Decoding A Company'S Dna: by Mohnish Pabrai Published On The Realmoney Section of

Decoding a Company’s DNA
by Mohnish Pabrai
Published on the RealMoney section of TheStreet.com on November 15, 2002
Editor’s Note: We’re pleased to introduce our newest contributor, Mohnish Pabrai,
who is the managing partner of Pabrai Investment Funds, an Illinois-based value-
centric group of investment funds. We hope you enjoy the column; as always, let us
know what you think.
The DNA structure of a business usually gets set in stone during the first 90 days
of its life, and trying to reprogram this genetic code after a few years is
excruciatingly difficult. The DNA structure dictates the way in which a company
will respond to various business challenges over time.
From an investment perspective, a lot of useful information can be gained from

decoding this genetic blueprint and understanding what transpired during the
very early stage of a given business. If you’re able to decode, you can
extrapolate business performance far into the future.
Let’s start with a study of Lucent. It used to be called Bell Labs, the research-
and-development division of AT&T. Before 1984, AT&T was a regulated
monopoly with a cost-plus pricing model. Regulators allowed AT&T to earn a
reasonable return on invested capital. The more the capital invested, the higher
the return. Thus, incentives to spend a lot of money and build a “gold-plated”
network infrastructure were in place. Thus, it ended up with a telephone
network with insanely high redundancy and fault tolerance. Price was never a
priority.
Lucent was where this bulletproof telecom gear was designed and built. With
the onset of deregulation and the spinoff of Lucent, a big change occurred. Now
Lucent needed to compete. AT&T wouldn’t necessarily be buying Lucent gear,
but choosing the best solutions from various vendors.
You can’t reprogram the bureaucratic R&D arm of a lethargic, regulated

monopoly to suddenly become as nimble and competitive as Cisco or Qualcomm.
It violates fundamental laws of genetics. What transpired at Lucent since its
spinoff was totally predictable. Had investors studied its DNA, they wouldn’t have
taken the stock from $20 to $60 in the late ‘90s. More important, they wouldn’t
have ridden it down to $1 today.
Page 1 of 1
All Washed Up
Let’s examine the changes in Procter & Gamble’s DNA structure. This 175-year-
old company consistently produced high-quality products and overlaid them with
stellar brand-building to dominate its markets. Even as the product superiority
gap inevitably shrunk, the company’s branding power kept a steady revenue
stream flowing, even from 56-year-old products like Tide detergent.
In contrast, Wal-Mart’s DNA structure can be summarized by Sam Walton’s

phrase, “Stack it high ‘n let it fly!” The company sells Tide more efficiently than
anyone else on the planet. P&G’s brand power makes folks yearn for Tide and
Wal-Mart’s price leadership leads them to its door.
As Wal-Mart has scaled to more than $200 Billion in revenue, it found that it had
the volume to clone Tide and sell it as a store brand. Compelled by the price
difference, shoppers decided to try the store brand, and they began to abandon
Tide in droves. When they encountered Wal-Mart’s store brand for paper towels,
dishwashing detergent, etc., they now started switching - rapidly.
What just happened to P&G is cataclysmic. Its advertising generates store traffic
for Wal-Mart, but consumers end up switching to store brands, which have zero
advertising budgets. It’s clear who’ll win this uneven battle. P&G’s business
model now looks a lot different, and its genetic blueprint is completely
unequipped to handle the shift.
In general, as the mass-merchants scale their store brands, the consumer

packaged-goods companies will have a harder time competing. There’s nothing
P&G can do, and unfortunately, investment returns for P&G shareholders will be
very lackluster over the coming decades.
Programmed for Success
To further illustrate the predictive powers of DNA decoding, consider the

situation with Oracle, Sun Micro and Microsoft. Oracle and Sun had the right idea
about the big markets that open systems and relational databases would
eventually represent. Both companies scaled rapidly as they took off. In parallel,
Microsoft set its sights on dominating desktop operating systems and low-end
relational databases like Access and SQL Server.
Page 2 of 2
Over the years, with rapid advances in computing from Intel , Microsoft’s
Windows has evolved to be very competitive from a price/performance with
Sun’s servers and workstations. Sun only wins out in an increasingly small
market for very high-end systems. Similarly Oracle cannot match SQL Server
price/performance for all but the most demanding applications. Over time, both
companies will be forced to chase smaller and smaller high-end markets as the
volume driven “Wintel” combo continues to drive them out of their core markets.
Oracle and Sun are fundamentally incapable of competing with Wintel. Wintel’s
hyper-efficient sales model and amortization of R&D expenses over massive
volumes makes it impossible to match. Oracle and Sun, with their multibillion-
dollar market caps, can never compete head-to-head with Microsoft and make
money – yet that’s exactly what the future dictates. A negative annualized rate
of return is pretty much a given.
Microsoft, on the other hand, has a very unusual genetic structure. It isn’t an
innovator, but a cloner – and an aggressive one at that. Windows was lifted from
Apple, Word from WordPerfect, Excel from Lotus, Explorer from Netscape/Mosaic
and Xbox from PlayStation.
But even as a lowly cloner, Microsoft isn’t very good. It took MSN eight versions
to finally become better than AOL and Microsoft Money still lags Quicken.
Anytime Microsoft has tried to be innovative, it has failed. Any business that
succeeds – despite poor cloning attempts and innovation failures – simply has
terrific genes.
Spend some time figuring out the genetic blueprint of a given business before
making an investment. If it has great genes and you can buy it well below
intrinsic value, back up the truck. Otherwise just keep on driving.
_____________________________________________
Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value
centric group of investment funds. At time of publication, Pabrai held no positions in any
securities mentioned in this column, although holdings can change at any time. Under no
circumstances does the information in this column represent a recommendation to buy or sell
stocks. He appreciates your feedback at mpabrai@realmoney.com. You can access his Web site
at www.pabraifunds.com.
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Decoding a Company’s DNA

Published on the RealMoney section of TheStreet.com on November 15, 2002

From an investment perspective, a lot of useful information can be gained from

You can’t reprogram the bureaucratic R&D arm of a lethargic, regulated

In contrast, Wal-Mart’s DNA structure can be summarized by Sam Walton’s

In general, as the mass-merchants scale their store brands, the consumer

Programmed for Success

To further illustrate the predictive powers of DNA decoding, consider the

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