Toys R Us – How Bad Assumptions Fed Bad Financial Planning Creating Failure

Toys R Us – How Bad Assumptions Fed Bad Financial Planning Creating Failure

Toys R Us filed for bankruptcy this week.  And the obvious response was “another retailer slaughtered by Amazon and on-line retailing.”  But this conclusion comes short of describing why Toys R Us leadership did not do the obvious things to keep Toys R Us relevant.

toy retailing sales in us from statista

Amazon and WalMart both eclipsed Toys R Us in toy retail sales.
Chart courtesy of Felix Richter, Statista

Everyone, and I mean everyone, knew over the last decade that customers were buying more stuff on-line, including toys. And everyone also knew that WalMart was pushing extremely hard to keep customers going to their stores by offering products like toys at low prices.  And, it was clear that customers were shifting to buying more toys from both these retailers.  If this was so obvious to everyone, why didn’t Toys R Us leadership do something?  After all, Toys R Us is a multi-billion dollar revenue company.

The LBO

It was over 30 years ago when financiers discovered they could buy a company, sell off some assets and otherwise increase the company’s cash, then convince banks and bondholders to load the company with debt.  These financiers would then pull out the cash for themselves, and leave the company with a ton of debt.  The LBO (leveraged buy out) was born, invented by investment bankers like KKR (named for founders Kohlberg, Kravis & Roberts.) They would use a small bit of private equity, and then use the company’s own assets to raise debt money (leverage) to buy the company.  By “restructuring” the company to a lower cost of operations, usually with draconian reductions, they would increase cash flow to make higher debt repayments.  Then they would either take the money out directly, or take the company public where they could sell their shares, and make themselves rich.  This form of deal making birthed what we now call the Private Equity business.

In 2005, KKR and Bain Capital (which included former Presidential candidate Mitt Romney) bought Toys R Us for about $6.6billion, plus assuming just under $1B of debt, for a total valuation of $7.5billion.  But the private equity  guys didn’t buy the company with equity.  They only put in $1.3billion, and used the company’s assets to raise $5.3billion in additional debt, making total debt a whopping $6.2B.  Total debt was now a remarkable 82.7% of total capital!  At the time of the deal interest rates on that debt were around 7.25%, creating a cash outflow of $450million/year just to pay interest on the loans.  At the time Toys R Us was barely making a profit of 2% – so the debt was double company net profits.

KKR and Bain buy Toys R Us logos

Debt led to bad management decisions and ultimately bankruptcy of the U.S. company

The biggest assumption behind a debt-financed takeover is that the company can cut costs to improve cash flow and thus pay the interest.  But behind that assumption is an even bigger assumption.  That the marketplace won’t change dramatically.  The KKR and Bain Capital leaders assumed they could shrink Toys R Us in a way that would lower operating costs.  They also assumed they could sell some under-utilized assets to raise cash.  They did not assume they would need contingency money if competition, and the marketplace, changed in some unplanned way.

eCommerce was pretty new in 2005.  Amazon was an $8.5 billion company, but it didn’t make any profits and very few predicted then it would become today’s $100 billion behemoth.  Because the financiers didn’t anticipate a big market shift to ecommerce, they focused on the war with Walmart and Target.  Their plans were to lower operating costs, close some stores that were underperforming, license some offshore stores, and sell some assets (like real estate owned or leases) to raise cash and repay the debt.

amazon.com toy car screen shot

But they weren’t prepared to take on another, entirely different competitor on-line.  As Amazon’s growth affected all retailers, Toys R Us simply did not have the resources to fight the traditional discount and dollar brick-and-mortar retailers, and build a major on-line presence, and keep paying that debt. While it is easy to sit on the sidelines and say that Toys R Us should have spent more money building its on-line presence in order to remain relevant, the fact is that the deal in 2005 left the company with insufficient cash flow to do so.  Regardless of what leadership might have wanted to do, simply keeping the lights on was a tough challenge when having to pay out so much cash to bondholders.

And the investors simply did not expect that the growth of on-line retailing would stall traditional retail stores, thus creating a major loss of value for retail real estate.  U.S. retail real estate value had increased in value for decades.  The assumption was that the real estate, whether owned or leased, would continue to go up in value.  Real estate was a “hard” asset that KKR and Bain Capital could bank on for raising cash to repay the debt.  But as on-line retail grew, and traditional retail declined, America became “over stored” with far too much retail space.  Prices were shattered in many markets, and it was not possible for Toys R Us to sell those assets for a gain that would meet the debt obligations.

With $400 million of debt coming due next year, Toys R Us simply doesn’t have the cash flow, or assets, to repay those bondholders

Old assumptions about finance are a big problem for companies today.  Assumptions about “leveraging” hard assets, and intangibles like brand value, are no longer true.  Competitors emerge, markets change, and old assets can lose value very fast.  Assumptions about business model stability are no longer true, as new competitors using newer technology create new ways to sell, and often at lower cost than was ever expected.  Assumptions about customer loyalty, and market share stability, are no longer true as new competitors appeal to customers differently and cause big shifts in buying behavior very fast.  The speed with which technology, competitors, markets and customers shift now requires companies have the funds available to invest in change.

This story isn’t just about debt.  The very popular activity of “returning money to shareholders by repurchasing stock” is a terrible idea.  Stock repurchases do not make a company more valuable, nor a stronger competitor.  Instead they burn through cash to reduce the company’s capitalization, and manipulate ratios like EPS (earnings per share) and P/E (price/earnings) multiple.  Stock repurchases hurt companies, and make them less competitive.  Good companies return money to shareholders by investing in growth, which raises sales, profits and increases the stock price making the company truly more valuable.

Toys R Us isn’t a story about Amazon, or eCommerce, taking out another retailer

A&P Family store 1950's painting

Toys R Us isn’t a story about Amazon, or eCommerce, taking out another retailer

A&P Family store 1950's painting

The important part of the Toys R Us story is realizing that the wrong financial decisions can doom your organization.  You can have a great vision, and even great ideas about new ways to compete.  But if you don’t have the money to invest in growth, it won’t happen.  If leaders don’t have the money to spend on new projects and new markets, because they’re sending it all to bondholders or using it to  repurchase shares in hopes of propping up a stock price, eventually there will be a market shift that will doom the old business model and leave it unable to compete.

To succeed today leaders need the money to invest in change, and they have to constantly invest it in change, or their companies will lose relevancy and end up like Toys R Us, Radio Shack, Circuit City, Aeropostale, The Limited, Payless Shoes, Gander Mountain, Golfsmith, Sports Authority, Borders Books and the great, original American retailer A&P.

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Sears Today, Walmart Tomorrow? Why You Don’t Want To Own Any Retail Stocks

Sears Today, Walmart Tomorrow? Why You Don’t Want To Own Any Retail Stocks

(Photo by Scott Olson/Getty Images)

Traditional retailers just keep providing more bad newsPayless Shoes said it plans to file bankruptcy next week, closing 500 of its 4,000 stores. Most likely it will follow the path of Radio Shack, which hasn’t made a profit since 2011. Radio Shack filed bankruptcy and shut a gob of stores as part of its “turnaround plan.” Then in February Radio Shack filed its second bankruptcy — most likely killing the chain entirely this time.

Sears Holdings finally admitted it probably can’t survive as a going concern this week. Sears has lost over $10 billion since 2010 — when it last showed a profit — and owes over $4 billion to its creditors. Retail stocks cratered Monday as the list of retailers closing stores accelerated: Sears, KMart, Macy’s, Radio Shack, JCPenney, American Apparel, Abercrombie & Fitch, The Limited, CVS, GNC, Office Depot, HHGregg, The Children’s Place and Crocs are just some of the household names that are slowly (or not so slowly) dying.

None of this should be surprising. By the time CEO Ed Lampert merged KMart with Sears the trend to e-commerce was already pronounced. Anyone could build an excel spreadsheet that would demonstrate as online retail grew, brick-and-mortar retail would decline. In the low margin world of retail, profits would evaporate. It would be a blood bath. Any retailer with any weakness simply would not survive this market shift — and that clearly included outdated store concepts like Sears, KMart and Radio Shack which long ago were outflanked by on-line shopping and trendier storefronts.

 Yet, not everyone is ready to give up on some retailers. Walmart, for example, still trades at $70 per share, which is higher than it traded in 2015 and about where it traded back in 2012. Some investors still think that there are brick-and-mortar outfits that are either immune to the trends, or will survive the shake-out and have higher profits in the future.

And that is why we have to be very careful about business myths. There are a lot of people that believe as markets shrink the ultimate consolidation will leave one, or a few, competitors who will be very profitable. Capacity will go away, and profits will return. In the end, they believe if you are the last buggy whip maker you will be profitable — so investors just need to pick who will be the survivor and wait it out. And, if you believe this, then you have justified owning Walmart.

 Only, markets don’t work that way. As industries consolidate they end up with competitors who either lose money or just barely eke out a small profit. Think about the auto industry, airlines or land-line telecom companies.

Two factors exist which effectively forces all the profits out of these businesses and therefore make it impossible for investors to make money long-term.

First, competitive capacity always remains just a bit too much for the market need. Management, and often investors, simply don’t want to give up in the face of industry consolidation. They keep hoping to reach a rainbow that will save them. So capacity lingers and lingers — always pushing prices down even as costs increase. Even after someone fails, and that capacity theoretically goes away, someone jumps in with great hopes for the future and boosts capacity again. Therefore, excess capacity overhangs the marketplace forcing prices down to break-even, or below, and never really goes away.

Given the amount of retail real estate out there and the bargains being offered to anyone who wants to open, or expand, stores this problem will persist for decades in retail.

Second, demand in most markets keeps declining. Hopefuls project that demand will “stabilize,” thus balancing the capacity and allowing for price increases. Because demand changes aren’t linear, there are often plateaus that make it appear as if demand won’t go down more. But then something changes — an innovation, regulatory change, taste change — and demand takes another hit. And all the hope goes away as profits drop, again.

It is not a successful strategy to try being the “last man standing” in any declining market. No competitor is immune to these forces when markets shift. No matter how big, when trends shift and new forms of competition start growing every old-line company will be negatively affected. Whether fast, or slow, the value of these companies will continue declining until they eventually become worthless.

Nor is it successful long-term to try and segment the business into small groupings which management thinks can be protected. When Xerox brought to market photocopying, small offset press manufacturers (ABDick and Multigraphics ) said not to worry. Xeroxing might be OK in some office installations, but there were customer segments that would forever use lithography. Even as demand shrunk, well into the 1990s, they said that big corporations, industrial users, government entities, schools and other segments would forever need the benefits of lithography, so investors were safe. Today the small offset press market is a tiny fraction of its size in the 1960s. ABDick and Multigraphics both went through rounds of bankruptcies before disappearing. Xerography, its child desktop publishing, and its grandchild electronic screens, killed offset for almost all applications.

So don’t be lured into false hopes by retailers who claim their segment is “protected.” Short-term things might not look bad. But the market has already shifted to e-commerce and this is just round one of change. More and more innovations are coming that will make the need for traditional stores increasingly unnecessary.

Many readers have expressed their disappointment in my chronic warnings about Walmart. But those warnings are no different than my warnings about Sears Holdings. It’s just that the timing may be different. Both companies have been over-investing in assets (brick-and-mortar stores) that are declining in value as they have attempted to defend and extend their old business model. Both radically under-invested in new markets which were cannibalizing their old business. And, in the end, both will end up with the same results.

And this is true for all retailers that depend on traditional brick-and-mortar sales for their revenues and profits — it’s only a matter of when things will go badly, not if. So traditional retail is nowhere that any investor wants to be.

Donald Trump – Why It’s Easier To Be CEO Than Mayor, Governor or President

Donald Trump – Why It’s Easier To Be CEO Than Mayor, Governor or President

Donald Trump has had a lot of trouble gaining good press lately. Instead, he’s been troubled by people from all corners reacting negatively to his comments regarding the Democrat’s convention, some speakers at the convention, and his unwillingness to endorse re-election for the Republican speaker of the house. For a guy who has been in the limelight a really long time, it seems a bit odd he would be having such a hard time – especially after all the practice he had during the primaries.

The trouble is that Donald Trump still thinks like a CEO. And being a CEO is a lot easier than being the chief executive of a governing body.

CEOs are much more like kings than mayors, governors or presidents:

  • They aren’t elected, they are appointed. Usually after a long, bloody in-the-trenches career of fighting with opponents – inside and outside the company.
  • They have the final say on pretty much everything. They can choose to listen to their staff, and advisors, or ignore them. Not employees, customers or suppliers can appeal their decisions.
  • If they don’t like the input from an employee or advisor, they can simply fire them.
  • If they don’t like a supplier, they can replace them with someone else.
  • If they don’t like a customer, they can ignore them.
  • Their decisions about resources, hiring/firing, policy, strategy, fund raising/pricing, spending – pretty much everything – is not subject to external regulation or legal review or potential lawsuits.
  • Most decisions are made by understanding finance. Few require a deep knowledge of law.
  • There is really only 1 goal – make money for shareholders. Determining success is not overly complicated, and does not involve multiple, equally powerful constituencies.
  • They can make a ton of mistakes, and pretty much nobody can fire them. They don’t stand for re-election, or re-affirmation. There are no “term limits.” There is little to tie them personally to their decisions.
  • They have 100% control of all the resources/assets, and can direct those resources wherever they want, whenever they want, without asking permission or dealing with oversight.
  • They can say anything they want, and they are unlikely to be admonished or challenged by anyone due to their control of resource allocation and firing.
  • 99% of what they say is never reported. They talk to a few people on their staff, and those people can rephrase, adjust, improve, modify the message to make it palatable to employees, customers, suppliers and local communities. There is media attention on them only when they allow it.
  • They have the “power of right” on their side. They can make everyone unhappy, but if their decision improves shareholder value (if they are right) then it really doesn’t matter what anyone else thinks

One might challenge this by saying that CEOs report to the Board of Directors.  Technically, this is true.  But, Boards don’t manage companies. They make few decisions. They are focused on long-term interests like compliance, market entry, sales development, strategy, investor risk minimization, dividend and share buyback policy.  About all they can do to a CEO if one of the above items troubles them is fire the CEO, or indicate a lack of support by adjusting compensation. And both of those actions are far from easy. Just look at how hard it is for unhappy shareholders to develop a coalition around an activist investor in order to change the Board — and then actually take action. And, if the activist is successful at taking control of the board, the one action they take is firing the CEO, only to replace that person with someone knew that has all the power of the old CEO.

It is very alluring to think of a CEO and their skills at corporate leadership being applicable to governing. And some have been quite good. Mayor Bloomberg of New York appears to have pleased most of the citizens and agencies in the city, and his background was an entrepreneur and successful CEO.

But, these are not that common. More common are instances like the current Governor of Illinois, Bruce Rauner. A billionaire hedge fund operator, and first-time elected politician, he won office on a pledge of “shaking things up” in state government.  His first actions were to begin firing employees, cutting budgets, terminating pension benefits, trying to remove union representation of employees, seeking to bankrupt the Chicago school district, and similar actions. All things a “good CEO” would see as the obvious actions necessary to “fix” a state in a deep financial mess.  He looked first at the financials, the P&L and balance sheet, and set about to improve revenues, cut costs and alter asset values. His mantra was to “be more like Indiana, and Texas, which are more business friendly.”

Only, governors have nowhere near the power of CEOs. He has been unable to get the legislature to agree with his ideas, most have not passed, and the state has languished without a budget going on 2 years. The Illinois Supreme Court said the pension was untouchable – something no CEO has to worry about. And it’s nowhere near as easy to bankrupt a school district as a company you own that needs debt/asset restructuring because of all those nasty laws and judges that get in the way. Additionally, government employee unions are not the same as private unions, and nowhere near as easy to “bust” due to pesky laws passed by previous governors and legislators that you can’t just wipe away with a simple decision.

With the state running a deficit, as a CEO he sees the need to undertake the pain of cutting services. Just like he’d cut “wasteful spending” on things he deemed non-essential at one of the companies he ran. So refusing funding during budget negotiations for health care worker overtime, child care, and dozens of other services that primarily are directed at small groups seems like a “hard decision, well needed.” And if the lack of funding means the college student loan program dries up, well those students will just have to wait to go to college, or find funding elsewhere. And if that becomes so acute that a few state colleges have to close, well that’s just the impact of trying to align spending with the reality of revenues, and the customers will have to find those services elsewhere.

And when every decision is subjected to media reporting, suddenly every single decision is questioned. There is no anonymity behind a decision. People don’t just see a college close and wonder “how did that happen” because there are ample journalists around to report exactly why it happened, and that it all goes back to the Governor. Just like the idea of matching employee rights, pay requirements, contract provisioning and regulations to other states – when your every argument is reported by the media it can come off sounding a lot like as state CEO you don’t much like the state you govern, and would prefer to live somewhere else. Perhaps your next action will be to take the headquarters (now the statehouse) to a neighboring state where you can get a tax abatement?

Donald Trump the CEO has loved the headlines, and the media. He was the businessman-turned-reality-TV-star who made the phrase “you’re fired” famous. Because on that show, he was the CEO. He could make any decision he wanted; unchallenged. And viewers could turn on his show, or not, it really didn’t matter. And he only needed to get a small fraction of the population to watch his show for it to make money, not a majority. And he appears to be very genuinely a CEO. As a CEO, as a TV celebrity — and now as a candidate for President.

Obviously, governing body chief executives have to be able to create coalitions in order to get things done. It doesn’t matter the party, it requires obtaining the backing of your own party (just as John Boehner about what happens when that falters) as well as the backing of those who don’t agree with you.  ou don’t have the luxury of being the “tough guy” because if you twist the arm to hard today, these lawmakers, regulators and judges (who have long memories) will deny you something you really, really want tomorrow. And you have to be ready to work with journalists to tell your story in a way that helps build coalitions, because they decide what to tell people you said, and they decide how often to repeat it. And you can’t rely on your own money to take care of you. You have to raise money, a lot of money, not just for your campaign, but to make it available to give away through various PACs (Political Action Committees) to the people who need it for their re-elections in order to keep them backing you, and your ideas. Because if you can’t get enough people to agree on your platforms, then everything just comes to a stop — like the government of Illinois. Or the times the U.S. Government closed for a few days due to a budget impasse.

And, in the end, the voters who elected you can decide not to re-elect you. Just ask Jimmy Carter and George H.W. Bush about that.

On the whole, it’s a whole lot easier to be a CEO than to be a mayor, or governor, or President. And CEOs are paid a whole lot better. Like the moviemaker Mel Brooks (another person born in New York by the way) said in History of the World, Part 1it’s good to be king.

5 Leadership Lessons from 2015’s Business Headlines

5 Leadership Lessons from 2015’s Business Headlines

2015 was not short on bad decisions, nor bad outcomes. But there are 5 major leadership themes from 2015 that can help companies be better in 2016:

Bad decisions1 – Cost cutting, restructurings and stock buybacks do not increase company value – Dow/DuPont

There was no shortage of financial engineering experiments in 2015 intended to increase short-term shareholder returns at the expense of long-term value creation. Companies continued borrowing money to buy back their own stock – spending more on repurchases than they made in profits.

Unfortunately, too many companies continue to increase earnings per share (EPS) via financial machinations rather than creating and introducing new products, or creating new markets.

In a grand show of value reducing financial re-engineering, 2015 is ending with the massive merger between Dow and DuPont. There is no intent of introducing new products or entering new markets via this merger. Rather, to the contrary, the plan is to merge these beasts, lay off tens of thousands of employees, cut the R&D staff, cut new product introductions and “rationalize” the company into 3 new businesses intended to be relaunched as new companies, with fewer products, less business development and less competition.

Massive cost cutting will weaken both companies, put thousands out of work and leave the marketplace with fewer new products. All just to create 3 new, different profit and loss statements in the hopes of improving the EPS and price to earnings (P/E) multiple. This story has become all too familiar the last few years, and the only winners are the bankers, who will make massive fees, and hedge fund managers that rapidly dump the stock in the terrible companies they leave behind.

2 – Doing more of the same is not innovative and does not create value – McDonald’s

McDonald’s has been losing market share to fast casual restaurants for over a decade. Yet, leadership insists on constantly maintaining its undying focus on the fast food success formula upon which the company was launched some 60 years ago.

As the number of customers continued declining, McDonalds kept closing more stores. Yet, sales per store remained weak even as the denominator grew smaller. Unwilling to actually update McDonald’s to make it fit modern trends, in 2015 leadership decided the path to growth was serving breakfast all-day. Really. It is still hard to believe. No new products, just the same McMuffins and sausage biscuits, but now offered for more hours.

Because of McDonald’s size and legacy the media covered this story heavily in 2015. Yet, as 2016 starts we all can look back and see that this was no story at all. Doing more of the same is not in any way innovative or revolutionary. Defending and extending an outdated success formula does not fix a company strategy that is out of date and rapidly losing relevancy.

3 – Hiring the wrong CEO is a BIG problem – Yahoo

We would like to think that Boards are really good at hiring CEOs. Unfortunately, we are regularly reminded they are not. The Board at Yahoo has spent a decade making bad CEO selections, and now the company’s core business is valueless.

In 2015 we saw that the decision by Yahoo’s board to hire a CEO based on political correctness (gender advantages), and limited experience with a well known company (a short Google career) rather than leadership capability could be deadly. Although Marissa Mayer was hired in 2012 amid much fanfare, we learned in 2015 that Yahoo is worth only the value of its Alibaba shareholdings, and no more. Yahoo as it was founded is now worth – nothing.

After 3 years of Mayer leadership it became clear that “there was no there, there” at Yahoo (to quote Gertrude Stein.) The value of the company’s “core” search and content accumulation businesses dropped to zero. Although 3 years have passed, practically no progress has been made toward developing a new business able to compete in the market shifted to social media and instant communications.  Investors now realize Ms. Mayer has failed to grow future revenue and profits for the historical internet leader. Following a decade of incompetent CEOs, Yahoo has been left almost wholly irrelevant.

What was once Yahoo will soon be Alibaba USA, as the company gets rid of its old businesses – in some fashion, although who would want them is unclear – in order to allow shareholders to preserve their value in Alibaba stock purchased by Jerry Yang in 2005.

Yahoo has become irrelevant, replaced by its minority stake in Alibaba, largely due to a Board unable to identify and hire a competent CEO – ending with the wholly unqualified selection of Ms. Mayer, who will achieve at least a footnote in history for the outsized compensation package she received and the huge severance that will come her way, wildly out of proportion to her poor performance, when leaving Yahoo.

4 – Even 1 dumb leadership decision can devastate a company — Turing Pharmaceuticals and CEO Shkreli

In 2015 former hedge fund manager Martin Shkreli raised a lot of money, and obtained control of an anit-parasitic pharmaceutical product. Recognizing that his customers either paid up or died, and being young, naïve, enormously greedy and without much oversight he decided to raise product pricing 70-fold. This would leave his customers either dead, bankrupt or bankrupting the insurance companies paying for his product – but he infamously said he did not care.

Thumbing your nose at customers, and regulators, is never a good idea. And even if they could not roll back the price quickly, they could target the CEO and his company for further investigation. It didn’t take long until Mr. Shrkeli was indicted for stock manipulation, leaving Turing Pharmaceuticals in disrepair as it rapidly cut staff and tried to determine what it will do next.  Now KaloBios Pharma, controlled by Turing, is forced to file bankruptcy.

Never forget that Al Capone did not go to prison for stealing, bribing police, bootlegging, number running, murder or other gangster behavior. He went to prison for tax evasion. The simple lesson is, when you think you are smarter than everyone else, can do whatever you want and thumb your nose at those with government powers you’ll soon find yourself under the microscope of investigation, and most likely in really big trouble.  And in the desire to take down the unwise CEO corporations become mere fodder.

The pharma industry is a regular target of consumers and politicians. Now not only are the investors in Turing damaged by this foolishly incompetent CEO, but the entire industry will once again be under close scrutiny for its pricing practices. Arrogantly making brash decisions, based on ill-formed thinking and juvenile egotism, without careful, thoughtful consideration can create enormous damage.

5 – Putting short-term results above good business practice will hurt you very badly long-term – Volkswagen and Takata

VW cheated on its emissions tests. Takata sold deadly, exploding airbags. Both companies are large organizations with layers of management. How could judgemenetal errors so big, so costly and so deadly happen?

These outcomes did not happen because of just “one bad apple.”   Cultural acceptance of lying takes years of leadership focused on short-term results, even when it means operating unethically or illegally, to be inculcated. It took years for layers of management to learn how to turn away from problems, falsify test results, fake outcomes, lie to customers and even lie to regulators. It took years to create a culture of tolerated deception and willful misrepresentation.

Unfortunately, the auto industry is a tough place to make money. There is a lot of regulation, and a lot of competition. When it becomes too hard to make money honestly, cheating can become far too easily accepted. Rather than trying to revolutionize the auto making process, or the product itself, it can be a lot easier to push managers all the way down to the front-line of procurement, manufacturing or sales to simply cheat.

“Make your numbers” becomes a mantra. If you want to keep your job, or even more importantly if you want to move up, do whatever it takes to tell those above you what they want to hear. And those above don’t ask too many questions, don’t try to figure out how results happen – just keep applying pressure to those below to do what’s necessary to make the numbers.

As VW and Takata showed us, eventually the company will be caught. And the consequences are severe. Now those companies, their customers, their employees and their shareholders are suffering. And industry regulations will tighten further to make it harder to cheat. Everyone loses when short-term results are the top goal, rather than building a sustainable long-term business.

Let’s hope for better leadership in 2016.

Two Lessons For Us All from Crumbled Crumbs Bake Shop

Two Lessons For Us All from Crumbled Crumbs Bake Shop

Crumbs Bake Shop – a small chain of cupcake shops, almost totally unknown outside of New York City and Washington, DC – announced it was going out of business today.  Normally, this would not be newsworthy.  Even though NASDAQ traded, Crumbs small revenues, losses and rapidly shrinking equity made it economically meaningless.  But, it is receiving a lot of attention because this minor event signals to many people the end of the “cupcake trend” which apparently was started by cable TV show “Sex and the City.”

However, there are actually 2 very important lessons all of us can learn from the rise, and fall, of Crumbs Bake Shop:

crumbs cupcake

1 – Don’t believe in the myth of passion when it comes to business

Many management gurus, and entrepreneurs, will tell you to go into business following something about which you are passionate.  The theory goes that if you have passion you will be very committed to success, and you will find your way to success with diligence, perseverance, hard work and insight driven by your passion.  Passion will lead to excellence, which will lead to success.

And this is hogwash.

Customers don’t care about your passion.  Customers care about their needs.  Rather than being a benefit, passion is a negative because it will cause you to over-invest in your passion.  You will “never say die” as you keep trying to make success out of an idea that has no chance.  Rather than investing your resources into something that fulfills people’s needs, you are likely to invest in your passion until you burn through all your resources.  Like Crumbs.

The founders of Crumbs had a passion for cupcakes.  But, they had no way to control an onslaught of competitors who could make different variations of the product.  All those competitors, whether isolated cupcake shops or cupcakes offered via kiosks or in other shops, meant Crumbs was in a very tough fight to maintain sales and make money.  It’s not you (and your passion) that controls your business destiny.  Nor is your customers.  Rather, it is your competition.

When there are lots of competitors, all capable of matching your product, and of offering countless variations of your product, then it is unlikely you can sustain revenues – or profits.  There are many industries where cutthroat competition means profits are fleeting, or downright elusive.  Airlines come to mind.  Magazines. And many retail segments.  It doesn’t matter how much passion you have, when there are too many competitors it’s a lousy business.

2 – Trends really do matter

Cupcakes were a hot product for a while.  And that’s great.  But it wasn’t hard to imagine that the trend would shift, and cupcakes would be displaced by something else.  Whatever profits you might have when you sit on a trend, those profits evaporate fast when the trend shifts and all competitors are fighting for sales in a declining market.

Remember Mrs. Field’s cookies?  In the 1980s an attractive cook and her investment banker husband built a business on soft, chewy, warm cookies sold in malls and retail streets across America.  It seemed nobody could get enough of those chocolate chip cookies.

But then, one day, we did.  We’d collectively had enough cookies, and we simply quit buying them.  Mrs. Fields (and other cookie brand) stores were rapidly replaced with pretzels and other foodstuffs.

Or look at Krispy Kreme donuts.  In the 1990s people went crazy for them, often lining up at stores waiting for the neon sign to come on saying “hot donuts”.  The company exploded into 400 stores as the stock flew like a kite.  But then, in a very short time, people had enough donuts.  There were a lot more donut shops than necessary, and Krispy Kreme went bankrupt.

So it wasn’t hard to predict that shifting food tastes would eventually put an end to cupcake sales growth.  Yet, Crumbs really didn’t prepare for trends to change.  Despite revenue and profit problems, the leadership did not admit that cupcake sales had peaked, the market was going to decline, competition would become even more intense and Crumbs would need to find another business if it was to survive.

Few trends move as fast as tastes in sweets.  But, trends do affect all businesses.  Once we bought cameras (and film,) but now we use phones – too bad for Kodak.  Once we used copiers, now we use email – too bad for Xerox.  Once we watched TV, now we download from Netflix or Amazon – too bad for NBC, ABC, CBS and Comcast. Once we went to stores, now we order on-line – too bad for Sears. Once we used PCs, now we use mobile devices – too bad for Microsoft.  These trends did not affect these companies as fast as shifting tastes affected Crumbs, but the importance of understanding trends and preparing for change is a constant part of leadership.

So Crumbs Bake Shop failure was one which could have been avoided.  Leadership needed to overcome its passion for cupcakes and taken a much larger look at customer needs to find alternative products.  It wasn’t hard to identify that some diversification was going to be necessary.  And that would have been much easier if they had put in place a system to track trends, observing (and admitting) that their “core” market was stalled and they needed to move into a new trend category.