Sunday, January 26, 2014

It Was My Party, And I'll Deny Its Demise If I Want To

You are in the cocktail party business. In this business you throw parties every Friday and Saturday night. There are two characteristics of this business that would have probably surprised those who originated the "industry" 150+ years ago: it is highly profitable and tends to have a natural monopoly aspect. These are self-reinforcing phenomena. Upstart competing party suppliers face strong headwinds namely because the first mover advantage is high--who wants to risk going to the new party if most of the desirable partygoers still attend the incumbent party. Further, being at the right party is everything. It is a who's who of the local scene. Being there exposes one to all the good gossip, but more importantly it is a status-establishing and trust-creating event. Business partnerships and marriages come out of the encounters the gatherings foster.

It is also not cheap to enter this business or do it well. Startup costs include building a facility large enough and entertaining enough to sustain the business, which means accommodating nearly all tastes. Running the business means straddling a delicate balance between indulgence and moderation. Know thy customer is paramount as what will fly at a San Francisco party might be verboten at a Bible Belt party.

The on-going costs are steep as well: music, drink, food, performers, etc. require scale operations done efficiently. Here good supply-chain management has strong rewards.

Thankfully the locals tend to be fairly loyal and almost defensive about their party supplier. When travelling to other cities, people tend to long for the hometown party and feel out of place navigating their way through another town's party.

The typical revenue model holds across the industry. To wit, there is a membership fee that is low on a per-party basis but is high in absolute terms because there are so many parties in a given year (~150 when the special holiday parties are considered). Added to that are the many locals from businesses to individuals who actually pay to have special privileges at the party. These range from reserving/sponsoring rooms some of which are invitation only to being the bartender in a choice corner which grants exposure to desirable partygoers to having a charismatic escort introduce them to interesting attendees and even to having people paid to spread whatever news the sponsor wants spread.

As one can imagine, this is a complex business with a deep and wide book of both accounts payable and accounts receivable. Although it is highly profitable, what actually drives the profits is poorly understood. The salespeople believe that nearly every patronage deal makes not just a profit but a high profit at that. Likewise, the regular staff including performers, waitresses, bartenders, et al. believe the membership fee covers almost all of the revenue the business brings in--this is a false belief as it is nearly the reverse that is true. Additionally, the regular staff is virtually in the dark about how profitable the business actually is suspecting it is only moderately profitable. But although it is highly profitable, nearly all of the profit is driven by just one business line--room sponsorship. What's more these sponsorships are more "bought" than "sold"; in other words there is little the sales staff can do to drive this business, but this truth is poorly understood. Sponsors tend to be large, national companies. If sponsors are interested, they buy across many markets--hopefully yours is included.

Now, the naive interpretation, that this means many business lines can be cut so as to grow the bottom line, is patently false. The party is a bundled good. As such there are many loss leaders when looked at on an individual basis. But these all tend to contribute to being in the business of cocktail parties. It ain't a party unless A, B, C, . . . X, Y, and Z are there. Even if only Z is truly profitable. So if you properly build "it" (a thriving cocktail party), profitable factor Z will come. The rest is necessary but insufficient (for business-sustaining profitability).

Everything is going great until one day someone introduces the world to commercial websites on the Internet. Most importantly businesses who currently are buying room sponsorships now have a new, much lower cost alternative--rooms not just sponsored by a firm but owned and maintained by that firm and open all the time. At the same time individuals are realizing they can have cocktail parties at their homes as well as afternoon parties in the park and get togethers in a large variety of venues that include only their select friends or associates and cater specifically to their tastes and desires. These parties are as small and limited as the industrial cocktail parties were big and open.

Suddenly the cocktail party industry is subject to competitive threats like never before. The business is eroding quickly. Because it was misunderstood, the business's adaptation is clumsy. Efforts to shrink run into threshold problems--you can only get so small until you are no longer truly in the cocktail party business. Efforts to break up into small, nimble units (small parties for select partygoers) falter because efficiencies from economies of scale are lost. Everything the business was good at is now working against adaptation. No one element of the cocktail party was the best in class. It was the whole party itself that was great--value of the whole exceeded the sum of the parts. But that synergy is now gone.

Questions like "Who will supply parties?" are misguided distractions. People will always find ways to get their party on. They don't need the cocktail party industry to do it for them. At least not anymore.

This is my analogy for the newspaper industry. Specifically, cocktail parties are newspapers; memberships are subscriptions; the entertainment and refreshments are journalism; patronage deals are advertising; the Internet is, well, the Internet. In six years as an internal financial analyst learning the business inside and out, top to bottom, I think this analogy best encapsulates the dynamics at work. One thing I learned from my own efforts was that four relatively distinct business units exhausted all the sources of profit--employment ads, national-firm ads, preprint insert ads, and color newsprint or run-of-press (ROP) ads. There was no amount of "feet on the street" that was going to drive this business. My understanding of the business's sources of profit was overwhelmingly met with dismissal. I understand why. It was an awkward thing to hear--that most of the things you as a business are doing are just means to an end. And generating and sustaining a profitable business is a complex process filled with nuance.

The things you do as a business are not necessarily the business you are in. For decades most of McDonald's profits have not been from selling hamburgers, et al. per se. They have been from the real estate fees from franchisees. Newspapers were no more in the profitably selling content business as they were in the putting ink on paper business. It was simply a necessary but insufficient (for business-sustaining profitability) part of the process. I am not saying they didn't do content well. They definitely did. They also were very efficient in running press and delivery operations and great at relationship management with businesses seeking advertising. But ultimately they were cornering the market on an invented commodity--access to eyeballs. The newspaper bundle was a great medium for a very long time with strong competitive advantages. And the culture of the industry was rightfully resistant to change--don't rock the high-profit boat. But add this to the list of advantages that became hindrances.

Journalism (more broadly defined than the very important people would like) will go on. Advertising will go on. Newsprint in some fashions will go on. But the newspaper industry is on the back nine of a decade-or-so-long process of ceasing to exist for all practical purposes.

Denying that the party is over doesn't change the fact that the guests have gone home.