Bernie Madoff was arrested in 2008 for running what is believed to be the largest Ponzi scheme ever. Over a period of more than twenty years, Madoff had convinced wealthy, high profile private clients like Steven Spielberg and the Wilpon family (owners of the New York Mets) along with sophisticated commercial clients like MassMutual, Banco Santander, and HSBC to entrust their money to his firm. The reason these folks went along with the scam is not because Madoff delivered eye-popping results with a brilliant strategy. He was not like John Paulson, who famously made over four billion dollars personally in a period of less than twelve months by using credit default swaps to bet against the subprime mortgage lending market. Madoff drew high profile clients and sophisticated financial firms into his orbit by falsely projecting modest but consistent returns. Over a period of 174 months (just longer than fourteen years), Madoff reported results that were only modestly better than the return of the Standard and Poor’s index, but over that very long horizon, he only reported a monthly loss seven times. This extraordinary consistency led several financial forensics investigators to question Madoff’s legitimacy, but the allure of consistent, albeit modest, positive returns was a powerful magnet for investors. They all turned a blind eye to the fraud while funneling enormous sums of money to Bernie.
The lesson for the service contractor is not that fraud is a good road; Bernie is serving a 150-year sentence for his crimes and the related $17.5 billion in losses he cost his clients. The lesson for the service contractor is that predictable, steady growth over a long period of time is an irresistible attraction for sophisticated investors. One day you will want to have some outsider set a value for your business as part of an exit strategy or for the purpose of passing the business to a new generation. What management metrics will you use to guide your efforts during the many years leading up to that valuation day? How can you deliver steady, market-beating results that are not affected by the various dips and swings that you inevitably experience while serving your customers? The key is to find a strategy that minimizes volatility and maximizes consistency over a long period. You need to deliver for real what Bernie falsely projected in order to impress the investors that will ultimately value your business.
In an earlier blog post about Red Hat, I described the efforts that Red Hat undertook to avoid being labeled as a company that provided “break-fix” support for technical issues associated with Linux technology. The directors at Red Hat were savvy investors, and they understood that a volatile “break-fix” revenue model was far less valuable than a consistent subscription model. During my time with DunnWell, the service contracting company that preceded ServiceTrade, I witnessed firsthand the difficulty of delivering steady, predictable income performance when the mix of services leans too heavily towards a “break-fix” model. One particular management meeting stands out in my mind. It was a March meeting to review the February results, and the tension between the steady, predictable outcomes of maintenance work as compared to the more volatile “break-fix” type work became vividly clear.
February temperatures that year had been brutally cold throughout much of the country, and lots of sprinkler pipes had frozen at our customers’ locations, even in the southern states. The emergency revenue was very high for that February as we responded to so many frozen pipe situations. The maintenance and planned repair revenue, however, was somewhat lower than expected, but the total revenue exceeded our target by about fifteen percent based upon the strength of the emergency service calls. The gross margins were OK, but not what you would expect when you have much higher revenue to absorb the delivery costs. “Shouldn’t the margins be higher since we charge more for emergency work?” I naively asked. “Nope,” replied Sean McLaughlin, the head of operations. “We have to pay an arm and a leg to get people to respond to these emergency calls on a bitterly cold winter night. It is always a scramble. Costs are higher, and the administrative burden is also higher because you have to constantly field calls from the customers and then call them back with updates.” Looking at the numbers I guessed “So the maintenance revenue is lower because our people were focused on chasing down problems instead of staying on top of the planned work?” Sean snorted “That MIT education is paying real dividends for you right now, isn’t it?”
During a typical month, DunnWell would deliver between 92 – 96% of the planned maintenance, inspection, and repair work that was available under contract. We called this measurement the “due versus done” ratio. It represented the amount of work delivered and invoiced divided by the total amount which customers had authorized, either via a maintenance contract or an approved repair quote. To be strictly correct, it should have been called the “done versus due” ratio, but it was named before I got there, and “due versus done” had a better ring to it. That cold February, the “due versus done” ratio sagged downward to about 80%.
When the metric lagged, Joe Dunn, the largest shareholder in DunnWell, would remind everyone that “the customer has written a check and laid it on the counter, and we couldn’t be bothered to show up and cash it.” Put in those terms, it seems pretty silly to let anything get in the way of cashing a check, but it was surprising how often people with good intentions could become distracted by chaos and neglect to pick up those checks. The distractions typically take the form of some emergency, and in the case of this cold February month, the distraction was caused by frozen pipes and irate customers. But the February revenue was really good, and the overall margin was good, so what was the problem?
The problem is that not all margin dollars are equal. That sounds silly, but it is true. For this February period, DunnWell did not cash some checks for planned maintenance because we were busy cashing checks for emergency work. How do you suppose the customers that were due for planned maintenance felt when we did not show up as promised? How about the customers whose pipes burst? Do you suppose they were happy with the emergency response fees? And do you believe those emergency service dollars are going to show up consistently every February like contract maintenance dollars do? Nope. Emergency service calls by their very nature are unpredictable – the opposite of consistent results. So even though revenue was higher and overall margins were acceptable, that cold February was a failure. Just because the gross margin on every job is in an acceptable range does not mean that the business is performing in a way that maximizes value for the owners. The emergency “scramble” gets in the way of the Bernie Madoff lesson that teaches us that consistency is better.
So fraud is never a good road, but Bernie understood very well what investors want. You can take a lesson from his fraud and focus your business on minimizing the chaos and disruption of “break-fix” type services and instead attempt to maximize the revenue you receive from consistent revenue services like monitoring, inspections, planned maintenance, and planned retrofits and repairs. Next week, we will do a follow-on post to describe the metrics and give example management charts that you can use to be certain you are on the right road to maximizing the consistency of results to yield the highest value for your shareholders.
Read part 2: Consistent Results are Worth Billions, Part 2