Evolution, Not Revolution

The Daily Reckoning Presents: A Guest Essay in which the author ponders the impact of red contact lenses on the chicken farming business.

EVOLUTION, NOT REVOLUTION

After the market closes this afternoon, longtime DR whipping-boy Cisco Systems will report its fourth- quarter earnings. Analysts expect the company to earn .02 cents per share.

But what do analysts know? Not much, if they are the same analysts who did not foresee that JDS Uniphase would lose $500 million dollars and .30 cents a share when it last reported earnings.

Granted, seeing into the future is a murky business. We don’t profess to possess the ability ourselves. But Cisco has valiantly tried to make things easier. It has beaten analysts’ estimates with Cal Ripken-like consistency. Between 1998 and 2000, Cisco beat analysts’ expectations by exactly one penny, 14 consecutive times.

But don’t underestimate Cisco’s uncanny talent for “guiding” analysts to a reasonable facsimile of its current financial condition. Cisco’s 11-year streak of being in the black ended in May, when they announced they lost $2.69 billion in their third quarter.

Nonetheless, odds are it’ll come in at three cents later today, come deflation, depression, or outright balance sheet disembowelment.

I could be wrong. Maybe Cisco will take the write-offs that others in the tech sector have. If it did so, Cisco would be admitting to what has become embarrassingly true: many of the companies it has acquired for stock in the last two years are not worth the paper their shares are printed on. More likely is that Cisco, like an aging Hollywood beauty whose jowls have seen firmer days, will opt for one last vanity pose in front of the Wall Street paparazzi.

As ghastly as things could get, the company has much bigger problems than appearance. Take reality, for example. Tech firms are facing a time when it’s increasingly difficult to know where their core businesses are headed, how fast profit margins are shrinking, and what their investments in other companies are truly worth. Wall Street likes to call this a problem of “visibility.” It’s another way of saying you no longer understand what’s happening to demand for your products.

Perhaps what’s lacking, though, is a proper perspective. It’s not Wall Street’s vision that’s poor. It’s the Street’s understanding of the impact of technology on profits. If only Wall Street knew the story of the chickens with the red contact lenses, their foresight might be nearly as good as their hindsight.

From 1910 to 1943, the price of a dozen eggs in America hardly changed. Egg farmers’ costs remained constant. And as a result, so did profit margins. Margins weren’t good, either. Egg farming was pretty inefficient. It was considered the job of the farmer’s wife. And because chickens were left to roam the barnyard, they often got gobbled up by opportunistic dogs.

But from 1943 to 1986, an amazing thing happened. The real price of eggs, adjusted for inflation, fell almost 80%. This was at the same time that the production of eggs skyrocketed. Falling prices on higher volume. What was going on?

The answer is simple. Firms producing eggs saw that there were profits to be had in incremental technological improvements. Aptly-named Darwin Farms of San Francisco is the best example. Darwin Lewis was a teenager growing up on chicken farm in the 1930’s.

In his book, Bionomics, Michael Rothschild tells us the first incremental improvement in egg farming came when young Darwin realized moving the chickens into a shed would enable farmers to find more eggs. Up until then, farmers searched the farmyard for whatever they could find. What’s more, chicken mortality would go down because the shed would keep the chickens safe from dogs. And yields would go up yet again because more live chickens meant more eggs.

Thus began the commodification of the egg farming business. Each incremental improvement in the process led to falling production costs and higher egg production. The firm that accumulated incremental changes the fastest always earned a higher profit per dozen eggs than other firms. And as volumes went up, prices came down for the consumer.

Today, just one Darwin Farms chicken coop houses 280,000 hens. 160 rows of parallel cages stretch 700 feet.

Rothschild tells us “the rows are arranged in pairs stacked ten high, and each bank of 20 rows is separated from its neighboring banks by narrow aisles. Running along the floor, down the center of each aisle, is a single rail, and atop each rail sits a rather bizarre looking contraption – a feed-dispensing robot.”

The most stunning improvement? Red contact lenses – for the chickens. You see, one of the leading causes of chicken mortality in farms is violence. All hatchlings at modern chicken farms are debeaked with a hot metal blade. It keeps violent hens from literally pecking other hens to death.

But chickens, like Baltimoreans, still kill one another in confined spaces. Each dead chicken is a profit lost. And it’s also a cost to remove and replace.

It had been known for years that red light made chickens more docile. They spend less time fighting and clucking and more time laying eggs. But installing red tints in plant lighting wasn’t feasible. Human beings can’t see in red light well enough to function. And when red goggles were attached to the chickens, they ended up getting caught in cage wire and strangling the chickens.

But in 1987, a Boston firm named Animallens, Inc developed a red contact lens for chickens. Rothschild reports that “…by using the red contact lenses to reduce feed consumption and stop pecking battles, Darwin had found a way to slash costs by about 4 cents per dozen eggs.” This was enough profit for Darwin to actually buy back his farm from the bank, which had repossessed it earlier.

As Rothschild points out, cost savings rarely lead to a permanent profit advantage. In economics, it’s known as the Fallacy of Composition. You think that because you do one thing differently, it will translate into a permanently high plateau of profitability over and above your competitors. But it doesn’t work that way.

Your innovation is imitated and the cost savings accrue to other businesses as well. Gradually, the advantage disappears. What results for the consumer is an endless cycle of falling prices…in fact, most products become commodified over time.

And thus we arrive at the great challenge for today’s technology companies who wish to survive a sea-change in their business. Will they understand that long-term business success does not result from having a dominant physical advantage? Change in technology is rapid. And physical advantages, no matter how dominant they seem at the time, are fleeting.

The real truth of the entire New Economy experiment is that new technology alone does not create permanent profits. At least, not in any way that investors can take advantage of over a period of time. Profitable businesses are built by steadily accumulating small reductions in product costs over time. Businesses evolve.

It’s a rare company that can prevent itself from commodified extinction…even if they do beat analysts projections by a penny.

Dan Denning,
August 7, 2001

The Daily Reckoning

Daniel Denning is the editor of the Daily Reckoning Investment Advisory. For investment advice consistent with the ideas in this essay, please subscribe to the Daily Reckoning Blue Service.

*** Today’s the big day…the world will officially learn that the productivity miracle – the aegis of the American economy – was a “sick joke.” And that the chimera of a new era was nothing more than…well, fraud.

*** You’ll recall that Dresdner Kleinwort Wasserstein Global Equity Strategist Albert Edwards wrote a note to his clients on Friday warning them that today, “The U.S. ‘new paradigm’ will then be officially revised away!”

*** Edwards went on to suggest, “the risks of an equity crash are high.”

*** Longtime DR readers will, of course, be puzzled by the hullabaloo made out of this story. Aren’t these Dresdner guys a little late to the table?

*** The “news” of the demise of the American miracle economy has long been hammering away at the market. Bill, your humbly vacationing editor, penned a dirge for the New Era on May 5th, 2000 – over 15 months ago. And whatever information is included in the Bureau of Much Belabored Statistics report has likely been digested by a plethora of Wall Street insiders…

*** Our prediction: the “news” will be a dud. Heck, we might even see a little boost in the markets today.

*** Today too, all eyes are on Cisco…after beating estimates “by a penny” 14 times in a row, Cisco Systems will report 2nd quarter earnings…will they too lay a big fat egg? See Dan Denning’s comments in a guest essay below. But first, let’s see what’s shakin’ on the Street:

*****

Eric Fry reports from New York:

– In the absence of any real news yesterday, several negative stories from Barron’s over the weekend set the tone for the day’s trading.

– Notable casualties of the Barron’s onslaught included GE, Intel and one lesser-known company called PolyMedica. “Federal investigators are closing in on PolyMedica, the country’s largest provider of diabetes home-testing kits,” reports Cheryl Strauss Einhorn. “A federal Grand Jury is looking into possible Medicare and investor fraud at the Woburn, Massachusetts-based firm…” The stock fell 32% on Monday.

– Concerning General Electric, Barron’s writes, “America will be awash in electric power soon. Bad news for electric utility stocks – and for GE.” The stock headed south from the opening bell – dragging the Dow down with it – and finished more than 3% lower by closing bell.

– Lastly, Alan Abelson poked fun at Intel President Craig Barrett’s pronouncement that the worst is over for the personal computer industry. (Thorough Daily Reckoning readers will recall that we too, poked fun at Barrett a couple weeks ago).

– Abelson, citing the work of Fred Hickey, writes, “…[A]top a 20% decline in June, PC sales were down 25%, year-to-year, in the first week of July, 47% in the second week of July and 38% in the third week…[T]he trend is not exactly heartening and, as a matter of fact, such gosh-darn awful numbers have never been seen before.”

– Intel shares slid almost 4 1/2% on Monday, and many other semiconductor company stocks suffered even larger losses. By the time the dust had settled, the Dow had fallen more than 111 points to 10,401 and the NASDAQ had dropped 32 points to 2,034.

– Every once in a while, a few female strippers (always fully clothed) hang out down on Wall Street handing out invitations to “gentlemen’s clubs.” There are whores on Wall Street as well, but they wear suits and ties (except on Fridays) and vacation in the Hamptons.

– In fact, on Wall Street, the basic job description – sell self, get money – doesn’t change much.

– Financial whoring is nothing new, of course. It is perhaps the second oldest profession. But it has gotten a lot of attention recently under the nomenclature: “conflicts of interest.” A wide range of abuse is now coming to light…the most egregious of which, as we pointed out last week, was the habit of some Wall Street analysts to buy certain stocks for their own account before issuing “buy” recommendations.

– A far more prevalent practice has been the tendency of many sell-side analysts to issue and maintain buy recommendations – no matter what – on the companies who have hired their firm’s investment bankers.

– Consider Prudential Securities analyst Nicholas Heymann. We have absolutely no doubt that he is an honest and upstanding individual. However, according to Crain’s, Mr. Heymann “keeps a sailboat at the dock of one General Electric Corp. executive and his Jet Ski at the house of another. There, he spends July Fourth at a barbecue swarming with GE execs, many of whom he invites to an annual bash back at his house in Vermont. The party also includes some of his clients, who just happen to be investors in GE stock. No wonder that down on Wall Street, the highly-ranked stock picker for Prudential Securities Inc. is considered Mr. GE.”

– Crain’s writes: “The fact is that for people following Mr. Heymann’s investment advice, his legendary closeness to his flagship company has come at a troubling cost: an unswerving predilection for positivism. In the nearly two decades that Mr. Heymann has followed GE – through expansions and recessions alike – he has only once seen fit to downgrade GE from a ‘buy,’ a decision he rescinded less than 72 hours later.”

*****

Back to Addison in Paris…

*** Okay…so we’re not the only ones who think the BLS unemployment numbers smell funny. Challenger, Gray and Christmas, a consulting firm, released a private study that found US businesses cut 206,000 in July – the highest one-month hatchet job since the firm began keeping track in 1993. So how come the BLS reports no rise in unemployment? Well, if you add back in 155,000 uncountable jobs created – the so-called ‘bias’ factor – voila! Only 50,000 people hit the dole last month. Not a noticeable amount; no need to worry.

*** What else…”If you’re like the overwhelming majority of boomers,” writes Daniel Okrent in Time magazine, “your career has hit a brick wall, you haven’t saved enough, your pension is underfunded, your health is deteriorating, even the medical advances that will probably extend your life will, in an especially cruel paradox, mean that later life will be meaner and more Spartan.”

*** “I loathe my generation,” writes Joe Queenan, age 50, “we became culturally frozen in time at a very early age and continue to think of ourselves as trailblazers. It’s completely pathetic.”

*** According to The NYTimes, Okrent and Queenan are purveyors of a new fad among boomers – “literary self- loathing”.

*** Let me get this straight. On top of saddling the nation with a mountain of debt, fulminating of the most excessive stock market bubble in history and abusing the world with the Bee Gees, we have to spend the next 20 years listening to boomers whine – and call it an art form?!

Yikes…next they’ll want something crazy, like legislation guaranteeing we’ll pay for their retirement years.