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Not all problems are “fixable”: Investment lesson from one scandal

by | Jan 20, 2017

Many fund managers evaluate a stock when it gets hit by some “headline” issues like fraud, investigation etc. The crux of the research is to figure out whether the “headline problem” is repairable or not.

A few days ago, I came across this old [risky] situation.

Sweepstakes scandal

Simon Worldwide was a multi-national, full service promotional marketing company.

Simon Worldwide was in charge of McDonald’s promotional-prize contests (‘Monopoly’ and ‘Who Wants to be a Millionaire’). Simon Worldwide’s Security Officer [Jerome P. Jacobson] removed the expensive game pieces which were then passed to people he recruited through friends and family. They shared the prizes.  A total of $13 million worth of prizes were awarded fraudulently.

In 2001, the fraud which had deep roots since 1995 was uncovered by FBI.

Impact

The impact for the two companies that got hit by this scandal is different.

To sooth irate customers, McDonald’s announced cash price worth $10 million at randomly selected McDonald’s restaurants. McDonald could stomach the losses.

McDonald’s, which had outsourced all of its marketing work to Simon Worldwide, cancelled the 25-year contract. At that time, McDonald accounted for nearly 65% of its revenue. On the date of announcement, the stock (Simon Worldwide) fell 77%. Other customers also terminated their relationships with Simon Worldwide, resulting in the company no longer having a business. By April 2002, the company had effectively eliminated a majority of its ongoing promotions business operations and was in the process of disposing of its assets and settling its liabilities.

Key takeaways

a) “Significant” may not necessarily be monetary.

Frankly, the $13 million fraud is meagre for Simon Worldwide, which generated nearly $ 1 billion in sales in 1999. Even McDonald’s could easily stomach the loss. But that is not the whole picture. The fraud was deep – it ran for 7 years! Simon lost its trust, the biggest asset for a sweepstake managing company.

Jerome P. Jacobson was the only employee who had access to McDonald’s game piece, which was worth millions of dollars, which is a perfect example of poor lack of control.

Given the duration of the alleged conspiracy, the lack of any meaningful oversight and the magnitude of the losses, it was the only responsible course of action – McDonald’s public statement at the time of cancelling the contract.

b) Huge customer concentration + Lack of competitive advantage + Fraud = Disaster

In my first series on competitive advantage, I highlighted how switching cost (design win) could put off a customer of Silicon Laboratories to switch to some other service provider. But this is not the case with Simon Worldwide. McDonald’s decision to end its 25 year relationship with Simon Worldwide validates that Simon’s promotional marketing business does not enjoy any competitive advantage.

Fraud triggered McDonald’s decision to cancel the contract; lack of competitive advantage fastened the process; and huge customer concentration killed the company.

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