Buffet's 10 x

10x Pretax Earnings! Case Studies: KO, BNI etc.

So, one of the great things about writing a blog is that I get feedback from some pretty intelligent people.  Most of us don't have a Munger to call, but a blog works well too.  If I say something wrong, I'm sure someone would jump in to point it out.

10% Pretax for Stocks Too?

Anyway, I have mentioned 10x pretax earnings or 10% pretax yield as Buffett's valuation measure numerous times here and more than once I've gotten a response saying that this hurdle is for private deals and not for pricing listed companies.  The argument, of course, is that if you buy a stock at 10% pretax earnings, you won't actually earn 10% pretax (due to the additional tax at the investee corporate level whereas in a wholly owned business, a 10% pretax return is actually a 10% pretax return).

It is true that when Buffett speaks of returns in the stock market, he uses GDP growth and dividend yields; earnings can't grow more than GDP and stock returns will reflect earnings growth over time plus whatever dividends you get.

Translating that into individual stocks, you will get earnings growth plus dividend yield equals expected return on the stock.

The only problem with this is that it doesn't tell you what the business is worth.  Would you pay 50x p/e for it?  20x?  The above calculation only works if valuation stays the same.

Anyway, my usual response to this is that many value investors (including Buffett) likes to analyze businesses based on what a rational businessperson would pay for the business in a private transaction.

So, if Buffett is willing to pay 10x pretax earnings for Wells Fargo in a private transaction to buy the whole thing, that is a valuation benchmark for me.  I know that this is not actually possible.  There are size and regulatory issues that will make this unlikely.  But in terms of valuing businesses, I think it is still a useful benchmark.

Is this how Buffett thinks about it? If he pays 10x pretax earnings for WFC stock, he will not necessarily earn a 10% pretax yield.  I don't know the answer to that question. Maybe that's a good annual meeting question.

But as long as I know that Buffett  would be totally happy to pay 10x pretax for the whole business, that's good enough for me regardless of whether that will actually happen.

Yes, you can argue that these "private business transaction" valuations are only valid when there is some chance of a private deal occurring.  But I only think of that when the private valuations don't make too much economic sense to me; valuations per eyeball or per POP valuations in the past, for example, or 40x EV/EBITDA for some media assets, or per acre land valuations etc.; just because some people are paying high prices doesn't mean anything unless there is a real prospect that what you are looking at will also be taken out at some point at the same high level.

Is 10x Pretax Reasonable? 

But 10x pretax earnings, even for listed companies, is not unreasonable at all.  You can translate that 10x pretax into a 15x after tax p/e ratio, and that wouldn't be far off from the 100 year or so long term average of U.S. listed businesses.   Since Buffett buys quality, above average businesses, paying 10x pretax 

is like paying an average price for an above average business.

So even if my view is wrong, it passes the rationality test; why not pay average prices for above average businesses?  And this is not dependent on market p/e or interest rates because you are using a long term average.  We are not increasing valuations due to decreased interest rates.

Case Studies

So, this discussion piqued my interest again so I decided to go back and look at some more of Buffett's big deals.  I use the term "case study", but it's far from it, really.  I'm only looking at one measure; pretax earnings yield or price to pretax profits.  So I apologize for the exaggerated terminology and to folks who come here looking for a 300 page paper on why Buffett bought something; you'll only see one line.  We all know how great the businesses he owns are, so there really is no need to look at that.

So, I looked at the 2005 purchase of Wells Fargo, Walmart and the recent IBM purchases, but what about some of the other older ones?

Again, since the Warren Buffet Library of Corporate Annual Reports doesn't exist yet, I can only look at some of them.

I got lucky and found a 1988 annual report of Coke, so that's good. Let's start there.

Below, let's take a quick look at Coke (KO), American Express (AXP) and Burlington Northern (BNI) (which a prominent value investing academic said was a crazy/insane deal or some such.  We'll see if it really was a bad price) and some others.

Coca Cola  (KO)

From the 1988 KO annual report:

Pretax earnings:   $1,582 million

Net earnings:        $1,045 million

EPS:   $2.85

Shares outstanding: 365 million

Year-end stock price:  $44.63

From the Berkshire Hathaway annual reports, the cost of KO was:

                     #shares owned           cost ('000)       cost/share (my calculation)

1988 AR       14,172,500                  $592,540       $41.81

1989 AR       23,350,000               $1,023,920       $43.85

So with $1,582 million in pretax profits and 365 million shares outstanding, that's $4.33/share in pretax earnings per share.

So it turns out he paid 9.7x pretax earnings as of 1988 and 10.1x pretax earnings as of the end of 1989.  

That's a pretty stunning discovery, even for me.  I think a lot of value investors were puzzled at what looked like a growth stock purchase by Buffett at the time, but it fits right in with the 10x pretax benchmark perfectly.  He didn't payup because KO was a really high quality business; he paid what he normally pays. 

American Express  (AXP)

So this one doesn't quite fit the mold, but let's take a quick look at it (it doesn't fit only because he didn't pay almost exactly 10x pretax earnings, but far less).

The 1994 annual report is the first time AXP showed up in the BRK letter so let's look at that and what he paid for it:

                        # of shares owned          cost  ('000)          cost/share (my calculation)

1994 AR         27,759,941                     $729,919             $26.29

By the way, I know that this is only an estimated cost per share of the stocks.  There may be some adjustments somewhere that might throw this off, but I don't think it would change things materially.

Thankfully, the SEC database goes back to 1994, so let's pull the relevant AXP figures from 1994:

Pretax earnings:  $1,891 million

EPS: $2.75

Shares outstanding:  496 million

So we don't even have to go very far with this one.  It looks like Buffett paid9.6x net earnings for AXP.

Pretax earnings per share comes to $3.81/share, so he paid a 6.9x pretax earnings.

It looks like he got AXP really cheaply.   It got pretty cheap in 2009 too.

Moving on.

U.S. Bancorp (USB)

It looks like he started buying USB in 2006, but maybe earlier.  It shows up first in 2006 on the annual report.  He bought more in 2007.  This is from the annual reports:

                     #shares owned           cost ($mn)       cost/share (my calculation)

2006 AR       31,033,800                  $969                 $31.22

2007 AR       75,176,026                $2,417                $32.45

And here are the figures for USB in 2006 and 2007:

              Pretax          diluted (mn)                  Pretax

              earnings       shares outstanding        EPS

2006       $6,912         1,804                            $3.83

2007       $6,282         1,758                            $3.57

2013       $7,990         1,849                            $4.32

So in 2006, BRK was paying 8.2x pretax earings, and the total cost through 2007 comes to 9.1x pretax earnings of 2007.

And interestingly, BRK increased shares held in USB from 78 million in 2012 to 96 million at the end of 2013.  The pretax EPS of USB was $4.32 in 2013 and the stock traded in the range of 7.4 - 9.5x that figure throughout the year.

Burlington Northern (BNI)

So this is one of his other major purchases that made everyone scratch their heads.  There are two things to look at here; one purchase when he just bought the shares and then a second time when he bought out the whole company.  Let's take a look.

The first time BNI appeared in the annual report was 2007.  In 2006, he said there were two positions worth $1.6 billion that was not listed, so BNI was probably purchased in 2006 and other times too (could be some before and some after).

Here is what the 2007 BRK annual report showed:

                       # of shares owned          cost  ($mn)          cost/share (my calculation)

2007 AR         60,828,818                     $4,731                  $77.78

And these are the figures for BNI for 2006 and 2007:

                                                   2006               2007

EPS:                                           $5.11              $5.10

Pretax earnings:                         $2.96 bn         $3.0 bn

diluted shares outstanding:           370 mn        359 mn

Pretax EPS:                                $8.11             $8.25

So from this, it looks like Buffett was paying 9.4x - 9.6x pretax earnings per share.  Voila!

And then of course, BRK bought the whole thing in late 2009 (on an announcement basis).  The offer price was $100, so let's see what the BNI figures were for 2009.  Even though the figures haven't come out yet when the announcement was made, most of the year was over, so they would have known pretty much what the earnings were going to be.

Here it is:

BNI 2009

EPS:   $6.08

Pretax earnings:  $3,368 mn

Diluted shares outstanding:  348 million

Pretax EPS:   $9.68

So at $100/share, Buffett paid 10.3x pretax EPS of BNI.

A lot of people thought Buffett overpaid, but it turns out he just paid what he always seems to pay.  I know, I know.  What about capex, maintanence capex / depreciation and all that?   Yes, that was the argument back then.  I don't know.  I'm just looking at this and noticing a pattern.  I don't have all the answers!

BNI Tangent

What's a blog post here without a tangent?  As I was doing this stuff, I just took a quick look at the famous 'projections' of BNI that was included in the merger proxy.  Buffett has said that he ignores these management projections, but these are often done by management / investment bankers in mergers so they can do their cash flow discount model analysis and whatnot.

So here are the various projections for BNI from the proxy dated December 2009:

2010 Recovery Case

		2009E			2010E			2011E			2012E			2013E			2014E			CAGR
		(In millions, except per share and percentage data)
Total revenue		$	14,013		$	14,994		$	16,601		$	17,611		$	18,667		$	19,418		6.7	%
Freight revenue w/o fuel			12,372			12,830			14,063			15,014			15,834			16,558		6.0	%
Operating income			3,204			3,421			4,336			4,921			5,360			5,745		12.4	%
EBITDA			4,737			5,052			6,056			6,746			7,313			7,825		10.6	%
Net income			1,631			1,717			2,224			2,476			2,663			2,831		11.7	%
Earnings per share			4.77			5.04			6.88			8.41			9.71			10.96		18.1	%

2011 Recovery Case

		2009E			2010E			2011E			2012E			2013E			2014E			CAGR
		(In millions, except per share and percentage data)
Total revenue		$	14,013		$	14,254		$	15,436		$	16,629		$	17,839		$	18,877		6.1	%
Freight revenue w/o fuel			12,372			12,424			13,345			14,291			15,244			16,044		5.3	%
Operating income			3,204			3,092			3,638			4,241			4,775			5,209		10.2	%
EBITDA			4,737			4,723			5,357			6,063			6,724			7,283		9.0	%
Net income			1,631			1,515			1,842			2,149			2,386			2,572		9.5	%
Earnings per share			4.77			4.41			5.43			6.74			8.10			9.35		14.4	%

No Recovery Case

		2009E			2010E			2011E			2012E			2013E			2014E			CAGR
		(In millions, except per share and percentage data)
Total revenue		$	14,013		$	14,012		$	14,410		$	14,622		$	14,844		$	15,069		1.5	%
Freight revenue w/o fuel			12,372			12,377			12,736			12,953			13,176			13,401		1.6	%
Operating income			3,204			3,010			3,224			3,324			3,314			3,310		0.7	%
EBITDA			4,737			4,639			4,939			5,138			5,249			5,363		2.5	%
Net income			1,631			1,465			1,607			1,660			1,631			1,610		(0.3	%)
Earnings per share			4.77			4.27			4.65			4.87			4.94			5.07		1.2	%

Deeper Recession Case

		2009E			2010E			2011E			2012E			2013E			2014E			CAGR
		(In millions, except per share and percentage data)
Total revenue		$	14,013		$	13,544		$	13,618		$	14,000		$	14,283		$	14,756		1.0	%
Freight revenue w/o fuel			12,372			12,107			12,147			12,351			12,632			12,929		0.9	%
Operating income			3,204			2,759			2,728			2,778			2,841			2,898		(2.0	%)
EBITDA			4,737			4,387			4,440			4,588			4,770			4,943		0.9	%
Net income			1,631			1,310			1,295			1,326			1,369			1,399		(3.0	%)
Earnings per share			4.77			3.82			3.74			3.80			3.89			4.05		(3.2	%)

And check this out.  These are the figures for 2013 that BNI actually booked (from the BNI 10-K):

BNI 2013 Results

Revenues:             $22,014 million

Operating income:  $6,667 million

Pretax income:        $5,928 million

Net income:             $3,793 million

The most bullish projection in 2009 was for operating income of $5,360 million and net income of $2,663 million.  Operating income came in 24% higher and net came in 42% higher!

Lubrizol

OK, so here's one more acquisition.  This name might not give BRK holders a warm and fuzzy feeling (due to the Sokol incident), but it is a major acquisition so it is a relevant data point.

BRK bought Lubrizol in 2011 for $135/share.

For the 2010 year, here are some figures for Lubrizol:

EPS:  $10.64

Pretax earnings:  $1.00 billion

Diluted shares outstanding:  68.8 million

Pretax EPS:  $14.53

So a $135/share purchase is 9.3x pretax EPS.

Recap

So let's just recap all of this stuff I said in the last post (part 5) and this one.

These are the multiples to pretax earnings Buffett paid in these big deals:

KO in 1988/89:    10.1x

AXP in 1994:         6.9x

WMT in 2005:      11.4x

WFC in 2005:         9x

USB in 2006/2007:  9.1x

USB in 2013:  7.4 - 9.5x (range of stock price in 2013)

BNI stock purchase: 9.5x

BNI acquisition:  10.3x

Lubrizol:   9.3x

IBM:  9.7x

I exclude Heinz here as it is a different situation and I think he said he wouldn't have done the deal without 3G.  I may be missing some here as I didn't intend this to be comprehensive by any means, but just looked quickly at some of the large purchases he has made over the years and it is very interesting.

Conclusion

It's amazing how so many of the deals cluster around the 10x pretax earnings ratio despite these businesses being in different industries with different capital expenditure needs and things like that.

Even the BNI acquisition, which many thought was overpriced (crazy / insane deal! Buffett has lost his marbles!) looks normal by this measure; a price that Buffett has always been paying.

And yes, right now I'm the guy swinging around a hammer (seeing only nails), but I notice a pattern and think it's really interesting.

Of course, this actually makes no sense as every company has different capital needs (free cash flow / owner earnings etc.)  Of course, what Buffett calls "owner earnings" are more important than pretax profits.  This was one of the arguments about the BNI deal.

And it is silly to think you can price anything and everything at 10x pretax profits.  Buffett obviously looks at everything else and has a deep understanding of the various businesses and is only willing to pay this amount for the very best businesses out there.

Why he says he will pay 9-10x pretax earnings (OK, for private deals) and yet seems to go out and pay 9-10x pretax earnings on stocks is a good and valid question.

It's amazing, though, isn't it?  Even if it is an odd coincidence.

NEBRASKA FURNITURE (MY TWO CENTS:))

Paid 11-12x after tax earnings. Bought 80% of company at $60 million = 
100%value. This was a little more than BV. Sales roughly $100 mm about 
$7 mm pre-tax earnings; $4.5 mm after tax. German co was trying to buy at 
same time. 

But I don't think 10x pretax earnings for a stock is a bad price if it's a high quality business that can grow over time etc...  (But you still have to answer the question how much growth there will be and how much a shareholder can expect to get back.)

Aping the Big Investors from Graham Days

Walter Schloss: Apropos of that, while I was at Graham-Newman, a man called up and said he'd like to speak to Mr. Graham. Because he was out of town that day, I asked if there was anything I could do in his stead. He said, "I just wanted to thank him. Every 6 months Graham-Newman publishes their portfolio holdings. And I've made so much money on the stocks that he had in his portfolio, I just wanted to come by and thank him. That was one of the reasons I decided never to publish our holdings. We work hard to find our stocks. We don't want to just give them away. It's not fair to our partners.

Bubble Question

Klarman index - Yes
Prem Watsa - Yes
Buffett - Purchases decreased dramatically

From all the other places such as Shiller P/E (James Montier), Hussman Weekly, Tech multiples, it is quite clear that there is a bubble in the tech sector and in general the market is overvalued, interest rates are artificially low atleast in the developed markets.

clearly, US markets will drive the Indian markets elections notwithstanding - FII money tends to exaggerate the impact; Therefore the way to deal with this is to have a tight leash on investable opportunities and play arbitrage only for 2 years. Question then is do you buy long dated puts? how do you hedge the rest of the portfolio at least cost?

Buffets mistakes - Things to learn

Biggest Losers

• Airlines - US air
• retail stores
• Paper producer - Champion intl
• Brokerage - Salomon

Biggest winners

• consumer franchises
• newspapers
• television

Q: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?
Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.
So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

Bruce Greenwald: Do you want me to give you the answer to that? In the 1960s, their return on capital was 46%. In the 1970s their return on capital was 28%. In the 1980s it was 9% in the 1990s it was 6%. You want to guess how negative it is now?
Li Lu: So that is really fascinating. If you have that data, the amount of insight that would yield would be astonishing. So instead of just accepting the conventional wisdom that the auto business is bad — that is just not true. Or if you say well those guys just unbelievable money machines — that is not true either. So if you can really examine those statistics and understand it that will give you an advantage for analyzing new situations like in China and India. That is really what turns me on. Understanding this gives you a tremendous leg up.

Meeting with Managements

Almost everything we learn is from public documents. I read Jim Clayton's book, for example. There is adequate information out there to evaluate businesses. We do not find it particularly helpful to talk to managements. Often managements want to come to Omaha to talk, and they come up with all sorts of reasons, but what they really hope is that we become interested in their stock. That never works. The numbers tell us a lot more than the managements. We don't give a hoot about anyone's projections. We don't want even want to hear about it.

Buffett on banks

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. AKA PUBLIC SECTOR BANKS Instead, our only interest is in buying into well- managed banks at fair prices (his definition of fair price is ridiculous for ordinary souls)

He clearly has inclination for consumer oriented banks - no questioning that

With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no
genius," he said. "I'm smart in spots - but I stay around those spots.")

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings. WILL HDFC or INDUSIND ever get this cheap? Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price,would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more
avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

Hiring a Sales guy!

Through the Looking Glass: Hiring Sales People

April 15, 2013

inShare

He's a big bad wolf in your neighborhood
Not bad meaning bad, but bad meaning good
—Run DMC, Peter Piper

Perhaps the most common mistake that I see a technical founder make when building her sales organization is she applies strategies that worked in building the engineering team to the sales hiring process. This may sound shocking, but sales people are different than engineers and treating them like engineers does not work well at all.

It starts with the hiring process. If you attempt to hire sales people using the same assumptions that worked with engineering, then here are some of the things that will go wrong:

The Interview

A good engineering interview will include some set of difficult problems to solve. It might even require that the candidate write a short program. In addition, it will test the candidate’s knowledge of the tools she uses in great depth. A small portion of the interview may address personality traits, but smart managers will tolerate a very wide variety of personalities to find the best engineers.

A good sales interview is the opposite. You can quiz them on hard sales problems all day long, but only a horrible sales rep won’t be able to bluff her way through the most intricate quiz on how to sell a complex account. On the other hand, great sales people tend to have very specific personality traits. Specifically, great sales people must be courageous, competitive and hungry. They also need enough intelligence to get the job done. That’s the magic formula. Hire engineers with that profile and you’ll fail. Hire sales people who are really smart problem solvers, but lack courage, hunger and competitiveness, and your company will go out of business.

Dick Harrison, CEO of Parametric Technologies, home of perhaps the greatest enterprise sales force ever built, interviewed Mark Cranney, the greatest sales manager I have ever met, as follows:

Dick: "I'll bet you got into a lot of fights when you were a youth didn't you?"
Mark: "Well yes, Dick, I did get into a few."
Dick: "Well, how'd you do?"
Mark: "Well, I was about 35-1."
Dick: "Tell me about the 1."
Mark tells him the story, which Dick enjoys immensely.
Dick: “Do you think you could kick my ass?”
Mark pauses and asks himself: “Is Dick questioning my courage or my intelligence?” Then replies: “Could or would?”

Dick hires Mark on the spot.

Ask an engineer that same set of questions and at best she’d be confused and at worst she’d be horrified. By asking Mark those questions, Dick quickly found out:

• If Mark had the courage to stay in the box and not get flustered

• That Mark came from a rough environment and was plenty hungry

• That Mark was super competitive, but smart enough to calculate his answer

Hiring sales people is different.

The Background

When screening engineers from other companies, it's smart to value engineers from great companies more than those from mediocre companies. All things being equal, always interview the Google engineer over the Quest Software engineer. Why? Because, as an engineer, you have to be way better to get a job at Google than at Quest. In addition, Google’s engineering environment and techniques are state-of-the-art, so engineers who come from there will be well trained in an environment with high standards.

In contrast, anybody with a pulse can sell a massively winning product like Google Ads or VMware hypervisors, but people who consistently sold Lanier copiers against Xerox were elite. In fact, it might be a good sign that a sales rep was successful at a bad company. To succeed at selling a losing product, you must develop seriously superior sales techniques. In addition, you have to be massively competitive and incredibly hungry to survive in that environment.

The Cost of Making a Mistake

Great engineering organizations strive never to make hiring mistakes as hiring mistakes can be very costly. Not only do you lose the productivity that you might have gained from the hire, but you might well incur severe technical debt. To make matters worse, even when an engineering manager recognizes she’s made a mistake, she’s often slow to correct it, leading to more debt and delay. In addition, building an engineering organization too quickly will cause all kinds of communication issues, which makes slow hiring in engineering a really smart thing to do.

On the other hand, you often can’t afford to build out your sales force too slowly, especially if you have significant competition. Sales people, when compared to engineers, work in relative isolation, so there’s productivity loss, but relatively little long-term debt or fast growth issues. Sales managers generally don’t have issues with firing poor performers, so sales people go fast. I have a friend who was fond of saying, “We have two kinds of sales people: rich and new.”

The Conclusion

Applying engineering hiring techniques to a sales organization is like eating poison ivy to get more green vegetables. You will get the opposite of what you want.

doesn't matter Public or Private Companies - Cash is all!

Capital Market Climate Change

July 16, 2013

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Hope that you feel this
Feel this way forever
You can plan a pretty picnic
But you can’t predict the weather.
—Outkast, Ms. Jackson

If you run a startup and are currently raising money, you probably planned for a somewhat different fundraising environment than the one you find yourself in today. You probably thought that valuations would be roughly the same as they were the last time you raised money. But they most certainly are not. Perhaps you are caught in the “Series A crunch” or perhaps you are a consumer company and expected that you would be valued on users rather than revenue like the last time. Or maybe you are a lucky enterprise company and are pleasantly surprised—this time.

How could this be? What about the efficient market hypothesis? Aren’t markets rational? Won’t we just return to the “normal” environment that we experienced before? To find out, let’s look at the Price/Earnings (P/E) ratio of all S&P 500 IT companies at various points over the past 18 years. If markets behave rationally, one might expect the ratio of price to earnings to be reasonably stable over the period (click here for complete data set). One would be wrong:

3/31/1995: 21.0
3/29/1996: 22.3
3/31/1997: 23.3
3/31/1998: 30.8
3/31/1999: 49.7
3/31/2000: 73.4
3/30/2001: 26.3
3/29/2002: 82.5
3/31/2003: 44.6
3/31/2004: 31.6
3/31/2005: 22.8
3/31/2006: 22.8
3/30/2007: 22.6
3/31/2008: 19.1
3/31/2009: 14.5
3/31/2010: 18.8
3/31/2011: 15.4
3/30/2012: 15.5

So, the average company on the S&P 500 IT index with $10M in annual earnings would be worth $210M in March of 1995, $820M in March of 2002, $310M in March of 2004 and $155M in March of last year. And those are big companies with real earnings, so you can imagine how a private company’s valuation might fluctuate. If you have no imagination, consider my experience. In June of 2000, I raised money at an $820M post-money valuation. By the end of the year and despite more than doubling bookings, I could not raise money at any price in the private markets and was forced to take the company public at a $560M post-money valuation. Things change.  Why do things change? Because markets are not logical; markets are emotional.

Now that we’ve established that climate change is real, what should you do if the current environment is much worse than you expected?

In some sense, you are like the captain of the Titanic. Had he not had the experience of being a ship captain for 25 years and never hit an iceberg, he would have seen the iceberg. Had you not had the experience of raising your last round so easily, you might have seen this round coming. But now is not the time to worry about that. Now is the time to make sure that your lifeboats are in order.

Before we begin doing that, let’s understand the depth of the problem. First, if you did not understand how radically the fundraising environment might change, then there is no chance that your employees would have understood it. In fact, if you are like most companies, your managers probably implied to your employees that your stock price would only rise as long as you were private. They might have said something ridiculous like: “Based on the current price of the preferred stock, your offer is already worth $5M.” As if the price could never go down. As if the common stock were actually the same as preferred stock. Silly them. As a result, if you raise money at a lower price, your people will likely not only freak out, but possibly believe they were lied to. Note that they may very well have been lied to. As Scooby Doo once said, “Ruh roh.”

Now about those lifeboats.

If you are burning cash and running out of money, you are going to have to swallow your pride, face reality and raise money even if it hurts. Hoping that the fundraising climate will change before you die is a bad strategy because a dwindling cash balance will make it even more difficult to raise money than it already is, so even in a steady climate, your prospects will dim. You need to figure out how to stop the bleeding, as it is too late to prevent it from starting. Eating shit is horrible, but is far better than suicide.

When you go to fundraise, you will need to consider the possibility of a valuation lower than the valuation of your last round, i.e., the dreaded down round. Down rounds are bad and hit founders disproportionately hard, but they are not as bad as bankruptcy.  Smart investors will want the founders and employees to be properly motivated post-financing, so there may be a way to a reasonable outcome for both you and your people. Make sure that you figure out what kind of deal is better than bankruptcy and be sure to communicate to both your existing and potential new investors what you think makes sense. In this situation, it’s better to start low and get one bidder that may lead to many and the market-clearing price than have no bidders and the dream of a high price.

Once you begin your process, keep in mind that you are looking for a market of one. You don’t need every investor to believe that you can succeed. You only need one. If 20 investors tell you “no”, that does not mean that there is no market for your deal. You just need one to say yes and she will erase all 20 no’s.

After, God willing, you successfully raise your round and it’s a down round or a disappointing round, you will need to explain things to your company.  The best thing to do is to tell the truth. Yes, we did a down round. Yes, that kind of sucks. But no, it’s not the end of the world. We can probably re-price your options. If we took too much dilution, we will work with our new investor to make sure that every employee is still highly financially motivated. We are the same company that we were yesterday and if you believed in that company, then you should believe in this one.

If your managers intentionally or accidentally lied, then you will need to address that too. Find out what happened and deal with the damage as best as you can. Do not ignore these things or stick your head in the sand, as you cannot afford to lose any more trust than you have already lost.

If you by some miracle make it through this process, then the most important thing to learn from your experience is this: The only surefire antidote to capital market climate change is positive cash flow. If you generate cash, investors mean nothing. If you do not, then your success will depend upon the kindness of strangers.

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Einstein, Jobs and Franklin

http://fully-faltoo.com/2013/01/03/walter-isaacson/

Good companies - Joy of owning them

Understanding Current

Different strokes:
India Essen Welding
& Cutting 2012
Electricity
To explain electricity with a simple
example. Think of electricity as
water flowing through a pipe or
garden hose. The water is really
electrons in the metal that makes up
the wire. The hose is the wire that
transports electricity. Basically,
electricity is created by magnets
spinning inside a whole bunch of
wires. The magnets spinning around
cause electrons to move which
creates electricity.
The three most basic units in
electricity are voltage (V), current (I)
and resistance (r). Voltage is
measured in volts, current is
measured in amps and resistance is
measured in ohms.
Once again using transport of water
to explain the above phenomenon,
the voltage is equivalent to the
water pressure, current is equivalent
to the flow rate and resistance is like
the pipe size.
There is a basic equation in electrical
engineering that states how the
three terms relate. It says that the
current is equal to the voltage
divided by resistance. Further,
kVA = Volts x A
kW = Volts x Amps x Power Factor
or [kVA x Power Factor]
Looking at different electrical
equipment, you will notice that the

power ratings are either expressed 

in kVA or sometimes in kW . To 

understand the difference between 

kw and kva - KW is called actual or 

real power, or simply the amount of 

power that is available to do real 

work. On the other hand kVA is 

known as “apparent” power.

Everything Store: Questions on Flipkart!

Unlike traditional retailers, Amazon boasted what was called a negative operating cycle. Customers paid with their credit cards when their books shipped but Amazon settled its accounts with the book distributors only every few months. With every sale, Amazon put more cash in the bank, giving it a steady stream of capital to fund its operations and expansion.14 The company could also lay claim to a uniquely high return on invested capital. Unlike brick-and-mortar retailers, whose inventories were spread out across hundreds or thousands of stores around the country, Amazon had one website and, at that time, a single warehouse and inventory. Amazon’s ratio of fixed costs to revenue was considerably more favorable than that of its offline competitors. In other words, Bezos and Covey argued, a dollar that was plugged into Amazon’s infrastructure could lead to exponentially greater returns than a dollar that went into the infrastructure of any other retailer in the world.

Not sure FK qualifies on any of the counts above 1) negative op cycle or positive float business 2) consolidated warehouses (probably yes) and 3) return on $ of infra far higher for the company!

Look, you should wake up worried, terrified every morning,” he told his employees. “But don’t be worried about our competitors because they’re never going to send us any money anyway. Let’s be worried about our customers and stay heads-down focused.

Nice!

Clock of the Long Now, an aspirational project aimed at building a massive mechanical clock designed to measure time for ten thousand years, a way to promote long-term thinking

Theoretical response:

You seem like a really nice guy, so don’t take this the wrong way, but you really need to sell to Barnes and Noble and get out now,” one student bluntly informed Bezos.

“Amazon had to be focused on its own business,” says Tinsley. “Our biggest mistake was thinking we had the bandwidth to work with all these companies.”

Could a Wal-Mart-type story still occur in this day and age? My answer is of course it could happen again. Somewhere out there right now there’s someone—probably hundreds of thousands of someones—with good enough ideas to go all the way. It will be done again, over and over, providing that someone wants it badly enough to do what it takes to get there. It’s all a matter of attitude and the capacity to constantly study and question the management of the business.

Toys are so fad driven, it’s a little like betting on Oscar winners only by looking at movie trailers,” Miller says.

customer obsession, frugality, bias for action, ownership, and high bar for talent. Later Amazon would add a sixth value, innovation.

“The membership fee is a onetime pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else,” Sinegal said. “It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco.”10

At a two-day management and board offsite later that year, Amazon invited business thinker Jim Collins to present the findings from his soon-to-be-published book Good to Great. Collins had studied the company and led a series of intense discussions at the offsite. “You’ve got to decide what you’re great at,” he told the Amazon executives.

Bezos announced that employees could no longer use such corporate crutches and would have to write their presentations in prose, in what he called narratives

a six-page limit on narratives, with additional room for footnotes.
The goal was to get employees to distill a pitch into its purest essence, to start from something the customer might see—the public announcement—and work backward. Bezos didn’t believe anyone could make a good decision about a feature or a product without knowing precisely how it would be communicated to the world—and what the hallowed customer would make of it.

This is excellent!

The jewelry industry had a simplistic pricing model with generous margins. Retail markup was significant; stores doubled the wholesale cost (a practice known as keystone pricing) or even tripled it (known as triple-keystone pricing). Jewelry manufacturers and retailers clung tightly to that custom, which didn’t fit well with Bezos’s newly adamant resolve to offer the lowest prices anywhere.