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Horatio Gulash: Analyzing Advertising Expense

June 11, 2012 | About:
John Emerson

John Emerson

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Our last episode concluded with Horatio pondering various methods of growing his hot dog business. As you may recall, he still owes Pop a considerable amount of money which he must pay off within the next three years; thus far he has paid back approximately 40% of the debt.

Horatio has owned the hot dog stand and the lease on the parking lot for slightly over two years and still has nearly three years remaining on his lease. At that point he might be forced to move the stand from its prime location.

Horatio feels now is the time to expand but he must make certain that he does not over extended his limited finances. His moves must be frugal, strategic and above all, successful. He recalls the advice of his deceased father who once told him: "Hunters with a single-shot gun should not fire hastily but they can not spend much time aiming, or they will never get off a shot". Horatio feels he has only one bullet in the chamber so he must move abruptly while at the same time being extremely careful with his limited funds.

Horatio feels that Pop is a tremendous asset to his business. The customers who drop by the stand frequently carry on conversations with the elderly man as they dine. His thick German accent and his self-styled patois are entertaining. The old man is really quite amusing, possessing an innate ability to draw patrons to his stand.

While Pop talks Horatio listens and monitors the reactions of his customers. He notices that children as well as adults take to the old man. Pop is famous for carrying a sack of bubble gum which he hands out to children admonishing them: "dun't chew da gum til you eat da frankfurter."

It occurs to Horatio he is not selling hot dogs; rather he is selling a unique frankfurter which is not available from anyone else. The key ingredient of the frank is the special sauce that Pop has perfected. The sauce mixes particularly well with sauerkraut but is just as appearing without the kraut. The smell of kraut permeates the stand and provides it with a certain presence that reinforces the name "Old World Franks." Pop's thick German accent adds to the ambiance and the uniqueness of the stand.

Horatio concludes that he must create an atmosphere to enhance the delicious taste of the frank. He also decides that Pop must be part of that atmosphere if he is to succeed. He needs the image of the old man as well as his financial backing; otherwise his business will never amount to anything more that a temporarily successful, single hot dog stand.

Horatio plans on coaxing Pop out of retirement and offering him an inviting proposition. He offers him a full partnership in the business. In return, Pop must forgive the remaining loan which Horatio owes on the business, provide some modest additional working capital as needed and serve as the advertising face of the business. In essence, Pop is a walking billboard for Old World Franks. He provides an unmistakable image for the business which continually reinforces the brand.

Advertising and Old World Franks

Pop's image will become instrumental in promoting the new stands and growing "Old World Franks." He will visit the new stands regularly, greeting customers, passing out gum to the children, and telling stories about his immigration to the U.S. from Germany and the origin of the special sauce.

Old World Franks stands will become fixtures in every serious home show or special event in St. Louis which offers food, and Pop will always make appearances as long as his health allows. The business will have carts outside the famous zoo during summer weekends, as well as outside the Ram football games. Eventually, the franks will make their way into the concession stands in the stadiums of every major St. Louis sporting event.

Pop is dressed in traditional Bavarian attire, complete with suspenders and various decorated hats. When he arrives, the stand plays recordings of polka music as he welcomes the crowd, offering them small samples of his special frankfurters dipped in the delicious sauce. He asks the crowd, "Vould ya like a taste of de old vorld frankfurter? Its de secret sauce on de Bavarian frankfurter dat makes da difference. Come taste de German Frankfurter."

Later on when the business comes more successful and can afford more expensive advertising, Pop will be promoted as Papa Joseph Greiser, "Der Veiner Meister" on television. His thick accent and unique appearance will become the focus of the advertising campaign. A caricature of his face will appear on the shirts of employees and on the signs of all the Old World Franks restaurants. Der Viener Meister will become a highly recognizable character in the St. Louis area and gradually throughout the rest of the country as well.

Papa Joseph has but one rule in his restaurants, no employee will ever utter the word hot dog since he sells only "Bavarian frankfurters."

Advertising: The Key Ratio for Old World Franks

Despite his limited business experience Horatio was quite astute at recognizing the need for brand-building at Old World Franks. His decision to sacrifice 50% of his profits to utilize Pop's image and access his capital turned out to be a stroke of genius in the long term.

As it turns out the parking lot owner did not extend Horatio's lease after five years. It seems that he began to feel that Old World Franks was becoming too much of threat to the profits of his own restaurant and he attempted to run Horatio out of business. Similar to Sam Walton, Horatio never forgot that lesson. He never again undertook a short-term lease and he always insisted on having an option to extend the lease when he negotiated a property. Additionally, he made it a point to put an Old World Franks restaurant in close proximity to all of his former landlord’s burger restaurants. Call it a bit of vindictiveness if you like.

Horatio decides that he will invest 10 percent of revenues into advertising expense. The advertising will help secure new customers for his existing stores and new stores in addition to maintaining his long time clientele by reminding them how much they enjoy his unique frankfurter.

To assess the effectiveness of his advertising, Horatio charts same store sales at all his stands and restaurants and monitors the total amount of hot dogs sold. In that way he able to test the pricing power and the growth in sales of hot dogs. He is pleased to find out that he can raise prices to offset his rising costs while still increasing the total volume of hot dogs he sells at his stands and restaurants.

His gross profit (Revenues minus Cost of Goods Sold) is rising, as is his gross margin (Gross Profit divided by Revenues). Those figures indicate that his business is developing not only a successful brand but a competitive advantage in the form of the delightful taste of his frankfurter. He has verified that the original location of his stand close to Busch Stadium was only part of the competitive advantage of his business. Old World Franks apparently contains some advantages that are quite sustainable, thus reinvesting capital for growth is an intelligent decision.

Horatio also tracks his advertising costs as a percentage of sales; much to his delight he finds that his advertising cost as a percentage of sales is decreasing. He derives that figure by dividing his advertising costs into his revenues. His advertising has been quite successful; each dollar he invests is resulting in an increasing greater amount of total revenues. The diminishing ratio speaks volumes for the effectiveness of his ad campaign.

Using Advertising Ratios in Analyzing Stocks: PETS

Just as in the case of Horatio's fictitious business, investors need to monitor advertising effectiveness to successfully analyze equities. Careful analysis of key advertising ratios can provide investors with information that may indicate that competition is impinging on a company's profits. Most companies provide clues in their 10K filings.

Let’s take a quick look at PetMed Express (PETS) as an example. From the Fiscal 2012 10K:





Fiscal Year Ended March 31,








2012






2011






2010




Sales


100.0


%


100.0


%


100.0


%


Cost of sales


66.3


63.8


61.4


Gross profit


33.7


36.2


38.6


Operating expenses:


General and administrative


9.4


9.6


9.4


Advertising


12.8


11.8


11.6


Depreciation


0.6


0.6


0.6


Total operating expenses


22.8


22.0


21.6


Income from operations


10.9


14.2


17.0


Total other income


0.2


0.2


0.1


Income before provision for income taxes


11.1


14.4


17.1


Provision for income taxes


4.1


5.4


6.2


Net income


7.0


%


9.0


%


10.9


%


The above key ratio summary contains some troubling trends. First of all, gross margin and net margin are dropping; secondly, advertising as a percentage of sales is increasing. For the purpose of today's discussion we will focus on advertising.

The table suggests that either the advertising campaign for PETS is becoming less effective or that competition is intruding upon the competitive advantage of the business. Since gross margins are dropping significantly it seems that increased competition may be the source of the overall margin decline.

If we scroll down the 10-K we find some more troubling news:

Sales may be adversely affected in fiscal 2013 due to increased competition and consumers giving more consideration to price and trading down to less expensive brands, including generics. In response to these trends, the company will maintain a more aggressive advertising and pricing strategy combined with expanding our product offerings to pet supplies and generics.

This more aggressive pricing strategy has resulted in a decrease to gross profit margins, and no guarantees can be made that the Company’s efforts will be successful, or that sales will grow in the future. The majority of our product sales are affected by the seasons, due to the seasonality of mainly heartworm, and flea and tick medications. For the quarters ended June 30, September 30, December 31, and March 31 of fiscal 2012, the company’s sales were approximately 31%, 24%, 21%, and 24%, respectively.

In effect, the company is telling us in fiscal 2013, advertising costs will continue to increase and gross margins will continue to drop. That may translate into another significant increase in advertising expense as a percentage of sales.

Further down in the 10-K we find more interesting information:

Advertising expenses increased by approximately $3.0 million, or 11.0%, to approximately $30.4 million for the year ended March 31, 2012, from approximately $27.4 million for the year ended March 31, 2011. The increase in advertising expenses for fiscal 2012 can be mainly attributed to a more aggressive advertising strategy during the year. The advertising costs of acquiring a new customer, defined as total advertising costs divided by new customers acquired, was $42 for both the fiscal years ended March 31, 2012 and 2011.

Advertising cost of acquiring a new customer can be impacted by the advertising environment, the effectiveness of our advertising creative, increased advertising spending, and price competition. Historically, the advertising environment fluctuates due to supply and demand. A more favorable advertising environment may positively impact future new order sales, whereas a less favorable advertising environment may negatively impact future new order sales.

Note that advertising cost for acquiring a new customer was $42 for both fiscal years 2011 and 2012. What was the cost in prior years? The fiscal 2010 10K reveals the answer:

The advertising costs of acquiring a new customer, defined as total advertising costs divided by new customers acquired, was $34 for the year ended March 31, 2010, compared to $36 for the year ended March 31, 2009.

In other words, the effectiveness of the company in generating new customers through advertising has diminished significantly in the last two years. Since advertising is the key expense in generating new sales for PETS, the increase in acquisition costs does not bode well for future operating margins — particularly when those increased advertising costs are coupled with declining gross margins.

Fortunately for Horatio, his business is experiencing exactly the opposite scenario as PETS. His ad costs as a percentage of sales are declining, while his gross margin is increasing.

In the next episode Horatio expands the business outside the St. Louis area.

Disclosure: No position in PETS



About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.7/5 (6 votes)

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