The Race to the Bottom

By BA McKenna - July 18, 2012 | Tickers: AMZN, AAPL, CAJ, SNE | 0 Comments

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It seems to me that most consumer electronics companies – Apple (NASDAQ: AAPL) being a notable exception – would do well to borrow one from Bill Clinton strategist’s playbook and post “It’s The Commoditization, Stupid!” sign in their boardrooms.

Surely, the devil can be in the details, but most of these companies seem to get lost in the details and forget the big picture. Speaking of big pictures, they could even flash that message on one of their mega-sized-gazillion-pixeled-do-everything-except-walk-the-dog TVs. You know, one of those TVs that will be available for half the price in a couple years as competitors jump in with largely undifferentiated models – and the race to the bottom begins.

The commodization of LCD TVs.... 

Here's a long-term historical view. Cheaper consumer electronics from Japan started heavily flooding the market in the 80s.   

Impetus for Article   

The idea for this article popped into my head after doing some research on Kodak for another article. I came across a good number of articles in which the writers summarily dismiss Kodak’s failure to a single cause. 

I respectfully disagree -- or, at least, believe that's an oversimplification. 

The reason for Kodak’s fall has been attributed to its failure to jump into the digital camera business early and aggressively for fear of cannibalizing its lucrative film business.

Razor-and-Blades Strategy

Kodak employed a  “razor-and-blades” strategy – where the razor (the camera, in Kodak’s case -- or at least some cameras) is sold at a low or reasonable price, often providing no or very little profit for a company, while the blades (film here) are the profit drivers because they’re purchased frequently. Companies that sell printers also largely employ this strategy – with those pricey ink refills being the “blades.”

So, if your profits are coming from the blades, you'd darn be hesitant to destroy (or close to it) that business until you had a plan to replace those profits, or at least some of them.    

It just occurred to me that the cell phone business in the US largely employs a twist on the razor-and-blades strategy. The twist is there are two companies involved -- the phone manufacturer and the service provider. The consumer gets the phone at a lower price if he or she signs a multi-year service contract. The carrier subsidizes the phone, of course, but if you consider the two companies as one, it’s a razor-and-blades strategy.

It's Often All in the Grey

I do believe the reason attributed to Kodak’s fall is very valid -- companies have to be willing to cannibalize their existing products because someone else will if they don't. However, it's not the only reason, and perhaps not even the main reason. Although, it would be hard to rank reasons – they’re just too synergistic.

Black and white can make for sharp photos, but not usually such sharp thinking.  

What-If Scenario 

Let’s say Kodak moved into digital cameras very early and aggressively. It recognized the tide was turning and photography was largely going digital, either with or without Kodak on board. So it jumped on board before Sony (NYSE: SNE), Canon (NYSE: CAJ) and the others, and captured a good chunk of the digital camera market.

Sure, it could have done at least fairly well for a couple years -- after all, the lower-end digital cameras were going for roughly $400-500 when sales seemed to start to explode. However, with no other changes, the best-case scenario would likely be that Kodak's bankruptcy would have only been delayed, not avoided.

Like most consumer electronics, digital cameras quickly became commoditized (and later, largely cannibalized by cell phones with cameras). THAT is the #1 issue, or so it seems to me, not Kodak's slowness to cannibalize. Just look at how Sony (blue), who is often called out as the early-mover in digital cameras for consumers, stock has performed since 2000. (Kodak in green; S&P 500 in red.)

I don't follow Sony, but as I was obtaining its stock chart, I quickly perused its key financial data and ratios. Sony's stock closed at $12.30 on July 17 -- a loss in value of over 50% in one year -- but the interesting thing is Sony has $19.81 per share in cash (according to Yahoo Finance). 

This 'cash per share in excess of stock price' scenario could either present a great buying opportunity for a value investor, or it is indicative of Sony being on a Kodak-like path to bankruptcy. (Again, I don't follow Sony, but interested investors may want to check it out.)

iPhone to Kodak: We could have been good together, kid, as I could have been the k-Phone!

In addition to joining the digital revolution, Kodak needed to find a way to differentiate its products to the extent of being able to maintain healthy profit margins. (It also needed to expand its business beyond photography. Sony and Canon were -- and are -- quite diversified, so they could better "afford" to be in a race to the bottom with one product segment.)

Had Kodak had insight, there is no reason why it could not have been the first to produce a cell phone with a camera, and then even first out with a smartphone with a camera and music player for the consumer market. After all, Kodak had the photography piece going for it. It also had the money -- at that time -- to buy whatever it needed to get the job done. Keep in mind that Apple had zero experience in the phone business before developing its iPhone. (Company size alone can no longer be used as an excuse for not being innovative or nimble -- Apple has already blown that misconception out of the water!) 

This would have enabled Kodak to position itself as a broader consumer tech company making fun products that people want, rather than remaining stuck in the narrow "photography company" category.

This is just one kind of wild scenario, of course. The point is Apple has been hugely successful because it creates new markets by creating products people want and are willing to pay up for, and then is on to its next new product by the time the Kodaks of the business world start churning out a me-too product. 

It's The Creativity, Too, Stupid!

I also give a shout-out to Amazon (NASDAQ: AMZN)for creating the digital book market with its e-reader, the Kindle. Given the thinking that led to both that product, and the founding of the company itself, I'd not be surprised if Amazon comes out with another innovative product or service in the near future. 

Investor Take-Aways

• Companies need a sustainable advantage -- And price (low) alone is almost never a sustainable advantage in consumer electronics or other products that people don't purchase frequently.                             
• Margins are hugely revealing -- A company's profit margin trends, both over time (say, 3-5 yrs), as well as relative to direct competitors, reveal critical information. Shrinking margins are often an early sign that a company may be losing its competitive advantage and/or a specific product line is becoming commoditized.

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