These Companies Adapted Their Way to Success

By Ser Jing Chong - September 27, 2012 | Tickers: AMZN, AAPL, NFLX, SBUX | 0 Comments

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Quality of management’s a very important factor in determining the success of an investment, along with the quality of the business and its valuation. Usually, when discussing good management, words like ‘integrity’, ‘capital allocation’ and ‘visionary’ are thrown into the mix. While it is true that managements who are honest and upright, able to invest capital appropriately and who can prepare their business for changes in consumer and economic conditions are important, there seems to be another factor that is not discussed as much – the ability to Adapt.

In Tim Harford’s excellent book, ‘Adapt: Why Success Always Starts with Failure’, he highlights the importance of adopting a trial-and-error process for organizations in dealing with the complexities of the modern world. Organizations should go through a stage of learning, variation and selection. In learning, organizations should have leaders who are willing to listen to feedback coming from people leading the efforts from the ground and make adjustments to their strategies. In variation, the organization must be allowed to experiment and try out various ideas on a scale that would be not be disastrous should the ideas fail. In selection, the leaders of the organization must be able to come up with better feedback loops to know how existing and new operations are faring – in essence, they cannot be shielded in their ivory towers, which ties back to the idea discussed in learning. These three principles form the idea behind the ability to adapt.

When these three principles are translated into a business setting, it would mean that companies do not solely depend on their leaders to come up with a path to success but rather, a company should be able to adapt as a whole for a greater shot at prosperity. That is where a company’s management can be crucial to a company’s success – this might seem paradoxical, but please bear with me for a while. For a company to be able to adapt, its management must first set the right tone, being willing to make quick changes and learn from what is actually happening on the ground. So, even though management should not always be counted upon to come up with breath-taking visionary plans for a company’s future, they should be counted upon to set the right framework for the company to adapt by being able and willing to make changes in a trial-and-error process. In finding out what actually works, resources are then much better allocated.

Starbucks (NASDAQ: SBUX) actually provided a great example of how top management can allow the company to adapt. Back in 2005 to 2007, Starbucks’s ex-CEO Jim Donald was caught up with expanding Starbucks’s store count even though the expansion efforts were becoming unprofitable. Starbucks opened a total of 2505 stores from FY2005 to FY2007 and even though earnings had grown by a cumulative 19.3%, comparable store sales (comps) growth in the US fell to 4% from a high of 11% in FY 2004. Comparable store sales are a very important metric for Food & Beverage retail companies and the slowdown in comps growth started to show cracks in Starbucks’ policy of indiscriminate expansion. Starbucks founder Howard Schultz had to send a letter to Donald to highlight his concerns about the ‘commoditization of our brand’. If Donald could learn, he might have caught on to the deteriorating Starbucks experience from his ground staff. Schultz has since been shown to be very perceptive towards how customers perceive the Starbucks brand when they walk into a store with moves such as changing the way breakfast sandwiches were prepared so as to avoid the smell of food overpowering the aroma of coffee and decreasing the amount of automation during the coffee making process to infuse that ‘human touch’ into the Starbucks experience.

In variation and selection, Starbucks recently spent $100 million to acquire LaBoulange Bakery in an effort to improve the core food offerings for Starbucks. This seems to be a classic trial-and-error process where a small amount of resources (for a company generating revenues north of $11 billion in FY2011, $100 million is a relatively small amount for an acquisition) is devoted to a project to test for feedback. Starbucks also spent $30 million to acquire Evolution Fresh, a company that sells premium, high-quality fresh fruit juices in a bid to enter the juice market. After the acquisition, they rolled out the juices into existing Starbucks stores to gauge demand before deciding to open their first stand-alone Evolution Fresh store in Bellevue, Washington. Again, management gauged demand in the Bellevue store before deciding to open a 2nd one in Downtown Seattle. These calculated moves in addition to other projects like the Verismo machine, shows how Starbucks is trying to adapt. It has resulted in business success judging by how revenue and earnings grew by a cumulative 24% and 86% respectively from FY2007 to FY2011 while the first 9 months of FY2012 has already shown a 14.6% and 15.5% increase in revenue and earnings respectively compared to the corresponding period in FY2011. More importantly, comps growth in the US has increased to 8% in FY2011.

Netflix (NASDAQ: NFLX) also displays a tremendous ability to learn based on their data-collection of subscribers’ viewing habits. This allows them to find out what makes a program popular and they can use that data to decide on content spending and then judge the wisdom of their decision through any changes in subscribers’ viewing habits as well as subscriber count. Yes, Netflix’s stock price collapsed from a high of $300 in July 2011 to $56 in September 2012, however, the business performance of Netflix has been outstanding -number of subscribers grew from 857 thousand in FY2002 to 28 million in Q2 2012.

Management of Netflix has also adopted a great variation and selection strategy by spending not more than 5% of its content budget on original programming. Netflix wants to use its huge algorithmic data set to try and predict what kind of as-yet-unmade original programs would be popular and then finance the production of such programs – it is Netflix’s attempt to produce highly sought after original content that can drive subscriber growth and retention. By limiting the budget to only 5% of its planned spending on content, it allows Netflix the freedom for trial-and-error without catastrophic consequences should the foray into original content fail. Furthermore, the potential for rewards are good based on Netflix’s predictive algorithms and the success of their first original production, Lilyhammer. It would be interesting to see how Netflix continues to adapt and strive for business success.

There are other great success stories out there such as Apple (NASDAQ: AAPL) adapting to allow 3rd party App developers into Apple’s ecosystem through the App Store. Steve Jobs initially refused 3rd party App developers in the original iPhone and the App Store was only functional a day prior to the release of the iPhone 3G. Jobs was widely acclaimed to be a visionary but even he was capable of adapting to what was happening on the ground and cater to customers’ wants without posing any potential for long-lasting damage to Apple as the App Store was merely a conduit for developers and users and Apple did not have to sink in large costs to set the whole thing up. The App store now has more than 700 thousand apps for download and has definitely helped to strengthen Apple's iOS ecosystem.

I think Jeff Bezos of Amazon (NASDAQ: AMZN) summed it up the best possible way in his quote, “We say we’re stubborn on vision and flexible on details’’ which I found in this wonderful article. It is precisely the ability to be flexible about the details without the dangers of catastrophic failure which anchors the idea behind Tim Harford's Adapt. Perhaps, you might have come across other leaders who have set up their companies to be adaptable and learn from what they have done to seek out companies with similar characteristics to be added into your investment portfolio – I have a feeling they will be successful for a long time to come.

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