product strategy, market strategy, manufacturing, use of online systems. Then pull it together and examine what works from quarter to quarter.

A lot of questions need to be answered.

Virtually everyone interviewed for this book said business model design is critical in his or her investment decisions. After management, it was the second-most-mentioned profitability characteristic.

Some companies do an exceptional job of starting with or adopting a new business model and sticking to it. Others pick the wrong horse and ride it off into the sunset.

In this chapter you'll find a discussion of what to look for in a profitable business design, as well as examples of the good, the bad and the coyote ugly.

Some Sing, Some Hum

You need to know where the company is headed. Is it cutting down on spending, or is it increasing spending? If it is increasing spending, where is the money going and to what end? Will it bring the multiples of the company up or down? How disciplined is the company?

Georgia-Pacific once said it would pay down debt and buy back stock. It did that for a period of time, then all of the sudden made three acquisitions and leveraged up its balance sheet, just when analysts thought it wouldn't go that route again so soon.

There are all kinds of neat little examples of interesting business model tweaks.

Benetton Group SpA hasn't been successful in the United States, but it has been overseas, where its business model was quite different. In Europe, Benetton didn't color any of its sweaters until they were leaving the warehouse; the company produced everything in the same basic gray and dyed it on the way out of the warehouse so it could better match inventory with demand.

When Perdue Chicken switched the kind of feed it gave its birds ­ substantially reducing production costs ­ one of the side effects was that the new feed changed the color of the chickens. Never one to miss a marketing opportunity, Frank Perdue advertised that the color chicken that he sold was better for you.

That is less a business model than a changing of raw material input and a rebranding of the product, but it was effective.

Take The Home Depot as an example. It is a combination of business model plus, because its business model ­ big box stores instead of small neighborhood models ­ was copied by lots of companies. It made tremendous deals, reduced the amount of customer support at the stores and passed the savings on to the customer. Other companies mimicked The Home Depot, but few did it successfully.

Many companies in the early 1990s did business process re-engineering, but they did it from a process perspective as opposed to a business model perspective. Their approach was taking cost out, as opposed to rethinking the way they served customers. Places like JCPenney and Sears, which are shutting down stores, may be cutting costs without really thinking about getting the advantage in serving the customer. They end up shooting themselves in the foot by damaging the customer experience.

Sears and JCPenney have a huge merchandising problem. They tried being single brands serving everybody. Sears sold tools and appliances very well. It should have been the Home Depot of the hardware and appliance world. It had respected, recognizable brand-name appliances and tools but got lost when it wasn't willing to modify its business model.

Southwest Airlines turns its airplanes around very quickly. And the company tells the industry exactly how it does it, but nobody can copy it, because a lot of it goes into how you incentivize and motivate people.

Hot and Cold

You may not know the Masco Corp., but you have heard of its products: Delta and Peerless faucets, Baldwin and Weiser locks, Mill's Pride cabinets, Behr paints and Hot Springs hot tubs.

"If you put $10,000 into this company in 1959," says Raymond James & Associates analyst Budd Bugatch, "it was worth $20 million by the late '80s."

Masco used the cash generated by its original product, the single-handle faucet, to buy other companies. From 1959 to 1987, Masco reported 28 years of upward profits, year after year, and 10 percent net income and 20 percent returns on equity, according to Bugatch. The company just grew and grew and grew. The game plan was clear. Masco, in fact, was called the "Master of the Mundane" because it sold a superior product in a mundane industry.

Across four decades, Masco stood still with regard to its business design. Why fix what ain't broke? Because we live in a dynamic world, that's why. You may make a misstep as you get into the law of large numbers, and Masco did.

"They made a bunch of missteps," Bugatch says.

From the mid-1980s until the mid-'90s, Masco stock was flat. The company bought into the residential furniture industry in a multibillion-dollar way and ultimately wound up divesting that industry and that division, taking a $700 million charge. As Warren Buffett says, if you take a management renowned for brilliance and put it in an industry renowned for bad economics, it will be the industry that retains its reputation.

Part of what you should look for in dissecting a business design is a management that has not only a sense of where it is going, but also recognizes when that plan is pointed toward a dead end. Can management change models and roll with a new iteration?

It is a constant challenge. We don't have anything forever. If anything, we learn that the American economy is volatile. Great, respected businesses all of the sudden become publicly distressed. Montgomery Ward went out of business. It didn't take a long time.

Watch carefully, and even the casual observer will recognize that business is fragile. All business.

Absolutely, Positively Free Today
(And Gone Tomorrow)

Dot.com and Internet-based businesses changed the speculative financial landscape. These sometimes turgid, sometimes flaccid operations caused friction for classic business models.

Looking back, the common dot-com business model was not product or service but hype: "Create a brand and they will come." That's why 17 companies that most Americans had never heard of spent millions on commercials during the 2000 Super Bowl; a year later, just three, E*Trade, Hotjobs.com and Monster.com, were back to try again.

In fact, the New York Times called the 2001 Super Bowl commercial for E*Trade the "most effective, hardest-working spot of the game and also the most surprising." That's because it poked fun at the dot-com companies whom advertised during the previous year's Super Bowl and were already out of business.

The dot-coms spent an exorbitant amount of money putting their names out to America's watercooler buzz culture in a flat-line effort at manufacturing interest. Nobody even knew what product some offered, and the preponderance of them advertising during the NFL championship game (OurBeginning.com, Pets.com, Britannica.com, LastMinuteTravel.com, WebMD, Computer.com, Epidemic, Kforce.com, MicroStrategy, OnMoney.com, Oxygen Media, LifeMinders.com) made focusing on what individual companies did even harder.

What made the dot-com business designs so much more tenuous was their reliance on the effectiveness of advertising. Many traditional corporations get sucked into repetitive forms of advertising without ever really measuring or re-evaluating their usefulness. But the traditional corporation has fallback reputations and profits; the dot-coms had none.

E-commerce further distorted the nature of advertising. A typical Internet business plan called for raising $50 million in capital, of which $40 million might be spent on awareness advertising and $10 million on infrastructure investments.

Think of the distortion that occurred. The dot-com spending spree crowded traditional advertisers out of the usual arenas, most notably the 2000 Super Bowl, and falsely inflated ad values in terms of both effectiveness and cost.

As far as retired PricewaterhouseCoopers consultant Don Burnett is concerned, the typical dot-com business design never set forth how it would accomplish its aims, rending most of their plans inert.

"When I look at a plan," Burnett says, "I am a dumb old guy. I want it to be a logical plan that I can understand. I want to understand what they are going to do to get where they are going and how they will do it."

He also looks at whether the company can describe who its customer is. An example of that is a company that one of his relatives is in. You pay it money every year, and it will send you your horoscope every month. Its marketing director knows his market: divorced and widowed women who are over 50 and have come from certain mailing lists that he uses. Other companies' targets are more vague: "We will shoot for the 50-and-over crowd."

One of the greatest contradictions for dot-coms or any new business seeking capital is that, like the average consumer, lenders are most inclined to hand over cash to people who look like they don't need it.

Some people will warn you away from companies that have offices filled with a lot of flashy baubles and that spend too much on fancy furniture and location, but investors expected to see just that because it seems to say "substantial." The very people who got burned the most were the ones they went for the flash.

That was smart, wasn't it? That was real smart. That's why they lost money. They should have been looking for substance. And what is hilarious is that the dot-coms that will survive are the ones that took the leverage money to buy real companies that did real things, or they used the money to build a bricks-and-mortar infrastructure to support their business. It was entirely predictable.

The dot-coms were only partly to blame. In late 1998 and 1999, the markets threw an unconscionable amount of capital at that sector. It gave them free money to try to build corporations. Some were built on solid platforms and eventually shaped reputable business models. But a disproportionate number didn't because part of their business model was that they sold goods below the true cost.

How can you build a business when your first offer is free?

These companies ­ the ones that actually sold something desirable ­ figured they could inculcate consumers to ordering online with free or half-price offers, and those people would soon return with credit cards at the ready. But a restaurant doesn't open its doors and say, "We are giving away free burgers today." It might offer a weekly discount or a two-for-one coupon, but nothing is ever free. Yet the dot-coms overlooked that.

Many of the dot-coms don't really know what their model is. Most of them are thinking about ways to get somebody to come buy them.

And it wasn't just the new kids on the block that built business models with questionable returns.

"I used to subscribe to USA Today," says Craig Weichmann, a corporate finance consultant in Memphis, Tenn., "but why should I spend a couple of hundred dollars annually on the print edition of USA Today when I can get it when I want it, electronically (http://www.usatoday.com), for no cost? As soon as my son graduates from high school, I will even stop taking the Memphis paper. Why should I have the paper coming in that I just have to cart out? Newsprint is for training a dog. Why should I have that paper trail when I don't need it? The dot-com newspaper changed our way of life."

And even if an Internet company has a proper business design, keep your eye on the bouncing dot.

If you look at a business model of an Internet company, it may change six months later. It's tough to argue that there is a sustainable model when it is changing every quarter or every six months. And there is no history. If you look at the balance sheet, look at operating costs after taxes. You may see negative numbers. You need something else going for you to be a believer.

Stunt Model Design

Phil Hickey heads a restaurant company called Rare Hospitality. He has had a hand over the years in Rio Bravo and Applebee's Neighborhood Bar & Grill before landing at the parent company of Longhorn Steakhouse and Bugaboo Creek. His business discipline changed Rare Hospitality's direction, and today it is one of the top-performing restaurant operators in the U.S.

But earlier in Hickey's career, he ran a company called Cooker Restaurant Corp. Rather than spend money on advertising to develop a brand, Cooker spent money on what really drove people to the business.

That meant creating a "Wow!" image within the four walls of the restaurant. Customers were so satisfied with their experience that they would come back, and more than that, they were so satisfied with their experience that they would tell friends.

How did Hickey do that?

For starters, he developed the standard that a meal was supposed to be served within a specified time frame. He also designed a stunt in which a manager would personally walk a meal out to a customer and say, "I am terribly sorry, but we had a delay in the kitchen. Your meal is free tonight because we didn't meet our standard." Wouldn't that cause the kind of shock and delight you'd tell your friends about?

In Hickey's restaurants, he cemented the premise that the customer was always right. If the customer said, "I ordered it medium" and one of Hickey's waiters served it well-done, the automatic response was, "I am terribly sorry; we will not charge you for that meal."

Hickey spent three percent of his budget on such customer satisfaction tactics. It worked out to be about the same amount his competitors spent on advertising. But Hickey spent it at the table and created incredible volume in his Cooker restaurants.

As often happens, Hickey eventually left the company. What he created survived without him for a while and eventually ran out of energy when the company abandoned his unique approach.

The Peanuts Model

David Johnson applies a simple test of logic to a company's business model.

"I want to understand just what the hell they do, which is different from knowing what they do," says Johnson, a Dallas-based business analyst and host of the daily radio program "Marketplace" syndicated nationally by Public Radio International. "I can read something that will tell me that they 'make the inverse correlator that is uniquely responsible for facilitating the hub driver that delegates inputs from various telecommunications.' I don't know what the hell that means! I want to understand what they do because I figure if I can, then other people can."

Ultimately, we should understand what a company does before falling in love with it. Investors should research business models and cash flows and customers. But equally important is knowing the uniqueness of its product, how easy it is to knock off or replicate.

One of the prime business models often cited by analysts and journalists alike is Southwest Airlines.

When Southwest started, it had only four airplanes. God help them if one went down. And it was flying 50-minute flights with 10-minute turns.

As for its business model, the difference between Southwest and everyone else in the air was that it thought so far out of the box that it went outside its own industry.

But Southwest Airlines wasn't trying to be an airline. It was trying to be a bus company. Its competition really wasn't so much other airlines as it was the car and the coach. Southwest went into other markets, and there was plenty of competition. But if there were 1,000 people a day that already flew between city pairs, it wasn't long before Southwest carved out a little piece of that. If it was successful after a couple of years, there were 1,300 people flying between city pairs, and it created a market. It made the pie bigger because of frequency and price.

Most people doubted Southwest would ever lead the industry, let alone survive it. Meanwhile, every airline, and Braniff in particular, was quietly boasting that it could run Southwest out of business. They didn't. Southwest actually built market shares. You had to pay attention. And it looked like regional air travel was a fairly easy market to enter. You go out and get a bunch of 737s, do some quick turns. Yet all the competition failed over the years.

European regional carriers enjoyed more success with the Southwest Airlines model than Southwest's domestic competition.

Was it the business design that worked, or was it the attitude? Was it management?

It was really the whole thing. It was the uniqueness of the business model, which was, "We are not an airline, we are a bus company." And it was going after a niche but also creating a market. It is one thing to serve a market. Other companies can serve a market, but boy, if you can go out and create one, now that's really something.

One of the interesting sidelights to Southwest Airlines' success is the companies that expand based on where Southwest flies. Southwest is restricted out of its hub in Dallas to the contiguous states, and there are companies such as a Houston-based chain of tuxedo stores that, when they expand their own businesses, won't go into a city that is not served by Southwest Airlines.

Why not?

Because, number one, price, and number two, frequency. Southwest never enters a market that it can't saturate. So, if you missed the 4:00 but you still want to be home for dinner, maybe you can catch the 5:00.

The companies that hitch a ride with Southwest can avoid hotel bills because employees can travel to and fro, conveniently, on the same day. It's also great for people who don't want to be away from their families for long periods.

Smorgasbord Design

Brinker International is the parent company of Chili's Grill and Bar, Romano's Macaroni Grill, On The Border Mexican Cafe, Maggiano's Little Italy, Cozymel's Coastal Mexican Grill and Corner Bakery, eatZi's Market & Bakery, Big Bowl and Wildfire. It is another innovative company that created its own market, first through shrewd insights on the changing social fabric of America, then through expanding tastes.

"Norman Brinker is just a remarkable guy," Johnson says. "It is as though 70 percent of the people that run large-scale casual dining companies in the United States went to Brinker U."

What he means by "Brinker U" is that Brinker founded the casual dining industry when he opened the first Steak & Ale in 1966. After selling the first 102 Steak & Ale units to Pillsbury in the late 1970s, Brinker started over with Brinker International. Among his graduate students and the brands their built:

(Source: First Tennessee Securities Corporation, "Restaurant Industry Overview {1970-2000}," by Craig T. Weichmann and William R. Renovich)

Once the casual dining market was established, Brinker recognized that though Americans were eating out more often, they wouldn't eat at the same place more than once a week. So he came up with other concepts, too. And he learned to cluster them. It is not unusual to see a Chili's nearby a Romano's Macaroni Grill and an On The Border Mexican Cafe. They share a common parking lot under the assumption that people are hungry and maybe they don't know exactly where to go. But they know they can drive up to this restaurant complex and make up their minds when they get there.

Brinker further tweaked his design to increase same-store sales without increasing square footage. How? Chili's, for example, started with hamburgers, fries and beer. Then Brinker International expanded the menu with more expensive entrees such as fajitas, ribs and chicken dishes.

It added some intriguing-looking appetizers and a broader array of tempting desserts. Along the way came the multicolored drinks with umbrellas in them or served in glasses that look like Buddhas.

And in a tight labor market, Brinker doesn't have any trouble finding employees. Why? Because food service workers aren't stupid; they go where the tips are.

Southwest Airlines and Brinker International work on two levels: management that investors like and concepts that they understand.

Brinker International was doing fine, zipping along, and yet it still tweaked its model to roll with the way things were changing. No management can be complacent, even with a viable business design.

The "Get Some Backbone, Son," Model

While an entire crop of vintage dot-coms was drying up on the vines in late 2000 and early 2001, the one Internet investment still encouraged by analysts was infrastructure. Analysts believed the Internet would continue expanding in demand and usage among businesses and consumers, even if individual companies came and went.

Companies that are involved in infrastructure can best provide added value and will bear less price pressure from competitors and therefore will stay in the market. Consider the dynamics of the business market: In a major urban market, the local phone company serves only 10 percent or 12 percent of all buildings with fiber-optic cable. That's an awful lot of opportunity. And the typical telephone company can't handle the crushing demand for additional capacity. A T-3 line might take weeks to get.

But if you're in San Diego, for example, Time Warner Telecom has the potential to provide that capacity overnight. And it can control it from its operations center in Denver.

Possessing fiber is only a small part of the business design for companies in this market. Equally vital factors include time to market and the ability to build fiber networks quickly and easily. It means providing service to the customers, which in this case means adjusting capacity quickly for them and customizing the service. Some of the newer carriers, such as Time Warner Telecom, have a greater ability to do that than the larger carriers.

"I know Time Warner Telecom can provide new high-capacity connections to UUNet in New York faster than WorldCom can," says F. Drake Johnstone, a research analyst and first vice president for Davenport & Co. LLC in Richmond, Va. "That seems kind of crazy, doesn't it?"

Time Warner Telecom has a business model that works for its industry and for itself. That's why being No. 1 or No. 2 in a market (see Chapter 5, "Market Share") may not be an absolute in terms of profit potential. There are other ways of understanding a company's business model and ascertaining whether that model is unique and provides it with a defensible business in the market it serves.

The "Thank God for Cash Flow" Re-Model

Novell is a company that traditionally relied on resellers to sell its directory products. But that business was in a long-term decline. Novell answered the market shift by allowing access to the newest software applications not only from Novell but also from competitors such as Commerce One and other e-commerce software products. In its re-jiggered business design, Novell might sell not only its own solution but its solution package with some other company's solution, making a complex but more value-added sale.

What does that mean? Novell had to hire internal consultants to work with potential clients and train them in all these new sophisticated services. That is a major transition. And rather than just having basic resellers, it now partners with major consulting firms such as EDS who have the expertise to install and implement complex e-commerce offerings. Novell is a company that is completely transforming itself via the marketing channel and sales process. It is a mature company that is completely transforming how it does business.

Novell is a good example of a company's business design model going through a dramatic transformation. "Thank God they have almost $800 million cash," Johnstone says. "And thank goodness they were still able to generate enough profits during the transition and have enough cash to help fund that transition."

Some companies are not as lucky. They recognize the need for rewriting their business plan but don't have the resources to keep the company humming in the process.

In the case of smaller and more speculative companies that need capital, it is important to know how much cash and investments they have on hand to fund their business plan. For example, CompanyGreenhouse.com is funded through 2002, but it is not fully funded through the generation of free cash flow, which could happen sometime in 2003. If the company raised some additional capital sooner and all of the sudden was fully funded, its stock might double from current levels.

If you thought that CompanyGreenhouse.com had a good business plan and it had raised enough capital to fund its business for a few years, then maybe it is worth considering.

Yesterday Was a Good Day to Change

When does it become apparent that a business is doing wrong what it once did right?

Usually when it's already too late. Usually when the stock is at its peak.

"When we visit the stores, sometimes we get lucky," says Gary Balter. "Toys 'R' Us is one where we saw it at the stores before the company deteriorated. We were able to call it because we saw the service going down. AutoZone is tougher to call. As a white-collar customer going into blue-collar stores, you might have a tougher time having a conversation with the guy working in the store and getting a feel for what the customer service levels are like unless you drive an old jalopy. I would go in and say, 'I need a new carburetor,' and finally one of these guys said, 'You know, they stopped making carburetors in, like, 1986.'"

Another tip: You might hear of management changes but get a sense that they are not reaching the front lines, where mere lip service is being paid to improving customer service.

Stacked Ifs

Here's a novel way to approach a business design: Look for what Geoffrey James calls the "stacked ifs." "When you read 'if this happens, and this happens, and this happens,'" he says, "then I would say there are a lot of ifs in there."

James also believes it's a bad sign if the company is articulating itself almost entirely in buzzwords and cornball cliches. "That is usually a worrisome sign for me."

The cliches that concern him might be a picture of a runner with the line, "There is no finish line." Or, "The harder you work, the harder it is to surrender." They're the kind of bland, meaningless slogans he sees in a chain of shopping mall poster shops. If anything about the company's statements rings like one of those things, they are probably pretty clueless.

You want to find a company capable of articulating its mission and its plan in a language that we can all understand. Not in hyperbole, and not in New Age gobbledygook. If it says, "CompanyGreenhouse.com empowers customers through the application of technology and is forward-looking about strategy," you should probably think, "These people don't know what they are doing."

What you want to hear is "We are making the best freakin' networking switches that anyone could ever possibly conceive of," and, "The reason we will win is because we set up the best distribution network using the hottest technology that anyone's ever conceived." And it is usually written down like that. That is what you should look for when investing in the smaller companies. Here's a useful business saying: "You can't pin Jell-O to the wall." Any time a company describes what it does and it flops around like Jell-O, then it probably don't know what it is doing.

In other words: Move on.

More Jamesian wisdom: "If the company says they are going to be the next Microsoft, you probably shouldn't invest in it. Because that is code for a company that is just trying to take your money."

Software, Hard Models

There are only so many models, and there are only so many ways to sell software, recognize revenue and bring something to market. The Web offers a new distribution mechanism, but coming up with a wholly new model is difficult.

The questions we should ask about some models are, how do all the pieces fit together? Is the technology any good? Does the distribution strategy seem viable? Is the forecast overly ambitious? Where the pieces put together make sense, then that is considered a good model. But coming up with a completely new way of selling something that hasn't ever been bought before, that is a tough one.

There is room for that elusive new model in technology, however, if a software company can offer a good enough, cheap enough solution that makes some headway.

For example, many software companies are investigating application service provider (ASP) software that would be accessed online for a monthly fee rather than a heavy up-front investment. This might become a form of "sticky business."

That will be one of the ways in which software is deployed over time. But it is not material to date. It will be one element of the sale and the availability of software as a service, an alternative to the traditional method of sale and distribution. But it is not really a material part of anybody's business yet. That model is one that may well serve vendors extremely well, but it is not something that most end-users will warm up to quickly.

A Prize Model

There was a time when Dell Computer grew at a phenomenal annual percentage rate. Wall Street, in turn, awarded Michael Dell and his company two times the growth rate in price to earnings, so the stock might have traded at many, many times the expected earnings for the following year.

It had real revenue and real profits and real efficiency if you compared how efficient it was to other PC sellers.

Every company has its different strengths. Dell's was in being the first to sell directly to consumers by phone, mail and fax, and then over the Web. It eschewed traditional retail channels. Dell's business model took a tremendous amount of cost out of the overhead equation and allowed it to be a more cost-efficient enterprise than a company selling only through retail outlets.

One of the bets that Dell made was that the consumer was growing up to the point that they were now actually using Internet technology and would be comfortable ordering in this new mechanism. So it was a bet on how adoption was changing, more so than just saying, "Hey, we are going to create a new business model." If those things hadn't meshed, there was nothing magical about Dell selling online; the magic was that the consumer was becoming accustomed to these new ways of interacting. It wasn't so much a push; it was more of a pull from the client.

Dell revenue per employee was higher than at Compaq or Apple. Selling direct was its innovation. It was selling better computers necessarily, but the business process itself was innovative and more efficient. It had a unique plan. Gateway copied the plan to some extent and did okay, but that whole idea of configuring a computer on the Web and then we will ship it out to you was Dell's.

Dell was early in and did it better because it was first. It waited until an order came in and then got the parts together and shipped it out so the company could maintain a smaller inventory. It didn't tie up all of its capital in warehouses full of computers; another company might stockpile 30 days' worth of computers, Dell reportedly had five or six days' worth.

Dell deployed a great plan and was ahead of the curve on selling over the Internet without getting stuck with massive inventory. And as smart as Dell was, not enough companies followed its lead. We read every day about companies that sold online but failed because they couldn't get the product out the door.

Apple, by comparison, sold its computers at first through a network of mostly small computer shops. It carried on a personal relationship with these mom and pops ­ and through them, their customers ­ putting a serious obstacle in its path to following Dell's model. If Apple adopted the direct model too soon, it risked alienating its prime channel at the time. It is not the easiest thing in the world to tell the stores, "We are going to start selling directly from our Web site, competing with you, even though you are our partners."

And some things work well over the Web and work better than others. To say that everyone should have jumped on the process of selling online probably overgeneralizes it. You should be able to make money as an online retailer if you are in the right business. If you do online well, it can be just like being a catalog company, but more cost efficient.

In 1999, it became clear that the growth rate in Dell's business had slowed. Revenue growth, which had been 60 percent year after year, fell to 50 percent and then 45 percent. But the stock didn't go down right away, until all of the sudden Dell missed Wall Street estimates one quarter.

Keen observers might have seen it coming if they noticed that the revenue growth was starting to slow for a number of reasons. There was a slowdown in the overall PC market, for one thing. But more importantly, Dell was now a huge company. It is hard for a huge company to grow at the same rate as a small company. It is hard for a $50 billion company to keep growing at 40 percent a year. The only company that humongous and still experiencing runaway growth may be Cisco, which reportedly sells more than $32 million in products every day.

At some point you should ask yourself, "How much am I willing to pay for that profitability?" Dell is still growing profitably, but how much should an investor pay for that combination of growth and profitability? The answer? More when companies grow at 60 percent than when they are growing at 35 percent.

It was impossible to keep up with where Dell was. The PC market is fairly mature now.

Blinded by Science (and Infrastructure)

The e-tailers, even the ones that failed, did succeed in creating a huge public awareness about the idea of buying online. Despite the high profile dropouts, more money is spent every year by people buying products online and getting comfortable with the notion.

More and more shopping will be done each year online, but now the question is, who will be the big winner? Maybe it will be online versions of Wal-Mart and Kmart. Maybe people want to be able to buy online and return it at a store. Charles Schwab, for example, points out that the majority of its accounts get opened in person, in offices, even though most of the subsequent trading is done online through eSchwab. Why is that? Because if we write a $10,000 check to open an account, we like handing it to a real person.

Financial services are, in some ways, uniquely suited to the Web because no one has to download a pair of shoes from E*TRADE. You just move the data/money from one account to another. The transaction is done once it is done online. E*TRADE doesn't need warehouses.

If the model is so obvious, why do many online retailers appear to be failing? Why are they having trouble succeeding?

It is a case by case question. But in some ways, there are some common problems that they encountered. The Internet created a mind-set that, "We must get big and go global because we can, because on the Internet, geography doesn't matter, so we should be everywhere at once."

The problem is that in order to do that, a company must build up a lot of infrastructure. That would include having enough computers and servers to handle worldwide traffic. Then it would need a distribution fulfillment infrastructure. How will the company deliver the goods to customers once they are ordered? Where will it warehouse inventory? Even Dell needed some inventory in the early, go-go days. Then it's the logistical nightmare: How will the company move product from distribution centers to warehouses, put it on trucks, etc.?

Take an example such as eToys. eToys provided a good consumer experience by all accounts. It built up its infrastructure waiting in anticipation of a huge online toy market that it could dominate. The problem was that this created a high amount of fixed costs. So all of a sudden, it had a system set up to handle ­ let's use a round number ­ 10 million customers. But it only saw 1 million customers. That means that it was only operating at 10 percent capacity, which meant that it was carrying a huge amount of costs, so it lost money.

eToys needed billions in annual sales to reach break-even. But it didn't come close, and it would take a few years for it to get to that point. Meanwhile, the market went south, and it was no longer able to raise money to keep it going until it grew into profitability, until it grew to the point where it used enough of its system to be profitable. But the capital market closed to eToys.

Amazon.com ­ which took over fulfillment for Toys 'R' Us when the latter's own online operation faltered ­ is a different situation. Amazon.com took advantage of capital markets when the stock market was raging. Company founder Jeff Bezos, a veteran of Wall Street, raised money in bond offerings to make sure that he had a lot of cash on hand.

Optimistic analysts expect that cash will keep Amazon going and will support its operations for up to two years, at which point people expect it to start turning a profit. Like eToys, Amazon.com also invested in distribution centers around the country that put it within one-day delivery range of 85 percent of the population. This means that Amazon can have something FedEx'd overnight from its distribution centers, and it won't cost that much money. But Amazon can charge the customer extra for this premium service, and it can make money on the shipping. Sometimes it can make more on the shipping than on the sale of the actual product.

Amazon was helped by starting with a smart business design that prepared it for rampant growth but didn't get too far ahead of itself. It also succeeded by being one of the first brand names connected with the Internet, much as Yahoo! became the de facto standard in online directories, and AltaVista in search engines.

Amazon.com is still a controversial company and a controversial stock because some people think it will never make money. It may have to change some things in order to make money. It expanded into multiple businesses beyond its perceived core of books and music, and they may have to cut back and pull out of some of the businesses that don't work as well. Books and CDs work well for them. The question isn't, "Will Amazon ever be profitable?" It will be profitable. The question for an investor is, "How much are you willing to pay for a profitable Amazon.com?" Some observers argue that it should be valued like a high-quality catalog company as opposed to some huge Internet company. Because even if it becomes profitable, it is not a business with fat profit margins the way Microsoft or even Intel is.

Eyeballs, Percentages and the
Newest New Math

Internet-hardened investors are getting more realistic about what makes a sustainable business and what brings about profitability.

There were many implied promises made by Internet-only companies that said, "There are $30 billion worth of shoes sold each year. If we can just capture 10 percent of that, we will sell $3 billion worth of shoes online!"

That brilliant New Math deduction sidestepped two important questions: Why would people buy shoes online? And: How long is it going to take you to reach that $3 billion in sales?

One of the things we learned, particularly with Amazon and even with Yahoo!, which is a real company that makes money, is it is not terribly difficult to grow revenues quickly. But it is difficult to grow revenues in a profitable way quickly. A company can spend itself into sheer size. But that is a business model of which investors should be wary.

Succeeding online is no longer about capturing a million eyeballs, no longer about being the dominant retailer of this or that online. Succeeding online now means finding a company that wants to make money within two or three years. Let it demonstrate that this is a real business, that it has real profit margins. A real business can't make money by selling items for less than they cost. Some dot-com companies in the past said, "We will grow and those profit margins will eventually turn around." But that is a slippery slope on which to start a climb.

We went through a very unusual time from the mid-1990s through late 2000. Many people received 25 percent or higher returns on their money during these years. And it was thrilling. We went through it once in this generation and it was a rocket, but the boosters fell back to earth and what's left of the ship is now a small capsule circling the Earth, rationing its resources.

Think Global, Invest Local

A Memphis financial institution, the National Commerce Financial Corporation (NCFC) is a tremendous company in terms of a slow-growing industry. Going back to 1992, the company had earnings of 34 cents a share; in 1999, it was 99 cents a share. The stock went from about $2 in 1990 to about $24 in early 2001.

To find a company that has that kind of consistency of earnings, again, you must do the research. It is not a characteristic to be taken lightly. And though past performance is not an indication of future performance, there is comfort to be found in a consistent earnings report.

Past performance is a good indication of future performance for an individual company. Not a stock, but for an individual company. And NCFC, for a modest company based in sleepy old Memphis, has earnings growth and profitability well over the industry average. Management treats the bank like they own it personally. Relative to the rest of the industry, it has a huge insider ownership that does large buying when they think the stock is attractive. That is something that should catch your eye in any outfit and make you stand up and take notice.

NCFC got this way with a solid, if somewhat odd, business model. It started small and grew nimbly and more rapidly than a larger organization might have. And it moved into niche businesses that were related to but not pure commercial or consumer banking and took those things far.

NCFC was one of the first banks to put branches in grocery stores. Most banks with significant grocery store operations used this company as a consultant to help them implement their supermarket banking, a niche National Bank of Commerce had that it ran with for the past decade.

With that niche conquered, NCFC started marketing fuel card processing and truck fleet transaction services. The trucking company client gets detailed data on spending patterns and mileage as well as convenience from card usage.

"The other thing NCFC has compared to any other bank I have seen," says Peter Tuz, a former Morgan Keegan analyst who is now a vice president of Chase Investment Counsel in Charlottesville, Va., "is impeccable credit quality. It is careful about who it lends money to. It thinks like owners, which I think is an important characteristic of a company."

When Tuz studies a company's business, he looks for at least the potential for consistently improving profitability and utilization of capital and growth. In the case of NCFC, it runs a very tight ship in Memphis. It uses that discipline to transfer its skills to Nashville, Knoxville, and on to Roanoke and Richmond, Va., then Atlanta, and so on.

If You Can't Run With the Big Dogs . . .

Analyst Phil Dow sits on his firm's commitment committee, which votes on whether Dain Rauscher Wessels in Minneapolis will do underwriting of certain companies. As the Internet bubble first took on hot air, one of the first and hottest new issues was a company called TheGlobe.com. There were very few institutional orders for the dot-com; it was almost all young, Internet-savvy day-traders. Somebody at Dain Rauscher Wessels guessed that the average age was about 32, average income $65,000. The average order was 400 shares. The IPO was priced at $12 and traded as high as $48 on its first day.

That kind of gives you an idea of what was going on. It wasn't institutions that drove it, it was individuals with a lot of money. They were in chat rooms talking things out.

At the time, people were willing to take unconventional risks in untested businesses, although the market eventually revealed itself as a thin, uneven bubble. (TheGlobe.com threw in the towel in August 2001. Its final share price: 13¢.)

"My job is to make money for customers," Dow says. "Part of that implies a risk-management discipline, and I just couldn't see how you could buy companies with no earnings. Early in my career, a very wise man taught me, 'If you focus on price with a customer, you can never win because the market is inefficient and emotional with regard to price. But if you focus on financial guideposts, you can at least say to the client, "Look, here's where they fell short this quarter; we are keeping an eagle eye on this part of their business and other factors, and let's watch the business, let's not watch the price."' I think it is a more intelligent way to invest, and certainly, it keeps you focused on what is important. And so here is a whole hot part of the market that I missed ­ the Internet ­ and I didn't feel bad because I didn't want to take the risk. But a part that I missed and didn't understand principally because of something simple: They didn't have a metric I needed."

The "Fantastic Voyage" Model

Profitable businesses are those that remain competitive. In today's world, that means re-creating themselves.

One example of that metric would be Medtronic Inc. (MDT). It is based in Minneapolis, a city that is to medical devices what Silicon Valley is to computers. A part of town called "Medical Alley" is home to perhaps 1,000 medical device start-ups and companies. Medtronic is the godfather of the business. It was one of the initial developers of the pacemaker. If your heartbeat gets too slow, the pacemaker will speed it up. The company then branched into newer products such as internal defibrillators.

Recent clinical trials have suggested that if you have a rhythm problem with your heart, medical devices are safer and may be better therapy for day-to-day living than drugs. So Medtronic and other medical device companies gained favor with analysts and investors. The nice thing about pharmaceuticals and medical devices in general is that if a company makes a great product, people will always buy it, even in a recession.

In a recent five-year span, Medtronic spent over half of what is spent globally on cardiovascular research and development. Dow thinks that kind of business model ­ existing products in growing demand plus smart spending on research ­ will keep Medtronics a leader and innovator for years to come.

Its basic business continues to be a good one, and it reinvented itself. It has devices that are great for types of pain that currently are not treatable, where it actually put a timing device on the spine, and it administers pharmaceuticals. It has a device that stops Parkinson's tremors by attaching to the spine. A risk part of Medtronic now, and all companies have risk, is that historically its business had always been cardiac. It spent billions in the last couple of years diversifying into orthopedic. As we get older, riding a mountain bike is still important to some of us, so we get the hip or the knee replaced. Quality of life is a huge issue. Medtronic bought several hip and knee companies, and pedicle screw companies for the back. The orthopedic side represents good promise but additional risk because the company has always been a rhythm management company.

"When I talk about bulldogs in medical devices, Medtronic is the leader and probably will continue to be the leader," Phil Dow says. "But its business model is a little riskier, so buy half a position in Medtronic and half a position in Guidant Corp. ­ a small but viable competitor of Medtronics spun out of Eli Lilly several years ago ­ and you will be positioned beautifully for what comes down."

There's Security in the
Status Quo Model, Too

Don't look for too much innovation in a business model. Don't expect someone to say, "We have an entirely different way of selling this product into the market." You want to know that the demand is out there and the product is out there.

Look at competitive forces, other people that might be trying to do the same thing, and gauge that. You don't want that whole picture muddied with a different sales channel. In fact, those are red flags. If someone says, "We will sell this completely differently," you should think, "Hmmm." Sometimes you can get home runs in those situations, but more so than not, the business models generally stay pretty much static.

In fact, Pip Coburn, a global technology strategist for UBS Warburg in New York City, says that Gateway's move from online computer sales to opening a chain of bricks-and-mortar "Gateway Country" stores was a red flag for him.

"Why do you need to do that?" he asks. "It sounds completely different than what its old philosophy was. Not that philosophies shouldn't change. They need to change and adapt and all, but you are really going away from a core philosophy for the company, so you really had to understand why that was a good strategy. And it is not totally clear it is, and it is not totally clear it isn't. Gateway's stores are operated in a much different fashion than any other store, so the company would say that the store is basically a billboard for the brand with low expenses and still no inventory and those types of things. But to me, it was a flag. It said that the old process that Gateway was using maybe isn't as powerful today as it was a couple of years ago."

The Internet, in some ways, is a new business model. It hasn't reached full profitability in a lot of cases, but it is a change of distribution method that consumers are gravitating toward in fairly large numbers. It presents a range of different things to look at and layer on top of normal analysis.

One of the things that became far more relevant over the past 10 years is the idea of a virtual corporation. Not all of this flushes through the P & L statements for most companies, but the reality is that companies are moving quickly toward crafting themselves as virtual corporations. They may not use that phrase unless they are a Cisco, but the idea of outsourcing anything the company is not world-class at doing to someone that may be world-class at it is catching on. It frees up management time from the things that it continually tends to mess up, and that is a powerful idea.

Inside the semiconductor business, we see more movement in that direction. We see companies that all they do is design integrated circuits. We see companies that all they do is manufacture integrated circuits. We see this disaggregation of industries because of the notion of the virtual corporation, whereas 10 years ago it wasn't under the halo of the virtual corporation. It was viewed as a weakness then.

Occasionally companies err by outsourcing the thing that they need to have as their own core. But if we look at Compaq as a representation of the computer business, Compaq does things that IBM would never have considered doing in the mid-'60s. Compaq is heavily reliant on Microsoft and Intel, and it is more of a name that you put on the box and a little bit of design. Compaq doesn't make all of its computers; maybe half of them. These are big changes.

Some companies like the virtual corporation model so much that they develop technology, license it and generate royalties from it. Rambus Inc. is an example of this approach. That new business model is finding some success, and a handful of companies are playing the virtual game well.

Dinosaur Designs

Still think business design isn't a big deal?

In the first 30 days of 2001, Montgomery Ward ­ owned by General Electric and ultimately controlled by management genius Jack Welch ­ went out of business after more than 100 years. Kmart, JCPenney, Eckerd Drugs, Sears, Crown Books, Lechters and Office Depot announced hundreds of store closings. Bradless closed, as did Strouds. Federated shuttered its Stern's department stores. Warner Bros. reported that it would close all 130 of its Studio Stores.

The challenge at Sears can be expressed this simply: How will they get my daughter's generation to shop there? "Sears is where your generation shopped, Dad, but not mine."

Dinosaurs such as Sears may secure their future by charging into the very tar pits that already consumed an unemployment office worth of bright entrepreneurs: dot.com retail.

Brick-and-mortar retailers should rewrite their business plans by using their deep resources and gobbling up cheap dot-coms with the infrastructure but not the cash flow to make e-commerce a success. The start-ups could go by the wayside and be turned over to the Sears and Wal-Marts of the world as an extension to their strong names. Twenty years ago we were introduced to cataloging and a number of people pontificated, "Four-wall retailing is dead."

But instead of hard catalogs, enduring four-wall retailers will offer electronic catalogs that combine the best of the catalog and dot.com alternatives.

Who Let These Dogs Out? (Part I)

Sometimes a supermodel overstays her welcome on the world's fashion runways. One day she's the queen of the universe, the next she's selling Thighcersizer equipment on late night TV and its time for a new princess to move onto the throne. In the beauty contest that is business, no one's good looks are safe forever.

Take AT&T, Lucent Technologies and WorldCom.

Or better still, don't. Not anymore.

It is so easy to see in retrospect and so hard to see going into it, but all three companies were totally reinventing themselves. Many observers felt as though the long-distance business would be a better cash flow with longer duration than it proved to be. In fact, the long-distance business deteriorated pretty rapidly. The cash flow, the amount they can charge deteriorated, and they piled on debt. Virtually the only business AT&T had was long-distance. It was a timing issue of, "Will the cash flow run out before we can turn profitable in other businesses?" And it hasn't yet turned profitable in its other businesses. It was almost impossible for anybody to have picked up. There are people that annoyingly kept the stock, thinking it was the old AT&T, and they are getting killed now.

Just think of all the capital AT&T was given over the years and how the telecom giant dissipated it by buying different business strategies. All that is visible. It is all out there in the public domain. The converse would be General Electric, which took what was a modest amount of capital and created tons and tons of shareholder wealth.GE acquired properties that fit its model. AT&T did not.

WorldCom is a different story. It was a more venturesome management with a much better stand-alone business in the UUNet division, which is the best of the Internet backbone fiber-optic networks.

It is still a great business. But the government got in the way under the Kennard-Klein policies and wouldn't let it buy Sprint. At first blush that looked like a bad deal because Sprint is long-distance, but it might have been a great deal for WorldCom because it gave it the wireless piece that it lacked. So you can blame the government partially for the problem at WorldCom. But it bet heavily on a flawed business model.

Lucent Technologies, formerly Bell Labs, spun off from AT&T in 1996, was widely viewed as a great, older economy name whose intellectual properties would be a safe way of being involved with networking and the optical side of networking and any development that would be coming. The stock was a huge winner, delivering reasonable financials, but the string ran out, and management didn't deliver anticipated product.

Bell Labs left the larder packed with technological breakthroughs including the invention of transistors, lasers, optical communications, data networking, digital transmission and switching, cellular telephone technology, communications satellites, digital signal processors, touch-tone telephones, and Unix operating System and C language. (Source: Lucent Technologies: "Bell Labs Innovations: 10 Bell Labs Innovations That Changed the World, http://www.bell-labs.com/history/75/changedworld.html.) It looked like Lucent was loaded with intellectual research and development that could place it at the forefront of technological innovation for years to come, particularly in the area of optical networking.

Lucent developed great designs, it just couldn't manufacture product. Nortel Networks came out with the most effective switch, what's called an OC-192 switch (according to Nortel's Web site, the OC-192 delivers up to 320 Gbps of capacity ­ the highest per-fiber capacity commercially available in the marketplace), for networking, and it has the lion's share of the market. Since then, even a little company like Sienna came out with the OC-192, but Lucent never developed, manufactured or delivered. In a press release, Lucent said, essentially, "We will skip the OC-192 switch and deliver you the next great product in optical networking switches." Analysts are skeptical. Lucent owns a wealth of intellectual information but can get no real products made and out in the marketplace.

"I don't know whether that's poor management or whether it is a very real problem with companies whose history is purely innovation," Phil Dow says. "You have to be able to have an entrepreneur with teeth that extracts a price for this intelligence and ensures the franchise can go on."

The Cisco-Lucent comparison receives a good deal of press. The difference may be one of business design.

Cisco Systems Inc. enjoys consistent high growth. It is a well-tuned cash engine with strong balance across multiple markets. The company understands managing product life cycles from beginning to end.

Lucent is just as adamant about technology and it just can't believe Cisco could move into their markets. Zeroing in on market share, it all goes back to the growth and the life cycles of the target markets, and market share is not the driver necessarily, depending on where you are.

You can look at life cycles several different ways. What are the company's target markets and product segments? Is it in routers and switches or software or widgets or whatever? What is its customer market? Small, medium or large? Business- or consumer-driven?

Market share may be important, but look at where the life cycle of each market is. When the markets are changing rapidly, there is more focus on a company's ability to change ­ exactly what Cisco has done so well.

The biggest difference between Cisco and Lucent? Lucent would say, "We are customer-driven; we will do what the customer wants." But what if what the customer wants is not profitable? Does it recognize when to kill off a product and move to the next life cycle to make sure it is not stuck with legacy products and processes?

Microsoft is extreme at that. It uses its control and power to prematurely end product life cycles. "This is the end of this version of Office, it is no longer supported, and it will not be compatible. You have to buy the new version."

Then there is Lucent on the other end. It said, "We will build to any wireless standard there is, we will do what you want, we will even do custom work." Well, how can it do that? Lucent creates all these products that just bog it down. It will not be able to move them. Eventually, it may not be profitable. Cisco, on the other hand, is the master, controlling the timing of the market, moving its products' life cycles in well-planned steps. There have been exceptions to that, where it no longer controlled certain market segments, and it reacted."

And while we're kicking the dogs once known for their stature in the world's Widows & Orphans Funds, let's not overlook IBM. IBM is a great company with a great brand name. It has some premium divisions that are great at what they do. And then it has others that hold IBM back.

If you look for organic revenue growth, there has been none at IBM. Any growth it shows is as a result of share buy-backs. If you ask what business IBM is in, it is in the business of buying back its own stock. That is how it creates better earnings, through financial gymnastics. We need companies that can really, really grow if we risk our capital versus inflation. Parts of IBM's business are great, but the whole business brings it down.

IBM knew years ago that it had to move its revenue base from hardware to software and services. But it is taking years to do it. And IBM knew it would take years to do it because the profit margin on the hardware was dropping more rapidly than it could increase their software and services revenue.

Who Let These Dogs Out? (Part II)

It seems everyone has a favorite story of a business design gone bad.

The B2C ­ business-to-consumer ­ model at the late e-commerce site Pets.com "is a laugh," says Faye Landes, a senior research analyst at Bernstein Investment Research and Management in New York City.

It cost so much to ship their product ­ 30- and 40-pound bags of dog food, for example ­ that the consumer would not pay for it. It just cost too much.

Some of the online grocery businesses, such as WebVan, don't really make much sense, either. How will they get around the fact that they add costs to what is a very low-margin business?

One of the best examples of a dog was Coca-Cola in the '70s. A fellow named J. Paul Austin took Coca-Cola and tried to figure a way to create shareholder value. Boy, did he waste it. He invested in a garden variety of different non-Coke items. But when the next CEO, Roberto Goizueta came in, he said, "Let's get focused." He unloaded the assets bought by Austin left and right.

At Xerox ­ the legendary corporation whose Palo Alto Research Center (PARC) is credited with inventing the graphical user interface, ethernet communications, the guts of digital printing and, essentially, the modern PC ­ the company's business changed, but it didn't. People used printers on their desktop more than they used to, which was to the detriment of Xerox's bread and butter, the office copier. Pricing in the black-and-white segment of the market grew highly competitive, and at the upper end of the market, competition came not only in the pages-per-minute black-and-white copiers but also in the color end as well.

Once you get a lot of pricing, profitability erodes. Xerox did not have a strong balance sheet, and it had an enormous amount of debt, and that was a prescription for essentially a disaster.

Honesty and integrity and all those little issues are important. We want companies we can trust. And that is not just trust in what they say to us but trust in the way they report their numbers.

A very easy thing for retailers to do is load up on inventory because it earns the company rebate dollars. The retailer then hides the fact that it is missing earnings.

Phar-Mor worked that way. It kept on buying more to get more co-op dollars. Then it took the co-op into earnings, and sooner or later, a company will implode from that. We want companies that, when they make the earnings, they tell us what they missed and they don't try to mask over weaknesses thinking that the business will come back next year.

In the office supply sector, one of the big-box stores used sales of computers to drive comparable store sales higher at a time its business was actually diminishing. But because comparable store sales appeared higher and it was getting better co-op dollars for the near term, it went through a two-year period of masking a deteriorating business. The company knew perfectly well what was happening and kept its stock at unsustainable levels. And when it blew up, it blew up big time. Blew up, as in it never recovered.

Let's use our hapless imaginary friends at CompanyGreenhouse.com for another example. After acquiring a competitor, UncommonShapes.com, it went to a common supplier of the two businesses and said, "You owe us money because you told UncommonShapes.com that it was paying the same price we were paying for merchandise, and it turned out they weren't. So we calculated you owe them ­ and now us ­ a million and a half dollars." CompanyGreenhouse.com added that into its earnings.

At the same time, CompanyGreenhouse.com's own business was slowing down, so management thought, "If we have this $1.5 million coming into earnings, why don't we don't we give deep, deep discounts on computers? We already have the earnings, so we can push our comparative store sales up. Earnings will go up, and everybody will think we are doing great." And they did it for two years, until it finally blew up.

In a somewhat similar real-world analogy, according to one analyst, one major retailer allegedly took advantage of another leaving the appliance business to get extra money from Whirlpool. The retailer then pushed appliances at extra low prices because it knew it had the co-op money. Some analysts downgraded its stock, however, figuring such fuzzy math would hurt the retailer the following year.

Said another way, when the recovery comes, that retailer will have already seen its.

Who Let These Dogs Out? (Part III)

Management should also be willing to change and change frequently, so he look for a fairly dynamic group of people, large and in charge.

As companies grow, the skills that are needed to expand or maintain growth rates change. It is a skill in itself that management teams recognize, especially in the early days, that at some point they may have to bring in people who have expertise they lack. Surviving that phase is a key challenge.

A good example is Dillard's. There's a company that was slow to change, and you can see what has happened to its earnings and its company.

Dillard's is the poster child for disease-riddled companies in Prudential analyst Wayne Hood's assessment of shortsighted business design models. The family-run retailer is approaching the point of nearly a decade of declining earnings.

"I understand why Bill Dillard Jr. says, 'We don't want to get into the promotional activity the way everybody else in the industry is doing it because it sends the wrong message to the consumer.' You know, the idea of couponing and midnight madness sales. I understand that. But I also understand that he doesn't drive industry fundamentals. He is, in fact, becoming less and less important in the industry as others continue to grow. He is fighting against the jet stream, and he is just not big enough to change things. I think that Dillard's stuck to its strategy too long."

If Macy's is offering newspaper or direct mail coupons good for 25 percent off Tommy Hilfiger fashions, why go to Dillard's, which isn't doing the coupon? If nothing else, Dillard's should send the message to consumers that "We will not coupon, but if you see someone else's ad that is at that price, we will meet it." The chain should give at least the impression of being competitive. "We are not just taking your business for granted. We don't assume that just because you're in the mall and know our name, you'll drop by and spend $200."

Consumers tell Dillard's how they feel about the way it operates its business with their feet. "There have to be radical changes," Hood says. "If it were any other company, the CEO, in fact, the entire management team would have been booted a long time ago."

Could an individual investor have picked up on the inherent problems at Dillard's? Hood says it is possible ­ if you know where to look.

"You would look at Dillard's and say, 'Geez, it is not promoting the way everybody else is. Why is that?' You could read its earnings releases and hear how it was adamant about sticking to strategies that proved to be incorrect. Those are the two most telling things that we see."

When Hood looks at a retailer's business model design, he looks at the sustainability of store-level profitability, and what might cause those variables to change over time. For example, if Target begins opening supercenters (food and general merchandise stores), similar to Wal-Mart's supercenters, how does that change the business model? Is it sustainable? Is it a proven business model?

In 2003, many observers believe that The Home Depot will begin hitting the wall in terms of the number of new stores. Wal-Mart would have done the same thing had it not ventured out into a new business model, which is food. In the case of Depot, what is the new model for them to be? It is opening EXPO stores, but it is not like Depot can get into the food business. Over time, the models change.

Or they don't. Which is a complaint about Nordstrom.

We love shopping those stores and the management team is very likable. But it hasn't bought a shiny new clue in a while. Once Nordstrom moved outside of the Pacific Northwest and specifically outside California, things really unraveled for it.

Nordstrom went from a small regional chain with great service that did a $500 million business to a billion-dollar business. That requires a new level of management expertise. It brought some outside people in, and it didn't work. It is so scared about bringing people in from the outside and losing its culture. That's understandable, but at the same time, the pace of change is seen as static. It is also an example of a company accused of being slow to adopt technology.

That said, part of the pressure on Nordstrom and other national retailers is accelerated by the demands of analysts.

They often sit down with a CEO, and he will say, "We are over-stored." Then the analysts ask, "How many new stores have you opened?" and he will say, "200." And there is pressure on from analysts and investors to continue opening new stores, because it is part of growth. Maybe the answer is a better balance: pull back on the growth and focus more on improving productivity in the existing store base.