Strategy Today

After Fiorina left HP, what’s next?

2005-06-06T19:40:00.000-04:00

For almost two decades, the printer business of Hewlett-Packard has sailed along on a river of ink-cartridge profits, dominating rivals with a market share of more than 50%. The $24 billion-a-year division accounted for 76% of HP’s $4.2 billion in earnings for fiscal 2004. It has remained blissfully detached from the problems at HP’s computer units, created by the high profile, $19 billion acquisition of Compaq in 2002. But with overall growth in printer demand slowing and margins tightening in the face of an assault from Dell and others, HP has realized there is no room for complacence. After a recent reorganization that merged Imaging and Printing Group and Personal Systems Group to form the HP Imaging and Personal System Group, chief Vyomesh Joshi, who has been executive vice president of the imaging and printing unit for past three years, is planning a knee-deep “transformation” to ensure HP’s dominance in printing and imaging. Joshi is to refocus on the biggest opportunities while lowering costs to maintain profit and margins amid falling printer prices. The plan will involve 10% or more head count reduction and streamlining the cluttered portfolio of businesses in the division.
Hewlett-Packard was reinvented by Carleton S Fiorina via her “big-is-better” strategy since she took the helm in 1999. HP has doubled its sales in the past five years and become a competitor in an unrivaled number of markets, from $100 digital cameras to billion-dollar tech-services deals. Yet in too many of the businesses, HP is losing stream. Except for the printing division, the crown jewel, the rest of HP is an underachiever. Investors are not impressed, they want a far simpler solution: break the company up. Fiorina insisted that HP needs the broadest reach possible to capitalize on her vision of technology’s future and believed that spinning off printer business would destroy shareholder value. However, when shareholders are asked, they have different opinions about the spin-off. "I would like them to spin off the printer business," says Kenneth A. Smith, senior portfolio manager at Munder Capital Management, which owns about 2.9 million HP shares. After the ouster of Fiorina in February 2005, observers say HP could be edging closer to spinning off its cash-cow printer business from the rest of the sprawling company. The shares of HP surged $1.40, or 7 percent, after Fiorina’s announcement. Although HP declined this idea, investors believe that Fiorina’s departure makes such a move more likely. But they were disappointed again when the new CEO Mark Hurd said at a press conference on March 30 that it is too early to consider spinning off HP’s printer business.
HP says that combining the groups internally will foster greater efficiency and help the company to bring products out more quickly. The synergies between the two groups are believed to help HP drive its consumer electronic effort. This is supported by some HP’s customers who like to have access to PCs, printers, servers, storage and networking devices all from one company. "Our commitment has increased. We've purchased a full server infrastructure through HP, and desktops, they should not spin off any part of the business" said Paul Cullen, Macquarie Textiles IT manager. Others think that the cash flow of printer business put HP in a much better shape than those that have to rely on the computer business for cash flow. One of the oddities of modern business is that companies often seem to feel compelled to spin off their best performing businesses on the idea that in selling it out, they can get a better return on the standalone business than when it's saddled with other businesses that are dragging it down. That's why AT&T spun off AT&T Wireless a few years back, despite how obvious it was that having a wireless component was going to be a necessity in the future.
We believe that the key question here is what is the benefit and cost of synergy. To some extent economies of scale exist between the printer and PC businesses due to the similarity in the manufacturing process. A single sales force can sell bundled products to end customer and brings economies of scope. But will these two business lines reinforce each other? Will any consumer buy a HP PC because he prefers a HP printer, or vice versa? Not necessarily in a commoditized market where cost often plays bigger role. First, in the PC business, the direct-sale, build-to-order model is crucial for HP to compete with Dell. At the same time HP has to keep thousands of traditional retailers and resellers, who help HP sell its printers and ink, happy. These two systems often operate at odds with each other and operating in both worlds leaves HP doubly exposed. HP failed to match Dell’s scale and efficiency in the direct system. As a result, HP PC slipped to No. 2 with 15.7% share, behind Dell and operating margins in 2004 were a meager 0.9%, miles behind Dell’s 8.8% margins. A break-up would help resolve this dilemma, freeing the computer division to adopt the Dell approach. Second, most of printer business’ profit comes from selling high-margin consumable – ink cartridges and installed base is the key in this business. The printer business could expand its market and partner with HP’s computing rivals, including IBM and Dell – once it was unhitched from the computer company. Analyst Steven Milunovich of Merrill Lynch & Co. estimated that the total value of HP’s businesses could increase by 25% to 45% if it were split into printing and nonprinting operations. Lastly, HP’s push for synergies has gotten in the way, say insiders. To pull off a big sales deal at HP these days often requires delicate diplomacy. Putting together a package involving servers, printers, and software, a sales rep has to hammer out an agreement with each division. If one unit is concerned about financial targets and unwilling to bend its price, the whole deal can fall through. The company lacks an effective process to resolve conflict and motivate cooperation.
With all above, is it the right time to spin off the printer now? We don’t think so. It is hard to see how a separate HP PC business would be any stronger or more profitable on its own. HP should work on getting the computer business profitable without spinning of the printing operation. This would mean that HP must get its own business settled down. There has been enough wrenching of the culture at HP/Compaq that time still needs to be taken for a new cultural equilibrium to congeal. Furthermore, the market is still unsettled and unclear so it may not be the best time to spin-off. They should maybe explore and experiment with its current configuration along the lines of a 3M “make a little, sell a little” model, rather than lurching around in search of a radically different structure, or seeking to imitate IBM or Dell too closely.

Evrim Erdem
Kathy Liao
George Maurice

…With IPod Woes, Will Apple Rot?

2005-06-04T22:23:00.000-04:00

Being an early adopter of the iPod, I can speak first-hand about Apple’s digital audio player. The iPod can be used to travel, in vehicles, and also as a backup to store pictures and other files. Apple got many things right, most notably the user interface. The UI is easy to learn, simple, and has fairly robust implementation. The Mini’s design is ideal for running and exercising. Apple has sold more than 15 million since late 2001. Although the iPod is a good product, it’s nowhere near perfect.

The most prominent issue is the batteries. The constant charging/discharging of an iPod eventually leads to poorer battery longevity and eventually failure. The batteries were not designed to be replaceable. Initially, Apple told consumers they would have to buy new iPods. In November 2003, Apple began offering a battery replacement service for $99. Class action lawsuits were filed in December, 2003. A proposed settlement, valued at $100 million, will apply to as many as 2 million iPods sold before May 2004. Apple had agreed to replace some iPods and give other consumers up to $50 in cash or credit on Apple purchases. The non-removable battery is a major flaw. If batteries fail, consumers weigh the hassle and cost of replacing the battery versus buying a new generation MP3 player.

Another issue is multiple computers and multiple iPods. What if you want to move music from one computer to another? Once CDs are recorded onto a hard drive it’s very cumbersome to transfer iTunes files to another computer. Third party products that facilitate the process have been blocked by updated versions of iTunes and iPod software. Users can’t copy from the iPod to a computer for Apple’s fear of copyright issues. Apple is not allowing customers to do things with the music that they have fair use rights to. This will eventually hurt Apple in the long-term.

The ultimate problem with iPods is that Apple appears to be executing an isolated strategy, which will erode market share when competitors release new generation products. They have not established any logical licensing agreements. If you want a hardware device to be standard, the software has to be in play. Apple probably realizes that the iPod isn’t unique beyond its design and thus can’t be protected as a standard. Apple has great innovations, but has no idea how to give them long-term legs. This weakness will become more apparent as firms begin releasing comparable products.

Apple is behaving just like they did with the Macintosh. Initial product and iterations are consumer friendly and enticing. Price hasn’t decreased, performance hasn’t increased, quality issues remain, users’ demands haven’t been met, the system has been kept closed and unlicensed and eventually Apple will be left with little market share and just a small, loyal following.

Competitors will soon be selling hard drive-based portable devices. Will any of them have the right combination of usability, style, and compact size to lure consumers away from the iPod? Apple has had a free ride because making a great music player is no secret. Vendors attempting to emulate the iPod say the best choices in 1.8-inch hard drives are from Toshiba (Apple’s orginal supplier) and Hitachi. To gain leverage in negotiating hard drive prices, some iPod competitors will size their cases to fit both. The difference is only a few tenths of an inch in each direction, but this could add up to a 20% increase in volume. Some manufacturers use 2.5-inch hard drives, making the players up to twice as big as the iPod. As hard drive MP3 player prices move down toward $200, the desirability of flash memory players may decrease, too. If you could get 350 hours of music for $200, would you pay $125 for 2 hours (128MB) of music?

Analysts have dismissed most of the issues related to the iPod. IPods now account for nearly one-third of Apple’s revenue, generating $1.01 billion in sales in the quarter ending Mar. 31. Piper Jaffray has maintained an “outperform” rating and $52 target price on Apple Computer, expecting the fiscal third quarter to outperform the second. The research firm raised the fiscal 2005 and 2006 EPS estimates on Apple to $1.32 and $1.48, respectively, from $1.27 and $1.38, citing indications of a strong launch for OS X Tiger.

Analysts believe in Apple’s stock performance in the long-run because Apple is a survivor. Even as its personal computer business lost market share, the company found a way to be relevant as a niche player. Even though its computer business is booming again thanks to iPod users migrating back to the Mac platform, that’s not the primary catalyst for faith in Apple. Apple is a company that personifies innovation. MP3 players and computers are commodities, for the most part, yet Apple has been able to make its products distinctive. While that also implies that Apple sometimes rests on its laurels when things are going well, it’s still an amazing company that will likely find future niches that are worth differentiating.

Jua Mitchell

The Reinvention of the Infomercial

2005-06-03T18:46:00.000-04:00

The “long-form” format of commercials otherwise known as infomercials has been plagued by a past reputation of cheap production and a mass peddling of junk products. The key word is past; now infomercials are creating a medium for mass appeal products that could give commodity products a decisive competitive advantage in an increasingly crowded market.

In the past infomercials were seen as a way to peddle junk products that were traditionally marked up ten times or more over their direct price. Most of the products were not available in retail outlets and were housed in warehouses ready to ship. The number of infomercials that were pulled by the FCC and/or charged with deceptive advertising was many. Many of the infomercials were aired late at night to prey upon unsuspecting insomniacs. The primary products advertised were fitness and diet, health and beauty, home convenience appliances and get rich quick schemes.

There are now a number of successes from the infomercial sector. The George Foreman Grill has earned $1 billion in sales; ironically good infomercials also drive traditional in-store sales because the retail revenue from the hit infomercial by Foreman was many times higher than actual infomercial sales. Ron Popeil has sold $1billion worth of Ronco rotisserie ovens. Endorsements for Proactiv acne products ($2.1 billion is sales) from such mega-stars as Jessica Simpson, Alicia Keys, and Sean (P. Diddy) Combs have encouraged us to do a double-take. Infomercials are well-suited for introducing new products, high-ticket items and complex products within the specified time format by varying between entertainment, information, and a hard pitch that includes multiple calls to action and purchase incentives. Interactive television technologies such as digital cable, satellite TV, TIVO, and video-on-demand are creating new infomercial sales opportunities.

The products that have been successful as mentioned have mass market appeal and solve a common denominator problem. The products must seem like a bargain. Quick, easy, greed, new, fun, and vanity must be reiterated many times over to appeal to the masses. Only one in sixty infomercials turns a profit. The products traditionally have been easy to demonstrate and all have been pitched as a story to tell. Approximately thirty percent of viewers will buy anything from the TV. However as aforementioned good infomercials boost brand awareness and motivate shoppers to seek products in retail stores. In light of this it seems appropriate to build a two-channel sales strategy.

Fortune 1000 companies are seriously integrating infomercials into their brand differentiation strategy. Apple Computer, Braun, Nissan Motors, and AOL Time Warner have started using the infomercial medium to combine rigorous product development, exhaustive consumer targeting, and daily scrutiny of advertising rates to create pitches that can be altered to maximize sales. Joined with the opportunity to boost margins by selling directly to consumer infomercials can be a powerful tool to create brand recognition and translate it into sales. Land Rover and Disney are creating their own infomercials. The brand recognition power comes from viewer recall which can be three times higher than for traditional 30-second spot commercials. Approximately ninety two percent of consumers have heard of the Nautilus Bowflex home fitness system (featured in infomercials), about the same number of people that recognize the Nike brand.

Experienced infomercial producers have begun to take a “soup to nuts” approach when marketing its marketers by changing product packages, collecting customers’ cash and purchase data and building customer loyalty. Warren Direct, the direct marketing firm for the SCOOTER Store, identified the target market, repositioned the product and designed complementary messages that created synergies which reinforced the SCOOTER Store brand name. Warren Direct also asserts that there are 14 steps to infomercial success including “The Art of The Sale”, “The Art of Delivering the Brand Relationship”, and The Science of Analytics.

Many industries could leverage the power of infomercials to give them a strategic advantage in the ever increasingly competitive commodity markets. Automobile manufacturers such as Nissan and Land Rover have already begun implementing infomercials into their brand awareness strategy. The automobile is essentially a commodity which has an increasing number of new manufacturing entrants. To distinguish themselves automobile manufacturers such as Ford Motor Company spend roughly $30 billion for commercials per year. At the same time audiences are scattering as television fragments into hundreds of cable channels and the Web, video-games, DVDs, MP3 players, and satellite radio compete for consumer attention. The infomercial segment could allow this same company to target its products directly at consumers. Jac Nasser former CEO of Ford Motor Company actually envisioned the two-source strategy during his tenor at the automaker; Nasser felt automobiles should be made to order and available through e-commerce (website) and through traditional automobile dealerships. Recall that effective infomercials use a two-source strategy that requires products to be available for purchase directly through infomercial and retail outlets. Product differentiation could be further realized through the infomercials and reach consumers on a more cost effective basis than what would have been otherwise possible.

Infomercials are just beginning to be realized as a powerful medium for building strong brand recognition, cost effective advertising, and product development strategy. We believe this type of medium should not be overlooked in increasingly competitive commodity markets where company’s struggle to differentiate themselves.

Submitted by:

Sachin Kelkar
Riahna Phillips
Bryant Houston

An Invasion of American Capitalism or of American Socialism?

2005-06-02T19:04:00.000-04:00

Malcolm Glazer, the billionaire-owner of the NFL’s Tampa Bay Buccaneers, recently completed his 2-year quest to gain control over the world’s most valuable sports franchise, Manchester United, a publicly-traded firm. On the surface, one could easily group this purchase with the many recent acquisitions by US-based private equity shops of European firms. In classic LBO style, the acquisition will be considerably funded by debt, the firm will become private at the completion of the transaction, and the new owner will try to realize significant operational synergies. However, the uniqueness of the situation is clearly demonstrated by the reaction not only of the team’s vast legion of fans, but also by the British government.

Oftentimes, when LBO’s occur, employees of the target firm vigorously protest the transaction, fearing the loss of their jobs if the transaction were to go through. Typically, the new equity owner wants to ensure good labor relations, but they can also go out and find replacement workers if the workers are becoming too problematic. Manchester United’s potential problem is not in alienating its employees (i.e. the players don’t really care who the team owner is as long as they’re collecting their $100K per week), but rather with alienating what is arguably their most valuable asset, an extremely loyal fan base.

We believe the recent uproar of Manchester United’s fans over their beloved club being taken over by an American capitalist is not only highly ironic, but likely short-lived. Man U, unlike virtually all American sports franchises, is a publicly-traded entity that is directly responsible for delivering returns to its shareholders. Man U has delivered tremendous on-field performance since the early 1990s. This was initially largely driven by the club’s ability to develop great local players (i.e. David Beckham, Paul Scholes, Ryan Giggs, etc…) via its youth system, but its biggest stars today (i.e. Ruud Van Nistlerooy, Wayne Rooney, Christiano Ronaldo) have arrived via purchase from other clubs. If Man U fans believe their team’s on-field success today comes from the superior ability to train local boys, they are simply mistaken.

According to analysis presented in The Business of Sports: Text and Cases on Strategy and Management, there was an extremely strong correlation between payroll and on-field performance from 1999-2003 in the English Premier League, Man U’s domestic soccer league. This correlation greatly exceeded the correlation in any of the major US sports leagues, suggesting that Man U was ‘buying performance’ more than any other major sports team, including the NY Yankees. The capital need to purchase this success did not come from some benevolent team owner, as one might describe Chelsea’s owner Roman Abramovich, but rather from the merchandise marketing machine that is Man U. We would suggest that before a Man U fan starts protesting, he should notice the huge corporate logo on the front of his replica jersey and ask himself whether he’d rather have on-field success or a logo-free jersey. We believe that virtually all fans would choose on-field success and that as long as Glazer delivers on-field performance, the current uproar will rapidly subside.

Ironically enough, we believe that Malcolm Glazer potentially biggest value-add to British soccer is not his experience as an American capitalist, but his experience in the socialist world of American professional sports. Compared to the EPL, the major sports leagues in the U.S. have actively worked to ensure competitive balance between teams. Nowhere are these efforts more prominent than in the most financially successful of leagues and the one where Malcolm Glazer has deep experience, the NFL. We believe the NFL’s financial success is a direct result of its ability to ensure competitive balance via mechanisms like a salary cap, particularly one that all teams can afford with revenue sharing in place, and a reverse-order collegiate draft.

Should Glazer try to introduce similar collectivist features to the EPL? While modeling the EPL on the NFL would like greatly enhance total revenue and profits of EPL-teams, we believe that Man U’s financial performance could decline significantly as it wouldn’t be able to internalize most of the value of these changes (however, we note that these changes might be more economically rational for Man U to push for in the Champions League competition or in a future European ‘Super-League’). In the short run, we believe Man U should try to deliver the best on-field EPL performance and squeeze as much incremental operating profit as possible out of opportunities like marketing pushes into the US and China, selling off home stadium naming rights, raising ticket prices and negotiating an independent TV deal. This will allow Glazer to de-lever the firm. However, Glazer must ensure that in the long-run, fans don’t abandon Man U and the EPL because they are bored by the same team winning every year. If any hint of that alienation begins to occur, Glazer could push for more redistribution of the wealth within the EPL so that poorer clubs can become more competitive and indirectly benefit Man U.

In reality, we would expect Man U’s fans to remain interested as long as at least one viable domestic competitor exists. That is certainly the current case given the strong squads of Chelsea and Arsenal. If all three of these entities were rationally-driven, profit-maximizing entities, they would likely try to implicitly collude to limit investments in new players. Unfortunately for Man U, Chelsea’s owner currently appears to be committed to winning, independent of the economic ramifications of his actions. Glazer may succeed in talking Abramovich out of this philosophy, but assuming he can’t, should Man U try to play an arms war with Chelsea or resign itself to aiming for 2nd place in the EPL? We believe that they can’t profitably play the arms game with Chelsea in the long-run. In fact, their best action would likely be to try re-positioning as a lovable underdog. This re-positioning would likely prove quite difficult, so Malcolm Glazer better hope that either he can talk some economic sense into Roman or that Roman finds a new hobby (possibly in a jail cell courtesy of Vladimir Putin) if Glazer’s investment in Man U is to provide a handsome return.

-Vlad Bystricky, Tim Ligue, Justin Segool

Morgan Stanley: Hunted or Hunter

2005-06-02T19:03:00.001-04:00

During the past month, the roles of the game seem to have been reversed for the Wall Street powerhouse Morgan Stanley. Well regarded as a dealmaker, the focus is on Morgan Stanley again, but this time the storied firm is in the uncomfortable and unimaginable position of acquisition target. The apparent cause of this change in fortune lies in internal disagreements, related to the company’s management performance, between its Chief Executive Officer Philip Purcell and old-line Morgan Stanley investment bankers. The firm’s turmoil has encouraged outsiders to bet on the likelihood of spin-offs or even a complete sale of the firm, in which players such as Bank of America and HSBC Holdings top the buyer’s list. If the rumors turn into reality, this will have been the first attempt of merger with another investment bank since Credit Suisse First Boston’s disastrous $13 billion deal with Donaldson, Lufkin & Jenrette Inc. in 2000.

Cultural clash or merely a conspiracy? The eight former executives waging the campaign against Mr. Purcell are veteran bankers from the firm before its merge with the retail brokerage house Dean Witter. They are claiming weak performances by businesses in the latter division drag down the performance of the whole company. They are also accusing Mr. Purcell – a former McKinsey & Co. consultant credited with making Dean Witter into a consumer powerhouse – of favoring executives from his old firm. Indeed, the recent nomination of two co-presidents (Stephen Crawford and Zoe Cruz) triggered the departure of several bankers (including the “rainmaker” Joseph Perella) feeding a growing culture clash between the white-shoe Wall Street firm and the retail division, including its Discover card unit.

HSBC: The White Knight? Lately, London-based HSBC Holdings plc. has been making a push in the global merger and acquisition advisory business, but it is still far away from the top position in the famous (or infamous) league tables, especially in the US market. Measured by market value, HSBC is the largest banking company in the UK and second largest in the world. In addition to commercial banking services, the firm provides asset management, leasing services and, primarily through HSBC Investment Bank, investment banking services.

During the last few weeks, rumors intensified that HSBC was weighing a possible $75 billion bid for Morgan Stanley. However, sources say the British bank would not make such an aggressive move, and would consider an offer only with the full agreement and support of the US bank’s board.

Morgan Stanley under fire. Amid efforts to quell the firm’s turmoil, the US investment bank announced its intention to spin off its Discover credit card unit (a business built by Purcell). As the seventh largest issuer of general-purpose credit cards in the United States, Discover would be an attractive target in the credit card industry. In addition, its spin off would pre-empt calls by shareholders to break up the company, while making the remainder of the firm less appealing as a takeover target. However, the strategy seems more of an attempt of the firm’s CEO to remain in power than addition to shareholder value. Indeed, one could argue that the investment bank will decrease market value for the following reasons:

Through divestiture of its Dean Witter retail brokerage or Discover credit card businesses, Morgan Stanley would lose the benefit of having diversified businesses that keep its revenue stable through downturns;

Divestitures would likely unleash ratings downgrades from important rating agencies such as S&P and Moody’s. In this regard, Standard & Poor’s analyst Tom Foley said, “We would consider downgrading Morgan Stanley if they were to spin off one of their divisions”.

The firm could be too small to be able to compete against its rivals who are all expanding instead of shrinking. Examples are Lehman Brother’s acquisition of asset management Neuberger Berman, Merrill Lynch’s decision to keep its own asset management division, and Bank of America and JP Morgan’s huge mergers.

On the other hand, one could argue that by divesting, Morgan Stanley could return to its roots: a pure investment bank focusing all its efforts in revenue growth and profitability margins.

Is Morgan Stanley worthy? Absolutely. Under all conditions, the US investment bank would foster HSBC’s ambitions in the US market. With a market value of $177.8 billion, HSBC could easily swallow Morgan Stanley whole, and finally consolidate a top position in investment banking. Despite prior history of investment banking acquisitions resulting in a massive departure of talent, firms like Morgan Stanley could absorb such large-scale departures by rapidly replacing old talent with new stars.

Considering solely the Discover credit card unit spin-off, which the market prices at around $14 billion, HSBC could be considered a strong buyer, due to its expansion strategy in US market. This strategy is evident in the firm’s $14.2 billion acquisition of Household International, a major provider of consumer finance and a top 10 issuer of credit cards in the United States.

Finally, Morgan Stanley’s current situation could not be better from an acquirer’s perspective: it is the worst performing stock among the five largest independent securities companies (shares were down 27% in the past four years, plunging 50% since its peak in September 2000) and the series of internal conflicts make the venerable investment bank not only a vulnerable prey but also attractive at a discounted price.

Marcelo Hanan
Gabrielle Lambert
Valentin Pitarque

Eight Men Out….Take Your Balls and Go Home!

2005-06-02T19:03:00.000-04:00

Recently, eight former directors of Morgan Stanley staged an attempt to overthrow current CEO Phil Purcell and insert themselves, along with several recently departed senior executives, in leadership positions. The plan was simple: leverage their one percent equity stake in Morgan Stanley and exploit their prestige as retired and/ or recently fired Morgan Stanley directors to promote their idea of how Morgan Stanley should be run.

No one can deny that Morgan Stanley under Phil Purcell has lately stumbled on hard times. In the past year, Morgan Stanley stock price has lagged behind its financial competition, numerous top level executives have exited the firm, and it has faced two highly-publicized lawsuits. One of those lawsuits ended with a jury awarding Ron Perelman $1.4 billion in damages for Morgan Stanley’s perceived mismanaging of the sale of Mr. Perelman’s Coleman Company.

Soon after the Group of Eight made their case public, Morgan Stanley announced a plan to spin off its Discover Card unit, a move that was seen as a reversal of strategy for Mr. Purcell. Purcell had always toted Discover as part of Morgan Stanley’s strategy to remain diversified and help smooth earnings when the market took a downturn. Most critics and analysts viewed the spin-off of Discover as a strategy chosen by the Board of Directors’ and/or Mr. Purcell’s attempt to throw the group of eight a bone, hopefully ending their public attacks.

Despite recent difficulties, Morgan Stanley still sits atop the vaunted league tables in most of the major investment banking categories: M&A, Debt underwriting, and Equities. Morgan Stanley recently jumped 16 spots from number 25 to number 9 in a recent Fortune Magazine poll asking MBA grads to rank their most desirable employer. Morgan Stanley placed ahead of Lehman Brothers, Bear Sterns and Merrill Lynch, trailing only Goldman Sachs amongst investment banks.

If the group of eight were serious about effectively reforming their former firm, they should have brushed up on their history first. Teddy Roosevelt once said ‘walk softly and carry a big stick’. The group of eight, with their one percent equity stake, instead decided to run like a bull in a china stop and wear a bell around their neck. The group of eight could have used their Wall Street connections to obtain some institutional backing and maybe even set a goal for a double digit equity stake in favor of ousting Phil Purcell. Everyone thought Michael Eisner was in trouble at Disney in the early 2000’s due to a struggling stock price and poor growth, but it was not until some of the big institutional players like CalPers got involved that the Disney board decided to act.

In terms of strategy, the group of eight would have been much better off not going directly for the throat of Mr. Purcell. In taking such harsh actions, they left Mr. Purcell no choice but to staunchly defend himself. The group of eight also placed current employees and shareholders in a sticky situation, having to choose between the current CEO and the former directors. Their approach backfired, and although they were able to drum up plenty of media attention, they never really acquired enough shareholders’ or board of directors’ votes, the items that mattered most.

The silver lining of this Wall Street soap opera is that it has brought attention to the fact that Morgan Stanley stock has been lagging and that Mr. Purcell does need to come up with some answers or seriously consider handing over the reins to someone else. More importantly, it brings attention to the importance of an independent board of directors and the significant roll the board should play in corporate America. Morgan Stanley’s board, largely consisting of Purcell’s ex-McKinsey buddies, certainly does not fit the ideal of a truly independent board. Morgan Stanley shareholders cannot blindly assume that the board is acting in their best interest, but instead must actively consider not re-electing some of the existing directors at re-election time.

We feel that one of the problems with the group of eight is that they still are upset about the 1997 merger between the two financial behemoths Dean Witter Discover and Morgan Stanley. The often overlooked fact is that Dean Witter Discover bought Morgan Stanley and eventually dropped the Dean Witter name in favor of the Morgan Stanley name. It is no secret that the executives at the white shoe Morgan Stanley never liked the idea of being taken over by the gym shoes of Dean Witter. However, that takeover is the past and they must focus their attention on Purcell’s current strategic vision and the opportunities and challenges facing Morgan Stanley going forward.

In conclusion, the group of eight is like the kid who had the basketball at the park and would let others use it only as long as he was playing. Well, as in every playground around the world, the kid with the ball ends up getting beaten up, and like most kids with the ball he does not like it, so he clearly states for everyone in the park to hear, “if I can’t play I’m going to take my ball and go home.” Our advice to the kid and the group of eight are you got beat fair and square and now its time to take your ball and go home or sit down, shut-up, and watch to see how the game unfolds. Maybe you will play in the next game (particularly if you can get some big institutional investors on your side), maybe you won’t, but you had your chance, you lost…so deal with it and deal with it privately.

-Vlad Bystricky, Tim Ligue, Justin Segool

India to the Rescue?

2005-06-01T21:07:00.000-04:00

Is it possible for the two largest automakers, Ford Motor and General Motors, to maintain its market strength within the automotive industry via the previously ignored India market? The two are currently facing financial and competitive challenges around the globe which are depressing recent earnings and sales, and one of their strategies is to put the full court press on the rapidly growing India market. You can be sure that there are plenty of doubters of their strategies, as evidenced with the recent downgrade of their debt by Moody’s and S&P to below investment grade status…and from what we can tell there is good reason for worry if either Ford or GM are counting on the Indian market to contribute significantly to profits anytime soon.

To date, Ford and GM have been unable to keep up with their competitors in the Asian markets (both have a measly 3% market share even though they have been in the market for more than seven years) which is led by Maruti (50%), Tata-Motors (16%) and Hyundai (15%). The infamous SUV and light truck vehicles that have led the US automakers to large market share and profits in the US do not apply in India and both have struggled to come up with viable solutions. Up until recently both companies have relied on the same old pricey mid-sized cars they sold elsewhere, gambling that middle-class incomes would rise and the consumers would be in the market for larger cars. Unfortunately for them, they were only half right. Incomes did rise, but consumers didn’t upgrade nearly as fast as expected. Just as importantly, the ones that did upgrade, upgraded to newer Asian models with more style and better technology. A quote from a Ford representative says it best: “We saw a car like the Escort as being at the heart of the Indian market. If you took a standard emerging-market template, it seemed like a logical conclusion…what we found was is that in India, unlike in some of the other emerging markets, the segment shift happened much more gradually”. They missed, plain and simple. A new strategy was needed.

The new strategy was not to abandon India. India is the third largest growing market in the world – and the third-biggest market in Asia in terms of unit sales after China and Japan. Over the last 18 months, India’s economy grew at a 6-8% clip. According to the International Organisation of Motor Vehicle Manufacturers, OCIA, India’s car production in 2004 grew 30%, while the next closest economy, Brazil grew at only 17%. The new strategy was to go to market with products that the customers were demanding. In order to crack the India market GM and Ford would need to come to market with more affordable cars tailored to local tastes and needs (re: cheap and small). And that is exactly what Ford did with its introduction of the Ikon. It promoted the car as having enough head room for a turban and only costing 450,000 rupees (only 50,000 rupees more than most mini cars). This led to an uptick in sales, leading them to expand the line to more than six models covering the entire mid-size car range. Last year alone they sold 40,000 Ikon, compared to 2,300 Escorts in 1999.

Problem solved right? Wrong, they only have 3% market share and the market is competitive as ever. Automotive market analysts in India say that “Ford and GM could have been market leaders if they had introduced their latest models, priced competitively, five or seven years ago, however, now they are just behind the ball as the market has become a lot more competitive”. With competition comes falling prices, combine that with a regulation change that lowered excise duty taxes (which increase competition) and now we have even tighter margins and fewer opportunities for profit.

So the conclusion seems obvious, there is no way that India is going to save GM or Ford anytime soon. So why haven’t Ford and GM given up? Because neither Ford nor GM are in this market for its short-run potential. The Indian market currently only represents about $6 billion in revenue. If Ford had 100% market share it would only increase its total revenue by 3.5%. So, while winning 20% of the market would be a huge success, it wouldn’t even dent their top line growth. The bottom-line then, this is a long-term play…according to a source at Toyota "Toyota believes that India will be one of the biggest markets in the world in this century”. That’s right folks, this CENTURY. By the time it does happen, Ford and GM want to be established players not late entrants (as they are already perceived) in order to take advantage when the market does move to larger more profitable cars that are right in these US manufacturers wheel house. Any money spent by Ford or GM in this space should be chalked up to R&D.

Baruah McGrath and Shelly

How to Save a Sinking Ship

2005-05-30T20:56:00.000-04:00

Long suffering Time Warner may finally be pulling itself up from market whipping boy and pre-market bust joke back to a stable firm. Ever since the “visionaries” of the mega-merger between AOL and Time Warner, Steve Case and Jerry Levin, raised their hands in victory and promised to build the most valuable company in the world, Dick Parsons, the current CEO of Time Warner, has led the company from being known as the “worst merger in business history” back to a prominent player in the cable and media industry. Since then, Parsons has accomplished most all of what he promised when coming into the company as Chairman and CEO in 2002- he has reduced corporate debt by half, stabilized America Online, settled two federal investigations, and is now set to take control of Adelphia’s cable assets. Due to all of Parson’s success, Time Warner has been reaping the fruits of success, posting a profit of $3.3 billion on revenues of $42 billion… but will the company be achieve similar success long term while winning back the hearts and minds of a skeptical market?

Before jumping into the analysis of Parson and team’s strategies for long-term success, a quick walk through the company’s operating units would be valuable at this juncture. The following data was provided by Standard & Poors. AOL, the global leader in online services, had about 31.6 million subscribers worldwide, while the Film entertainment business unit, mainly Warner Bros., consists of both film and television properties. According to Deutsche Bank equity analysts, the AOL business unit, together with the film unit, was both bright spots in Q1 of this year. Another large business unit of Time Warner, the Cable segment, is the second largest U.S. cable operator, serving about 10.9 million subscribers. It offers high speed data and other interactive digital services. Analysts were also encouraged by the cable business unit’s solid results, meeting their estimates. Although Time Warner has additional business units within its control, these are the three primary foci for future growth of Time Warner.

Although equity analysts are coming around on the short term prospects of the stock, investors still seem confused. As stated in the article in Fortune Magazine titled, “Will Wall Street Ever Trust Time Warner,” the author believes that growth investors like the prospects of cable and AOL, but find the publishing and broadcasting businesses a major drag- and would rather put their money in pure plays such as Comcast and Yahoo. Value investors, on the other hand, are averse to the risks in the cable and online properties. Finally, investors who believe in the value of content would put their money in Disney even though Time Warner owns some of the most valuable entertainment and media properties.

Based on the Fortune article references above, Parsons understands that the past failures to capitalize on synergies and complementarities between the diversified business units (the core of the value proposal from the AOL and Time Warner merger) is the key source of confusion with investors which has caused the company to trade at the same value as over a year ago and nine times 2005 earnings (below other diversified media companies). At the same time, though, we believe that Parsons has the correct strategies in mind to drive strong earnings from all business units with the backup plan to spin off those business units that under perform, which should begin to re-build investor confidence.

At the business unit level, he and his management team have refocused the underperforming business units into more profitable units. For example, in the AOL business line, while subscriptions continue to drop over time, Parsons and team have taken a page out of the Yahoo business model and plan to release a free portal with content and other value added features with the sole purpose of capturing a larger piece of the online advertising market. Analysts have taken this as a very favorable strategy, and this is one of the key points driving the bullish outlook of the company. With the same desire to strengthen the cable business line, Parsons also made a strong investment by purchasing the cable lines from Adelphia’s cable properties, providing Time Warner’s networks with access to approximately three million cable viewers. The deal also calls for the company to create a separate cable stock that would have its own equity, although Time Warner would still have controlling interest. This is a very positive move for Time Warner since it will allow them to make moves in the cable and wireless area without further confusing shareholders and market investors. Both of these moves to strengthen two of their core business units, if successful, should allow Parsons to begin to capitalize on synergies and complementaries between the business units.

A primary step before doing this, however, is for Parsons to focus his energies to truly break down the fiefdoms between the various business units, a key factor in driving synergies between the business units. The architects of the original AOL and Time Warner deal had the correct idea in mind, but they clearly did not consider the internal culture clash that was to come that would torpedo the success of the deal. However, thanks to Parsons, the focus from the top down is to focus on Human Resources to promote information sharing and harmony between the units.

If Parsons is truly successful in building the AOL and cable businesses into consistently profitable business lines while building strong lines of communication between all business lines within the enterprise, only then will the company begin to capitalize on the synergies and complementarities that they have only been able to speak about in the past without any tangible success. If Time Warner is successful, the company will own a suite of complementary products and services that will saturate the market producing significant barriers to entry to other diversified media companies. This is a tantalizing vision for the business units, the management team and shareholders alike. On the flip side, the backup plan to spin off the AOL and cable units depending on success or failure of these initiatives will provide some solace and clarity to investors that AOL’s chairman and CEO still has the shareholder’s best interest in mind. Based on Parson’s success to-date turning around one of the biggest corporate disasters in history, even the most risk averse investor should think twice when deciding on whether or not to pass on investing in Time Warner and its chairman.

-- Bryant Houston, Sachin Kelkar, Riahna Phillips

Collusion Behind the Ivy Walls? Harvard, Wharton, and the Business School Rankings

2005-05-27T19:24:00.001-04:00

Business School rankings are a source of pride for students and alumni, a guide for applicants and corporate recruiters, and cash cows for the publications producing them. On the surface, rankings are a win-win situation for all participants, but two of the “industry” leaders, Harvard Business School and University of Pennsylvania’s Wharton School, don’t appear to agree.

Over the past year, Harvard and Wharton have taken steps that some in the business school community perceive as taking a stand against the proliferation of business school rankings. A year ago, both schools took the unprecedented step of refusing to provide journalists with access to the graduating class of 2004 and alumni. More recently, both schools refused to provide the Financial Times with statistical data involving their executive education programs, making it very difficult for the publication to rank the schools.

Are these actions intended to send a signal to such publications about business schools’ participation in other, more comprehensive rankings? In the past, the business school ranking issues have been top sellers for the major business and financial publications. These publications have everything to gain by conducting the rankings, but it is arguable as to whether these rankings provide actual service and value to readers. Most of the rankings are written by journalists who don’t have intimate “knowledge” of a business school’s program, relying instead on subjective opinions and data provided by the very schools they are ranking.

In the game of business education versus ranking publications, Harvard and Wharton are suppliers. By limiting the publications’ access to information, Harvard and Wharton are increasing the price of producing a legitimate ranking by forcing publications to compile the information they need through alternate channels. Rather than being supplied with this information “pro bono” from the schools, as was done in the past, publications will have to spend more resources contacting students and alumni on their own. Publications who are considering starting their own rankings may think twice, now that two of the more highly regarded institutions in the world have increased the input costs.

Or, could Harvard and Wharton’s actions be simply indicative of perceived slights by the publications? The jilted publications (Business Week and the Financial Times) cite hypocrisy on the part of the business schools, claiming that they should be held to the same transparency as public companies. Prior to the decisions made by Harvard and Wharton, neither school finished in the top two spots of the 2002 Business Week rankings, and finished out of the top ten in student satisfaction.

Whether Harvard and Wharton’s defections are merely finger-shaking at the double-standard cited by the publications or a premeditated effort to collude in order to shift the market so that business schools have more supplier power isn’t clear. In either case, though, other top-tier business schools may be incentivized to no longer cooperate with publications, collectively falling to an un-spoken “focal point.” This focal point would create an “elitist” group of business school programs with increased supplier power.
Should other top schools take this route, the responsibility falls on the members of this new group to develop a more organic marketing strategy for presenting their program to the public and sustaining their brand differentiation. Alternatively, should other top-tier schools remain in the ranking game, they may now have more power to negotiate with the publications, insisting upon a different approach to the ranking.

Elite schools having power over publications would be a first for the rankings industry. Currently, publications exert buyer power by establishing a structure for the rankings wherein much of the weight is derived from peer reviews - surveys that are filled out by the deans of other schools measuring various programs, concentrations, and specialties for each school (25% of the U.S. News rankings are based on peer review.) This forces schools to compete against one another in a “tit-for-tat” environment, where schools literally market themselves to one another by mail, often just days in advance of peer reviews. This creates a second game, where the publications are forcing business schools to compete against one another in tit-for-tat fashion.

These days, schools have plenty of reasons not to play this game. For example, in 1991, a top-tier business school only had to respond to two surveys. Today a full time employee at this same school spends approximately three-quarters of their time filling out surveys submitted by the publications for rankings and information guides. Harvard and Wharton argue that this has been an incredible time sink, pulling away valuable resources from more lucrative endeavors. Additionally, top-tier business schools already have considerable brand equity. The economic value added by participating in the rankings is highly suspect considering the opportunity cost of completing the surveys. Even after all this effort, schools are not guaranteed good “shelf space” in the rankings.

So what is the true value of these rankings? First, there are certain barriers to entry in the business school and education. Schools with low brand equity, new programs, and even new programs at established schools need the rankings to spread the word about their program and measure incremental successes in recruiting and placement. Second, even top schools’ “line extension” programs – executive education, part-time programs, and non-degree professional programs – can benefit from the recognition of the rankings. Finally, education and brand equity alone may not be enough to differentiate top schools from one another. Arguably, the strength of a school is in its network. Denying publications access to alumni and students diminishes the legitimacy of relevant information about the network power of a school. This can be incredibly damaging as schools increasingly promote its alumni network as a key differentiating characteristic.

To gain a better understanding of why some in the business school community are concerned with the rankings, one should ask who is compiling this data and doing the initial analysis. Is it seasoned industry professionals, or is the bulk of the information being compiled by journalists who are short in the tooth and lack the perspective or experience to understand what attributes truly differentiate one school from another and what is just marketing blather. Publication staff compiling the data may not know enough about a particular program to rank its merit, and may base judgments on biased actions or qualities.

We think Harvard and Wharton seek to change the way the ranking game is played. When two of the top programs are dropped from a ranking, the new ranking results can be deemed artificial and may lose relevance. This new game has a potential for new rules, where schools stop competing on rankings, and start competing on the quality of the education and culture.

By: Edward Connolly, Deborah Battat, and T.K. MacKay

This Ain’t Cola (the DVD rental wars)

2005-05-27T19:24:00.000-04:00

Following its Deal with Wal-Mart, Netflix Hopes to Set the Rules for the Online DVD Rental

Last week Wal-Mart, the juggernaut of the retailing world, announced that it was conceding defeat and giving up its DVD rental business. Well known for dominating every market segment in which it operates, Wal-Mart seems to have been pummeled into submission and has agreed to transfer its DVD rental business to its upstart competitor, Netflix. In the deal announced last week, Wal-Mart’s subscribers will be referred to Netflix’s web site and offered to continue their membership with Netflix, while Netflix will promote Wal-Mart’s DVD sales to its three million customers. With this deal, Netflix hopes to finally achieve a level of pricing power that will allow it to stop the flow of red ink.
Netflix entered the DVD rental market in 1997 and offered an innovative model that eliminated the despised late fees, increased selection and offered the convenience of on-line ordering, mail delivery and low price. Blockbuster, the long-established market leader in brick and mortar DVD rentals, entered the online rental market last fall offering a service similar to Netflix’s at a lower price. Although the competitive war between the companies extends to the fronts of selection, availability of titles and service, the main competitive weapon remained price. This led to rapid and heavy price cutting that sent both companies into the red. Most industry analysts have pointed to this lack of industry profitability, caused by the Netflix – Blockbuster price war, as the main reason for Wal-Mart’s sudden exit.
The impact of the exit on the online DVD rental industry and the end result of the partnership with Netflix are contentious. Will this partnership change the dynamics of the battle? Some think that the partnership will radically change the competitive landscape by establishing a clear market leader who can set the rules of the game. Others argue that, in reality, Wal-Mart’s exit doesn’t change the fundamental dynamics of the competition, since Blockbuster will continue to challenge the dominance of Netflix. This week Blockbuster has already fired a responsive shot, and begun offering special deals to those subscribers who defect from Wal-Mart and Netflix. Indeed, Blockbuster seems to be showing signs that it will not quietly accept the number two position in this market.
Traditionally, Wal-Mart is known for flexing its muscle in extracting value from all parts of the value chain. Wal-Mart has built on its strengths in low cost distribution and procurement to provide value to customers. Wal-Mart has some power over suppliers and has experience dealing with DVD distributors thanks to its DVD sales business, but we believe that these are not significant enough to support Wal-Mart’s low-cost model. Wal-Mart may have some room to bargain, but pushing hard on suppliers may not be possible due to the numerous and fragmented channels through which movies are distributed.
Both Netflix and Blockbuster are likely to have comparable DVD distributor relationships. Blockbuster also has greater synergies in the rental marketplace, already a core part of its business model. Netflix is supplied by 67 studios and distributors. Although exact costs are not published, we assume that the three competitors had similar costs per movie in the rental business and therefore, Wal-Mart did not have a long-term sustainable competitive advantage in this market and were not able to gain significant market share (analysts estimate their number of subscribers by anywhere between 100,000 and 250,000). After seeing nothing but losses, Wal-Mart finally decided to cut its losses and leave the battlefield to the Netflix/Blockbuster duopoly.
In the DVD online rental market, we would expect customers to have low switching costs due to lack of long-term subscriber contracts. In addition, Consumers now have a plethora of options for obtaining DVDs, both through the rental and purchase markets. However, Netflix states in its annual report that new subscribers are more likely to switch than old subscribers, meaning that Netflix benefits from its first-mover advantage. “Despite is size and merchandising savvy… Wal-Mart couldn’t overcome Netflix’s headstart in the rapidly expanding niche of online DVD rentals.” This could be explained by customer loyalty, or low customers’ sensitivity to price.
Analysts seem to disagree on what signal the deal sends to other potential market entrants. As a result of Wal-Mart’s exit, Amazon, which has already started a DVD rental program in England and had been planning to enter the US market, may now be less likely to do so due to Netflix’s now dominant position. Others point to Amazon’s recent talks with Blockbuster and Netflix as indication that Amazon may still enter, although they may now do so in cooperation with another existing market player.
Wal-Mart may have decided that it has more to gain from cooperation than from further competing. By agreeing to remove itself from the industry, Wal-Mart has immediately reduced the competition that has been driving down prices in the DVD rentals market and potentially cannibalized its DVD sales. Additionally, the exit sends a signal to Amazon and other potential entrants that the industry is not profitable, even for a power like Wal-Mart. This strengthens the positions of the remaining players (i.e. Netflix and Blockbuster), possibly allowing them to raise prices. Wal-Mart hopes that this will drive customers back to Wal-Mart stores to buy DVD’s that will be comparatively cheaper to renting. Furthermore, by engaging in cross-promotion, the deal may help both Wal-Mart and Netflix to grow both the rental and sale market pies.
As mentioned above, Blockbuster has already responded to the deal and offered subscription discounts to those defecting from Wal-Mart and Netflix. However, there are some indications that this may be a sign of desperation and a one shot, short-term reaction to take advantage of a fleeting change in the marketplace. This strategy is clearly not sustainable by Blockbuster. Price reductions affect their online and store business. Blockbuster’s online DVD rental business has been bleeding cash since inception and has also been suffering from internal management problems. Carl Icahn, who recently joined Blockbuster’s board, has publicly criticized Blockbuster for its loss making businesses. Carl and other board members are expected to push for higher prices sooner rather than later.
The market for on-line DVD rentals is expected to continue to grow at 60% over the next few years. With a market potential of 70 Million potential households, the current DVD rental market is far from mature. However, to show short term profits, Blockbuster may be forced to concede to Netflix the number one position, and be content to remain the follower in this market. While this will be a new and unfamiliar spot for Blockbuster after dominating the bricks and mortar video rental market for so long, it will probably come to realize that the pie will be large enough for it to sustain a large customer base and finally start to realize future earnings.
Both Wal-Mart and Netflix hope that their deal will lead to higher rental subscription costs. This would bring Netflix back into the black, and might also help Wal-Mart to sell more DVD’s as they become comparatively cheaper. Wal-Mart may also be getting a cut of future Netflix profits, allowing them to have something to show for their failed foray into the online DVD rental market. The only holdout remains Blockbuster, which tested higher rental fees last week and matched Netflix’s price.
Stability in price may decrease competition and allow both players earn hefty profits. However, studios, who earn more than half of their income from DVD sales and rentals may object to price increases, and support new players or other channels. In the short term however, it seems that customers are likely to see fewer price promotions and should prepare to increase their entertainment budget.

Leann Tchaikovsky, Ohad Reshef, John Rhoads

The future is… now?!

2005-05-27T19:21:00.000-04:00

In a recent Forbes article, GM restated its goal of producing a hydrogen-based car at the same price point as today’s average car by the end of the decade. George Jetson, here we come! But before we reach into our pocketbook and start saving the environment one mile after another, we need to evaluate the reality of this initiative. Is this technology for real? If so, will we drive these cars and where will we fill them up?

First, we need to realize that fuels cells are not something new. Identified back in the 1800’s, they were considered an improbable device until the 1960’s when NASA began using them in the space program. But unlike so many computer related technologies, fuel cells have not progressed much over the last 20 years. GM says this is all changing.

GM first announced their intentions back in October of 2002 when a Wired article revealed to the world their billion-dollar gamble. Since that time, DOW Chemical announced their involvement in using a GM fuel cell to generate a portion of the electricity requirements for one of DOW’s Texas operations. Encouraging to be sure, this is a far cry from the complete overhaul of the century old petroleum based auto industry. But let’s say for the sake of argument that GM can overcome the technical issues of storing hydrogen, fuel cell life and the costs of production. How does GM’s strategy stand up to other auto manufacturers?

All of the other auto manufacturers are spending some R&D on hydrogen vehicles. But they do not see potential for 20-30 years. In the meantime, hybrids and alternate fuel systems are their focus. GM will be the only buyer in the market for purely hydrogen vehicles components for upwards of 10 years. The positive side of this story is that GM will have strong bargaining power with the suppliers once they have invested in hydrogen vehicles technology. The negative side is that many suppliers will have no incentives to start investing in developing components for an uncertain market with only one costumer. Going alone GM could capture huge profits if successful, but they will have to bear the risk of most of the required investments in any step of the Supply Chain.

Another factor in the success of this strategy will be the complimentary products and services needed to support a hydrogen-based vehicle. First and foremost is the production of hydrogen as well as the distribution. Current hydrogen production is nowhere near the volume needed to support the transportation needs of the American economy. In the case of DOW Chemical above, DOW produces and stores hydrogen as a part of their business. It is unlikely that many of GM’s customers will have the same capability to leverage. Service industries will also have to change to support an entirely new vehicle platform. What incentives are there for these industries to develop and / or change?

That brings in the role of government. Today there are state and federal tax incentives to get buyers to purchase hybrid cars. This may help on the purchase side, but what about infrastructure? If the market demand is composed of even 1 million autos in 2010, will any of the large petroleum distributors be interested in developing a nationwide network for hydrogen distribution? A recent study estimated the cost of building such a network throughout Europe could cost as little as $4.6 billion. Clearly the costs to develop the United States will be more. How much will the ruling party in 2010 be willing to spend to make this a reality? Politically, they would be helping to save the environment. On the other hand, they’re using public funds to subsidize large corporations and the few elite who are able to purchase these cars.

But, let’s say a distribution system is developed. What would be the adoption in 2nd and 3rd world countries? At a time when rivals in the industry are looking for ways to sell their cars abroad to growing markets, this car would most likely only be viable in the US, Europe and a few other small 1st world markets for at least a decade. Fortunately, GM is continuing to invest in their current lines of business through continued introduction of new models across their collection of brands. Will there be any complimentary technologies from the hydrogen effort that can enhance future conventional models? Only time will tell.

Is this a worthwhile endeavor? Will GM’s investment ever return a profit? The risks against success seem huge. There’s the development of the technology to cost efficiently power a car; the ability to store an effective quantity of hydrogen onboard; hydrogen production and distribution capabilities and ultimately consumer adoption. History is littered with technologies that were superior to the competition, and yet were never embraced by the market. A first mover advantage is rarely the sole key to success, yet this is what GM appears to be betting on. Is a hydrogen only based car really the best option? What about hybrids? Imagine driving your company down a curvy road vs. speeding through a hairpin turn. With a gamble this big, one really needs to expect a large payoff. But in this case, the payoff could be decades away. That gives the competition plenty of time to develop their response and build on the work GM has done.

To be true, we would love to see the vision of a hydrogen economy become a reality. Cleaner fuels for transportation (remember, the production of hydrogen is not without its dirty side) would help relieve the issue of smog and could reduce the consumption of fossil fuels. But at what cost? A billion here and a billion there? GM is already fighting for market share along with its survival. Let’s hope GM will be successful and that they will be able to gain some of the profits generated by their efforts to help the world. But for right now, we’re not betting on it.

Rafael Calderon, Jay Geiger, Joan Gelpi

Take-Off for America West and US Airways…or Emergency Landing?

2005-05-26T21:13:00.000-04:00

The recently announced merger between US Airways and America West Holdings would create the 6th largest airline carrier, with $850 million in equity. With the infusion of external equity, the new ownership structure will have 41% owned by these new equity investors, 45% by current America West shareholders and the remaining 14% by US Airways’ creditors. The deal, expected to close in the fall of 2005, is estimated to net approximately $600 million in cost savings and revenue synergies, which is optimistic by many accounts. US Airways is attempting to emerge from bankruptcy, for the second time since September 11, 2001, while America West Holdings is making an effort to break into the realm of major carriers and expand on its strategy as the low-cost carrier. The combined company is targeting to be a major carrier, while competing at the price and cost levels of Southwest Airlines.

The deal is seen as risky by analysts due to US Air’s bankruptcy spell and high cost structure. The new company will have 90% of its capital structure in debt, so it is highly leveraged and needs to focus on building equity. Doug Parker, the current CEO of America West, who will assume the title of CEO of the new company, has a history of risky, but successful endeavors. After becoming CEO of America West only days before September 11, Parker secured loan guarantees from the government to avoid bankruptcy.

What should this new airline be named? Consumer research suggested that the name US Air has better global brand recognition than America West for a global carrier. However, US Air has damaged its brand with a series of service issues. For instance, US Airways has been previously rated as the worst carrier with respect to lost baggage and below average in on-time ratings. Some experts still think it makes sense to go with the US Air name because of its name recognition. Others believe that since neither airline has a great reputation for service, they should start over with a brand new name. Creating a new brand name could be an expensive and risky option. Ultimately no matter what name they choose, the company needs to address the true underlying issues related to customer service.

While America West’s strength is its coverage of the West, US Air has typically had a stronger share of the eastern seaboard, with New York, Boston and Washington, DC shuttle flights considered as its key assets. The combined airline will use a traditional hub and spoke system with hubs in Phoenix, Philly and Charlotte. The plan calls for America West to service the domestic market, while the US Air entity would focus on the international market.

As part of the deal, the new airline will also reduce its fleet by 58 planes to 361, which is seen as good for the overall industry. The reduced capacity in the industry should help several players increase capacity and profitability. According to Merrill Lynch, who raised its rating on AirTran Holdings, the industry could benefit by the potential reduced capacity on the East coast. Delta will probably be hurt the most by the deal with the increased pressure in several competing markets, but in general, most carriers should benefit.

Potentially the most difficult variable of the merger will be retaining and motivating employees, while not escalating costs. US Airways is a much older company, and has a workforce that is older on average. If time of employment or start date is used to categorize employees, America West pilots, flight attendants and mechanics could feel the brunt of the layoffs. Union negotiations will also be challenging when combining these large companies, with complicated contracts. In order to compete at the level of Southwest Airlines and become profitable, the new company will have to significantly reduce its cost structure.

There appears to be a concerning disconnect in the strategy and tactics behind this merger. America West has said they want to use this merger to better compete with the discount airlines. The problem is that their entire structure, from the high cost structure of US Airways to the use of the hub and spoke system, is contrary to the model for success in that segment of the airline market. The successful discount carriers have succeeded by developing much lower cost structures and flying point-to-point routes.

On a broader scope, the deal does not seem to be indicative of additional mergers in the industry, as many carriers are struggling with their own cost structures and bankruptcies. However, the deal will force competitors to review their strategies and determine if a structural change is needed in order to succeed in the long run. The airline industry has been struggling for several years, with the smaller, low cost airlines, left as the only profitable carriers.

As customers and competitors await the outcome, the question that remains is this deal an attempt to compete at the smaller carrier level or simply a desperate attempt at survival for US Airways?
By Jeff Fechalos and Paul Mountain

Everybody Needs a Friend, Even Airlines

2005-05-26T21:12:00.001-04:00

When things get tough, it tends to bring friends close and enemies closer. The air transportation industry has experienced just the type of situations that make friends and enemies come closer. After struggling through the rampant bankruptcy of the 1980’s, many airline companies rebounded during the strong economy of the 1990’s. However, dual economic shocks of the bursting internet bubble (fewer business trips and deep-pocketed customers) and the terrorist attacks of 9-11 (overall reduction in travel) nearly crippled the industry in early 2000’s. Fast forward to 2005, with oil prices above $50/barrel and consumers demanding lower fares, and it is easy to see why many of the 15 airline competitors are scratching and clawing for mere survival, much less a piece of the airline industry profit pie. How much can one industry take? The time has come for a combining of wills, resources, and routes. That brings us to the merger of America West & US Airways. They attempt to succeed where history shows evidence of failed mergers; they will battle politics along with conflicting reports of cost and revenue synergies. Will this merger be redemption for US Airways and provide needed growth for America West? Does this merger make any sense strategically?

Analysts are, on the whole, upbeat on the potential partnering. S&P notes that a combined America West-US Airways merger may have better odds than other airline mergers at succeeding because of little geographic overlap. Businessweek notes that this merger is similar to the last successful airline merger (Delta-Western Air) through the combination of geographical routes to divert traffic away from competitors. One prominent consultant notes that the merger should be very appealing to consumers in the mid-west, where neither America West nor US Airways have a presence. Customers, particularly business customers, may now consider America West as a viable option for national travel. By pricing and scheduling as one company instead of two, further revenue synergies are possible. However, a Goldman Sachs analyst notes that America West’s revenues may suffer from culture issues and from adding the more-competitive and over-capacity Eastern routes, much different than the mildly over-capacity Western routes America West currently flies.

When evaluating the proposed merger, the first thing we analyzed was the alignment between the merger and America West’s competitive advantage and strategy. America West seeks to be a low-cost and low-fare airline carrier and achieves its competitive advantage through improved customer service and efficient operations. However, as the airline industry moves toward lower fares, and larger rivals move aggressively to cut costs, America West’s advantage has been eroded. After the merger, America West’s larger size and national market presence (formerly just West coast) will provide improved negotiations with suppliers (such as Boeing and Airbus), improved incentives for buyers (national flights instead of just regional), and will bring America West closer to the same economy-of-scale levels as its larger rivals (boosting it to the 6th largest airline). This merger does not appear to be just an attempt at “empire building” by America West’s CEO Parker but instead should help America West compete in an ever-changing and difficult industry.

Next, after verifying a true strategic fit, we questioned if the potential synergies of the merger are significant enough to justify the efforts and costs involved in the merger. The synergies of the merger can be thought of as two types: cost synergies and revenue synergies—with cost synergies having a much higher probability of actual achievement than proposed revenue synergies. The cost synergies available to a merged America West appear to be significant: $200 million annually from cutting unprofitable routes and matching aircraft size to route demand; savings from improving US Airways operational efficiencies (more flights per gate per day); and $200 million from direct fixed cost reductions such as redundant work staff, redundant gates, and returning 59 leased airplanes no longer needed by US Airways. The total annual synergies are expected to reach $600 million annually, once the $200 million in revenue synergies are added—mainly from the improved connections between the formerly separated route networks (East coast and West coast) of the two airlines. While the revenue synergies are somewhat dubious, the cost synergies appear to be sound and significant; therefore, we feel that there is attainable value within this merger.

Finally, we questioned if the proposed merger is executable—the strategic fit is there, the value is there, but does America West have the experience/ability to successfully implement the merger as planned? We feel that the biggest challenge of this merger will be the ability to merge the human capital of the two airlines, specifically the unionized workforces which are very different in average tenure. In fact, we believe that the most resistant group to the merger will be the unionized employees of America West. They will undoubtedly be forced into some concessions as they merge with the more experienced union of US Airways. Yet, America West’s Parker has a track record of successful union negotiations and is known for his humility and tact, providing evidence that the difficult union negotiations may be obtainable. While not without risk, we feel that a successful merger is possible as long as Mr. Parker recognizes that communication with, and buy-in from, his own employees will be just as important as the millions of dollars in synergies from the merger.

Rich Foley,Jamie Hood, & Bryant Mitchell

Can We Still Say “What’s Good for GM Is Good for America?”

2005-05-26T21:12:00.000-04:00

Burdened by legacy costs, retiree healthcare expenses, and increased competition, General Motors Corp (GM) faces shriveling profits and eroding market share. The company supports 900,000 jobs and represents the American industrial might of the 20th century. Once commanding 60% of vehicle sales in the nation, this behemoth size and reputation seem to be the very force that paralyzes GM. The company and its Detroit management have comfortably sat on the cushy Number 1 spot for so long that in the face of so many threats they employ business as usual tactics. It appears as if GM can no longer come up with innovative ideas to cut costs, respond to consumers’ changing car tastes, or combat shrewd competitors. Yet GM must change its marketing strategy, overhaul its automotive operations, and restructure the company in order to avoid continued shrinkage or worse extinction.

GM currently supports 8 divisions and 89 models. Even with this portfolio experts criticize that GM “is producing legions of automobiles that are outdated, poorly constructed and wrapped in dull, cookie-cutter styling.”[1] Research dollars are spread across all of these divisions and models. Its Japanese counterparts spend more on Capital and R&D (GM spends $13.7 B while Toyota spends $15.3 B), focusing on packing fewer models with the latest features and technologies. Toyota models stay on the market for only 3 years while GM keeps its models on the market for 4 years, resulting in consumers switching to foreign competitors to replace aging vehicles since GM has the same old models sitting in the showroom. GM inventories are above the 60 day industry average; Toyota, in contrast, has less than 55 days of inventory. These high inventories force GM to offer attractive rebates and 0% financing to consumers, as well as sell to rental car companies at low margins—tactics leading to further profit decay.[2]

GM is also strangled by legacy costs and union agreements; yet cutting expenses is complicated, and even costly. The automaker is burdened by a $1600-per-vehicle handicap in legacy costs, consisting mostly of retiree health and pension benefits. Average medical expense per vehicle for overseas auto makers is $425.[3] Union agreements prevent GM from simply closing plants or laying off workers without paying stiff penalties. They also dictate that GM must run plants at an 80% capacity minimum. This rule causes GM to engineer cars to use up production capacity.[4]

GM’s revival depends on its ability to win concessions from the United Auto Workers (UAW) union. The next negotiation with UAW is scheduled for 2007. Due to GM’s strong balance sheet ($52.6 B in cash and equivalents) UAW might not compromise on cutting benefits. However, it is imperative that GM reaches an improved agreement with the UAW in order to be competitive.

In the past, superior consumer segmentation was a competitive advantage that helped GM dominate the US market and beat ruthless competitors like Ford and Chrysler. GM is trying to use this same tactic to turn around sales now. In an effort to thwart competitors and fix the money-losing auto business, GM plans to roll out a new marketing strategy in lucrative markets and boost SUV sales. It will launch a counterattack against foreign brands in the East and West Coast markets and in fast-growing areas like South Florida. The strategy includes cutting and simplifying a complex pricing system, focusing on models that will compete with the popular Honda Accord and Toyota Corolla, diversifying marketing messages to gain minority consumers, and consolidating Buick and Pontiac dealerships. SUV models are also being redesigned and introduced to the market more quickly. Unfortunately, this strategy seems like a gamble considering SUV sales are diminishing with higher gasoline costs and a growing number of environmentally savvy consumers.[5]

We wonder whether this new marketing strategy will revive GM and help regain prior dominance. Cutting price and introducing an aggressive discount strategy might be effective in the short term. However, it is questionable whether this is a sustainable competitive advantage. Considering GM’s huge legacy costs, foreign competitors are more flexible in pricing. They can easily copy or surpass any price cuts. Furthermore, consumers seem to be more sensitive to oil price changes than to car price changes, even preferring more expensive Japanese cars with high mileage to the gallon. GM’s financial situation is unlikely to be drastically improved in an extended price war.

Alternately, GM might consider adopting differentiated marketing to attract various consumers in differing geographies. Full market coverage is costly but not efficient. GM can focus on different products for each market segment and design different programs to attract these segments. Chevrolet can satisfy consumers’ penchant for gas efficiency and environmental concerns in areas like California and Florida, while Cadillac can attract richer and pickier consumers in both coastal areas.

GM should also emphasize R&D to develop new, high quality models to attract consumers. How would the auto behemoth get the money for costly R&D and marketing campaigns? Restructure its business and cut costs. GM suffers from redundant production, overlapping promotion and distribution, and excessive management. Combining similar functional products and brands will help increase synergies, improve productivity, eliminate redundant management staff, and avoid cannibalization. Closing less profitable plants and spinning off non-productive businesses is also reasonable to get more cash funding. These strategies do not require GM to give up on its traditional advantage of customer segmentation. On the contrary, focusing a product to a particular segment centralizes resources to support more popular products.

Outsourcing partial production and expanding OEM business to nearby countries like Mexico is another way that GM can reduce operating costs. GM’s OEM business in Japan is pretty profitable, which can monetize up to $3 billion. Benefiting from their low cost, GM Asia and South America are the only two profitable business units in the 1st quarter of 2005.[6]

While the Japanese manufacturers are known for quality, the Koreans for price, and the Europeans for performance, GM can still find its niche. By restructuring and reinventing itself, the American giant can once again return to greatness.
[1] Yates, B. “What’s Good for General Motors?” The Wall Street Journal, May 24, 2005.
[2] Levy, E. “Standard and Poor’s Industry Survey: Autos & Auto Parts,” Standard and Poor’s, December 23, 2004.
[3] “The Burden for GM Revive,” Asahi Newspaper, May 25, 2005.
[4] Welch, D and Beucke, D. “Why GM’s Plan Won’t Work,” Business Week, May 9, 2005.
[5] Hawkins, L. “Struggling GM Rolls Out A New Marketing Strategy,” The Wall Street Journal, May 23, 2005.
[6] GM’s 2005 Q1’s 10K report.

Abigail Akzin
Naomi Nakagawa
Natalie Yu

US Air - America West: Synergies between Two Sinking Ships

2005-05-26T21:11:00.000-04:00

We need to get this out of the way early: airlines are a terrible business, oil prices are sky high, and companies have no pricing power. Whew! OK, now that we have that out of the way we can dissect the recent announcement that US Airways and America West will be merging into one low-cost carrier that competes with Southwest. To sum the conclusion early, round pegs do not fit into square holes.

The motivation behind this merger is based on the dire prospects that both firms face as stand alones. In fact, US Air has been in bankruptcy twice this century already. It is important to dissect first why both firms cannot stand on their own: intense competition (that was easy). Sure, pension costs, volatile demand, and high fuel costs play major roles, but firms like Southwest and Jet Blue have been able to compete effectively in this environment with a lower cost structure and, therefore, with lower prices. The cost disparity between firms, and therefore the genesis of the intense competition, is the main reason why neither US Air nor America West could survive alone; the only method of staving their inevitable charge to bankruptcy was to merge with each other and claim massive synergy savings as the savior.

To put it simply, the only business model that will function in this dire dynamic is simple: low-cost fares combined with a low-cost business structure. Doug Parker, the new CEO, claims to have a business model that produces enough synergies to compete with Southwest (we’ve heard it before, I know) as discussed in the Wall Street Journal this week. The string of synergies also sounds familiar: $200 million from cutting aircraft and $250-300 million from cutting overhead. Where to begin? Sure, firing a lot of people will save money, but we question the new firm’s ability to accomplish this task. Merging two powerful pilot unions will be difficult; remember they are the ones who land the planes and provide the majority of the value to the consumer. The flight attendants and mechanics will also be difficult. Unionized workforces do not always lead to exorbitant costs, but each union will have to accept lower salaries. As if negotiating with three unions wasn’t hard enough, the new firm must now deal with six. We sincerely question Mr. Parker’s ability to cut compensation costs enough to become Southwest, and there is no middle ground as others have proven.

By far, the most powerful synergy apparent in this merger is that another firm is gone and they may finally take some of the excess capacity with them! When Mr. Parker says they will save $200 million in plane costs, we interpret this to mean that the firms have overlapping routes. This provides a partial solution to the main problem already described in this industry: intense competition (i.e. from overcapacity). Unfortunately, losing a competitor helps everyone equally, not just the merged companies. The overcapacity that has plagued this industry has led to intense price wars. Every time one company attempts to raise prices, the allure of higher utilization becomes too great and one firm ruins the party for everybody by lowering prices again. If the government had not bailed out many airlines with loans after 9/11, then maybe we wouldn’t be in this mess in the first place, but this is no excuse. As it stands, too many competitors are fighting it out and this merger is actually a part of the solution to this problem. Unfortunately, this does not mean that the combined firms will survive since less capacity helps Southwest as well.

It is our opinion that America West, the lower cost of the two, would have been better off if US Air had gone the way of Chapter 7 (third time is a charm). The industry would have still benefited and America West would not be stuck with a firm that cannot seem to keep itself out of bankruptcy. The argument could be made that the combined firms offer better service levels to consumers through wider flight coverage, but this sounds eerily familiar to the argument for the inefficient hub-and-spoke systems seen at Delta and American. Southwest flies point-to-point on profitable routes, coverage is nice only if it is profitable. Adding lines is only beneficial if it is profitable, but the new firm does not want to discuss these issues.

We do not feel that an old firm can change its stripes and become Southwest (remember United Light?). Only a new firm with an obsessive control of costs can create the service-friendly, happy union environment of Southwest or Jet Blue. Combining two sinking ships and hoping they can magically synergize into Southwest is not viable because employees, passengers, or investors do not easily forget the past. It’s an easy prediction, but, in the end, we think these two sinking ships will continue to sink and Southwest will continue to prosper.

Shane Hart, JP Millsap & Tyler Partridge

The Return of the King

2005-05-25T22:11:00.000-04:00

The turnaround of Burger King under new CEO, Greg Brenneman

Since its establishment, Burger King, the second largest fast food chain behind McDonald in the United States, has experienced frequent changes in ownership and fallen in big troubles in the past decade. Embroiled in a down-and-dirty price war trying to steal market share, the fast food giant experienced declining same-store sales together with other large chains. Consumers have been more aware of eating healthier alternatives and began to abandon greasy menus. Burger King also suffered from several failed attempts to redesign its brand. Many of its franchises are filing bankruptcies. To make it worse, Burger King experienced a revolving door in the board room: since 1989, the company has welcomed ten CEOs.

In August 2004 the company announced Greg Brenneman as its latest CEO, a Harvard M.B.A. who had led turnarounds at Continental Airlines and PricewaterhouseCooper's consulting unit. Mr. Brenneman moved quickly to boost morale at headquarters here and improve relationships with franchisees, who own about 90% of the company's U.S. restaurants. He cut costs, increased sales and introduced a slew of products. Burger King now has posted 14 consecutive months of sales growth in stores open more than a year. Customer traffic is up 7% since the fiscal year begun July 1, for the first time since 1997.

Is Greg really a master of turning around companies or just lucky? Is this success sustainable? We might want to know how well Greg’s new strategies worked and what differentiated him from the other 10 “unlucky” CEOs.

First, facing the strong competition of McDonald, Greg didn’t simply launch a price war to gain more market share, as his predecessors did before. Instead, Greg changed the focus to offering new products. Since McDonald turned to salad offerings, Burger King kept focusing on chicken sandwiches to avoid direct conflict. New products included the Angus Steak Burger, the Spicy Chicken Sandwich in 2004 and Enormous Omelet Sandwich early 2005. Since their debut, new products have helped grow Burger King’s breakfast sales 20 percent.

Secondly, Greg re-segmented the customers to boost the revenue. Enthusiastic about customers’ desires, Greg decided to focus on blue collar workers aging from 18 to 34, a population accounts for 18% of Burger King’s customers but 49% of business. New products, like chicken sandwich with pepperjack cheese and Red Bull-inspired coffee coming with 40 percent more caffeine than regular, were rolled out to cater these repeat customers’ desires. Concentrating on the most valuable customers, Greg increased sales by 11% and demonstrated the magic of identifying and serving the potential core customers.

Thirdly, Greg integrated Burger King’s complicated market images into a basic concept - "Have It Your Way". Launching aggressive advertising campaign, Greg changed the advertising agent and developed new commercials to promote this new image and target core customer segments. This new promoting strategy and “breakthrough advertising” were an important part of Burger King’s resurgence.

Fourthly, unsatisfied with Burger King’s franchise restaurants, Greg shrank the size of restaurants to save cost and improved the respect between Burger King and franchises. He broke tradition rules of designing fast-food restaurants to improve the utilization and customer experience. New design saved one-third of startup cost, making franchise restaurants more competitive in the market. Also, he urged the communication in Burger King to avoid “Civil War” and started treating franchisees with dignity and respect. He rebuilt company’s culture by visiting restaurants every week, coaching new employees, and sending out voice mail every week. His effort made every employee understood the company’s target and strategies clearly.

Although Greg’s turn-around strategies cover many other fields, like international growth and compensation system transformation, these four aspects is basically how he differentiates from his predecessors. Reviving macro economy might contribute partly to Burger King’s growth, but Greg’s strategies are the key to turning around Burger King. With a great talent in understanding customers’ requirements, Greg knows the way to satisfy them to get the maximum profit from them. He knows how to use comprehensive product, promotion, and channel strategies effectively to rescue staggering companies. Moreover, his decisive personality and strong mind in culture reforming and employees motivation are crucial to revive depressed teams.

Greg’s strategies don’t seem to be hard to understand. However, why didn’t the other 10 CEO do it? Is it because of Greg’s Harvard MBA education? Greg mentioned that his success didn’t come from his education, but from his past working experience and addiction to turning around business. For senior business leaders, hands-on experience, personality, and passion might be 3 important factors that really make differences in their lifelong career progress.

By: Masato Eguchi, Yuxiang Luo, Yihui Zhang

Allen – Edmonds Shoe Corporation: “We’ll be back on your feet in no time.”

2005-05-25T22:10:00.001-04:00

The Allen – Edmonds Shoe Corporation (AE) makes some of the nation’s finest men’s shoes that retail from $235 to $425 a pair. The privately held company has been making fine shoes since 1922 and has withstood its fair share of difficulties. In 1984, a fire destroyed the company’s manufacturing plant. Determined to keep the company afloat, AE’s CEO John Stollenwerk set-up operations in a school house until a new facility was built. The new facility was a God-send to the company, whose operations needed a make-over to keep up with the evolving shoe industry, where US protective tariffs were gradually waning. With the new facilities, the company enjoyed steady growth and profitability up until 2001.

After 2001, the company began to face its biggest challenge. The shoe industry was changing and scale was necessary to serve large department stores, shoe warehouses, and discount retailers and the best way to achieve scale was by outsourcing operations to cheap labor countries. The changing landscape deeply affected many of AE’s competitors. For instance, the Florsheim Shoe Company declared bankruptcy in 2002. Cole Haan was acquired by Nike and Johnston & Murphy was acquired by publicly traded Genesco Shoe Company. The new mantra was to outsource all shoe manufacturing to China. In fact, nearly 98% of the current shoes Americans wear are imported. Except for Allen-Edmonds and rival Alden, who both have stayed the course producing shoes made in America. The differences in labor costs can be as drastic as $1 an hour in China compared to the $15 an hour that Allen-Edmonds pays its employees before benefits. The economics seems to have taken a toll on Alden shoes, who mainly sells to independent shoe sellers. It is becoming increasingly difficult to find these fine independent shoe stores who sell Aldens for many of these independents are making way for the large stores. It seems that Alden too may disappear like so many other fine shoe makers.

Faced with the option to sell to a larger competitor or to start producing shoes in China, AE evaluated its courses of action and ultimately decided to follow a different strategy: to focus on quality and service by producing in the United States. Stollenwerk explains that by producing shoes in the United States, AE can beat competitor’s quality (due to the skilled laborers who have been hand crafting AE shoes for years). Stollenwerk believes that cheap labor leads to cheap shoes. He also believes that the savvy customer will know the difference and begin to purchase AE shoes instead. Hence, Stollenwerk believes his contrarian strategy will not only allow AE to stay afloat, but it will also serve as a growth driver for the company. Also, production in the US allows for shorter shipping distances that allows AE to respond quicker to their customers than its competitors. AE also maintains lower shipping costs this way. To further shorten the gap with cheap foreign labor, AE completely revamped their operations by installing a new manufacturing process that cut down inventory stock levels from 70,000 pairs of shoes to 10,000, with plans to reduce it even further to 5,000 shoes. Now, AE can deliver a large order to a client within 5 – 7 days, down from 4-6 weeks in the past. Stollenwerk believes this too will help better service clients and lead to increased sales.

AE historically was at the mercy of its buyers. Nordstrom alone accounts for 50% of its wholesale business. To stymie this extreme buyer power, AE began installing retail stores in major US cities. Stollenwerk explains that as long as AE doesn’t undercut the department store’s prices, this initiative has been allowed by department stores. Additionally, AE began selling their products on-line through its company website. These moves have allowed the company to grow sales by targeting a different customer segment that doesn’t frequent the busy and time consuming department stores, while increasing AE’s margins. AE also began a shoe re-crafting business, despite the criticisms from industry experts that said AE would shoot themselves in the foot with this move. On the contrary, this new business has been bringing in constant revenues and also allows for cross selling other products such as belts and shoe accessories. The re-crafting segment has successfully raised the switching costs for consumers as well. Now a customer thinks twice about buying another competitor’s $300 luxury shoe, for there is no recourse for the shoe buyer but to eventually throw them away. At AE, the customer can re-craft their shoes to their original form for a nominal charge, adding to the value proposition of an AE pair of shoes.

AE was also able to reduce the size of its work force from 1000 to 600 employees. The company did this without firing employees but rather through natural attrition – further leading to the loyalty of its workers. Stollenwerk believes this loyalty shows up in the quality of the shoes. Hence, the new operations not only lowers working capital and allows for quicker response rates to customers, but it also lowers the amount of total wages paid to produce an even greater quantity of shoes. Hence, the company is achieving some of the necessary scale needed to compete in today’s market place.

So what have been the results of AE’s gamble? So far, its revenues have been growing by 6 -8% every year since, the quality of their shoes have remained superb, and new retail stores are opening across the country. However, the New York Times believes that this “patriotism” will only get AE so far. Will AE’s new strategy be enough to stay competitive with cheap Chinese labor? That is a good question that only time will tell. In a recent chat with a dozen Chicago GSB students, John Stollenwerk exclaimed that you students are our target customers. If it’s any indication of the company’s future success, this target market left the AE headquarters averaging two pairs of Allen-Edmonds shoes each – a hefty sum for debt laden business school students!

Submitted by:
Mike Barfoot
Jason Boles
Brad Davey

IT'S A BLOCKBUSTER NIGHT - MAYBE?

2005-05-25T22:10:00.000-04:00

The landscape in the DVD rental business has changed significantly over the past few days. On Thursday, May 19th Wal-Mart announced that it would exit the DVD rental market, and partner with online innovator Netflix. This adds a spark to the highly competitive sector which has seen numerous pricing and structural changes over the past several years. Walmart.com began offering DVD rentals online in late 2002 in an effort to grab a share of what appeared to be a profitable and growing online rental market. Wal-Mart’s use of scale and leverage didn't pay off as hoped, evidenced by its ability to capture just 1% of the online DVD rental market. Wal-Mart's effort was fiercely combated by pricing and convenience incentives pushed by Netflix, eventually forcing Wal-Mart to reassess their key goals. Bowing to Netflix on DVD rentals, Wal-Mart decided to align itself with the Los Gatos, CA-based Internet company creating synergies for both parties. Wal-Mart will now direct all 3 million of its DVD rental subscribers to Netflix.com, while in return Netflix will promote DVD sales for Wal-Mart. Wal-Mart CEO John Fleming indicated that the company’s online relationship with its customers is intended to drive the user back to the store. The relationship with Netflix is geared to do just that. "The decision was really a question of focus", Mr. Fleming indicated in the May 19th announcement.

Whether or not the new relationship between Netflix and Wal-Mart will bear fruit is yet to be determined. However, one thing is for certain, Carl Ichan and the restructured management team of Blockbuster did not sleep well Thursday night. The major third party player in this multiyear struggle for DVD rental dominance is Dallas, TX-based Blockbuster. The brick and mortar behemoth has dominated the rental landscape for almost a decade through scale and the numerous locations of their retail outlets. With progress and threats in the virtual world increasing by the second, Blockbuster began to see pressure from the more convenient and user friendly online model created by Netflix. As Netflix's subscriber base grew, Blockbuster was forced to press new initiatives in an effort to level the playing field. Entry into the online market was the first attempt by Blockbuster to compete directly with Netflix on the web. This process was accompanied by a significant increase in infrastructure and marketing spending. Blockbuster’s management team is slated to direct 170 million dollars to grow the online effort in 2005 alone. The acceptance of the online subscription-based model (vs. the traditional rental approach) that allowed users to keep movies for a non-specified period of time, forced Blockbuster to become more dovish on their traditional rental penalties. The Board of Blockbuster decided to eliminate late fees, even though they made up 16% of Blockbuster’s total revenues. The repeal of late fees, coupled with increased spending on new ventures, and the lack of attention paid to the core business model infuriated large shareholders, most notably financier Carl Ichan. As a result, Mr. Ichan strong-armed his way onto the board in an effort to return shareholder value to the company. No more than a week after Ichan succeeded at securing a spot on Blockbuster's board, Netflix and Wal-Mart announced their new partnership. This prompted an immediate reaction from Blockbuster's disheveled leadership. By offering two months of free rentals, Blockbuster is making a clear attempt to poach Wal-Mart subscribers during the transition to the Netflix platform.

Reaction to the news was generally positive (though analyst opinion of Netflix as a whole remains divided). Analysts cited the addition of Wal-Mart’s customer base of 500 million visits per year as a significant gain for Netflix. Wal-Mart would benefit from an increase in its customer base for DVD sales as well as the ability to exit a market in which it failed to make significant inroads. One pundit did put forth the question, however, of whether Netflix sold itself short in some respects by forgoing a potential partnership with Amazon.com (and its coveted IMDB.com database) by partnering with Wal-Mart.

We tend to agree that this is a good move for both parties. We view the DVD rental and purchase markets not necessarily as substitutes for one another, but as complementary in their ability to draw customers from one segment to the other. This partnership will offer customers a one stop shop where they can first preview a movie (Netflix) before deciding to purchase it (Wal-Mart). We believe this arrangement can both increase the size of the DVD market and enable Netflix and Wal-Mart to capture a large share of it.

Korb, Shade and Thornton

Intel Inside Apple?

2005-05-25T22:09:00.000-04:00

Steve Jobs must be getting fairly bent out of shape. About 11 months ago, he promised users a 3GHz PowerMac G5 would ship within a year; just about every month since he’s had disappointing news for the Mac faithful. The root of the problem lies in IBM’s ability to produce the faster chips with thermal properties that don’t require sophisticated (read: expensive) liquid cooling systems to keep them from spontaneously combusting in users’ offices. Perhaps less dangerous but equally disturbing is the glaring lack of chips that has choked the supply chain of Apple’s second most popular product line.

So, the rumor mill does what it does, spitting out timely talk of Apple climbing into bed with Intel. The story goes that Apple would get access to new Intel dual-core processors and vastly better thermal properties (which would finally allow Apple to turbocharge their PowerBook line) while Intel would get an implicit endorsement from the trendsetting Apple evangelists. But this isn’t the first time these two giants have flirted. As recently as 2002, Jobs let fly speculation that Intel might have a chance at getting inside Apple. But the situation then was different; IBM was still trying to win chip business from Apple and the move seemed designed to tilt the field in Apple’s favor.

With the benefit of hindsight, we know what has transpired. IBM was successful in tying the next version of the Mac operating system (the completely new OS X) to its PowerPC 970 processor, only to bear the brunt of a very rare outburst from Apple’s PR department. In 2004, Apple publicly blamed Big Blue for the disappointing sales of the G5; they even went so far as to delay the launch of a new iMac because of IBM’s inability to meet chip demand. There is widespread speculation that IBM hasn’t been focusing on Apple lately, instead spending their time and energy on the “Cell” processor that will debut in the forthcoming Playstation 3.

So is Apple really serious about ditching IBM? The street has mixed feelings (surprise, surprise). Analysts are neatly carved into two camps, those who believe this is all game-playing designed to send IBM a message, and those who don’t. The skeptics (strategists?) point to the difficulty associated with porting an OS to a new platform (for the uninitiated, porting means re-writing software to run on a different chipset) and the massive tangential effort in recoding all of the existing OS X software. They say that this talk is designed to re-focus IBM and get better PowerPC chips out of the factory faster. Insiders suggest that the in-development 970MP (a dual-core version of the Mac’s brain) and the all-important 3GHz clock speed announcement are closer to market than many think, facts that could placate Apple enough to quit talking about Intel.

Others think that a marriage between the two industry opposites could produce some pleasant synergies. Intel would love to call Apple a customer, and Apple could use to take some power away from their sole chip supplier. New beta products from Intel could push prices for Apple’s products into the mainstream, allowing them to compete more effectively with the likes of Dell and HP. And there might not be a better time to move; Intel is a company in transition, with Andy Grove’s departure marking the end of the old-school era at the chip maker.

But does Apple even care to compete in the ultra-competitive personal computer industry? They’ve carved out a nice niche of die-hard fanatics and graphics professionals with a very high willingness to pay. The problem has been their ability to get those consumers the products they want. There exists a somewhat symbiotic relationship between Apple and the PC world insofar as the differences in platform are small enough to allow users of each to collaborate but large enough to ensure that the cost of switching between the two stay high. So long as Apple continues to serve the part of the market that will pay for their highly styled, high performance machines, they’ll continue to escape retribution from PC manufacturers interested in keeping costs and prices low.

A move to an Intel-based platform could change that dynamic somewhat dramatically. If Apple moves to cheaper Intel processors, they run the risk of spoiling one of the world’s premier brands and alienating their user group, which is nothing if not hardcore. They could also find knock-off Macs flooding the market once key hardware components are available freely, further damaging profits and forcing Apple to fight a counterfeit battle they have thus far avoided. When it comes down to it, Apple isn’t in the PC market so much as they are in the “electronic lifestyle” market, where differentiation (Think Different, remember?) is key to their high margins.

Most likely these rumors are just that; strategically timed volleys over the bow of IBM’s corporate ship. Apple made a move in 2001 to a linux-based kernel so that future threats of flight would have some level of credibility. They aren’t in a position to give up the user base and continued growth opportunities offered by complementary products like the iPod any more than IBM’s flagging chip business is to let Apple go. What this comes down to is Apple not wanting to play second fiddle to Sony, Toshiba, and the PS3. Mac users want faster, cooler machines and Steve Jobs wants to sell them. The hope is that the possibility of losing Apple’s business will get IBM back to toeing the line, and fast.

J. C. Groon
Kevin Hardy
Amrit Sahasranamam

With flattening sales, athletic footwear companies are ‘sole’ searching…

2005-05-25T22:08:00.000-04:00

According to the National Sporting Goods Association (NSGA), the athletic and sports footwear market size was $14.75 billion in 2004. Annual growth has averaged 2% since 2000. During the late 1990s, the industry suffered sales declines as large as 10%. Nike dominated the market from the mid-1980s through the early 1990s, while its most popular styles had price points near $100. Athlete driven advertising campaigns and cutting-edge designs drove worldwide market share to nearly 30%. Nike controlled over 40% of the U.S. domestic market. Sales declines were attributed to declining retail space and consumer trends that began to favor lower-priced models and discount brand such as Skechers.
The sneaker industry was a long favorite of growth investors, but began selling at levels reserved for value stocks. After trading for years at multiples equal or greater than the S&P 500’s, Reebok and Nike were valued at 13 and 20 times earnings, respectively, in 2000-01. As of today’s market close (5/25/2005), both maintained such multiples with Reebok’s stock price of $40.63 and Nike’s $81.61. Analysts are pleased to see that Reebok and Nike have recovered from their late 1990s slump. Both stock prices have more than doubled since 2000. Earnings have been supported through acquisition and increased market segmentation.
Since 2000, the industry has achieved annual market growth of nearly 2%. Footwear manufacturers have sought alternative design and marketing strategies to gain market share. Industry research has shown that nearly 80% of all athletic footwear sold is not used for sports. Companies such as Puma, Adidas, and Converse are teaming up with high-fashion designers to create limited edition styles to take advantage of the ‘lifestyle’ market segment. Puma joined forces with designers Jil Saunder and Neil Barrett, Converse with John Varvatos, and Adidas co-opted Yohji Yamamoto.
During the height of the early 1990s ‘sneaker boom’, sporting brands did not embrace fashion. Designers focused primarily on function and refused to view their products as fashionable apparel. Companies have begun to embrace the trend, realizing that brand awareness can be broadened through segmented marketing and distribution.
The only company to stick to their purist guns is Nike. Although, Nike has offered limited edition designs for its retro styles, they refuse to include fashion as a marketing tool. These limited editions are distributed through alternative channels such as sneaker boutiques, skateboard shops, and high-end department stores. At some point, Nike had to realize that its retro styles stabilized sales declines, in the late 1990s, as their $100+ shoes suffered decreased demand. Nike segmented this market with its SB, Air Force 1, and Dunk retro lines. These styles are typically only distributed to urban retailers where Nike had never lost its luster. There is also an active reseller market that is facilitated through sneaker chat rooms and EBay. Shoes that wholesale for $35 can fetch up to $500 in this worldwide market. Sneaker enthusiasts collect and trade these shoes similar to pieces of famous art.
Brands such as Reebok are even going as far as signing non-athlete endorsers for their shoes. Their most recent hottest selling shoes have been endorsed by rappers 50 Cent and Jay-Z a.k.a. Sean Carter. When Jay’z’s shoe line S. Carter’s premiered, they sold out within days at major retailers such as Foot Locker and Athlete’s Foot. They have begun to cross-market their non-athlete styles with sport celebrities for the traditional consumer. Thus far, the marketing has been successful as Reebok is capturing increased market share and becoming a close second to Nike, in the US domestic market, with approximately 25%.
As the athletic footwear industry is suffering from almost flat sales growth, companies are seeking alternative ways to engage consumers by offering a diverse product line. ‘Lifestyle’ sportswear brands are becoming more popular and battling for market share from industry giants such as Nike and Reebok. Competitive strategies are being developed to combat such charges. Nike has decided to stick to its winning formula of product innovation with the release of its newest development, Free, which debut with a $100 retail price. The shoes recreate the effect of running barefoot. The shoe is aligned with Nike’s fundamental focus on the ‘true’ athlete. Nike has acquired Converse to regain lost market share that has occurred over the last six years. Reebok responded to maintaining its market share with acquiring brands such as Rockport, Ralph Lauren footwear, and Classic Footwear. Reebok has followed Nike’s 1990’s marketing scheme by signing top name athletes to multi-million dollar endorsement contracts to market alongside their non-athlete endorsed shoes. Regardless of the strategy, fierce competition and a fickle consumer are forcing companies to search of their true ‘sole’.

Jua Mitchell and group

Consumer Products Industry: Too old to experience growing pains?

2005-05-24T22:14:00.001-04:00

The evolution of the consumer products industry occurred during the 20^th century, experiencing the highest growth rates from the 1950s to the beginning of the 1980s. As the signs of the subsequent slowdown began to emerge, companies began to respond with large-scale consolidations. More recently, companies have turned to cost-cutting measures in order to improve their bottom line results, but the fact remains that the industry’s average annual revenue growth rate has stagnated in the last 10 years. Most consumer packaged goods (CPG) companies today anticipate revenue growth rates of only 3 to 5% per year and are struggling to define new growth strategies.

Recent publications from two prominent management consulting firms explore the issue of where consumer products companies can look to now for growth opportunities. Steffen M. Lauster and J. Neely of Booz Allen Hamilton have developed the assertion that the future of the consumer products industry lies in “recentralization” and focusing on core competencies to reestablish growth. The counter-argument from Peter D. Haden, Olivier Sibony, and Kevin D. Sneader of McKinsey & Company is that companies have already extracted most of the benefits of this strategy and need to begin investigating other avenues for growth.

Consolidation has been a common response to the slowdown within the CPG industry. Lauster and Neely argue that this strategy has its flaws because mergers rarely deliver synergies and, as a result, many CPG firms have become a smorgasbord of unrelated businesses that could not possibly benefit from significant commonalities in their value chains. They cite the example of Unilever, which, even after a series of recent divestitures, still has approximately 400 brands under its umbrella. Companies like Unilever have arguably lost their business focus, and are therefore faced with the challenge of adhering to a core strategy; historically, companies that stick to a consistent strategy outperform their peers in the long term. Lauster and Neely believe that firms need to consider which capabilities contributed to their past success and redevelop their strategies to fit these strengths. Heinz is one example of a company that has shed some of its excess businesses with the sale of its former food brands to Del Monte in the interest of regaining its focus in condiments.

In recent years, discount retailers and warehouse clubs have taken a bite out of the ability of CPG companies to sell and leverage their brand power. Wal-Mart, for example, due to its size and buyer power, has convinced its suppliers to limit spending on advertising and marketing so that it can offer low prices to its customers; this tactic threatens the brand loyalty that CPG companies have built over time. Gregory Melich, a Morgan Stanley analyst, agrees that CPG firms can only hope to succeed by “working with Wal-Mart through increased efficiency, reducing promotional and distribution costs.” Warehouse clubs such as Costco have had a negative impact on innovation and product proliferation due to their narrow product selection – a warehouse store typically carries only one brand in a category. For these reasons, Lauster and Neely believe that CPG firms must commit to their core strengths in order to better maintain their brand equity and promote continued growth.

Haden, Sibony, and Sneader suggest that consumer products companies must take their strategies beyond their core capabilities and seek new paths to growth. They suspect that most of the benefits from reestablishing core brands and improving productivity have already been reaped. The McKinsey team proposes several options that CPG companies should explore, once they have identified their core functions: 1) improve execution in order to build capabilities; 2) target emerging markets for future growth opportunities; and 3) develop value segments to serve mature markets.

Haden, Sibony, and Sneader identify brand marketing to be a key factor in driving the success of a CPG firm. With pressures from discount retailers to keep marketing costs low, the greatest challenge to these companies is to find more efficient allocations of funds for these functions. Firms may rely more heavily on non-traditional forms of advertising such as banner advertising on the internet. Interactive marketing has potential advantages over conventional advertising in that 1) it is cheaper and faster than television and direct mail and 2) online interactions can reveal more about a company’s client base and may allow marketers to make more informed decisions about where they spend their marketing dollars.

Few companies with a presence in emerging markets such as Brazil, China, and India have reached their full potential. Many target a small segment of the population in these countries that can afford expensive consumer products, leaving the majority of the market share to local companies that cater to the average consumer. In order to become truly global players, major CPG firms must make it a priority to tailor their products to meet local needs.

Lastly, the McKinsey team asserts that, while some companies have enjoyed success with premium product lines, there has been a shift to value segments in many CPG categories in the mass market. This trend has been perpetuated by the growth of discount retailers and has prompted many manufacturers to develop private-label lines in addition to their branded lines. Those brands with a smaller share of the market or those who find it difficult to maintain leadership positions due to high marketing and advertising costs may find the private-label option attractive.

In our opinion, both of these articles address valid observations of the CPG industry. However, we also feel that the diversity of the firms within the industry makes it difficult to make general recommendations for successful growth strategies. A strategy that works for one firm will not likely work for another; for this reason, individual companies must concentrate on what has worked for them in the past and build on prior successes by employing a mix of the strategies recommended above, and should also continue to strive for more unorthodox and innovative methods for success.

Charlotte Ho

Reshma Patel

Matthew Rodrigues

Blink and Your Money’s Gone

2005-05-24T22:14:00.000-04:00

Last week JP Morgan Chase, the largest credit card issuer in the United States, announced the launch of its new Blink cards. According to the fact sheet issued by JP Morgan, the Blink cards use contactless payment technology to process transactions. Rather than handing over your card to the cashier to be swiped, the customer waves the Blink card in front of a special terminal. RFID technology securely transmits the required data to complete the transaction. Blink cards also contain magnetic strips and are backwards compatible with the traditional swiping technology. Transaction time is cut by 10 to 40 percent versus traditional cards at no additional cost to the consumer. Merchants such as 7-11, CVS, and Regal Entertainment have already signed up for the Blink terminals.

There are however a few drawbacks to this new system. According to the staff at DigitalTransactions.net, widespread adoption of this new technology will be slow, and not without its problems. Merchants must spend an additional $100-$150 to install the new terminals. This new technology is primarily designed to replace “low-cash” transactions, such as purchases under $25. Would a merchant be willing to pay a fixed cost, along with a transaction cost, to replace a simple cash transaction?

There is also the issue of compatibility. Mike over at Techdirt.com wonders if differing proprietary systems will cause the market to fragment. Merchants will be unwilling to install multiple terminals for each bank’s competing cards. Coupled with the consumers desire to have one easy to use system, these kinds of problems might be the death of a promising new consumer technology.

However, we do see multiple benefits to this new payment system. Jenny Strasburg of the San Francisco Chronicle writes, “Faster, no-contact credit transactions will speed up lines in convenience stores, movie theaters and fast-food restaurants.” We couldn’t agree more Jenny. She also points out “The different credit card issuers are using standardized radio-wave technology that allows various credit-card brands to be read by the same scanners.” This speaks to the issues raised about differing proprietary systems and the problems that it might cause.

Our opinion is that this new technology being pushed by JPMorgan Chase will be an enormous benefit to the average consumer. The system will provide its users with a fast, secure, easy to use credit card that saves valuable time. No longer will the customer have to sign his or her name when using a credit card, a practice that has gained widespread acceptance amongst users with the growth of Internet shopping. The benefits of saving transaction time are immediately recognizable to anyone that has stood in a long, frustrating line at the checkout counter.

With 90 million credit card users, JPMorgan Chase has the influence necessary to gain immediate support from merchants. Privacy concerns will be a non-issue since customers are not liable for transactions made from a stolen card. The backwards compatibility of the Blink card will be a benefit to merchants and consumers alike. Even if a store does not have the wireless terminal, a customer can still swipe it the old fashioned way.

The technological advancements of the past decade have dramatically increased the pace of our lives. With these changes, time has become a very valuable commodity to the American consumer. The Blink card addresses this shift in consumer preferences by reducing transaction times and might significantly reduce time wasted standing in lines.

There will always be resistance to new technology by those who fail to see the long-term benefits. $100 terminals are a small price to pay for your customer’s satisfaction. In fact, those merchants who resist the new technology may see less traffic as consumers refuse to stand in their long lines. If you could avoid a 10-minute line to buy a bottle of Coke, wouldn’t you get a Blink card? The bottom line is this technology gives people what they want, less wasted time. It provides consumers multiple benefits with little cost to all parties involved. Students of the GSB certainly understand the frustrations of waiting in slow moving lines. Could JPMorgan please talk to the cafeteria on the 2^nd floor of the Gleacher Center? After that, could they please speak with the owners of the parking lot?

Michael Antonelli

Steve Dormanen

Private Equity in Europe: The Future’s So Bright, We’ve Got to Wear Shades

2005-05-24T22:13:00.000-04:00

These days, Europe is seeing an unprecedented wave of private equity deals. Deal size, country and sector do not seem to be a deterrent factor for the large private equity houses making investment decisions. What explains this surge in the European private equity sector, which languished for a number of years? Conventional wisdom states that US private equity firms, who have encountered limited growth opportunities in the ultra-competitive US market, have increased their forays into the European markets. This idea is supported by the fact that these firms have deep and full pockets after record levels of fundraising from investors looking for successful alternatives to the post-bubble equity markets. As pension funds, endowments and wealthy individuals have become increasingly sophisticated investors, the amount of capital in private equity has soared. Concurrently, there has been a dramatic growth in both the size of private-equity funds and in the size of the top firms that manage them. Finally, macroeconomic conditions have been very positive for the private equity industry in the last two years, due to very low interest rates – which cheapen debt service and cost of capital – and a somewhat resilient equity market that still enables an “exit” of the investment through an Initial Public Offering.

However, it is Asia and Europe that are portrayed as the new promised lands. On one hand, China has shown an outstanding 10% annual growth in the last few years. The world’s most populous country has vast reserves of labor and no shortage of capital. A history of inefficiently run companies an untapped market, and an appetite for foreign direct investment are part of the explanation for the surge in growth. India, Taiwan, Thailand and other South Asian countries pose a similar landscape, with particularities to their economic fabric and with other issues that affect their attractiveness for private equity firms. Nonetheless, most of these countries lack a fundamental requirement for private equity: a stable, effective and efficient legal environment.

Is this really a factor to consider? Europe presents only moderate growth, but it offers a stable legal framework and a great deal of opportunity, especially when it comes to turning around poorly managed companies poorly. Deal size is no longer an obstacle for private equity firms in Europe. With multi-billion euro funds to invest and a ready supply of debt, these firms are ready to tap the high-end market. There has been a lot of activity across the board, but particularly in the telecom, general industrial and retail sectors. Firms are targeting companies with hard assets, such as property, which will allow them to refinance.

While the value of deals has been soaring, the number of transactions has remained the same. This implies that the average deal size is growing. Buyouts worth about €60bn were completed in the first nine months of 2004, compared with €47.2bn in the same period of 2003. The number of deals increased by 2% to 748.

The size and quantity of buyouts had a noticeable effect on the M&A business of investments banks, who provide advice to the vendors and purchasers and also assemble the debt financing and offer their own equity to hold up deals. During the first six months of 2004, private equity firms were responsible for 40% of global M&A by value.

There are at least 10 US funds with more than $5bn (€3.7bn) to invest globally. The Blackstone Group, for example, raised more than $6.4bn for its fourth fund, and Thomas H. Lee Partners raised just over $6bn. At the same time, debt is being issued at unprecedented levels. Leverage in the €2.1bn VNU World Directories buyout was more than 6x EBITDA. Private equity firms have taken advantage of the lack of interest shown by corporate in M&A in recent years.

Multi-billion euro deals were almost commonplace this year. CVC Capital Partners and Permira won control of the Automobile Association, the UK motoring organization, for €2.6bn, while Apax Partners and Cinven acquired VNU World Directories, the Dutch publications company, for €2.1bn. US-based Blackstone Group won the German chemicals group Celanese for €3bn-plus.

These aspirations are clearly reflected in the €12bn ($15.5bn) bid for Auna, a Spanish telecom company. Ten of the world's largest private equity firms have divided into four groups to bid for the cable giant. Just this week, The Blackstone Group walked out on a consortium bidding €12bn for Auna and joined rival bidders Providence Capital Partners and The Carlyle Group in an €8bn offer for the company’s mobile telephone assets. Blackstone had been bidding for the entire company as part of a consortium with UK private equity firms Apax Partners and CVC Capital Partners. To make things more complicated, Carlyle and Providence are already backing a separate €2.6bn bid for Auna's cable assets, along with Spanish cable competitor ONO. It seems that Apax and CVC are now considering their options, which may include abandoning their bid or partnering with Cinven to replace Blackstone. The consequences of this deal, for Auna, the private equity firms investing, and to a lesser extent to telecom industry in Spain, are still unclear. Only time will shed light on these important questions.

At this stage, it seems clear that the old tale of Barbarians at the Gate is just beginning in Europe. Are we going to see a wave of takeovers, LBOs, MBOs in Europe similar to that of the US 10-15 years ago? And if so, what is the implication of such a threat for corporations across Europe? One important difference is the state of the junk bond market in Europe. The European junk bond market ground to a halt after last week’s downgrade of Ford and General Motors, threatening more than €10bn ($13bn) of high- yield bond issues coming to the market. The collapse in sentiment also threatens to dent the surge in private equity by raising the cost of financing on buyouts. Leveraged buyouts have been the main driver of junk bond issuance for the past two years, which has seen record demand and levels of issuance.

After fostering the image of corporate wrecking crews, private-equity firms can now plausibly describe themselves as providers of a safe haven in which firms can pursue long-term growth, sheltered from the short-term storms of the public stock markets. This role has the most strategic importance because both venture capitalists and buyout firms work with large numbers of firms undergoing big changes. In this sense, private-equity firms can also reasonably claim to offer a solution (though an expensive one) to the corporate-governance problems that have blighted so many public companies. “If you examine all the major corporate scandals of the past 25 years, none of them occurred where a private equity firm was involved,” noted Henry Kravis, one of the founders of KKR, in a recent speech. Is this bold assertion true? Is private equity the solution to corporate governance in Europe and more broadly at a global scale?

Finally, there is an important issue to be addressed: how easily can private equity firms dispose of their investments? These firms need an exit to realize their profits, and the two likely routes are selling a firm to a large corporate buyer or offering ownership through the public stock market. Despite the improvement in equity markets during the last two years, markets now seem to lack a strong growth bias, making an initial public offering much harder to pursue. In addition, increasingly popular alternatives, such as selling to another private-equity firm, are becoming more controversial.

Marcelo Hanan

Gabrielle Lambert

Valentin Pitarque

Hung Out to Dry – The Maytag Man Packs Up

2005-05-24T22:12:00.000-04:00

On May 19, Maytag Corporation agreed to be bought out by a consortium of private equity groups led by Ripplewood Holdings LLC, for $1.13 billion in cash and the assumption of $975 million in debt. The deal values Maytag at $14 per share, a far cry from the $45 it was trading at 3 years ago, or even its much lower 52-week high of $26.44.

This is the sad endgame to a 6 year tailspin that the owner of brands such as Maytag, Amana, Hoover and Magic Chef could not pull out of. Therein lies the cautionary tale that even the most well-known brands will not guarantee financial success if management doesn’t have a clue.

Sleeping on the Job

As a mid-size player in the consumer durables industry, Maytag was increasingly squeezed by its lack of distribution scale versus behemoths like General Electric and Sears Holdings’ Kenmore brand. It was also blindsided by the emergence of a new breed of players like Electrolux, Samsung and LG, who displayed a heightened responsiveness to consumer desires.

Buffeted by rising costs of inputs like steel, plastic and energy, Maytag was slower to restructure and improve manufacturing efficiency than similar sized competitors like Whirlpool. Its social commitment to its home base in Iowa may be laudable, but as the man said, you’re no good to anyone if you’re dead.

Its stellar reputation for quality and reliability aside, it certainly didn’t help that Maytag continued to plod along with insipid designs, and even ignore entire segments of the market altogether. Hoover, once synonymous with vacuum cleaners, squandered its lead by refusing to introduce economy-priced models that consumers flocked to. Even if Hoover wanted to stay upscale, Maytag could have at least introduced economy vacuum cleaners under one of its other brands.

Turning a Sinking Ship Around

Maytag needs help on multiple fronts. They need to cut costs and rationalize production capacity. They need to bring out snazzier designs. And they need to grow beyond their core North American market.

Maytag has done a good job recently in bringing out appealing products at the top end of the price range, such as its Neptune^® line of kitchen appliances, but it needs to stop boxing itself into the premium corner of the market. Ripplewood brings with it expertise in operating in Europe and Asia, and will likely look to move production overseas in a bid to get costs in line with industry averages. Any realistic turnaround strategy will take a few years to execute, and it is probably easier done outside the glare of the public markets, where the pressure to deliver earnings growth every 90 days can throw companies off track.

Our key concern here is Ripplewood’s plans for Maytag. They are acquiring a positive cash flow business with an image of solid reliability, and as a private equity firm they could simply ride out the investment for the free cash flow. Will they simply lay off everyone in Iowa and move operations to China? Or will they actually invest in developing innovative new products that can compete head on with Electrolux and Samsung, who have had remarkable success integrating information technology and electronics to traditional consumer durable products? How do they intend to penetrate markets abroad when Maytag has already tried and failed?

A Fair Deal for Investors?

Shareholders are staring at losses on their investment in Maytag, considering that most of them bought their shares at significantly higher prices. The consensus seems to be that Ripplewood will get away with highway robbery if it snatches up Maytag with the offer currently on the table. In fact, Maytag is already trading at prices higher than the $14 offer price. This indicates a belief that the deal does not offer fair value to shareholders and is probably not going to happen unless Ripplewood loosens its purse strings some more. Maytag’s debt is already rated junk, so its questionable how much more debt Ripplewood can pile on to go through with the leveraged buyout.

This has naturally led to speculation that there may be other offers forthcoming. GE and Electrolux have been mentioned as possible candidates, although Electrolux may itself be a likely target. The fact remains that Maytag’s stable of brands is a tempting draw for anyone looking to break into the North American consumer durables market. Even though they have been damaged by long-term neglect, their brands are still among the most well-known in their segments, and we still hold out the hope that they can be nursed back to health.

But hey, look at the bright side – at least $14 a share is better than nothing if Maytag goes belly up!

Amit Chandra

Oliver Banz

Full Throttle: Can Kerkorian Put the Motor Back in GM?

2005-05-23T22:11:00.002-04:00

Aging billionaire set to become the third largest holder of GM
http://www.msnbc.msn.com/id/7790473/
On May 5, Billionaire Kirk Kerkorian's investment firm Tracinda Corporation, which has extensive interests in DaimlerChrysler, MGM Mirage and a number of airlines, launched an aggressive effort to purchase 28 million shares of troubled General Motors at $31 per share. This move will double the firm’s stake in the automotive company to 50 million shares, or 8.84 percent, and position it as the third largest shareholder behind State Street Corporation and Capital Research and Management Company. Tracinda already owns 22 million shares that it acquired in April at $26.33 just above the 12 year low.
Tracinda’s surprise offer, 13% above the previous day’s close, reflects Kerkorian’s assumption that GM’s stock price is undervalued. According to Dave Cole, chairman of the Center for Automotive Research, the move focuses more attention on how much GM is undervalued at today's stock prices.
GM shares decreased through March on warnings that the automaker was consistently losing money in its core North American operations and in April, prices fell to a 10-year low following the announcement that the company reported a $1.1 billion loss in the first quarter. Following the news release, GM shares rallied to close at $32.80, up $5.03, and 60 million shares traded hands. This was the largest gain for GM in more than 40 years. Regardless, GM’s status was reduced to “junk”, which will increase borrowing costs.
Industry Analysis
Dismissing similarities to a failed 1995 hostile takeover attempt of Chrysler, Kerkorian insists that this robust acquisition is for investment purposes only and that neither he nor his firm are interested in asserting control over GM’s business. "Tracinda became aware of rumors over the weekend concerning its possible purchase of shares of General Motors stock," said the firm's statement. “Since Tracinda's acquisition of General Motors stock is solely for investment purposes, it decided to go forward with this tender offer to remove any uncertainty in the marketplace as to its investment intent.” http://money.cnn.com/2005/05/04/news/fortune500/gm_kerkorian/
GM, on the other hand could benefit from restructuring and Kerkorian could reap significant benefits by forcing GM to lower bloated health care costs for union employees and retirees, and slashing excess manufacturing capacity. Notably, the reputable investor could sell off GMAC, GM’s finance division that earned $2.9 billion in 2004, which accounted for 80% of the company’s total earnings. "GMAC is worth itself more than the value of the company today," said Cole. "They have a power train operation that could be spun off as an independent company." UBS analyst, Rob Hinchliffe was quoted as saying “Kerkorian's stake can result in more forceful discussions with the union." The board and other shareholders will most likely welcome the increased leverage with unions and cost cutting measures that the acquisition will produce.
GM did not formally comment on Tracinda's provoking offer but insisted that its board and management are committed to enhancing shareholder value for all investors. However Kerkorian may become a thorn in the side of CEO Rick Wagoner, who recently assumed day-to-day oversight of the automaker's troubled North American automotive operations. Contrary to Kerkorian’s promise, he could continue to increase his interest and gradually exert more pressure on GM management to take more aggressive steps to cut cost and cultivate profitability. It is also speculated that other investors could also surface in the coming weeks, whereby igniting a bidding war. Some industry analysts believe that, despite any investor efforts, outside manipulation will only have a limited effect on the ailing automaker because of their depth of fundamental problems; lackluster growth, damaged brands, and mounting commitments to retirees.
http://www.detnews.com/2005/autosinsider/0505/05/A01-172472.htm
Independent Outlook
Recent trends in the underperforming hedge fund industry have evoked fund managers to acquire larger percentages in weaker or mismanaged companies with the intentions of shaking up the leadership. As significant shareholders, these hedge funds can assert the pressure that is required to get the ailing companies back on track. Despite, Kerkorian’s comments, we believe that he has every intention of restructuring GM. Obviously, he will look to spin off GMAC as quickly as possible, but will look much deeper than that. We expect to see rigorous cost cutting in effort to streamline GM’s tumbling North American operations. Kerkorian, renowned for his tenacity, will not sit on the sidelines once the additional shares have been acquired.
The market also believes that a shakeup at GM is on the horizon. GM was downgraded this month on the assumption that bankruptcy was imminent and as a result, the firm was dropped from the Lehman Aggregate Bond Index. Concurrently, money mangers will be obligated to drop GM, because of its junk bond status, from funds pegged to an agg bond index. Interestingly, however, many managers have not started dumping the distressed debt – they believe that GM will be back on track and reinstated in the index by the end of June.
GM will most likely buck outside interference, but it is apparent the premise of third party influence is a primary driver of fruitful forecasts. It is certainly in the best interest of Tracinda to exert pressure and GM, in its own best interest should bow to the wisdom of the aging billionaire.

David H. Smith
Greg Watson
Troy Stalter

What CAN’T brown do for you?

2005-05-23T22:11:00.001-04:00

On Monday, May 16th, UPS, the world’s largest package delivery company, agreed to buy Overnite Corporation, a leading provider of less-than-truckload transportation services, for $1.25 billion. Less-than-truckload (LTL) carriers, which typically carry freight of less than 10,000 pounds, consolidate the loads of numerous customers into single trailers through a network of terminals. The acquisition of Overnite, the fifth largest player in this LTL space, offering a full spectrum of regional, inter-regional, and long-haul services nationwide, marks UPS’ continued attempts to diversify beyond its original package delivery business. In 2004, UPS acquired Menlo Worldwide Forwarding , a move that strengthened its heavy airfreight and supply-chain management businesses. Highlighting the need for UPS to expand its product base, UPS Chairman and CEO Mike Eskew deemed Overnite a “perfect strategic fit”, as the company attempts to “offer…customers the broadest portfolio of transportation and logistics services available from a single source”.

The popular press has touted the purchase of Overnite as the largest acquisition in UPS’ nearly 100 year history. While certainly factual, it is still relatively small given the company’s considerable size. With a market capitalization of nearly $84 billion, and cash on hand of just over $4.5 billion, UPS has ample liquidity to absorb Overnite. However, while not a “blockbuster” acquisition, the venture into the LTL space represents a marked change in UPS’ strategy. Wall Street and the financial press are fairly unanimous in their belief that Overnite is a good strategic fit for UPS. The acquisition will help UPS expand its available transportation and logistics services and reduce its reliance on the domestic ground package business, a segment of the market that UPS continues to lose market share to rival FedEx. Analysts have observed that recent consolidation in the once-fragmented trucking division may be motivating UPS to move forward into the LTL segment sooner than expected. FedEx , currently the second largest LTL provider, acquired two former carriers and has experienced high revenue and operating income growth in their LTL division (Fedex Freight) over the past 3 years. The industry leader, Yellow Roadway Corp, solidified their competitive positioning through the acquisition of USF Corp in February. Citigroup analyst Scott Flower believes that, while it is encouraging to see UPS “fill an evident gap in its service portfolio”, the existing competition should not be ignored. Flower asserts that FedEx Freight is a “well-regarded LTL operation…that has resulted in cross-selling opportunities.” However, he believes that expanding their product base should enable UPS to better compete with those shippers that have a more expansive suite of freight hauling capabilities.

The acquisition of Overnite is certainly not without risk. All too often, management is quick to ascribe synergistic benefits from a proposed transaction. It appears as if UPS management, however, is somewhat realistic as they enter the LTL space. UPS should be able to capture some of the cross-selling opportunities that have made FedEx Freight such a success. However, management is correct in observing that the synergies will largely be confined to revenues, as the operational differences between LTL and UPS’ parcel terminal operations will mitigate any further cost reductions.

The potentially combative role of labor unions (i.e. Teamsters) poses the largest risk to the Overnite acquisition. If recent history is any gauge, the powerful role of the labor unions can be disruptive to UPS’ daily operations. The UPS labor strike of 1997 not only effected UPS operations ($700 million in lost revenue) but had a spillover effect on the U.S. economy as a whole. Eight years later, UPS’ labor force continues to be largely unionized. Overnite, however, is largely non-unionized, with only 1% of their employee base under union control. Labor strategy thus plays a crucial role with this acquisition. Will the Teamsters win out in their attempt to unionize the Overnite employee base? What the media and analysts have been focusing on is the effects of potential integration risks between the two companies However, one of Overnite’s competitive advantages within the LTL space is its lower cost business model. If this independent labor force becomes unionized, Overnite’s lower cost labor pool arguably will become more expensive for UPS. Very quickly Overnite’s competitive advantage could begin to erode.

What isn’t clear necessarily is how the purchase of Overnite is consistent with UPS’ recent strategy of increased growth via their international operations. Additionally, is UPS abandoning their strategy of maintaining higher margins versus their peers? Historically the company has remained focussed on maintaining price, while competitors such as FedEx and DHL have stolen market share by way of price cuts and/or increased service and marketing campaigns. James Valentine, analyst at Morgan Stanley, warned that the acquisitions of Menlo and Overnite have taken UPS into parts of the transportation industry with “lower returns on investment than in package delivery.” While his observation is certainly noteworthy, at nearly double the operating margins of their nearest competitors, it appears as if UPS does have some flexibility. And with this flexibility, UPS may very well be able to “gain some ground” in the U.S.

Michael Miranda and Brad Pitzele

The NHL Must Quickly Skate to a New Business Model

2005-05-23T22:11:00.000-04:00

As a result of a labor dispute between players and National Hockey League owners, the entire 2004-2005 season was cancelled. As the new season approaches, an agreement has still not been reached. With so much play cancelled, revenue is lost and advertisers are abandoning their sponsorship of the NHL.

A couple months ago Bain Capital Partners LLC and Game Plan International made a $3.5 billion offer to purchase the NHL and all its teams, and on May 22, 2005 upped its bid to $4 billion. Currently the NHL is like all major professional leagues, where all teams are owned by individual owners, so the recent offer radically changes the hockey landscape. Most analyzing the situation view the offer as too low, since the price of $133 mil. per team is well below the generally accepted price of $163 mil. as calculated by Forbes. For example, Sal Galatioto of Lehman Brothers said that it would be “highly unlikely” that the deal would proceed. Additionally, Boston Bruins Owner Jeremy Jacobs said “The Bruins aren’t for sale. I talked to a lot of my contemporaries. They didn’t take it terribly seriously.”

The heart of the labor issue results from the inability of the owners to impose a salary cap on the league. A recent proposal from the owners would impose a yearly total salary cap of $42 million to $52 million per team. Salary caps would make the league more competitive, and thereby increase excitement for the sport and grow its fan base.

Other sports that compete against hockey such as professional football, baseball, and basketball, have been attracting fans and gaining an increased fan base. Furthermore, consumers have a larger variety of entertainment opportunities available to them such as DVD’s and video games. There is also the threat of new and existing hockey leagues which are trying to capture the advertising and consumer dollars: the World Hockey League, the European Hockey League, NCAA hockey college league, and minor league hockey.

First, if the owners sold their teams they could increase their bargaining power with the NHL players. It would be a lot easier for the league to negotiate for one interest than the interest of all the individual owners and be able to pass the salary cap. In the U.S., the National Basketball Association and National Football League both have caps. In addition to being more competitive leagues and having an increased fan base, these leagues have not suffered lost revenue from prolonged labor issues. On the other hand, Major League Baseball which does not have a salary cap has had major labor issues including a missed World Series in 1994 which negatively impacted revenue.

Leagues like MLS (men’s soccer) and WNBA (women’s basketball) are currently functioning under a single owner format, so there is precedent and hence it might be difficult to stop this plan from taking effect under the premise of anti-trust issues. Similarly, private equity firms have done such deals before. The Boston Celtics, a basketball team, was partially owned by a private equity firm at one time. In 2002, Boston Basketball Partners LLC took the team private by buying the NBA franchise for $360 million from its then-owners, the publicly traded company Boston Celtics Limited Partnership. Although NHL owners are somewhat indifferent to the league starting up in the short term since most teams are loosing money, owners need play to resume or the NHL’s fan base might take a serious long-term hit.

Also, with a cohesive management structure, the NHL will be able to close unprofitable teams. As it stands under the current situation, NHL cannot close these teams. Since the teams are in poor financial standings, they lack the ability to field good hockey teams and manage their organization properly. Such poorly-managed teams just hurt the competitiveness of the league, ultimately reducing the revenue for the league as a whole. On the flip side, there would be a lack of politicization amongst the owners in establishing new teams and perhaps profitable teams could be started.

With the team under a single ownership, advertising could be more effective. As it currently stands, each team is just trying to maximize profit for their specific team. With a single owner, the NHL would have more bargaining power in advertising. Also, advertising would be able to increase profits for the league through synergies in advertising, rather than simply just for individual teams.

Most importantly, a single owner would make management consistent across the league. Many owners currently do not have any incentive to win the Stanley Cup. They simply hope to make a small return on their investment and believe that committing the resources to a hockey team (not just salary, but also facilities, publicity, and coaches) would not be profitable. However, a single owner would have the incentive to make the league more competitive, which would increase fan interest and generate increased revenue for the entire league and significantly reduce the league’s operating costs.

For Bain Capital, who has led multiple turnaround private-equity deals before, this is an attempt to reinvigorate an organization which has been destroyed by the ineptitude of current owners and a power struggle between the union and the owners. By collaborating with sports experts - Game Plan International, they hope to fix the management, quickly negotiate with the union, and help turnaround this loss-making franchise. Bain Capital plans on running the NHL like a large corporation, and each team would begin the year with a set budget and be able to make autonomous decisions.

Although the owners have not accepted the offer, there are signs that some owners may find the deal appealing. Recently, the Walt Disney Co. sold the Anaheim Mighty Ducks for a 27% discount of $75 million and Molson Coors is banking on selling their hockey team as well. These owners realized that it is in their best interest to sell the team; let’s hope the other owners realize that as well for the sake of all hockey fans.

Authors: Anand Kamannavar, Alex Viergutz, and Matt Koch

"Toyota-Sacrificing earnings to sustain market share"

2005-05-23T22:10:00.000-04:00

Competition in the US automobile industry continues to be intense as GM and Ford suffer various problems and Toyota Motor Corp (TM) tries to gain pole position. Toyota’s 2004 annual report boasted historical highs in sales (up 9.9%), net revenues (up 11.6%), operating income (up 13.1%), and net income (up 54.8%). However, Toyota seems to be losing momentum as earnings sank 17% by the end of March 2005. One of the reasons for this decline is the boost in sales incentives and rebates offered by Toyota. Incentives range from cash rebates, low financing offers, and leasing deals. According to Edmunds.com, Toyota’s average incentive rose 137% since last year. Analysts are concerned that Toyota has started a cascading effect and predicts that Toyota will have a difficult time putting the breaks on increasing incentives, which will result in the continued erosion of earnings.
The analysts’ rational is as follows – by increasing incentives, the value of used models decrease. Decreased value of used models will mean lower trade-in value for new cars. Thus, to provide incentive for consumers to trade-up to new cars, higher incentives will be needed to compensate for the lower value of the used car.
Our viewpoint is that Toyota’s strategy of now offering increased incentives (Toyota has been playing the incentive game for quite a few years now) to capture market share is driven by compulsion rather than choice. Rising oil prices have reduced demand for gas-guzzling SUV’s and the strengthening of the yen against the dollar has reduced margins of Japanese car manufacturers doing business in the US. Further the dollar weakness has also kept commodity prices high and the cost of raw materials (steel) has adversely impacted margins in the industry.
There are some key factors that are being overlooked by the analysts. Toyota’s move to offer incentives was a strategic move to maintain steady sales of their vehicles in the current economy. With gasoline prices staying above $2.00 a gallon and rising interest rates, cash rebates and low financing options keep the cars affordable. Although, Toyota’s earnings dropped this last quarter, car sales increased by 7%.
Another factor that needs to be weighed into the equation is the fact that Toyota is aggressively moving into the hybrid market. Toyota is convinced that the future is in fuel – efficient cars, due to environmental concerns and with the view that the cost of fuel is likely to keep increasing. In support of this belief, Toyota has invested a significant amount in expanding its hybrid vehicle offerings. The hybrids are priced at a premium, which will offset the incentives offered on the older models. Toyota’s current fuel-efficient models have so far been successful with long waiting lists. A-list celebrities are also in the market for these “it” cars, increasing the appeal of owning a hybrid vehicle. If fuel efficient cars are the wave of the future as Toyota believes, then incentives on the older models will not be as a big of a threat to their profits as analysts predict. Moreover, while this new product mix may be a good hedge against rising oil prices; given the large capital expenditure (Toyota’s capital expenditure is expected to peak in the year 2005) that the development of new technology involves, what happens if oil prices fall?
Further, automakers have raised prices last January, including Toyota. Toyota plans to further increase prices to encourage competitors to continue to raise their prices or cut back on rebates. If Toyota’s strategy works, the cascading effect described by the analysts will not be much of a concern.
Given this background, we believe that the biggest risk for Toyota is the possibility of oil prices falling/stabilizing and the yen continuing to strengthen. This is easily possible - even though oil prices and the USD are negatively correlated (ie. fall is USD value causes oil prices to increase). If China revalues its currency, it will cause the JPY to appreciate against the USD. Oil prices may not rise in the same proportion that the USD appreciates against the JPY. Under this scenario, the hybrid cars may not take off as envisaged and Japanese cars (already at increased prices) will further lose their price competitiveness in the US markets.
While the incentives are having some positive effects on increasing sales - they are eating into earnings - hence if sales do not increase proportionately, and the current trend (March, 2005) continues, Toyota could see its profitability dip further. So Toyota should establish a time frame by which it hopes to see an increase in the rate of growth of Sales, else gradually reduce the currently unprofitable scheme of increased incentives to levels which sustain growth in earnings.
Jenny Hannus, Shilpa Kumar, Ritesh Singhania

The Scions Don’t Fall Far from the Tree Either

2005-05-20T19:24:00.000-04:00

Toyota Motor Corporation, time and again one of the world’s most profitable auto makers and currently the second largest in terms of market share, has set an aggressive growth target for itself. It is aiming to boost its global market share from 10% to 15% by the next decade, thus surpassing GM to become the number one player in the auto industry. This is indeed a lofty goal but not an unachievable one. However, will the eventual growth be worth the soaring cost Toyota has already endured and will likely continue to incur? That is the multi-billion dollar question.

A major portion of Toyota’s current and future expansion plans are focused predominantly on increasing its presence in the emerging markets in Asia, South America, and Russia. The competitive landscapes in these less developed geographical areas are quite different from those in the more established markets, resulting in a different set of competitive strategies. In order to successfully compete in any foreign country, Toyota establishes local manufacturing plants to assimilate itself and its products into the host society. This not only allows Toyota to gain the good will of the locals, but it also provides valuable insights on their specific needs, leading to more suitably tailored products for each country or region.

In theory, Toyota also stands to add to its bottom-line through the lower labor costs in these less developed countries. However, in actuality, because the products of each plant are mostly intended to be sold in localized markets, the lower labor cost, more often than not, simply drives down the overall price and lowers product quality along with it. And, the intensive capital investments associated with creating these numerous new plants in places with little or no prior infrastructure have taken their toll on Toyota’s earnings. This (along with the temporary weakening of the dollar in relationship to the yen) has led to falling profits in the midst of steadily increasing revenue and market share figures.

As Toyota focuses more on its expansion plans in these less developed countries, it can’t help but shift some of its attention from the more mature markets, such as the US. However, there needs to be a balanced approach to Toyota’s overall strategy. The concept of “growing market share” in and of itself brings no inherent value to the shareholders; it is merely a means to an end. Ultimately, that end should be increased shareholder value in the form of profits, dividends, or stock price. That is why we think Toyota must not lose sight on the lucrative-ness of the US market.

In a highly sophisticated market like the US, Toyota could capture value, add to its competitive advantage, and stay one step ahead of its rivals by leveraging its excellent brand equity, its wide distribution channels, its superior customer relations, and its existing technological lead. Two specific examples come to mind as successful results of Toyota’s complementarity capabilities: its venture into hybrid vehicles and the Scion brand targeted at the younger car buyers.

The US is not only the largest market for automobiles, it is also the biggest market for hybrid cars. Increasing by 81% in 2004, more than 80,000 such vehicles were registered, of which the Toyota Prius consisted a whopping 64% (USA Today). To put this into perspective, Toyota sold a total of only 47,000 cars in Russia during the same time period. The overwhelming success of the Prius in the United States has caused a few other car companies to either start or increase their efforts in the hybrid vehicle segment. Notable among them are Honda’s Civic (31% market share) and Ford’s Escape (3% market share). Toyota must do its best to stick with the current plan of continued research in this area and roll out the other hybrid models, such as the Highlander or the Lexus RX400h. Demand for hybrid cars currently far outpaces supply in the US, as this disruptive technology gets closer to the growth part of the S-shaped technology adoption life cycle. Toyota’s interests would be very well served through continual focus on the wooing of the early adopters and maximizing its market share of the hybrid car market.

Another of Toyota’s latest success stories is the launch of the Scion nameplate. By leveraging Toyota’s massive distribution channels in the US and pent up consumer demand in the young male demographic segment, Scion utilized existing Toyota dealerships to create one of the most outstanding automotive brand launches in recent times. Around 100,000 Scions were sold in 2004, and about 130,000 are expected to be sold in 2005. More impressively, 85% of these buyers have never owned a Toyota before. Furthermore, the Scion brand is not only bringing in needed revenue, but it is also establishing customer loyalty at relatively early stages of adult-hood. Now Toyota Motor Corporation has a full line of vehicles to accommodate the full spectrum of customers, who can start with the hip Scion brand, graduate into the dependable Toyota brand, and perhaps eventually move up into the luxurious Lexus brands.

In short, Toyota’s current plan of global expansion by branching out into the less developed locales is not without merits. After all, wisely investing in the future is what keeps a market leader several steps ahead of its competition. However, in determining its competitive strategies for the future, Toyota must not lose sight of the importance of its highly profitable US business in the process. Although some may think this mature market is already too saturated, the (perhaps surprising) success of the Prius model and the Scion brand indicate otherwise. By leveraging its high product quality in the US, its entrenched dealership network, and its investments in new technologies, Toyota has already taken a few first steps in the right direction. Whether the company stays on this track will be a key determinant of its future success.

By Chia-Hao Han, Sachin Gupta, and David Kim

Oenophiles rejoice! (And it’s not too bad for the vineyards either)

2005-05-20T19:23:00.001-04:00

With all apologies to the movie Sideways, “If they want to drink [California] Merlot, we're drinking [California] Merlot.”

All over the United States, wine lovers are celebrating a Supreme Court ruling this past Monday that paves the way for direct shipments of wine from throughout the country. The decision overturns New York and Michigan state laws that allowed in-state wineries to ship directly to residents but made it illegal for out-of-state wineries to do the same. The ruling will likely cause legislatures in 24 states to review similar statutes. The decision has been lauded as a boon to smaller vineyards that were previously shut out from the nationwide marketplace due to the industry’s distribution structure and the bans on out-of-state shipments in many states, most notably New York. While wine lovers and small vineyards are clear beneficiaries of the decision, the biggest winners have yet to step forward to claim their prizes.

Wine lovers have been a bit too quick to pop the cork on their favorite California sparkling. What the Supreme Court decision actually outlawed was the discrimination by states between in-state and out-of-state producers. The main rationale given for these laws was the ability for states to collect taxes and to monitor sales to minors. Many observers have jumped to the conclusion that the decision means inter-state trade in wines will be legalized. However, the head of Michigan’s Liquor Control Commission has already come out and said she would pursue a ban on all online sales of wine rather than opening up the market to out-of-state vineyards in order to prevent sales to minors. While the exact legal ramifications have yet to play out, the decision has the potential to drastically alter the wine industry.

The industry is currently divided into three regulated segments: producers, wholesalers and retailers, which are outlawed from integrating vertically in most states. The original role of the wholesalers was an efficient means to collect excise taxes. The difference today is that in the past, a few thousand distributors competed, whereas today, there are only several hundred who have effective monopolies in many geographic areas. A study done by the FTC found that direct purchasing of wine could save consumers between 8 to 13 percent on wines costing more than $20 per bottle and 20 to 21 percent on wines costing more than $40 per bottle. The effect on consumers of the additional layers, especially the monopoly of the distributors, is quite clear.

The first reaction by many has been to focus on the effect inter-state shipping would have on smaller wineries. These vineyards have generally not been carried by the large distributors and therefore are only available on-site or locally. The decision could lead to a “snowball effect” benefit, according to Jim Trezise, president of the New York Wine & Grape Foundation. National availability of smaller vineyards will lead reporters to write about their wines, which will lead to consumers trying them, which, in turn, would create even more demand through word of mouth. The decision has the potential to expand the size of the market as people explore these newly available wines. Smaller producers gain the benefit of increased visibility as well as the increased pricing power created by the newfound demand.

What about the large producers? They have remained conspicuously quiet regarding the ruling, but the implications to them could be many times larger. A spokesman for Diageo, the worlds’ largest alcohol beverage company, has only said the company is in the process of reviewing the decision but it is “committed to the three-tier system.” With the implications of the decision still being determined, it is not surprising that these large producers would not want to alienate the distributors. If the ruling does indeed open up inter-state shipment in wines, it could dramatically alter the industry dynamics. Wine producers will be able to capture more of the value by creating their own direct to consumer online businesses. The effect of the three-tier system was that distributors “sold” access to their respective monopoly markets and extracted their piece of the pie in exchange. Internet sites like wine.com were only able to sell online by establishing a physical presence as a retailer in each state they did business and were limited to selling only wines distributed in that state.

The wine industry is stratified by price and the largest segment, wines under $7, so-called “everyday wines,” will probably remain unchanged. The cost of shipping cancels out the consumer’s savings on these wines, and sales in this price range will remain at the brick and mortar outlets. The impact on mid- and high- end wines is potentially a very different story. These “premium” wines make up 32% of the volume of California wines but 64% of the revenue. As you move further up the price range, consumers generally know which wines they want and make fewer impulsive purchases. A shift to direct sales on these wines would allow producers more opportunity to capture economic rents generated from these high-volume consumers that were previously siphoned off by the wholesalers. The benefit to producers is very direct and any gain in value capture would flow directly to the bottom line. It is feasible to imagine a scenario where consumers, who know which wines they want, whether from experience or a publication, will go online to ensure they find the vineyard and vintage they are seeking, rather than taking the chance on the local store. Online direct to consumer marketplaces would offer the wide selection and lower prices that would form a formidable one-two punch that could dominate the mid to higher end market.

No one is saying much publicly yet, but the decision has the potential to drastically shift the way wine drinkers purchase their wine. Considering that California alone shipped $9.6 billion of “premium” wine in the United States in 2004, the stakes are high.

Brian Home
Terence Lee

The Bankruptcy Gamble: Punting Pensions Doesn’t Solve Everything

2005-05-20T19:23:00.000-04:00

May marked a strange turn in the history of UAL. Eleven years after UAL completed a massive corporate re-capitalization where it became 53% owned by its employees through an Employee Stock Ownership Program, the company went the opposite direction by getting its bankruptcy judge to allow it to terminate its four employee pension plans. On top of that, the company is asking the judge to throw out its labor contracts but force employees to keep working.
Extreme, but not unusual. The last few years have marked the start of a popular trend whereby companies have begun thinking of bankruptcy as a strategic choice that will help them remove legacy liabilities granted to employees during more prosperous economic times and emerge as better companies. Initially the steel companies did it. Now UAL and many of its airline brethren are either doing it or contemplating it. In fact, some argue General Motors should follow this path.
Are all these companies correct that bankruptcy is somehow a strategic nirvana for them? Hardly. The problem with this trend is that bankruptcy is not a strategic solution, but rather a calculated gamble that the legal structure of bankruptcy, combined with the government sponsored PBGC, can fix the problems that have pushed them toward bankruptcy. The reality is this hardly qualifies as strategic, in the sense of it being “an elaborate and systematic plan of action.”
Instead, it is a short term band-aid for the companies to quickly eliminate costs. For instance, UAL claims it can cut $625 million annually from its costs by shelving the plans, but that would only reduce the costs reported in the first quarter by 10%. Of course what UAL fails to see is that in the sincerest form of flattery, others will follow. For an industry where the competitive dynamics have kept consumers in control and prices at levels that don’t allow for sustained profitability, it is fair to conclude that others will shed their liabilities to match UAL and further destabilize the industry’s profitability. This means consumers, not the corporations, will probably gain the economic value of the shelved pensions.
While UAL is also trying to cut labor costs, the bottom line is the industry is still positioned to compete the same way it did before deregulation. In fact, most of the companies who have chosen this route are in legacy industries where the competition has passed them by. In steel for instance, LTV, National Steel, and others disappeared after mini-mills such as Nucor and Steel Dynamics changed the rules of the game.
In the auto industry, as others have written about on this page, the Big 3 have long ago ceded the role of innovators to the Japanese and Europeans, hence GM’s slide from 60% market share to 25%. The discussion of GM filling for bankruptcy comes mostly on the heels of high fuel costs killing the SUV sales that have accounted for most the company’s profits. Although GM had started to devote resources to developing more rear wheel drive sedans, they continue to focus the majority of their resources on large SUVs in a bet that sales will rebound in spite of $2.20 gas. This doesn’t even begin to assess the strategic blunder GM made post 9/11 by staying addicted to its “Zero Interest” programs, which got consumers hooked on only buying American cars when they were cheap. GM apparently it thought it could keep this successful plan forever. While bankruptcy could help eliminate the $1,500 per car GM spends on retiree benefits, it doesn’t eliminate managements’ mistakes over the last 25 years.
This tunnel vision is probably best seen in the current airline mess. The discussion of bankruptcy in both UAL and Delta hardly mentions mirroring the only profitable airline, Southwest. The industry has spent little time in discussing gate turnover time, long versus short haul flights, outsourcing repair work, or improving labor flexibility. The latter actually seems to be the issue facing the auto industry where it is estimated the industry pays over $1 billion to workers who don’t work.
While United Airlines has tried to fight the low cost carriers with its own discount airline, the verdict on TED is still out. For UAL to survive, what it really needs to become is TED instead of TED becoming UAL. In its short existence, there does not appear to be compelling evidence that it will buck that trend. In fact, the lessons of US Air may be the most educational. US Air entered Chapter 11 August 2002, got the court to dump some of its pension plans, emerged from bankruptcy leaner and meaner, subsequently re-entered two years later, and is now selling itself to America West, a lower cost airline.
In the end, all of this assumes the courts will allow the petitioners out of their liabilities. While the legal rules are written in favor of the petitioners, they are still at the mercy of the courts. This also presupposes that the rules don’t change. Congress has responded by introducing legislation that would limit companies’ ability to punt employee benefit obligations in bankruptcy (which may force people to act sooner but still not solve their problems).
All of this leads to the question of whether the cost savings are worth the damage to employee relations. Employee morale in the industry as a whole continues to take a nosedive as workers, the clear losers in this battle, worry about the status of their benefits. In some ways, the move to dump the labor contracts may be a brinksmanship move that pushes the labor costs down, but can the airlines, and potentially the automakers, solve their problems by punting their pension and health plans in bankruptcy? The answer is no. United Airlines may see initial cost savings and a get some financial advantage, but that will be short-lived and doesn’t address their real problems.
Catherine Canman, Patrick Schott, and Lars Von Kingdale

HP: When Less is More

2005-05-19T20:20:00.000-04:00

Hewlett-Packard’s new CEO is facing intense pressure to share his plans for how to improve HP’s operations. Mark Hurd, who took over from Carly Fiorina last month, is facing investors unhappy about a lagging stock price and a loss of market share in key markets.

Under Fiorina, HP attempted to become a technology powerhouse competing in vastly different markets, from personal computers, printers, digital cameras, and big business servers, to consulting, software, and online services. Sometimes it seems as though there’s no part of the technology market that HP is not involved in. In fact, HP describes itself (in its most recent annual report) as:

“a leading global provider of products, technologies, solutions and services to individual consumers and businesses. Our offerings span information technology (‘‘IT’’) infrastructure and storage, personal computing and other access devices, multi-vendor services including maintenance, consulting and integration and outsourcing, and imaging and printing.”

In other word, it thinks of itself as everything to everyone. This has caused HP to lose focus and stray away from its core competency – it’s imaging division, which includes printers, scanners, and digital cameras. HP’s imaging division accounts for 70% of the firm’s profits, despite accounting for only 30% of HP’s revenue. This cash cow is now feeling some heat from a rapidly growing Lexmark and an aggressive market entry by the usual suspect, Dell. The growing competition is reflected in the reported operating profits in printing, which fell 14.5 percent from a year ago. And HP faces even more challenges ahead, from firms like from Kodak, which is widely expected to enter the printer market next year.

One of Fiorina’s most controversial moves was the Compaq merger, a move that never produced the anticipated results of putting HP in a better competitive position vis-à-vis Dell and IBM. Competition was fierce as Dell entered the market with a skimming strategy that was successful in stealing market share from a thinly spread HP. Dell’s lower cost structure posed a difficult situation for HP. It was faced with two options: 1) lower its price and start a price war with a much more efficient competitor, while losing margins or 2) relinquish market share and let Dell take the lead. Fiorina chose not lower its low-end PC prices and as expected, lost significant market share in the PC category. Furthermore, HP announced that it would focus on the profitability of its PC division - in other words, that it had settled for being second to Dell. As stated in the FT earlier this year, “HP is stuck in some commoditizing markets as neither the low-cost producer nor a successful innovator.” Analyst Andew Neff of Bear Stearns sums it up well in this article when he says: “The strategy is unclear when you compare to other companies. What is it that ties everything together? IBM is in software and services, Dell is the low-cost vendor, EMC is storage, HP is: Fill in the blank."

Hurd, the new CEO, was heralded in the last week for HP’s favorable second quarter results (most of which occurred before he took the helm). However, he has not announced how it plans to continue growing and sustaining its large scope of offerings. As Mark Stahlman, an analyst with Caris & Co said, investors are most interested in the longer-term plan that will provide a cure for HP’s fundamental issues-- "Investors want to know what he will do in order to accelerate growth.”

Some commentators have suggested that HP buy Gateway in order to obtain scale in the PC business, but this would be a mistake. HP’s problem isn’t that it needs greater economies of scale to compete with Dell – and even if that was the problem, Gateway’s $3.5 billion in revenues would do little to address this issue. Rather, HP needs to recognize that the skills required to succeed in the PC business have changed over the past decade, and that they are very different from HP’s core competencies. HP is a R&D focused organization and spends close to 5% of revenues on R&D – in contrast to Dell’s less than 1%. PCs are a commodity business, and Dell’s cost-focused model is simply much more suited to this business than HP’s. Rather than fighting a defensive battle against Dell, HP should face up to reality, and recognize that it can’t compete in the PC business. Similarly, HP should also recognize that it won’t be successful in the Enterprise Storage and Servers business. HP can’t compete with more focused companies like EMC, Network Appliance, and Sun – as evidenced by its anemic 1% profit margins on this business.

HP needs to refocus its strategy around its core imaging business, and divest everything else. This is a growth business where HP’s R&D skills can pay real dividends in the form of competitive advantage. HP’s recent purchase of online photo site Snapfish is a good start, but appears to be little more than an afterthought to the company’s current strategy. Divesting its other businesses will allow HP to focus on imaging and the growth opportunities it presents. HP should at a minimum sell or spin off the PC business and enterprise storage/server divisions, but it should also seriously consider selling its services division – there’s simple no strategic fit with the imaging business.

Analysts estimate that the parts of a split up HP would be worth 25-50% more than the firm is today. Spinning off the PC and enterprise business into a separate company - like it did with Agilent in 1999 - would likely also improve these divisions’ operational performance. As division managers are freed from the HP bureaucracy, we believe that improved operating results would make the true long term value of splitting up the company even higher.

Let’s just hope Mark Hurd agrees.

Veronica Herrero, Sophia Kamberos and Chris Rodskog

Search Wars: “Google Kicked Our Butts”

2005-05-19T20:19:00.000-04:00

Surprisingly, this comment came from the mouth of Microsoft Chairman Bill Gates in response to the ascension of Google as the preeminent player in the internet search market. It may seem shocking that the leader of the world’s most powerful software company openly admitted defeat. Although Microsoft had been on the forefront of most of the world’s software, they fell asleep when they should have been perfecting the next big thing - the search engine.
Google’s emergence as the leading search engine has helped position itself as a major threat to Microsoft’s dominance in software. How big is the search market? According to Safa Rashtchy of Piper Jaffray, Google leads in global market share in search at 51%, followed by Yahoo and Microsoft at 24% and 13%, respectively. Advertising revenue for the market is expected to be a $22 billion market by 2010, up from $7.5 billion in 2005.
It was only in 2003 that the light bulb finally turned on for Microsoft. Up until that time Microsoft outsourced its search function to third parties. Microsoft viewed the search industry as a money loser and merely a convenience service for its users. In the meantime, Google had developed a well regarded search engine that differentiated itself through its simple design and relevant search results from even the most arcane requests.
Google perfected a revenue model for the market which Microsoft had never identified. The list of vendors accompanying search results appeared adjacent, but not embedded, with the rest of Google’s results. Prices were set through an auction rather than fixed fees. This differed from Microsoft’s original approach whereby advertisers paid to be included in the main search results, which was often confusing and misleading to consumers.
In February 2003, Microsoft committed over $250 million to build and advertise its own search engine. Gates knew the company needed to act fast against Google’s attack on the core of Microsoft’s franchise – the ability to control the centerpiece or portal of the computer user. Rather than buy search software from another company (which Yahoo did in acquiring Overture), the company decided to develop search in-house completely from scratch. After more than two years of development, Microsoft finally launched its own search toolbar for Internet Explorer. The successful launch suggested that the software giant was ready to make its move on the increasingly competitive yet lucrative internet search market.
Two characteristics of the web search market will play an important role in determining a winning strategy: customer loyalty and network externalities. Switching costs are low, and many analysts agree that the better search technology will cause users to switch. Google and Microsoft have different advantages in terms of reaching out to the customers. Microsoft’s strong brand recognition gives it a large and loyal customer base they can reach. On the other hand, Google has already established a strong user base through its consistent and reliable search results, and more recently through its introduction of the e-mail service Gmail. The synergies between the two products have helped grow its client base.
Building a customer base has a multiplying effect in the search market. The relationship between a search engine, its customers, and advertisers creates a network externality. There is a “circular” relationship in that the more users a search engine has leads to more advertisers, which leads to more relevant results, which in turn leads to more users. Microsoft’s recognized brand name will help in luring advertisers, which as a result will help reap the benefits of the circular relationship.
Certain challenges exist for Microsoft in succeeding in the web search industry. Google is a huge brand with the “Kleenex” advantage - people use their name as a verb for searching. Google is a much leaner company that can respond better to customer needs. Although Microsoft can try to integrate search with its other products, they face the risk of antitrust lawsuits. Even if you remove this concern, Microsoft can not use predatory pricing tactics like they did in the browser wars, as search is provided to customers for free.
Yet the future is not so bleak for Microsoft, as several factors will play in their favor. Most obvious is their size and financial resources. As mentioned before, having the best search technology will greatly affect market share. For now, Google owns the claim to the best technology, but they can not match Microsoft’s investment in R&D. In addition, there is a large amount of content that can not be searched on because they are pay sites. Microsoft has the deep pockets to buy such content and make it available exclusively on their search. Lastly, if they can avoid antitrust barriers, Microsoft can greatly benefit from integrating search into the other products such as Internet Explorer and Office. Look for the next version of Windows called ”Longhorn”, coming late this year, to have search more integrated into the operating system.
Microsoft’s commitment to search is a smart one considering that Google’s success could be leveraged to compete in other types of software. According to analysts at Credit Suisse First Boston, “Google is one of the bigger long-term threats to Microsoft as it leverages its power position in the search market into a number of other personal productivity areas.” Google already beat Microsoft to market on a “desktop search” tool that uses their search technology for finding data on a user’s computer. Such advancements show how Google can take over operating system features from Windows. Even if Microsoft takes an approach of winning even if they end up losing money, it is a defensive move that will help protect the rest of their products.
- Joel Amico, Carol Pinlac, Jason Rosenthal

Omnicare: Suffering from the Common Cold or a Terminal Illness?

2005-05-19T20:18:00.001-04:00

Omnicare (OCR) is not a household name. However, this company is the nation’s largest provider of pharmaceuticals and pharmacy related services to long term care institutions such as skilled nursing facilities, assisted living facilities, retirement centers, hospitals and other institutional health care facilities. The company’s long term care pharmaceutical distribution business services over a million residents, controlling 37% of the US market and operating in 47 states.

The company’s main business consists of buying massive quantities of drugs in bulk and repackaging them into single doses and distributing them to long term care residents. OCR maintains a detailed data base on each patient allowing for cross checking on drug compatibility and provides suggestions for improved drug usage based on established guidelines. It also includes cost information allowing physicians to choose among the most cost effective drugs and provides suggestions for improved drug usage.

Omnicare had enjoyed rapid growth and improved profitability through the past decade. The company was #94 on Forbes list of the 100 fastest growing companies in America. Wall Street was enamored with the stock as it rose from $20 a share in 2003 to nearly $47 in early 2004. However, the good news did not last. The company saw its share price plummet 34% when it released its 2Q04 results.

Omnicare was suffering from intense competition and an unfavorable customer mix shift. Competition from small local pharmacies had intensified, cutting in to Omnicare’s profitability. The company was also seeing an increase of low margin Medicaid patients in its customer mix. These factors, in addition to uncertainty of future government drug reimbursement plans, marred the company’s future growth and profitability prospects. The average Wall Street analyst rating was “Under Perform”. It was questioned whether this business model was still viable given the new Medicaid Prescription Drug Plan, expected to become effective in the first quarter of 2006, which could remove the floor on drug reimbursements. Some value investors were touting OCR as an excellent buy citing a focus on short term issues and strength in the business model driven by the aging of America.

Omnicare’s strategy had been to acquire smaller companies and consolidate the highly fragmented institutional pharmacy segment. In an attempt to offset industry trends, Omnicare took its acquisition strategy to the next level when it announced its hostile take over of large competitor NeighborCare (NCRX), which would give it nearly 50% of the market. NeighborCare’s management quickly rejected the bid. OCR management made it very clear that they intended to proceed without the approval of NeighborCare’s management. Omnicare also announced cost cutting restructuring plans that would help to offset the gross margin pressure.

Many analysts were less than positive on the acquisition for a number of reasons and gave it only a 60% chance of consummating. NeighborCare is by far the largest target that Omnicare has tried to consume and may prove to be too much to handle. Also, the NCRX acquisition would double the company’s debt load while only increasing revenues 25%, potentially straining the company’s cash flows. More importantly, the effect on profitability was questionable given NCRX’s 2.5% operating margin compared to OCR’s 13% margin. There is also the issue of FTC approval given the combined company’s market dominance.

There also appears to be a number of powerful synergies resulting from this acquisition. OCR has an excellent track record of integrating companies and bringing their margins up to the corporate average. While NCRX’s margin is far lower than OCR’s, it is possible that Omnicare can not only bring them up to OCR’s average but also increase the overall company’s profitability. In this business, size and scale matter. Each acquisition allows Omnicare to spread its fixed costs over a larger client base and purchase a larger volume of drugs at better pricing points, further improving its pricing power. The size of this proposed acquisition would significantly strengthen the company’s bargaining power.

Omnicare is also removing a major competitor from the market and increasing its size to 4x that of its nearest competitor, further establishing market dominance. This alone should alleviate some of the competitive pricing pressures in the market. In addition NCRX’s network will fill in the few geographic holes that remain in OCR’s nationwide distribution network. The overlapping geographies fit perfectly into OCR’s restructuring strategy. The company closing down redundant, overlapping pharmacies and changing its distribution network to a hub and spoke configuration to increase efficiency and lower cost. The acquisition also serves to increase Omnicare’s data base of patient information which is difficult to quickly replace and gives the company some stickiness with long term care facilities.

A year after the takeover was announced, it still had not gone through. OCR extended the tender offer yet again on April 19. Management reiterated its intention to close the deal in a recent conference call. NCRX stock was recently trading at over the tender offer of $30 making it unlikely that additional shares would be tendered. Some analysts feel that OCR may have to increase the price of its offer to obtain the 80% necessary to gain control. The FTC is taking an unusually long time to give approval for this acquisition and OCR has agreed to not close the deal until June 16. Analysts feel that OCR may have to divest some of its assets in order to get approval.

Analyst sentiment seemed to become more positive when OCR announced its 4Q04 results. While the gross margin pressures continued, the company’s cost saving initiatives stabilized its operating margins. Though some analysts felt that pricing pressure couldn’t get much worse and with the cost saving initiatives taking full effect in 1Q05, there may be upside potential to estimates. One analyst turned bullish on the stock before the 1Q05 release based on both the positives of the potential NCRX acquisition and overblown concerns of the government’s new drug reimbursement plans. Omnicare’s 1Q05 results showed the first improvement in its operating margins in over a year, driven largely by its cost cutting initiatives and continued acquisition strategy. However, profitability fell versus the year ago period.

The institutional pharmacy market continues to experience continued gross margin pressure, both from government cost cuts and increasing competition. However, it appears that OCR has made the correct strategic moves to maintain its profitability and drive growth going forward. The potential acquisition of NeighborCare meshes well with the OCR’s existing strategy and the current market conditions. If the company can finally close this deal it should serve to strengthen the company’s future prospects.

Barfoot, Boles, Davey.

Wal-Mart, off Target, but aim is improving

2005-05-19T20:18:00.000-04:00

Number one Fortune 500 Company in America and the world’s largest retailer, Wal-Mart is huge, and profitable. In the quarter ending April 30, Wal-Mart’s earnings grew 14% to $2.46 billion. These profits are much larger than competitors’ and right in line in terms of growth; rival Target’s profits grew 15% to $494 million in the same period. Despite its mammoth size Wal-Mart’s fiscal efficiency is top in its industry. Wal-Mart’s return on equity, return on assets, and cash flow are better than its competitors. Then why does nobody like the stock? If you bought Wal-Mart stock five years ago you haven’t made any money. Wal-Mart is currently trading around $47, lower than it was in January 2000. Competitors Costco and Target have watched their stocks grow 12.4% and 49.6%, respectively, over the same period. Part of the reason lies in Wal-Mart’s most recent numbers, the latest earnings results missed wall street forecasts by 2 cents. Wal-Mart executives are now warning that they may miss their annual profit forecasts. In addition, the stock wasn’t that cheap five years ago when it traded at near 59 times earnings. However, earnings have grown consistently over the past five years and valuations are more reasonable now. So what exactly is going at the world’s largest retailer that has caused its stock growth to stagnate?
Most obviously, Wal-Mart has been at the receiving end of negative publicity related to union problems. Wal-Mart has managed to keep its workforce union-free and this has spurred many attacks on Wal-Mart of unjust treatment of its employees. There have been allegations that Wal-Mart has employed underage workers to operate dangerous machinery and blatantly discriminates against women by paying them lower wages than their male counterparts. This type of news may make investors wait until issues pass. However, these may not be the most fundamental problems; a look at some other numbers gives us a clue as to what really worries analysts and investors. Same store sales grew 2.9% last quarter, much lower than Target’s 6.2% increase. Wal-Mart claimed that their recent performance was due to bad weather and high fuel prices. Since Wal-Mart shoppers have a lower average income than competitors’ customers, the impact of the high fuel and energy prices may have been more deeply felt by Wal-Mart. This is part of the root of the problem. Wal-Mart’s customer falls in the lower income class with an average annual income of $35,000, approximately $20,000 lower than its largest competitor Target. Traditionally, Wal-Mart has been very successful at focusing on the lower income shopper who has greatly benefited from Wal-Mart’s everyday low prices.
Nevertheless, critics say that Wal-Mart has hit a roadblock with the large population of Americans who are on a very limited budget. Wal-Mart has been expanding its market share rapidly by building Supercenters as close as 4 miles from each other. The basic theory of the expansion holds that once a store reaches $100 million in sales, customers will go to a competitor before they wait in long lines, thus they might as well go to another Wal-Mart store. Critics worry that this strategy produces cannibalization and will not grow sales, Wal-Mart shoppers are tapped out.
Do low income shoppers simply not have anymore money or are there simply not anymore low income shoppers? A little of both, but if it is Wal-Mart’s focus on its core low income consumer that has made it successful in the past, this narrow focus may blind it from opportunities in the future. As a result of their focus, Wal-Mart has been slow to react to new trends in the marketplace. One such trend is to offer more fashionable apparel at low prices to target higher-income shoppers who don’t necessarily seek low prices, but value good quality at affordable prices, the key customer niche for Target. The traditional Wal-Mart shopper goes there for basic household products and groceries and does not venture into the furniture and apparel sections.
There are some recent indications that Wal-Mart has taken notice of Target and the buying power of their customer base. They have been testing products that may appeal to a higher income bracket in an attempt to get these customers into their store. Can Wal-Mart really attract the trendy Target shopper and still keep their low income loyalists? Yes, but it won’t be as simple as a few new upscale products.
The first thing Wal-Mart needs to do is clean up their act. Target shoppers are loyal and loving because they enjoy their shopping experience. Target has a tidy store, nice displays and a speedy checkout. Their shoppers reward them by purchasing a lot more than they intended to when they walked in the door. Wal-Mart shoppers just want to buy and get out. Wal-Mart leaves a lot of money on the table when people don’t enjoy shopping there. People in a higher income bracket simply won’t go there if they don’t like it.
In addition, Wal-Mart has to be deliberate about offering new products at a nicer store, not simply raising prices. This will accomplish two things. First, it will keep shoppers’ confidence that they are still getting the best price on whatever product they are buying, a key reason why people shop at Wal-Mart. Second, there will still be choice for Wal-Mart’s core customers. They will not be unhappy if they can get their typical supplies at their usual prices, all in a nicer store.
Finally, Wal-Mart needs to invest in improving its brand image. It will not be able to attract a new segment of customers by continuing to market themselves as the top low-price retailer. Wal-Mart needs to emphasize that in addition to low prices, they offer the best values, a primary concern of the new customer segment.
Cleaning up its image and bringing in new products will do nothing to hinder what Wal-Mart does well, squeeze enormous value from its distribution and purchasing power and then pass those savings on to its customers. In fact, appealing to this new segment will only help expand the value of their operations to a new set of customers and provide shareholders profit growth from an untapped segment.
The next time you step into Wal-Mart perhaps you will not only find that you get “Always Low Prices” but “Always Best Values, Always”

Lorena Kurtjian
Jason Oberheide
James Quinn

Internationalization for Chinese companies: A beautiful trap?

2005-05-18T20:41:00.000-04:00

On May 2, 2005, TCL Multimedia Technology Holdings Ltd., a subsidiary of TCL, reported a first quarter net loss of HK$205 million, down from net earnings of HK$253 million, a year earlier. Burdened by operating losses in the European and North American operations of its majority-owned joint venture, TCL Multimedia was a leading television manufacturer alongside Thomson SA of France. Meanwhile, its sister company, cell phone producer, TCL Communication Technology Holdings Ltd., posted a first quarter net loss of HK$386 million, down from net earnings of HK$206 million, a year earlier, as it struggled with excess inventory and the launch of a joint venture of its own with another French company, Alcatel SA.

What happened to TCL? As one of the most well-known conglomerates in China, TCL believed that teaming up with large international firms and seeking overseas expansion would be an effective way to enhance their competitive edge, especially as trade protectionism in Europe and the U.S. grew stronger. The purpose of setting up of the joint venture TCL-Thomson Electronics (“TTE”) and TCL & Alcatel Mobile Phones Limited (“TAMP”) in 2004 was to expand market coverage by gaining access to the obtained leading brands and exploiting low-cost manufacturing opportunities. These joint ventures made TCL the No.1 television manufacturer and the No. 7 mobile phone manufacturer in the world.

However, the worse-than-expected performance of these joint ventures made us rethink the goal of international mergers for Chinese companies. Does TCL aim to enlarge its size or enhance its brand value, increase sales or improve profits, become a market pioneer or just following the industry trends? What was the reason behind TCL’s “worse-than expected performance”?

First of all, television and cell phone industries are very competitive both domestically and globally, and demand growth is waning. It is very difficult for TCL to maintain an increasing rate of growth. One way out of the ever-changing and highly competitive market is through product innovation and through the fast pace of new product launches. However, in its joint venture with Thomson and Alcatel, TCL can hardly boost its R&D capabilities, since both companies are wanting in the area of product innovation. TCL’s focus on low-tech CRT television technology instead of high-tech LCD technology is also a high risk proposition. Although there is still some demand for CRT in China and other developing countries, such economies of scale from the cooperation between TCL and Thomson may not be sustained for a longer period of time.

Second, corporate management is a critical issue. Thomson is a huge company operating worldwide, while TCL has never run a global operation and can hardly glean such information from other companies in China. Within a limited timeframe (18 months as expected by management), TCL must integrate Thomson’s worldwide research, sourcing, production and distribution channels. However, a traditionally state-owned enterprise such as TCL has not integrated its corporate governance in the systematic way that Thomson has. Obviously, TCL had a hard time managing a company operating in totally different cultures. The low synergy of management styles between the two companies has prevented the new joint venture from better utilizing its resources. TCL and Thomson also have differing corporate strategies. TCL’s domestic competitive strategy is in the area of new product development while Thomson is well known for its quality improvement of existing products. Different operating environments among Thomson’s global branches have also worsened the integration of management in the new company. Moreover, the compensation design is not consistent within TTE. A senior manager in China complained that he earned less than the average employees of TTE in India. Such unfairness damages morale. Some employees have already left the company.

Third, the company lost its hold on the traditional market as the joint venture extracts too much attention from TCL. China’s domestic market is becoming more and more competitive as foreign competitors have begun entering low-end product markets which are traditionally the sole domain of domestic manufacturers such as TCL. As the joint venture did not enhance TCL’s overseas performance, the loss of its domestic competitive advantage certainly makes things even worse for the company. In 2004, TCL’s cell phone sales dropped 30.2%, causing it to fall from the ranks of the top three cell phone companies in China.

Finally, TCL faces the problem of cultural conflict. There is a joke about this. When the CEO of TCL planned to hold a meeting at the company’s French branch on a Sunday, the CEO was angry that he could not find anyone there. While Chinese culture emphasizes obedience and hard work, Western styles boast openness and efficiency. The difficulty of cultivating a unified culture in the new company has prevented the successful execution of the joint venture.

From TCL’s example, we can see that for Chinese companies which plan to expand abroad, perhaps the most important goal should be to analyze the market and devise strategies to suit that market. For example, although TCL wants to enter the French market through the Alcatel brand, the local customers in fact prefer the TCL brand to that of Alcatel. By establishing a joint venture, TCL sacrificed its brand equity, and the unattractive Alcatel brand became the bottleneck, impeding TCL from expanding into the European market. As a result, TCL has had to absorb huge losses from the overseas operation. Moreover, the products for the global joint venture have to be highly localized to meet customer needs in various markets. Lagging behind in LCD technology is the main reason that has prevented the new joint venture from rapid global expansion.

Needless to say, communication and mutual understanding between two different cultures is the foundation for the new joint venture to achieve sustainable development. TCL’s failure to integrate cultures and management styles is certainly impeding the new joint venture from improving its efficiency and building up its new competitive advantages.

TCL is certainly a pathfinder and its experience will serve as a valuable lesson for its followers. On May 1, 2005, Chinese PC manufacturer Lenovo announced that it finished the acquisition of IBM’s worldwide PC business. As more and more Chinese companies enter the global market and become increasingly experienced, internationalization should not be a beautiful trap.

Guyun (Clare) Tang
Lulu Xu
Xiaoli Zhou

“Game On: Microsoft and the Next Generation Console War”

2005-05-18T20:40:00.000-04:00

Microsoft announced the release of its successor to the Xbox game console (dubbed “Xbox 360”) with no small amount of fanfare, in a 30 minute-long infomercial on MTV on May 12. The Xbox 360, to be available in time for the 2005 holiday season, represents Microsoft’s next hope for market share in the highly competitive video game industry.
Sony has sold nearly 87 million PlayStation 2 units worldwide and 35.4 million in the U.S., while the Xbox lags behind with 20 million worldwide and 13.2 million in the U.S. Sales numbers for the Nintendo GameCube are largely unknown, with estimates ranging from 16 to 20 million consoles sold worldwide, and 9.5 million domestically. Part of the reason for Sony’s dominance is the long lead that the PlayStation 2 enjoyed over the Xbox – Sony released its system in October 2000 in the U.S., while Microsoft began selling its own system in November 2001. Game consoles traditionally go through a five to six-year cycle before the next generation, and the gaming industry is ripe for a change.
The new system will be formatted for high-definition televisions, with multi-channel surround sound and a DVD player to utilize more advanced home theater systems. It also includes a 20 gigabyte hard drive, wireless capabilities to network with any Windows PC, and an Ethernet port to connect to a high-speed Internet connection. The Xbox 360 is not just a gaming system – it intends to be the centerpiece of a fully integrated entertainment center. Accompanying the system is complimentary access to Xbox Live, an online service to provide downloadable previews and custom content for games. With a paid subscription, a user can access online multiplayer games to compete against similarly connected players.
Microsoft clearly hopes to gain first-mover advantage with this release – although Sony and Nintendo say their next generation consoles will be ready later this year, analysts do not anticipate a release until early 2006. Sales for new consoles are largely driven by the availability of high-profile game titles, and the Xbox 360 release party included clips of upcoming games to show the graphics capabilities of the new system. Microsoft is also giving a great deal of attention to the Xbox Live service, a revenue stream with great potential.
Some analysts rave about the technical aspects of the new system, citing the “honest to goodness…almost as good as video” graphics but others question Microsoft’s timing, cautioning that the market may not yet be ready for a next generation and that the Xbox 360 is only an incremental improvement. As kids play their state-of-the art video games, Microsoft is betting on parents being able to visualize a game system as the house’s digital center. Consumers may be difficult to convince. “This is more an Xbox 1.5 than an Xbox 2,” said PJ McNeely of American Technology Research.
One unknown factor is the cost of the console. Console manufacturers followed Nintendo’s model and have historically sold the game systems at a loss or at cost in order to drive sales, while making money from the licensing fees for the games. Microsoft has been no different, with its Home and Entertainment Division announcing an operating loss of $164 million for the first quarter of 2005 and losses on the Xbox running to about $1.2 billion per year since 2001. The traditional price point of a new console is $299, but estimates for the Xbox 360 vary between $299 and $399, with Microsoft refusing comment on the price point. The company also settled another pressing question on May 16 when it announced that the new system would be backward-compatible with games for the original Xbox.
Then there’s the matter of the current 800-pound gorilla of the video game consoles, Sony. With a launch window of spring 2006, the promise of a new Sony system may be enough to hold back initial sales of the Xbox 360 – after all, Sony has a much larger customer base, all of whom may be willing to wait three or four months for a new system that will still work with their existing games. The failure of the 128-bit Sega Dreamcast system, released in 1999 to initial success and discontinued in 2001, is partly attributed to a similar phenomenon – Sony announced its PlayStation 2 in April 1999, to be released in 2000. Millions of gamers, instead of purchasing the first mover of the 128-bit consoles, decided to wait for the release of the PlayStation 2 and waited to upgrade. Sony’s recent unveiling of the PlayStation 3 was much more muted than Microsoft’s splashy event, with executives focusing on the technical specifications and games and dodging the questions about cost or actual release date.
Nintendo is another unknown factor, with its console, code-named “Revolution”, to be released in early 2006. Unlike Sony and Microsoft, Nintendo is focusing solely on a system for games but has not released any other information.
While the initial hype and earlier launch of the Xbox 360 may help Microsoft gain some market share, the company cannot erase Sony’s lead and much greater share in one generation. Microsoft is doing all it can – generating widespread attention (even beating Sony to its unveiling), beefing up its system, and signing the important game developers for the highest-profile franchises. Unlike Sega, it has the deep pockets to compete with Sony. Ultimately, however, it will be extremely difficult to convince Sony’s much larger customer base to switch systems with a new PlayStation imminent. All Microsoft can expect is to gain some customers with its earlier launch date, and earn a few percentage points of the video game system pie.

Josh EmersonStephanie JoseDiana Sheehan

Netflix Fix

2005-05-18T20:39:00.000-04:00

Netflix (Nasdaq: NFLX) reigns as the world's largest online DVD movie rental service offering access to an extensive 35,000 movie library to over three million members. Netflix's founder, Reed Hastings, revolutionized the video rental market with his introduction of the "no late fees, no due dates" model in 1997, by eliminating the hassle involved in renting and returning movies. Once a near-monopoly, today the company is embroiled in a bitter price war over its coveted share of the online DVD rental market. Online newcomers, such as Blockbuster, Wal-Mart, and potentially Amazon, have entered following Netflix's success. Blockbuster announced its 'end of late fees' campaign for stand alone stores to begin in early 2005 and further put pressure on market prices with a $14.99 online subscription offer. Netflix fought back with a $17.99 price and subsequent results are that both Blockbuster and Netflix have reported Q1 losses this year. Likewise, Amazon launched an online DVD rental pilot in the UK and some speculate its likely U.S. entry by early 2006 will further fuel the fire.

So as the early leader, what should Netflix do? In his investigation for the Motley Fool, Beirne White describes the company as a "Rule Breaker" because of its disruptive advancements in the rental world. Years ago, the market leader failed to evolve thus allowing Netflix to radically change the way we rent movies. We agree with Mr. White's conclusions, however, he fails to further portray the reality: that in the near future, Netflix stands to have the rules it broke thrown back in its face.

Currently, Netflix operates a lean business model with low fixed costs, an extensive library of movies, a scalable model, an online recommendation platform, and fast delivery options. In its 2004 Annual Report, the company lists all of these as its competitive advantages. Clearly, most are not because they are easily duplicated. The market is now saturated with competitive "me-too" services capable of challenging Netflix's leadership solely on brand or price and costing the company increased subscriber churn rates and acquisition costs. Ultimately it is Netflix's established, strong subscriber network that is its primary advantage. In the short term, Netflix must capitalize on its customer database in order to grow and survive. We suggest allowing the loyal, tenured consumers the opportunity to benefit from helping the company through active recruitment and referral incentives. This might thwart subscriber migration and stabilize the rising churn during the price war. The company can also grow organically through product differentiation or by increasing purchase frequency within its existing customers, such as upgrading them to more profitable services. These ideas are only a temporary solution as each are easily mimicked, but they might help the market leader buy time to better position itself to tackle the long term dilemma faced by the online rental market.

Aside from the aforementioned escalating competition squabbles, the online rental market faces a real threat to its core business from video-on-demand (VOD) or some equivalent. As bandwidth becomes cheaper and the diffusion of digital video recorders (DVRs) continues to occur in the market, the increase in VOD users is expected to follow suit. It is certainly plausible that consumers of the near future will easily order a recent release from the Internet for viewing on a television, computer, or mobile DVD player. Better yet, customer may soon be able to order right from their Cable or Satellite TV Service, whether mobile or based at home. But at this point, the market has yet to take off, and as with any technology, there is not a 100% guarantee that it will. However, and based on recent history, it seems likely that something will soon better suit the publics' rental needs. Just as online DVD rentals were highly disruptive to the home movie rental market, VOD poses equal threats to the long term existence for the online rental market.

To combat this looming risk, Hastings plans to initiate the next round of 'broken rules' by announcing Netflix's dedication to transitioning into the VOD market and offering its first services by later this year. The company clearly recognizes VOD as the emerging technological disrupter to Netflix's existing business model and is ramping up its development and partnerships to better compete in the future. Competition in this early-stage market is still expanding and barriers to entry (and revenues) are still fairly low from a dollar standpoint. It will be a tough climb within the rapidly evolving new market that is currently dominated by a few select cable monopolies (a segment with even deeper pockets than those with which Netflix is currently competing). But given its choices, this is as good a move as any and plays well off its one major advantage—the Netflix subscriber base. If Netflix can convert its users to VOD subscriptions, it can continue to provide value to its customers long after the online DVD rental market dissipates. The move also complements the company's leverage within Hollywood (due to its buyer power) and Netflix has already signed on TiVo as a partner in this venture to broadcast its catalog directly into the home.

Ultimately, Netflix must recognize that its strategy to enter the VOD market will be difficult if it continues to spend all resources defending only its online rental lead. To help the company through the price war at hand, Netflix needs to innovate—shake up the market by causing some product differentiation, such that customers no longer select a service based solely on price—then focus substantial resources on infiltrating the VOD market by transitioning its loyal customer base. Netflix definitely broke the bricks-and-mortar rental rules. If it hopes to survive in the long run, it clearly needs to break the rules again.

Jon Hassert, Ryan Malone, Kristin Wisotzkey

Power Play Opportunity for the NHL

2005-05-17T20:27:00.001-04:00

In March, shortly after the NHL cancelled its 2004-2005 season due to the lack of a collective bargaining agreement (CBA), a group led by Bain Capital Partners approached the league with a $3.5 billion buyout offer. The immediate reaction of NHL owners and the media was lukewarm, and the deal was put on the league’s back burner. Two months have passed since then, however, and the league and its players union (the NHLPA) continue to make little progress towards a new CBA. As negotiations continue to stall, and the resulting decline in fan interest shrinks the league’s potential revenue base, we argue that the structure proposed in the Bain offer deserves a second look – if not the deal itself.

Advantages of Single-Entity Ownership

While the opportunity to buy assets at a reduced valuation was a large part of the motivation behind the Bain offer, NHL owners need to consider the other aspect of the deal – its structure. If the deal had occurred, all 30 teams would have been owned by one entity, with each team’s hockey operations run locally under a budget set by the new owners (essentially making them corporate subsidiaries). All revenue would flow to the corporate parent, and while that would provide some opportunity for revenue enhancement, the key change would be in the leverage each team holds with the players.

Indeed, under the old contract, bidding between teams had rapidly escalated the average player salary (from $700,000 to $1.8 million over the last 10 years), and player compensation accounted for roughly 75% of the league’s revenue at the time of the lockout (a far higher number than any other sport, or just about any industry period). In economic terms, the league’s suppliers (i.e. players) had too much power for the NHL to be a profitable business, and that is what forced owners to take a hard-line stance in negotiations and insist on a salary cap. While the NHLPA has been extremely reluctant to agree to a cap (unless it included terms very favorable to the players), single-entity ownership would accomplish the same goal. In essence, each team’s budget would serve as a cap, and the league would set the budget.

While the NHL’s current lockout strategy could eventually force the players into accepting a salary cap that favors the owners, in the long-run it would not change the balance of power between the two groups. The next time the CBA expires, owners would be back in the same position -- as powerless, small buyers of a good (talent) that is in limited supply. Conversely, with single entity ownership, the league will have turned the table on its players. The NHL needs only to look to the retail sector to see how effective this strategy can be, as consolidation in the retail sector (led by the emergence of Wal-Mart) has turned the table on previously powerful suppliers like Procter & Gamble. In this scenario, a salary cap could very well be the means through which salaries are kept reasonable, however its presence would merely be a symptom of a more important result – an increase in the league’s leverage with its players as a result of consolidation.

Potential Problems

Although the advantages of single-entity ownership are clear, the following three issues would need to be overcome before such a strategy could be implemented.

Competitive Nature of the Product

While there is aesthetic entertainment value in an NHL game (even though years of 1-0 scores may cause some to argue otherwise), we contend that more than anything else, hockey fans come to the arena to support their team and see if it wins. Under that hypothesis (which few would argue against), a league with one owner presents a problem: where is the competition? If not addressed properly, fans could easily come to the conclusion that the league is giving one team the best players, and that the outcome is predetermined.

That being said, we believe that the Bain proposal addresses this concern adequately – with each team managed locally, the single entity owner’s only input into a team’s success would be the budget that it allocates to each team. As long as all budgets are equal, each team’s local management would have one goal – to win as many games as possible. In fact, given the current disparity in team salaries, this could even result in superior competitive balance.

Antitrust Concerns

A concern of greater substance is that players would stop a move to single-entity ownership by claiming that it violates federal antitrust laws. The Bain proposal attempted to address this issue by offering equity in the league to players, and while that may have helped, we doubt it would have been sufficient to stop the NHLPA from crying foul. Indeed, a league with a single owner dramatically alters the balance of power between teams and players, and not in favor of the players.

However, there is reason to believe that the NHL would prevail on this issue even without player cooperation. First, a single-entity owner would likely have a larger war chest than the NHLPA to finance a superior legal team (especially after a year of lockout). More importantly, there is precedent for single-entity ownership in other leagues, such as the WNBA and MLS. We are not lawyers, but it appears that prospects of a battle on this front are not dim enough that they should deter the league from looking into a single-owner strategy.

How to Compensate Current Owners

While the benefits of single entity ownership are clear, how does the NHL get from here to there? This is undeniably a significant roadblock, and is probably the biggest reason why the Bain deal didn’t happen. Any prospective single-entity owner (even if it was just a corporation formed by current NHL owners) would need to convince every current NHL owner to sell. While the present state of the league (with the lockout and losses of $500 million over the last two seasons) definitely creates a compelling case for owners to sell, not all teams are losing money. In fact, some (such as the Rangers and Maple Leafs) have been consistently and highly profitable, and would clearly demand and deserve more than the average team.

However, with the help of consultants or investment banks, the valuation problem does not appear to be insurmountable – until you factor in two other issues, that is. First, many hockey owners are not in it for the money. They own their team for prestige reasons, and it would be extremely difficult for a financially-motivated buyer to get these owners to sell. Second, even if all owners are financially motivated, there is a prisoner’s dilemma problem. Even though all owners would be better off agreeing to a deal, each individual owner has an incentive to hold out and be the last to agree (where he could conceivable command a higher payment). As a result, the negotiations involved in making the strategic shift to a single owner would be quite complex and difficult.

Conclusion

Clearly, any attempt to transform the NHL to single-entity ownership will have to overcome some serious obstacles, none greater than the issue of motivating 30 different individuals to sell simultaneously. Nevertheless, we believe the NHL and most members of the media have dismissed this idea too quickly. The single-owner structure is the dominant model in second-tier sports leagues such as the WNBA and MLS, which is strong evidence that it is the best approach to control costs. That should make it attractive to any league, but particularly to the NHL – which faces the imposing task of generating revenue in a mildly popular league that has alienated its fans by missing an entire season (and possibly more). Convincing every owner to sell at a fair price will not be an easy task, but as the lockout drags on it will only become easier. At some point, NHL owners would be wise to take advantage of the opportunity and permanently switch the balance of power in their sport.

Authors: Pat Goff, Nathan Kieffer, John Morrison

Hold the fries: McDonalds Adopts a Healthy Lifestyle

2005-05-17T20:27:00.000-04:00

On May 11, 2005, McDonald’s CEO Jim Skinner announced 24 consecutive months of improved global sales, and plans to maintain the company’s momentum by offering healthier menu options and improved customer service. After posting its first ever quarterly loss in 2002 amid highly public criticism of its unhealthy food, McDonald’s has turned itself around. Does this signal a new trend in the global fast food industry? Is the big, fat-laden burger a thing of the past for McDonald’s? The answer is a yes … and no.
While competitors have also added healthier options to their menu, many have done the opposite of McDonald’s – adding even bigger, unhealthier options to their product mix. Carl Jr.’s hamburger chain has launched the very successful Monster Thickburger, and Burger King has seen a 20% increase in breakfast sales since introducing the Enormous Omelet breakfast sandwich this year. While hard-core fast food eaters only comprise approximately 18% of the consumer market, they represent 49% of fast food business, and this is good reason to stay in the business of providing unhealthy fast food. CKE Enterprise’s CEO Andy Puzder and Burger King’s CEO Greg Brenneman agree that they are providing what the consumers actually want – traditional fast food in the form of big, tasty and fulfilling sandwiches. Many fast food restaurants agree and are adding more fattening, higher calorie items to the menu.
Obesity and general health concerns are big news for both Americans and Europeans, yet NPD Group tracked consumer eating habits and found that hamburgers and French fries are still the top two items ordered at restaurants. Consumers are estimated to spend over $476 billion eating out in 2005, close to 5% more than in 2004. Much of this will go to hamburgers and fries, not salads.
By 2010 consumers will spend 53% of each food dollar on meals, snacks and beverages prepared away from the home, creating industry sales in excess of $577 billion. The growth stems from the small difference in overall cost between eating out and cooking, the decline in free time, and the growth in disposable income. In response, restaurants are trying to focus on their value propositions and differentiating themselves in the marketplace.
The quick-casual restaurants feature better food quality at higher price points and are already stealing business from fast food chains. Customers are willing to pay higher prices than previously assumed for quality products. Additionally, McDonald’s may have been a bit too close to its core set of customers – French fry fanatics – and lost focus on the health craze and serious obesity issues sweeping the nation. In the long run, obesity threatens the companies’ own customer base. Thus, places like McDonald’s are focusing on product innovation and adjusting menus to meet this new demand, thereby increasing average check paid and improving profitability and operating margins.
McDonald’s new products include premium coffee from Seattle’s Best coffee, fruit and walnut salad, upgraded chicken sandwiches, and deli style sandwiches. However the stores have seen an increase in sales and a CSFB survey indicates that new product news keeps customers coming back into the restaurants – but what they order when they get there is their own decision, and sales have been up across the board. Yet, the success of these new food products is still up for debate. Some of the rollouts have only been on a select basis and while the deli sandwich market could earn 17 billion annually, the cost of entry is high and U.S. test markets show that the sandwiches have cannibalized existing product sales. So what else is driving the 24 months of consecutive same store sales growth? Other operational changes. McDonald’s appears poised to create and capture a new portion of the restaurant pie – creating one stop shopping for both the “burger and fries” and “calorie sensitive” crowds.
In Europe, McDonald’s is moving to a bridge operating platform, remodeling stores, testing value menus in Germany, and offering breakfast foods in the UK. However this market hasn’t escaped the health concerns, especially around the lunch food market for children in the UK, and new menu options are still the main hope for future sales. In the U.S. market, operational changes include a doubling of 24-hour restaurants from 2500 to 5000 within the next year, and another 2000 restaurants being remodeled on top of the 2000 remodeled in 2004. Additionally, the increases in credit card payment capability and gift card purchases have provided stable growth. The theme of “better not bigger” has led to 24 consecutive months of same store sales growth and big plans to return cash to shareholders (there is more than 1.4 billion in cash on McDonald’s balance sheet). This strategy has helped re-focus the firm on expanding its core services instead of growth through new units. McDonald’s is moving from a commoditized burger-oriented business to a more value-added, sandwich-focused business.
The most recent analyst reports are favorable, predicting a growth of $3-8 per share over the course of the next 12-18 months. AG Edwards believes McDonald’s will trade towards the high end of its peer group based on solid fundamentals, global brand power, international infrastructure, and meaningful cash flow generation. The ever-present risks in the food industry include intense competition, volatile food/labor costs, and the impact of overall consumer spending on sales. Indeed, as a CSFB analyst report states, competitors are starting to take notice, and as McDonald’s achieves success it has become more important for other industry peers to differentiate themselves.
The restaurant industry is changing for the better and analysts are hopeful that the changes will reap financial rewards. However their predictions rely solely on customer response and average check paid. Yet other players in McDonald’s value net also significantly affect profit and operating margins.
· The Substitutors – Developing the new food strategy creates a win-win strategy amongst the competition. The former price discounting strategy in the industry was a lose-lose scenario. The S&P Industry Survey finds that the move from price discounting to product innovation has “significantly benefited overall industry profitability.” By changing the values, McDonald’s has begun to change the way the fast food game is played.
· The Suppliers – Food costs are one of the largest input costs for restaurants and can significantly affect profitability. While McDonald’s has traditionally held the bargaining-power over suppliers, with new products that rely on freshness and quality, they need to tread carefully. Additionally, the forward pricing options for traditional foods may not be possible for fruits and vegetables. Still, other external factors remain - unpredictable weather cycles, geographical location, or outbreaks of mad cow or bird flu, can severely impact the availability of new product raw materials, and ultimately add cost to the franchisee and to the end user.
· The Complementors – Franchisees and labor relations are also important to a successful transition to new products. Between 70 and 80 percent of McDonald’s locations are franchised – product consistency is key. Involving franchisees in the decision making process for new products will be valuable. Wages, often at the lowest end of the national pay scale, are generally the largest single expense at restaurants. To deliver this new high quality food product requires dependable, committed employees. Turnover has been low due to the high unemployment rate, but as the economy improves McDonald’s needs to stay on top of labor relations.
McDonald’s new initiatives will run through part of next year but beyond that, there is little on the horizon. There are many operational risks that need to be addressed before this consumer buys into this new revitalization plan. But the opportunity for success is just as possible. If McDonald’s manages to retain the typical burger and fries crowd along with attracting the salad and yogurt crowd, they will have created a recipe for success that may last for the next fifty years.
Questions regarding this blog can be directed to Vicki Ledajaks (vledajak@chicagogsb.edu), Deanna Markley (dmarkley@chicagogsb.edu) or Julia Zupko (Julia.wit@chicagogsb.edu).

Will “CrackBerry” addicts soon face an intervention?

2005-05-17T20:26:00.000-04:00

Research in Motion (RIM) recently reached the three million user milestone for its BlackBerry products and services and reaffirmed its status as the dominant player in the wireless e-mail market. RIM grew relatively quickly from the small firm that developed and launched the first product in the market to become the leading provider of servers, software, and handheld devices that provide wireless e-mail access and integrate it with wireless internet and mobile phone capabilities. RIM’s status as the innovator and first mover has generated a cult following earning the “Crackberry” nickname. Even as positive news regarding sales and strategic partnerships continues to emerge for RIM, analysts and journalists raise questions as to the company’s ability to sustain its position.
The speculation seems to be driven not only by competitive entry, but also by the way in which newer players seek to redefine the category. Mobile phone manufacturers, such as Motorola, Nokia, and Samsung, are planning to introduce smart phone devices similar to PalmOne’s Treo. These devices can incorporate digital photography and digital music. A number of companies are entering the network and service market as well. Smaller firms offer systems similar to those offered by RIM that include servers, software, and devices. Microsoft has focused its efforts on a software platform that can be run by multiple handheld devices. It currently offers software that supports wireless e-mail, requires no additional servers, and seamlessly integrates with its widely used Microsoft Exchange e-mail server software. According to product reviews like those published in BusinessWeek last month, the point of difference that inspires user loyalty to RIM’s BlackBerry products the “push e-mail” technology that allows a real time connection between a mobile device and an e-mail server. Microsoft is developing upgrades to eliminate that point of difference and will soon launch its Magneto software.
Analysts are divided on the issue of whether RIM will be able to withstand a barrage of current and potential competitive threats. While most analysts agree that RIM’s high share price reflects the company’s bright short-term prospects, the jury is still out on whether the company will be able to sustain its dominant position in the long-term. Hardware currently comprises 70% of RIM’s revenue. CSFB praises RIM’s efforts to shift its reliance on hardware to new applications like CRM and calls it a “key initiative to avoid commoditization and expand the addressable market.” Bear Stearns and Forbes both assert that RIM’s expansion into emerging markets will help it sustain its current market leadership position. Its expansion into China is particularly noteworthy as Deutsche Bank estimates a CAGR of 13.3% in this market. As RIM increases its globalization, it will increase its exposure to the foreign exchange risks associated with multi-national operations. Even currently, RIM’s revenues and raw materials are denominated in US dollars, while a substantial portion of its operating costs are denominated in Canadian dollars. While hedging reduces this risk, Smith Barney argues that it does not eliminate it, especially with the recent volatility of the exchange rate of the dollar versus other currencies.
With respect to competition, Deutsche Bank argues that Microsoft’s Magneto OS for wireless devices will pose a credible threat to RIM. Conversely, Smith Barney argues that the Magneto will not pose an immediate threat due to the time required to develop the necessary hardware and launch a product integrated with the new software. Forbes and Motley Fool contend that larger handset vendors are capable of competing against RIM, and Deutsche Bank states that “despite [RIM’s] award winning design and ease of use, ultimately it is not a very sophisticated device, which could be replaced by a newer design…just as regularly happens in the mobile phone handset space.” Despite the potential commoditization of RIM’s hardware, Forbes and CSFB believe that RIM will be able to defend its territory with its established Blackberry Enterprise Servers (BES) and partnerships with global wireless carriers and software providers. In addition, some argue that RIM’s loyal cult following for its Blackberry platform will serve as a strong line of defense for its dominant market position.
As the first mover in the wireless e-mail market, RIM has constructed some barriers to entry that have protected it from competition. The company has established sales and service partnerships with all of the large wireless service providers in the United States and continues to extend its partnerships around the world. As a result, RIM has been able to build its large customer base of corporations and consumers. Its push e-mail technology has remained unique in the market, and RIM’s partners develop additional applications that can be run on the BlackBerry platform. The superior products and services have allowed the company to retain and grow its share of the market.
RIM’s dominance of the market seems poised to fade. Excess profits draw competitors to the market, and entrants are ready to redefine the category that RIM created. RIM is vulnerable because competitors have the ability to offer products that provide both core email service and features that BlackBerry devices do not currently offer, such as digital cameras and mp3 players. While some might argue that these features are unimportant to RIM’s traditional demographic, market trends clearly demonstrate that consumers increasingly seek such features. Consumers are confronted with the discomfort of carrying multiple devices, and all-in-one devices resolve this tension. PalmOne and Hewlett Packard have slowly started attracting RIM’s traditional demographic (professional consumers). Such competition increasingly fragments what will have once been predominantly RIM’s domain. These devices may also appeal to new demographics, such as teenagers and young adults. It is unclear whether RIM has the technological resources to produce such an all-in-one device. In addition, RIM has and will continue to experience difficulties in its attempts to transfer BlackBerry software to devices manufactured by outside firms. RIM, therefore, is not well positioned to defend itself against competition in the hardware portion of its business or in the software and service business segment.
While some argue that RIM’s established “Blackberry Enterprise Servers” (BES) create high barriers to entry that enable it to maintain its position, this argument presupposes that competitors will be unable to offer technology that achieves a similar, if not better, result. While it may be some time before a competitor like Microsoft is able to achieve the same level of performance in its e-mail technology, competitors will benefit from the foundation that RIM has built and eventually catch up. Nintendo provides an example that illustrates the sequence of events that may occur in the wireless e-mail market. Nintendo once overwhelmingly dominated its market due to its ability to restrict access to desirable games. Ultimately, it surrendered its position to Sony and Microsoft, because the competitors were able to build on the concepts Nintendo had developed and capture market leadership by creating new metrics by which consumers evaluated products.
Though competing devices and software may usurp RIM’s market position in the future, BlackBerry’s branding has built a legacy that will stay with addicts as they adopt new products allowing them to remain in denial. The products have been culturally entrenched through widespread use across American corporations and through celebrity endorsements, particularly the inclusion on Oprah Winfrey’s 2003 list of her favorite things. Customers use BlackBerry as a verb, and compulsive users have inspired the “CrackBerry” nickname. This cultural identity implies that while competitors may redefine the market, RIM will always be credited with the original definition. The brand will likely be the next Rollerblade© as users purchase other brands of devices but refer to them as BlackBerries.
Anita Arbogast, Kate Hacker, and Aarti Patel

GM – RUNNING ON TOYOTA?

2005-05-16T21:11:00.000-04:00

The latest love affair in the auto industry between GM and Toyota is striking for its contrasts. GM is burdened by its health care and pension liabilities, first quarter losses in excess of a $1 billion, junk status debt, and a stock price at a 10 year low. Toyota however is humming along like a new Prius, with a “reported $2.8 billion in profit in the same quarter and commands an edge in the market for environmentally-friendly hybrid vehicles.” However, the market is abuzz with talk of cooperation between GM and Toyota ranging from Toyota’s sharing of its hybrid technology to cooperation in fuel cell technology and the Japanese car-maker raising prices to help floundering American competition. Is Toyota really being altruistic here? Will this partnership revive GM?

The biggest reason cited for Toyota’s overtures has been the possible return of Japanese car bashing of late 70s and 80s. Most analysts agree that these fears are overblown. According to Walter McManus, “Ultimately, U.S. consumers are consumers first and citizens second. Most people don't really think about where their vehicles are made.” So what else could be driving this cooperation? Toyota and Japan are heavily dependent on the US economy and will do whatever is necessary to maintain sales in this country. Another potential answer, according to Lindsay Brooke of CSM Worldwide, is that by combining efforts the industry giants would “have a lot more clout with other decision-makers and could help get government and industry more involved.” Given the expense of developing fuel cell technology, the real reason may be based in simple economics as the Japan Times reports, “Joining hands in development would benefit both automakers by reducing costs, which would bring down prices and make the vehicles more affordable for consumers.” The story on hybrids is also put down to pure economics of Toyota wanting to spread technology development costs over more units. Are the arguments for cooperation the complete picture or is there more to the economics of these deals?

We do agree with analysts that fears of an anti-Japanese car revolution are remote since the scenario has changed significantly since the 80s. Toyota has taken preemptive steps to alleviate potential domestic tension including joint ventures with US automakers and developing US plants. In Kentucky, where Toyota has one of its main US production facilities, Japanese firms have 35,000 employees. In addition, perceived value of Japanese cars significantly outweighs their prices in the markets and it would be difficult for patriotism alone to overcome the surplus, as stated by McManus. Continued outsourcing of products to China and success of Wal-Mart underscores this change in American consumerism. More importantly the drivers of the unrest in the 80s, Unions have been significantly weakened in their position as monopolistic suppliers of labor by globalization and, thus, do not pose as much of a threat. Overall economics and politics dictate against the much publicized backlash.

How about the economics of fuel cell technology? Will that help GM in the long run? Based on data in EV World, fuel cells are currently extremely expensive costing more than 50 times as much as an internal combustion engine to produce power and wearing out 5 times as fast. There are also significant technical issues with fuel cell today that makes Toyota predict that fuel cells will not be available for 25 years. Hence, Project Apollo would help share the development costs of the fuel cells and help the companies create value faster and cheaper. But who will capture the value created? In terms of engineering, Toyota is years ahead of GM in fuel efficient technology for small cars as is evident from their position in the hybrid market where used Toyota Prius sale for a premium and may adapt fuel cell technology for its cars faster than GM can. Thus, while they would be sharing costs, Toyota will capture more value from the partnership.

What about the hybrid technology sharing? Will the Toyota technology get GM purring in a market that is growing by 960% a year? It is important to note that Toyota came up with the proposal for hybrid sharing. Sharing of fixed development costs of the hybrid engine and reducing vehicles costs could have been a motivation for Toyota but it wasn’t the only one. If hybrids are the cars of the near future, how could Toyota maximize its benefits from this phenomenon? The best scenario for Toyota is to be the sole supplier of the hybrid engine, which is the core of the product, and dissuade competition from developing. Hence, this offer is a way to weaken the GM-Chrysler partnership on hybrids and maintain the Toyota-Honda duopoly in hybrids where Toyota today is the only manufacturer supplying hybrids to other car companies. Can GM use any of its learning curve in the heavy vehicle hybrid segments to counter Toyota’s power? Bradley Berman, Editor in Chief of hybridcars.com states “I can't help but think that it relates to GM's overall strategy as it relates to hybrids," he said. "They started with buses. They start with the biggest systems and test them out. I'm giving them a break here. They test it in fleets where you can get good data back. But do you do that and then leapfrog into vehicles that do millions in volume?"

So what is really going on here? Toyota seems to be playing a shrewd game that it stands to win in every state of the world. Even on price increases, GM stands to lose more since it faces greater price elasticity of demand, as evidenced by deep promotions needed to sell GM vehicles, as compared to Toyota. Hence, the unequal partnership with Toyota may end up hurting GM in the long run, given Toyota’s superior technology and pricing power. Improving the value to cost margins, better design and quality, cost cutting, and partnerships with an equal like Chrysler is the only way GM will get into the black, not subsidizing Toyota’s fuel cell research.

Robert Cummings Drew Dekett Debasis Rath

Game theory on the Korean Peninsula

2005-05-16T21:08:00.000-04:00

In the wake of recent revelations that North Korea has been producing weapons grade plutonium, leaders and policymakers are trying to make sense of a world in which North Korea has the capability of a nuclear strike. North Korea agreed to stop any nuclear weapons programs in 1994, but lied about it and revealed in 2002 that it had produced enough nuclear material for up to 6 warheads. It is difficult to know precisely why North Korea has taken a step towards nuclear armament, but possessing nuclear weapons can increase leverage in political negotiations, especially when the person with his finger on the button is considered erratic and extreme.
Game theory and strategic analysis can explain some of Kim Jong Il’s actions. First and foremost, he is unpredictable. He varies his actions and his words, which are frequently at odds, to keep the rest of the world guessing about his intentions. This unpredictability makes it very hard to anticipate Kim’s actions, which bodes ill for any doctrine of preemption. The closed nature of his regime aids Kim in achieving this lack of predictability, because the rest of the world can never be absolutely certain that he is telling the truth about either his intentions or his capabilities. Having a clear idea about Kim’s true goals would give the US an idea of where he is vulnerable to persuasion or coercion. Since Kim has not yet proven beyond all doubt that he possesses the wherewithal to launch warheads at the US or Japan, his adversaries must take the threat of nuclear weapons very seriously without being able to act on the certainty of their existence. For example, with certainty of a nuclear threat from North Korea, Japan might credibly threaten to develop nukes, which might lead China to take a firmer hand with Kim Jong Il.
The second technique Kim Jong Il uses is brinkmanship – making moves that may escalate into an uncontrollable situation. Engaging in this technique signals commitment to the extent that the participant is willing to risk a highly negative outcome to achieve an objective. Kim Jong Il is clearly using this technique with the re-initiation of his nuclear program. In signaling to the world that he possesses the building blocks for nuclear weapons, he risks starting a sequence of events that could end in economic isolation, military action against North Korea, or a nuclear exchange. Although it is hard to know what Kim Jong Il wants, it is clear that he is willing to risk the consequences from the numerous countries who have a stake in preventing him from manufacturing nuclear weapons. Additionally, brinkmanship becomes more effective if the outcome of an escalation is asymmetrical – one side has more to lose than the other. Not only does Kim Jong Il have less to lose – his country is starving and close to collapse – but he has also shown in his prioritization of resources that he is indifferent to the suffering of his people.
Kim Jong Il’s revealed preference to bolster and feed the military while letting civilians starve brings up a difficult question from the international community. The U.S., China, South Korea and Japan have supplied food aid to keep civilians in North Korea from starving and prevent the nation from total economic collapse. South Korea and China are terrified a collapse would send North Koreans streaming across the borders, and are reluctant to cease aid to Kim lest it result in such a collapse. In essence, Kim Jong Il successfully extracts foreign aid because he has shown that he is willing to let his people starve in favor of building military power. This makes his nuclear threat credible, demonstrating that he cares little for the well-being of his people, and would likely be willing to risk their annihilation before abandoning his God-like status as ruler of North Korea. The international community would prefer to keep the Koreans from starving when Kim does not have nuclear weapons for humanitarian reasons, and wishes to prevent a collapse scenario that might push Kim over the edge into using his nukes if he does possess them. Thus, whether Kim has weapons or not, the world will provide food to North Korea, making it a dominant strategy. With food aid enabling higher military spending, Kim Jong Il successfully puts the international community in the uncomfortable position of partially funding North Korea’s military program.
While it is easy to identify the classic gambits used by Kim Jong Il to implement his nuclear program while lifting aid from the international community, the more pressing question is: To what end? A nuclear North Korea increases the country’s leverage, but what are Kim’s ultimate goals? It’s difficult to say for certain, but nuclear weapons certainly advance North Korea’s presumed ideological objective of consolidation of the Korean peninsula. With nuclear weapons, the game changes for a conventional invasion of South Korea. The world would expect erratic threats from Kim Jong Il, and if a nuclear threat was made, it would be hard to decipher if it was genuine. Therefore, in the case of a North Korean invasion of South Korea, it would be difficult for U.S. and international decision makers to take an action that might result in a nuclear detonation on domestic soil.
Kim Jong Il’s nuclear option may be an even simpler matter: one of survival. It’s clear that North Korea is incapable of sustaining itself economically, and at some point the regime may implode. Although the world is aware of this, it is possible that Kim’s newest gambit signals an even more desperate situation than we realize. This may explain China’s unwillingness to consider using its leverage as Kim’s main benefactor; China fears the collapse of Kim’s regime even more than the consequences of a nuclear North Korea, especially since it is not established beyond all doubt that North Korea has achieved a working nuclear arsenal.
Whatever the aims of Kim Jong Il, the U.S., China, Japan and South Korea will have to tread carefully to achieve the objective of North Korean disarmament. From the actions taken so far, it looks as if Kim Jong Il will take any risk necessary to increase his strategic leverage with nuclear weapons. Ultimately, this situation shows the limits of game theory when applied to an actor like Kim Jong Il. The appearance of irrationality may be an asset in negotiations, but we cannot know for sure that Kim is not actually irrational, and the elegant logic underlying game theory assumes that actors will act in their own best interests. Being worshipped as a god for decades can have a corrosive effect on one’s grip on reality, and if the US, following Nietzsche’s lead, declares that “God is dead,” Kim Jong Il may just decide to take the rest of humanity with him.
Deirdre Campbell
Chuck Lyman
Jim McCabe

Baristas serving a double shot of - liqueur?

2005-05-16T21:06:00.000-04:00

Starbucks, seen as a homely refuge, a place to read a book and listen to a bit of mediocre jazz, says its mission is “To establish Starbucks as the premier purveyor of the finest coffee in the world while maintaining our uncompromising principles as we grow”. Starbucks currently is in 32 countries, has approximately 700 company-operated drive-thru locations and 5215 stores worldwide. Starbucks strategy is to reach customers where they work, travel, shop and dine typically in high-traffic, high-visibility locations. The Company’s retail sales mix by product type is comprised of approximately 77% beverages, 14% food items, 5% whole bean coffees and 4% coffee-making equipment and accessories. Approximately half of the stores carry a selection of “grab and go” sandwiches and salads. The comforting and classy leading specialty coffee retailer is known around the world for its relentless takeover of local community-based coffee shops. The company has seen compound annual EPS growth of 41% over the past four years and last-year EPS up 44% on revenue growth of 25%. Looking forward, consensus analyst estimates call for EPS growth of 24% this year and 21% next year. This is impressive to say the least for a company that started in 1985 and went public in 1992 at $17 per share, or a split-adjusted price of $1.0625 for the Company’s four subsequent 2-for-1 stock splits to a current price of almost $56.
So how is there a talk of selling alcohol at Starbucks? Actually this is not a new phenomenon: In the port city of Kobe, Japan, people head to a Starbucks kiosk to buy lattes, cappuccinos -- and beer and wine. This outlet quietly began selling such beverages two years ago and is the only Starbucks in the world offering alcohol. In 2003 shareholders of Starbucks Coffee Japan Ltd. approved a change to the corporate charter allowing the sale of booze at any outlet. In the Kobe store, Starbucks offers Red Hook beer and Columbia Crest and Staton Hill wines, alcohol brands from its home state of Washington. In 2004, the Company entered into an agreement with Jim Beam Brands Co., a unit of Fortune Brands, Inc., to develop, manufacture and market a Starbucks-branded premium coffee liqueur product in the United States. The Starbucks liqueur, which resembles Kahlua in texture, taste and alcohol content (20% by volume, 40 proof), will come with a premium price tag that should be familiar to devotees of its coffee. A 750-ml bottle will cost $23, compared with $17 for Kahlua. It will also be available in 1 liter and 50-ml bottles. A 1.5-oz serving of the liqueur has one-fifth the caffeine content of a "tall" serving of Starbucks coffee. The Company conducted tests of this product in two U.S. markets in the fiscal fourth quarter and expects to introduce the product nationally during the fiscal second quarter of 2005 in retail locations licensed to sell distilled spirits, such as restaurants, bars and retail outlets where premium distilled spirits are sold. The Company states that it will not sell the liqueur product in its Company-operated or licensed retail stores.
So is idea of Starbuck selling alcohol in its cafes a good one? Starbucks sales in Japan have slowed due to stiffening competition from newcomers such as like Seattle-based Tully's Coffee and local coffee chains like Pronto and Doutor run by mega Japanese beverage companies. There is a need to drive growth through diversified products. The results from the Starbucks café at Kobe could have provided some pointers. There are no indicators that the option of providing liquor there has led to loss in sales, at least in the short term. However, Japanese customers are known to eagerly embrace new ideas and new fashions and therefore the Kobe café’s sales have to be monitored in long term to determine efficacy of the new strategy. It will test aspects of Japanese culture which are different than those in the West. Japanese go out for drinks in combination of dinner. They rarely take alcohols alone at bars and restaurant without any food. Starbucks would need to serve higher volumes of foods to be successful in serving alcohol. Many Japanese drinkers also smoke while drinking. One of Starbucks’ main selling points is to offer best quality coffee including smell of it, hence do not have smoking areas. In addition, local beer and wine drinkers in big cities like Tokyo rather go to local pubs and fashionable restaurant for dating and business meetings. Finally the competition in local pub and restaurant is harsh. As an example, Pronto, operated by mega liquor distributor Suntory Ltd and the largest coffee company UCC, has café time (until 5:00 pm) and bar time (after 5:00pm). Starbucks will have to keep its differentiated image intact to charge its high premiums.
Whether Starbucks should introduce liquor in the cafes in US is even more debatable. The first hurdle will be due to differences in liquor-license laws between states. Further, extensive customer tests need to be done to ensure that the loyal Starbucks customer is not driven by rowdy liquor guzzling clientele. The consistency of serving liquor in a cafe that associates very strongly with coffee is unclear. Further, the competing firms such as Tully’s could capitalize on dilution of Starbuck’s focus.
The option of being able to sell liquor with its high margins and the growth of sales of premium spirits is sure attractive. Starbucks could ride some of this growth by offering a few coffee-based alcoholic drinks, such as Irish coffee and other coffee-based cocktails. As an analyst at UFJ Tsubasa Securities Co. stated, "One possible compromise is to offer a few coffee-based alcoholic drinks, such as Irish Coffee (hot coffee with a shot of whiskey and a dab of cream). It's easy to see Starbucks offering coffee-based cocktails.”
The other potential growth options would be to intensify its efforts to penetrate and dominate the Chinese market. Starbucks believes that, over the years, China will overtake the United States as its largest market (S&P 500 report). It should therefore concentrate on its expansion program there to establish dominant market position in time for the 2008 Beijing Olympics. Another way for Starbucks to diversify its business and gain a foothold in the “share of throat” products is to take up stake in liquor and soft drink companies as well as chain restaurants.

Kamal Jha, Kenji Yaguchi and Ali Kandaih

Microsoft Besieged

2005-05-16T21:05:00.001-04:00

Is Microsoft besieged and going the IBM way? Has it lost its focus and spread itself too thin? Has its business model become obsolete due to the new ‘open source’ paradigm to which it does not subscribe? Has it become a stodgy bureaucratic company that is unable to innovate? These are some of the questions, which this article will try to analyze.
Microsoft owes its tremendous success due to its flagship Windows OS which became the de-facto standard on desktop PC’s. This product coupled with the explosion of PC usage at the office and home added to their success. Along with their Office Suite of applications, Microsoft has dominated the market in the OS and software segment in the PC market. New products like MS Mail and RAD Client Server programming languages (Visual Basic) and databases (SQL Server) further helped them consolidate their market share.
Microsoft was not the first on the browser market, Netscape was. However in a few years Microsoft’s IE came to dominate PC browsers. Allegations of unfair competition and anticompetitive practices were leveled against Microsoft but the company succeeded in carrying the day. However this did blemish the company’s reputation especially in regards to their business practices.
Today Microsoft is perceived by some as a massive behemoth ($36 Bn in Sales, $8.2 Bn in profit and a staff of 57,000 (2004-BBC figures). It is facing the challenges of a large corporation, changes in technology and leaner aggressive competitors. Is Microsoft capable of assuring it’s future dominance or will it falter? A study of the issues facing Microsoft will aid us in our analysis.
Microsoft’s OS has faced numerous virus attacks and is perceived to have serious potential security flaws. It is extremely important for Microsoft to prove that it can create a secure OS. If they do not succeed, PC users will have a strong reason to migrate to another OS. One of the biggest challenges facing Microsoft is the new ‘open source’ paradigm. The Linux OS is based on this model. The model allows the source code of the OS to be shared, developed and improved upon (by any OS developer) and is not proprietary. Linux is perceived to be quite secure, easily customized and most importantly FREE to download and use. Linux has eaten rapidly into Microsoft’s share of the OS market. Also China, Japan and South Korea are exploring the option of developing an Asian version of Linux, which, if it occurs will be a serious setback to Microsoft. A new ‘open source’ browser Firefox has eaten into Microsoft’s IE browser and is showing explosive growth. Many of the features expected in Microsoft’s next OS ‘Longhorn’ are already available in the market while the actual release date of Longhorn is more that 1 ½ years away (at the earliest). In the multimedia market, Apple’s iPod and iTunes have dominated the market with Microsoft not having any comparable product. Clearly Microsoft is not able to innovate fast enough. Adding to Microsoft’s woes are regulatory and legal issues still being faced by the company.
Of course to preserve its dominance Microsoft has come up with multiple strategies. It is concentrating on improving security in its OS and is billing ‘Longhorn’ to be immune to security attacks. It is following an interesting strategy of trying to dominate multiple segments of the IT market. It is targeting the home ‘Living Room’ by making its ‘Media Centre Software’ a part of. home audio-video entertainment systems. It’s ‘X-Box’ product is targeted at the huge software gaming market. It is negotiating with Nokia to enter into a long-term contract for providing mobile software for Nokia’s phones and seeks to create a space for itself in the mobile software market. It believes cell-phone like devices will dominate the mobile market and will challenge products like iPod. In regards to Linux, Microsoft believes that it is at least ten years from being a consumer product. As far as open source is concerned, it is our view that this model cannot be a serious threat as it will not be interoperable with other software and that open source and secure software are oxy-morons!!
Microsoft has based its strategy on its vision of ‘Convergence’. It believes that software will be user centric, a digital nervous system, and that it is shaping this system. To gain dominance in this future environment it is seeking to establish a leading presence in the key future components of this system. While the vision is grand and the strategy all encompassing and has its merits, there are multiple pitfalls that Microsoft may face. We will briefly attempt to play devil’s advocate to their strategy.
Microsoft is discounting the ‘open source’ model as it has no real answer to this. This model does have benefits. It is innovative, customizable and FREE. It is unwise to discount it and we believe that Microsoft should examine sharing its source code openly. Microsoft has played a clever strategy of sowing doubt in regards to the security of an open source model. They may have a point there. One of the things that strike us is that Microsoft is not a pioneer or leader in any field. It has still not come up with a flawless OS and is not gaining required efficiencies from its learning curve. It is spreading itself thin over multiple areas (mobile, home-entertainment and gaming). Does it really have the core competencies to succeed in these areas? It seems that gaming is more about content than hardware/OS. The hardware/OS should be ubiquitous. What is to stop a cell phone company from writing its own code for mobile devices? Why is it so important to follow the Microsoft standard? Microsoft has done a very good job of managing competition based on its financial strength and monopoly in the past. Is this really sustainable if it does not excel in anything? Is this a sustainable strategy?
I guess time will tell. We are in for an interesting decade ahead!!

Daniel Chi, Arun Mohanchandra, Arvind Ramanathan

Trading the pit for the bit?

2005-05-16T21:05:00.000-04:00

On April 20, 2005 the NYSE announced plans to merge with Archipelago Holdings Inc., an electronic trading company. After years of trying to fend off the competition from foreign exchanges and electronic trading platforms, the NYSE is finally moving into electronic trading itself. The move will transform the NYSE from a not for profit organization into a publicly held company and change the dynamics of the intensely competitive trading environment.

Since its inception in 1792, the NYSE has benefited from several technical innovations to become the center of global financial markets. The introduction of the telegraph for example, allowed investors to place orders from all over the US and tremendously increased the volume and hence liquidity of traded stocks. Both the Wall Street Journal and Businessweek see the merger as tectonic shift and giant leap forward in the business of operating stock markets.

In the old days, investors would initiate trades by calling the broker. That broker would call the trader who would work with a specialist on the trading floor of the NYSE to fill the order. This open-outcry auction still dominates the floor of the NYSE. With the developments in information technology, computer based systems can handle the matching of orders and close the trade faster, cheaper and with better execution quality.
In the past decade, a new breed of electronic exchanges has been giving the traditional exchanges a run for their money by quickly gaining significant market share. Several traders and analysts, including Michael Panzner, head trader at Rabo Securities, expect the manual trading system to disappear.

While electronic trading systems have been around for several decades and has changed the trading, the NYSE has been reluctant to adopt the technology. The protection of the SEC to slow orders handled manually has let the NYSE get away with its reluctance to change. But the SEC is pushing the NYSE towards more electronic trading and has recently adopted the Regulation National Market System, a set of rules that require orders to be filled at the best price immediately. The Big Board has to adapt or face imminent losses in market share or even the risk of being wiped out. For sure competition will be fierce. As a response to the NYSE and Archipelago merger, NASDAQ announced to buy Instinet.

NYSE Chief Executive John Thain, who recently joined NYSE after John Grasso’s ouster, is a driving force behind the acquisition. Thain tries to break the NYSE’s reluctance to change and its tradition of preserving its structure and trading floor. The resistance to change can still be sensed in press releases: The NYSE and Archipelago have said they want to keep both markets separate - Archipelago's electronic exchange and the NYSE's trading floor. However, investors and analysts expect much of the volume to quickly migrate to improved and cheaper electronic channels. With the integration of Archipelago Thain also tries to give the NYSE culture a more entrepreneurial dimension.

The merger also means that NYSE members will get more value for their seats by going public. Seat prices on the NYSE have dropped from their peak of $ 2.7 million in 1999 to $ 1.6 million. The prices have come under pressure not because of the technology bust but due to the immense pressure the NYSE faced with concerns about its future. The deal which values a seat on the NYSE at $ 1.76 million will satisfy members who have been demanding that NYSE go public in recent years. Given the success of the Chicago Mercantile Exchange going public, it seems like the seat holders at the NYSE are poised to gain from this deal.

Goldman Sachs, where Thain previously was a president, also plays a key role in the merger. The investment bank not only advises both the NYSE and Archipelago in the merger, it also has interests in both entities. Goldman owns 30% of Archipelago and is a seat holder at NYSE and operates a "specialist" stock-trading firm at the NYSE. In the merger Goldman seems to strengthen its position in the new trading platform.

Investors are expected to benefit from the merger. Large investors will have the option of using the technology infrastructure for the simple and large volume trades. At the same time, they will have access to the floors of the NYSE for the more complex one-off trades that cannot be fulfilled by other electronic trading platforms. In addition the electronic platform would mean these players have access to stocks and other instruments listed on other markets. Smaller investors will not directly benefit, although the transformation of the NYSE and consequently of the industry will translate into lower commissions for these smaller players and eventually access to a variety of products that they currently cannot deal in.

The proposed merger will also have ramifications locally on the Chicago Board of Trade, Chicago Mercantile Exchange and Chicago Board Options Exchange. Along with the advanced electronic trading capabilities that Archipelago will provide to the NYSE comes the ability to target financial futures and options trading. Transforming the NYSE into a public company will also give them the financial leverage to buy futures.
The Chicago Stock Exchange may even be hit the hardest by the proposed merger. Currently the CSE acts as a trading alternative to the higher priced NYSE and Archipelago trading system may make the CSE irrelevant. This merger is going to cause these exchanges to change they way they are doing business or quickly grow to match the NYSE size.

The merger will give the NYSE a leg up in the financial markets of the future where speed and quality of execution will be key. The adoption of technology will also serve as a platform to branch into other instruments like options, exchange traded funds and exotic derivative products. The deal will cement the NYSE’s position as the center of financial markets. In any case the trading industry dynamics are bound to change. Only time will tell how the exchange of the future will look like.

Steven Coulembier, Daniel Groner, Vinod Iyer

The kind of place God would build if He had the money”

2005-05-13T19:38:00.000-04:00

Steve Wynn has returned to Las Vegas. Five years after a knock-down, hostile takeover of his Mirage Resorts by Kirk Kerkorian’s MGM Grand, Mr. Wynn unveiled The Wynn Las Vegas. The hotel opened on April 28th, with the aim of setting the new standard for luxury on Las Vegas’s famous Strip. Wynn Resorts (ticker: WYNN) spent five years and $2.7 billion building the 2,700 room, 9,500 employee, 217 acre property, making it the most expensive mega-resort hotel in the world. But does Wynn's triumphant jewel of a hotel truly offer visitors value? And if so, can that competitive advantage be sustained in a crowded and fickle market?

Mr. Wynn’s history would certainly lead one to expect success. Wynn's Mirage, opened in 1989, pioneered the "entertainment and recreation" paradigm on the Strip, and set off the town's explosive growth in the 1990's. Later, his $1.6 million Bellagio, opened in 1998, redefined Las Vegas class and luxury.

Now Mr. Wynn is attempting to move Las Vegas in a new direction. Las Vegas has become an international destination that attracts an increasingly aging population with money and sophisticated tastes. Further, conventioneers account for 15% of Las Vegas visitors, up from 5% in 1980. The result has been less gambling, and more luxury and entertainment: gaming now accounts for 25% of Las Vegas tourism revenues, down from 33% in 1980.

The Wynn Las Vegas is designed to compete on this stage. Like the Bellagio, it is vaguely theme-less, but lushly posh. Sunlight streams through a lobby adorned with brightly festooned plantings that dangle above whimsically colorful marble mosaics. Privacy is paramount: high-paying guests use a separate entrance away from the casino floor, and a waterfall-light attraction is inside, visible only to restaurant and hotel guests. The space has 200,000 square feet of attractive and modern meeting space, and is located very close to both the Sands Expo and the Las Vegas Convention Centers.

Bubbling anticipation and a hugely successful opening have created hype in some quarters of Wall Street. Marc Falcone of Deutsche Bank states that “although shares will remain volatile, investors may be hard-pressed to find a company with such rapid growth over the next several years." Nonetheless, the project has met complaints from the outset, as other analysts expressed concerns about cyclical trends, competition, and financing.

The project was funded and begun at the tail end of the 2001 recession, a time when tourism was being clobbered by September 11. The increasingly wide availability of legalized gaming, and the feeling that Las Vegas offered nothing fresh, compounded the effect. Las Vegas visitor revenues had increased on average nearly 8% per year from 1990 to 2000, but only 1.75% per year from 2000 to 2004. And the massive build-out in the late 1990’s left excess capacity: there were 131,000 rooms in 2004, up from 73,000 in 1990. Hotel occupancy rates had dropped to below 90%, levels not seen since the early 1990’s recession. This lead to a repricing of the Wynn Resorts' 2002 IPO, from $23 to $13 a share, and forced the company to seek junk bond financing costing $130 million a year in interest financing.

On the high end, the luxury market is witnessing increasing minimum efficiencies of scale. Las Vegas Sands is erecting the luxury, 3000 room Palazzo across the street from the Wynn Las Vegas; Mandalay Bay recently completed the ultra-modern, 1000 room THE Hotel, right next to its exclusive Four Seasons tower; and the MGM Mirage opened a new 900 room luxury tower at the Bellagio. Gambling in Macau is expanding, and Singapore is now allowing it. Both locations are close to Asian "Whales," gamblers who bet upwards of $10,000 a hand. Because this market is relatively finite, this growth in well-financed, luxury capacity is essentially chasing the same dollars.

Perhaps the biggest slam on Steve Wynn is his profligate ways. As the CEO of Mirage, he notoriously leased his renowned art collection to the Bellagio for $5 million a year, and had the company pay for his private jet. Today, those trends are tempered, but lurking. He leases the art collection to the Wynn for $1, and pays for the jets himself. But marketing and promotion costs were estimated at $38.1 million in the first quarter of 2005, and should be as high going forward. Consequently, Steven Kent of Goldman Sachs feels that Wynn Resorts is a “speculative investment in an industry that is overpriced relative to hotel and cruise ship companies and where there is little positive catalyst.”

Our concerns encompass these issues, but ask a broader question: Will Mr. Wynn’s strategy generate a long-term competitive advantage and yield profits commensurate with the risk of this venture?

On the face of it, the idea is a slam dunk: demographic and cultural trends favor a luxury “entertainment and recreation” experience. Wynn’s positional competitive advantage flows from this logic: The hotel’s amazing design sprung almost magically from the incredible imagination and local development prowess of Mr. Wynn. And Mr. Wynn has wisely chosen to name the hotel after himself, to create a marketing asset that is essential for differentiating social goods.

But with increased competition, experiential goods like pretty buildings with lots of amenities are becoming something of a commodity. To compete, then, the Wynn Las Vegas must keep service standards exceptionally high to target and retain price-insensitive clientele. But Mr. Wynn is more of a dreamer than a doer, which bodes poorly for his capabilities operating a luxury hotel and keeping costs in line.

Anecdotal evidence bears this out. On a recent visit to explore the Wynn Las Vegas, one of our group members found a cockroach (!) in his room, and a call to housekeeping offered only an apology and a suggestion to call the front desk for a room change. No employees assisted his wife with her luggage or opened the doors at the front entrance. And the casino floor, like any in Las Vegas, was swarming with fanny pack toting tourists playing the nickel slots. Pretty shoddy.

In the end, larger, better capitalized firms - MGM Mirage in particular - are better positioned to dominate the Wynn's market. The have the money and the talent to build high end buildings; they can sustain competition and cyclical downturns better; and most importantly, they can run these facilities better and at a lower cost. Yes, as Gary Loveman, CEO of rival Harrah's, quipped, the Wynn Las Vegas is "the kind of place God would build if He had the money." But would He stay there?

Suzanne Davidkhanian
Keith Guerrini
Yvette Nicholas

Is Kodak Dead? Maybe Not

2005-05-13T19:37:00.001-04:00

Here’s the latest on Kodak. Number one in the U.S. in digital camera sales. Biggest market share for home use photo printers. Lead position in franchising digital-photo finishing in retail outlets. Is this the same Kodak from Rochester, New York that had its obituary written several times over in the press over the last few years (see, for example, “Kodak?: Buh-Bye) and just last week in HPC09?

A series of recent reports has chronicled the turnaround. Kodak’s strategy was not a reinvention of the wheel but did recognize that, as new CEO Antonio Perez bluntly put it yesterday, “The world is rapidly moving to digital. Kodak has to do the same and do it in a hurry. This is doable.” Ok, perhaps this isn’t an earth-shattering epiphany and half of the world might already be digital, but it is a reflection that Kodak has finally embraced reality. Furthermore, Perez and his predecessor Carp have also, and this is important, lowered expectations for future earnings, emphasizing the imminent death of the silver halide cash cow. (There is still significant money to be made from traditional film in places like China where Kodak has relocated manufacturing plants from France and elsewhere, though this too is expected to taper). Margins will be slimmer in digital, they argue, but we can compete and we will survive.

So what has Kodak actually done to pull off the apparent turnaround? For starters, they fired a bunch of people and shifted production overseas. Eleven thousand have already been let go and another 15,000 or so will be gone by 2007. Kodak will be left with a 33% leaner operation that numbers 50,000. While not exactly nimble, the smaller workforce cuts costs and enables Kodak to change directions more quickly. Kodak has also made some key acquisitions to head off competition and bolster its presence in the printing business. Just last week the European Union approved Kodak’s $980 million bid for Creo Inc., a Canadian maker of digital printing equipment. Creo might not be a household name here in the U.S., but it’s a heavyweight player in the industry and positions Kodak for significant expansion.

Kodak has also increased its presence in the commercial printing and medical imaging field through the purchase of Sun Chemical Corp.’s 50% interest in Kodak Polychrome Graphics and Israel based Orex Computed Radiography. The combined value of these acquisitions is just over $850 million.

Through work-force reductions, strategic acquisitions and a focus on growth in the digital world, Kodak’s income statement this past year, for the first time, saw digital sales exceed film sales. What’s more, and perhaps more importantly, digital profit growth will exceed the decline in profit from film. The stock market has taken notice. From May of 2004 to the middle of April of 2005, Kodak’s stock price surged more than 23%.

Analysts, however, are not convinced that the new Kodak is out of the woods. Deutsche Bank is concerned about exiting CEO Danel Carp’s makeover strategy and as analyst Chris Whitmore somberly notes, “We believe underlying fundamentals remain difficult for Kodak.” Standard and Poor’s further downgraded Kodak’s credit rating from BBB- to BB+, reflecting recent lower-than-expected earnings reports, a stock price plunge back to the level of May, ’04, and doubts about the company’s ability to make timely payments on their increasing debt. Cross Research sees a lot of uncertainty in the near term, and predicts high volatility due to demand shifts, new acquisitions that might or might not work out and lags between restructuring and the realization of cost savings.

While the analysts’ reports might seem sobering, they are not unexpected and there is a big, fat diamond gleaming in the rough. Volatility. This suggests the possibility of huge upsides if Kodak’s strategy succeeds. If it doesn’t, well, many had written them off anyway.

The big upside for Kodak isn’t the massive profits that they enjoyed for so many decades. It is, rather, survival and profitability at a non-monopoly level.

Kodak didn’t roll over simply because they missed the boat when digital first took off. The company regrouped and moved forward with a coherent strategy to drive growth internally by capitalizing on an exceptionally strong brand, technical expertise, and international presence and externally through targeted investments. Furthermore, Kodak opted to focus on the core areas of digital capture, imaging kiosks, home printing and online mobile imaging. While Kodak recognized that the traditional film business was in a decline, it was still a cash flow rich business that could fund their transition to digital. Clearly, the strategy is working to a certain extent. There’s no arguing with the fact that they’ve made substantial headway into the digital market. The problem is that Kodak faces intense competition across the board. Future success is within reach but far from certain.

Here’s to you, Kodak, for hanging in the game and not calling it quits. You did rest on your laurels and became somewhat complacent over the years, but as former CEO Carp put it, “Although we’re 124 years old, there’s a spring in our step.” Let’s hope there’s a lot of bounce in that spring.

Victor Casier, Sebastien Leroy and O’Neal Spicer

Food for Thought

2005-05-13T19:37:00.000-04:00

Established in Austin, Texas, upscale grocery retailer Wholefoods is the nation’s largest chain of natural foods. For the fiscal second quarter of 2005, the company’s sales increased 20% and net income was up 22% to $42 million. As recently as 1991, the company had only a dozen stores in three states. Today Wholefoods is a publicly traded company, boasting 168 stores across the US. Its quarterly sales exceed $1.1 billion, and profit margin per square foot is double the industry average. Scott Van Winkle, analyst at Adams Harkness, says the company should be able to grow earnings at “a 20% to 22% rate consistently over the next five years and still have only achieved half of its market opportunity”. That said, is Wholefoods’ growth trajectory sustainable? The stock trades at an enterprise value-to-revenue ratio of 1.6, pricey relative to other leading retailers including Wal-Mart and Costco.
Wholefoods differentiates itself from its competitors by cashing in on the “shopping experience.” Buying groceries is no longer a chore when buying at Wholefoods. Shopping is “showtime” and “you don’t need a ticket”. At Wholefoods you will not only find foods free of artificial preservatives, colors, and flavors but a shopping experience designed to wow the customer. There is Candy Island, where you can dip a fresh strawberry into a chocolate fountain, Lamar Street Greens, where you can have an organic salad handmade for you, Fifth Street Seafood, where you can have any of 150 fresh seafood items cooked for instant eating, and Whole Body, where a massage therapist will give you a 25 minute deep tissue. Each section in Wholefoods is designed to create an intimate feel with self-contained architecture so that shoppers feel like lingering. The lighting is the same as that used in art galleries, and the store stereo plays calming classical music. The store is not just about groceries: you will find, among other things, organic baby clothing, Wi-Fi hot spots, and wholesome prepared foods. Wholefoods has done what traditional supermarkets do not – it lures customers in and makes them want to linger.
Wholefoods draw comes at a time when chic urban living has regained popularity and leading healthy lifestyles a must. City sophisticates enjoy shopping at Wholefoods and do not mind dropping a wad of cash doing so. The retailer charges premium pricing, and one will not be surprised to find a vat of almond butter for $89.99. Wholefoods gets away with its pricing because it is in essence selling a way of life. John Mackey, CEO of Wholefoods, says that Wholefoods attracts the educated, who in turn are more likely to be rich enough to afford shopping at Wholefoods.
Despite these growth figures, Wholefoods has further potential for growth. The European and Asian markets are yet untapped, and the company expects to expand into the UK, Netherlands, and Ireland. Fresh & Wild, owned by Wholefoods, has already made its debut in the UK.
Wholefoods’ performance is not by chance. Similar to the Enterprise model, each store is an “autonomous profit center composed of an average of 10 self-managed teams…with designated leaders and clear performance targets”. Each team and store competes with each other in the areas of quality, service, and profitability. The results of these competitions translate directly into bonuses, recognition, and promotions. Each team screens and hires its members, and it takes a two-thirds vote and a 30-day trial period for a candidate to become a full-time employee. This hiring methodology affects the behavior of everyone from the job candidate to the team to the store team leader. It exacts performance measures on employees, who are pressured to perform by their peers rather than their superiors.
The results are obvious: staff is cheerful, knowledgeable, and eager to answer questions. Produce is “gleaming, stacked head high, perfectly arranged, each apple stem and celery stalk facing in the same direction”. In short, Wholefoods organizational structure is its competitive advantage.
We believe Wholefood’s internal structure is very sound, but the firm is vulnerable to external factors- potentially threatening Wholefoods’ dominance and profitability in the long run within the organic grocery segment. The company’s success is driven by its margins in the organic produce department. While healthy living is very much the fashion today, it might not be tomorrow.
Wholefoods could also face competition from a low cost provider, as there are no real barriers to entry. The market for organic produce might be too small today to attract potential entrants, but this might not always be the case.
Lastly, the company’s premium pricing means that its sales and profitability (per square foot) could suffer in an economic downturn. Currently Wholefoods bucks the industry trend by building 50,000 square foot supermarkets as the rest of the industry shrinks its stores to an average of 34,000 square feet. It is has become a metropolitan magnet and “must have” for residential developers in swank new buildings. This could set Wholefoods up for a tremendous fall if consumer confidence dropped or if the real estate bubble burst. Wholefoods needs to be wary of this scenario and plan its contingency plans accordingly.
Conclusion
Wholefoods has done a stellar job of differentiating itself from other grocery retailers. Its’ competitive internal organization drives profitability and ensures high quality service. Growth opportunities exist both in the US and internationally. Combined with the current healthy living fad, Wholefoods is on an upward trajectory to success.
While there could be threats from a low cost organic grocer, Wholefoods has made such an effort to differentiate itself that we believe that it will be able to retain its market share going forward, as long as the economy and consumer spending remains robust. In addition to its current emphasis on store growth, we urge Wholefoods to strategize for the alternate scenario and build up additional resources and new competitive advantages.
Ho, Huang and Sambasivan

GENERAL MOTOR’S RIDE DOWNHILL

2005-05-13T19:35:00.000-04:00

G
eneral Motors Corp., the world’s largest automaker, is in red. It reported a consolidated loss of $1.1 billion for Q1 2005. Although GM has 28 models among segment top three in initial quality and dependability studies by the J.D Power and Associates, its market share in North America declined to 25.2% in Q1 2005, down from 26.3% last year. The stock price continues a downward trend, declining from $68 in end 2004, to the current price of $31. The credit rating has been downgraded to a junk status. CEO Rick Wagoner faces some of the toughest challenges in Corporate America: rapidly shrinking market share, restrictive labor rules, growing foreign competition, and a $1,600 per car cost disadvantage compared to Asian competitors.
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Moreover, all his strategic options seem messy. Should he anger dealers by culling weak car brands they don't want to lose? Or does he antagonize his unions by aggressively cutting the fat benefits they so treasure? No easy choices here. Perhaps that's why Wagoner has been desperately trying to maintain the status quo rather than face the inevitable need for seismic change. But half measures won't do at the $193 billion giant. Instead, GM must commit itself to a risky and costly transformation if this turnaround tale has any hope of a happy ending.

TUNNEL VISION
O
wing to management hubris that tolerated sluggish responses to its threatened industry dominance, GM has found itself stuck in second gear for a quarter century. Dealers, eager to protect their own showrooms, have been loath to let the company shrink the number of brands it offers. Asian competitors gain an advantage by spreading development and marketing dollars across fewer nameplates. And United Auto Workers leaders, fixated on maximizing the take of their members, have saddled GM with work rules and benefit costs that make it unable to compete globally. The result of all this self-interest and tunnel vision: GM has effectively become a finance company that actually loses money making cars.

INDUSTRY OVERVIEW AND ANALYSIS
A
s elicited in the recent S&P Industry report, with pressure from higher raw material and healthcare costs, expenses for retirees, increased competition, greater incentives, and lower production volume, profits directly from manufacturing and selling vehicles have shriveled for the US big three auto-manufacturers. However, profits from financial operations grew. As a result, they are vulnerable to decreased financial profits, a risk that should increase in the expected rising interest rate environment. It also means that they need to improve profitability from their core manufacturing operations. Automobile inventories, especially for the two largest domestic brands (GM and Ford), are above average.

Profit margins of manufacturers have been hurt due to rising prices of inputs as a result of consolidation of steel suppliers with increased pricing power, and manufacturers have been unable to pass increased costs to consumers due to fierce competition in the US market. However, consolidation of suppliers also contributed to more efficiency and lower cost to produce vehicles.

While the domestic market is saturated, growth in international markets provides domestic manufacturers opportunity for sales and profit growth. Many, including GM, have taken joint venture projects in China. Capturing large market share is vital in the industry due to economies of scale. However, the “Big Three” US automakers have been losing shares to foreign companies in the last few years.

With more information available on the Internet and overall improved quality among manufacturers, buyers have gained substantial bargaining power based on price. With market share at stake, many manufacturers offer generous incentives in the forms of rebates and discounted financing which further cut into their low profit margins.
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MUST DO…
A
nalysts at the Business Week feel that first, management has to give up the naive notion that it can survive by simply holding on until the retiree base begins dying off later this decade. Also, GM's unions must accept that the days of some of their most lucrative benefits have passed. Such changes will hurt, but because of GM's huge number of current and retired workers, small changes reap big savings. Management must address such strategic challenges while GM still has time and cash to mount a comeback.

Second, GM dealers have to recognize that the auto maker's collection of me-too nameplates has to be trimmed. GM has 89 car nameplates across eight brands in North America; Toyota Motor (TM ) Corp. has only 26 nameplates across three brands. Triage is warranted on one or two GM brands so the remaining ones can get the distinctive vehicles and marketing support they'll need to beat back competition from the likes of Toyota and Honda, and eventually new entrants from China. This is unavoidable if they hope to match the leaner selling structures of Asian competitors.

Also, GM should continue to focus on external and growing markets like China, where it already has an establishment, as this would provide a natural hedge to a certain extent to its performance with relation to the US economy.

Finally, shareholders have a part to play. They must allow management to use some of its huge cash horde to shutter up to four assembly plants, fund early retirement buyouts for thousands of workers, and speed up replacement of GM's aging car models -- all while probably cutting its dividend. That's asking a lot from folks who already have seen $38 billion in GM market value evaporate over the last five years. But if they don't aggressively push for transforming the behemoth quickly into a smaller and eventually more profitable company, they risk watching the value of their shares erode even further.

RAY OF HOPE?
A
dvent of the Kerkorian: In a recent development, Kerk Kerkorian, the famed corporate investor, doubled his stake in GM to 8.8%. Analysts from JP Morgan feel that this is likely to be beneficial to the overall cause of the firm and its shareholders, and may particularly bring about some radical strategy changes and more empowered negotiations with the Union. The shareholders may get the cash dividends that were earlier threatened due to GM’s losses.

Toyota’s helping hand? – Toyota's Chairman has recently urged Japanese car companies to raise prices to help ailing U.S. rivals. At the same time, Toyota has been investing in its US manufacturing facility even as GM and Ford find it difficult to invest capital in view of downgraded junk bonds (Boston Herald). A friend or a foe?

Unless all sides share the pain, this American icon could easily find itself on a collision course with Chapter 11 in as little as five years -- even sooner if the economy turns sour. That's a race nobody wins.

Submitted by Pooja Vivek, Shigeru Kusunoki, Atima Bhatnagar

Policy on steroids catches baseball player’s union in a pickle

2005-05-12T21:26:00.001-04:00

Over the past 30-odd years, the business of professional baseball has been marked by disharmony between the owners and the player’s union. Since 1972 baseball has had 8 work stoppages (5 strikes and 3 lockouts), 3 of which led to games not being played, including the strike in 1994 which cancelled the World Series for the first time ever.
By and large, the player’s union has been the clear winner in these negotiations, winning such rights as free agency which has fundamentally changed the landscape of sports, substantially increasing the portion of profits paid to players. It has even been argued that baseball’s player's union is the most powerful labor union in the US; it certainly is in American professional sports. Comparing baseball to the NFL and the NBA, only baseball does not have a salary cap, and until recently only baseball did not have a meaningful policy to deter the use of performance-enhancing anabolic steroids.
It is that last issue, steroids, that has consumed the news lately. Over the past several years, steroids were the elephant in the corner of the room—everyone knew it was there but no one talked about it. However, the issue has become increasingly acute. In 2002 Ken Caminiti, the MVP of the National League in 1996, admitted that he used steroids during his career; in 2004 he died at 41 from a heart attack many believe was related to his steroid use. Earlier this year, Jose Canseco, the MVP of the American League in 1988, wrote a tell-all book describing how he and many of today’s biggest stars regularly used steroids. All these events prompted Congress to look into the steroid issue.
In the most recent collective bargaining agreement, a new policy towards testing was established. The old policy had “counseling” as the penalty for the first positive drug test, 15 days suspension for the second, 25 days for the third, 50 days for the fourth and one year for a fifth positive result. This is a very lenient policy in comparison with other leagues, such as the NFL and the NBA. Even minor league baseball has a more stringent steroid policy: 15 games suspension for just a first time violation and a lifetime ban for the fifth violation.
While the more recent agreement adopted this past January is harsher, it still appears generous to outsiders. Congress is pushing for even more severe penalties and has threatened to take matters into its own hands. Commissioner Selig, as a response to the pressure from Congress has recently written a letter to the labor union head, Donald Fehr, proposing stricter guideline for steroid use in the major league. In this proposal, Selig is suggesting a 50-game suspension for first time offenders, 100-game ban for a second violation and lifetime ban for the third violation.
This new proposal has placed the labor union in the hot seat. The player’s union probably will not accept these terms as is without clarification and some negotiation. Fehr has responded to Selig urging a discussion that will not involve the media. However, player’s union bargaining power might not be as strong as it has been in the past. The deal in January on steroid testing was a testament to the players’ concern over how fans might perceive the steroid situation. Fearing potential fan alienation, the player’s union will need to work with Selig to arrive at a compromise. This past week, owners have unanimously endorsed Selig’ steroid proposal and urged the players to come on board soon.
Most in the media, including Joe Morgan on ESPN, agree that the proposal is on the right track, especially with the lifetime ban after the third violation. The initial reactions amongst players are mixed with some favoring the proposal, some needing more details, and others flat out rejecting it. The timing of all these events has been interesting. For the first time in a long time, maybe ever, Commissioner Selig and the owners may have the upper hand over the player’s union, and we think both parties know it.
In labor disputes of the past, mostly about salaries and revenue sharing, the players always seemed to have the support of the fans. It’s easier to be on the side of millionaire players who can perform amazing feats on the field than billionaire owners who just sit in the box and watch the game. But with steroids, public opinion has fallen squarely against the players; in the eyes of many they are cheaters who are ruining the game.
Commissioner Selig and the owners should be able to take advantage of this environment and take concessions from the player’s union as they have not been able to in the past. While the final agreement may not be exactly the program proposed by the Commissioner, it should be something close to it. If the player’s union negotiates too hard, they are likely going to be seen as steroid-using cheats who want to protect their habit. As such, the player’s union can only hope to make minor changes to the Commissioner’s current proposal. And this should be seen as one of the first victories for the owners in a long time.

By Andrew Van Fossen and Jim Wu

Kerkorian shifts to OverDrive.

2005-05-12T21:26:00.000-04:00

On May 4, 2005, shares of the world’s largest automaker, General Motors (NYSE: GM), were boosted by 18% with the announcement that Kirk Kerkorian’s Tracinda Corp. was making an offer that would give the multi-billionaire casino mogul and financier an approximately 9% stake in GM. Kerkorian has taken big stakes and has exerted various degrees of control over automakers, casinos, movie studios, and airlines. This led Wall Street to think that General Motors would be Kerkorian’s next victim, but Tracinda officially communicated that the offer was made for “investment purposes”. Given Kerkorian’s investment track record, we have reasons to believe that he is probably contemplating to exert influence on the company and force some major restructurings. On the other hand, we also believe that GM is currently a bad investment to make in light of the company’s failure to devise and apply a sound strategy to respond to fierce competition and changing market dynamics. Should Kerkorian pursue control over GM, he should carefully review the company’s strategy as a guide to any restructuring alternatives.

Analysts have been pessimistic about the true nature of the tender offer issued by Mr. Kerkorian’s Tracinda Corporation. Moreover, they believe GM to be in borderline financial distress; S&P downgraded the company’s credit ratings to junk status arguing GM’s inability to address its competitive disadvantages. GM’s 1Q 05 results were weak, stating increasing healthcare and pension benefit costs. Morgan Stanley argues that GM is diminishing the importance of other key factors such as weak market share and volume, weaker product mix, and excess capacity. Despite the slump in earnings, the company seems to be undervalued according to Citigroup, which values the company at 4.2x 2005E EBITDA, versus a higher median of 4.9x for the automaker comparable universe. JPMorgan anticipates more upside potential than downside risk due to GM’s prudent approach to bloated inventory levels. The bet that some analysts perceive in Tracinda’s tender offer is that the financing division in General Motors will be able to provide more than enough cash flows to increase the current stock price to the mid thirties range, making Kerkorian’s investment in GM similar to the one he did in Chrysler a few years ago.

In sum, the research community depicts an underperforming company with some potentially better outlook in the short term, but a bleak one in the longer term. Moreover, Citigroup’s analysis, and perhaps Kerkorian’s as well, point out a possible undervaluation by the market. If all of this is true, then Kerkorian should aggressively rectify GM’s strategy to focus on some key factors to ensure a better valuation in the longer term. First, GM should focus on better addressing consumers’ needs. For instance, in Europe, where GM has been unprofitable since 1999, the company has made an extremely late move into using diesel engines in its cars. In the US, Japanese car makers adapt as much as possible to the American market by changing sizes and specifications of cars. GM, on the contrary, has been criticized to simply have converted some key Saab and Cadillac models in Europe to right-hand drive. Second, GM should diversify from too much focus on larger vehicles. Oil prices are at all-time highs and research has demonstrated that consumers will tend to smaller cars, a segment in which Japanese cars are dominant. In addition, GM’s performance has been heavily dependent on the profits from SUVs, the sales of which have softened due to a possible shift to smaller cars and the incursion of Japanese automakers in the segment. Third, GM should focus on maintaining its brand strength and not pursue abysmal price reductions to regain market share. Fourth, GM should pursue innovation more aggressively. The company has become stagnant in diversifying product offerings and has failed to catch up with alternative technologies such as hybrid engines.

Kerkorian’s move with GM is strikingly similar to what he did with MGM. Recently, Mr. Kerkorian failed to take over Chrysler and has just lost a 10-month battle with the company’s management over the merger with Diamler; situation that is parallel to that of his unpleasant exit form the International Hotel. At the same time, he has been quietly buying GM’s stock and could become the company’s third largest stockholder if the announced transaction takes place; very much like his approach when he took over MGM right after his hotel venture. It seems a déjà vu to hear his spokesperson state that the GM transaction is purely for “investment purposes,” when it was much more than that for MGM. Given everything Kerkorian has done in the past, we don’t believe he will stand on the sidelines, but it is yet to be seen what he has in mind for the automaker. Whatever the outcome, he will definitely be in for a winding drive to extract value from ailing GM.

Gomez, Hiriart and Lozano

‘ . . . Bartender, Grey Goose and tonic please!’

2005-05-12T21:25:00.000-04:00

How to pour $2 billion out of a bottle with marketing wiz Sidney Frank.

"We charged $30 a bottle. The next competitor was Absolut at $15. The consumer thinks that if it's the highest priced, it's the best. The difference between $15 and $30 is profit", said Sidney Frank, now a billionaire after selling Grey Goose Vodka to Bacardi for more than $2 billion in 2004. This sounds like an interesting strategy. Open a fast food joint next to, say, McDonald’s. Charge twice what they are charging for everything and make a bundle. Then when you’re tired of it, sell it for millions to McDonald’s. Obviously, it’s not that simple but it can be done. Let’s take a look at this unusual strategy and how Frank was able to pull it off.

The hard alcohol business is an interesting one. While distilled spirit consumption has been declining over the past several years, revenue has actually been increasing. People are drinking less but they’re paying more for what they consume. They are substituting away from beer towards hard alcohol which is counter-intuitive. That seems like it’s going the wrong way but more likely it was an income effect from all the wealth gained in the late 90’s. People wanted more luxury items, including exotic alcohol brands and Frank noticed that trend.

In 1996, there was no super-premium niche of vodka even though it represented 26.5% of the distilled spirits market, the largest share. These were the early Dot Com days. Lots of 20-somethings with cash ready to throw around on Friday and Saturday nights. Absolut had the largest market share at the time and was charging an unheard of $15 a bottle. Frank decides he wants to enter that market but how? Come out with a better product that’s cheaper? The fact is most people can’t taste the difference between vodkas so differentiating on taste was going to be difficult. Price is another option. If you make the same tasting vodka and charge less, maybe there’s an angle. Frank decided he was going to use price but not by under-cutting Absolut, he’s going to double it!

Another interesting aspect of the distilled spirits business is that the consumers are very image conscious. The drink says something about who’s drinking it. You want to be sophisticated and successful; you need to have a favorite drink and particular ingredients. Frank knew to enter the market at a premium, he was going to need a good story and a strong image, to reach is target customer.

He went to France because in his words ‘everything good comes from France’. He struck a deal with the distillers of Cognac. Their production had slowed so they switched the excess capacity to vodka. Frank then started to build his story around quality. This wasn’t some regular Russian vodka; it was from France, a luxury good. He put ads in the Wall Street Journal telling he’s target customers how Grey Goose has won awards in international competitions. He shipped it in wood crates like a fine wine, rather than cardboard boxes like cabbage. The bottle design was distinctive and extra large bottles were put on the shelves at bars to grab attention. Then he started his viral marketing campaign: ‘The Grey Goose Girls’ started appearing at all the hot spots on the best nights. What’s key here is Frank recognized he needed to ‘influence the influencers’, the people who liked to tell others what was cool and get the early adopters and the early majority hooked. Once he convinced them, it was only a matter of time. Even characters on the HBO hit series ‘Sex and the City’ were ordering Grey Goose Cosmos. Grey Goose’s position as the premium vodka was solidified.

It sounds crazy, doesn’t it? Go after the market leader with a product you don’t have by doubling their price. Strategically, it sounds like suicide. We’re supposed to stick to what we do the best, where we actually have a defendable competitive advantage. Hiring models to promote your drinks in trendy clubs and charging a premium hardly seems like defendable competitive advantage. Absolut has since launched its own premium brand, Level and Stolichnaya has a premium brand, Elit, boosting its price to $60 a bottle. But even the guys who should know what they are doing seem to have trouble duplicating the recipe. In fact, Bacardi before buying Grey Goose tried with its own brand, Turi, but sold a meager 20,000 cases in 2002.

The competitive advantage seems to be Frank himself. He certainly has the ability to build a good story around a brand (Jägermeister and Grey Goose). He also seems to know where to find the influencers and how to convince them to persuade the early majority so critical to a product’s large scale success.

Is the strategy is repeatable? Frank is certainly going to find out. He signed a non-compete agreement with Bacardi so he’s out of the vodka market for another four years but that hasn’t stopped him from looking into the rum business, Bacardi’s bread and butter. He’s already found an Australian rum he wants to call ‘White Pelican’ to launch into a new super-premium rum category. When questioned, executives at Bacardi say they don’t think there’s really a super premium rum category. That’s fine. In a few years Frank will sell them one for another $2 billion.

Paul Thomas
Allison Brown

Is it Cereal or Airlines? Boeing-Airbus and the Hunt for Zero Profits

2005-05-12T21:24:00.000-04:00

For the past couple of years, business journals have been flooded with articles detailing the high-stakes stand-off between Boeing and Airbus. This drama is currently being played out in every medium imaginable: political, business, and legal. As these two behemoths point fingers at each other while trying to launch their respective savior planes (Boeing has the Dreamliner while Airbus has the A380), another interesting game has begun to emerge: announcing orders in succession, with rarely a mention of underlying profitability, in an effort to create a sense of momentum. With the media fanning the flames, this practice shows the signs of an intense rivalry that could damage a once highly profitable industry.

We have noticed a recurring pattern over the years; Boeing and Airbus announce multiple airplane orders all at once with the latest installment being exhibited in an Economist article titled “Taking Off in Toulouse (and Seattle).” This article details Boeing’s recent success in landing orders with Air Canada, Air India and Northwest Airlines, as if they all signed on the same day. Airbus had a similar multi-deal announcement at the end of last year that seemed to show the tide was rolling in its favor. The timing of Boeing’s latest proclamation could not have been an accident; this week, Airbus accomplished the first successful test-flight of its super-jumbo plane. While the timing is inconvenient for Airbus, this action and the order announcement process itself depicts the troubling symptoms of an intense rivalry. For example, orders are obviously withheld and then announced together in succession in an attempt to create momentum; this makes it appear that planes are flying off the production line (pun intended). The firms likely hope this leads other airline executives and purchase agents to believe one company is superior to the other, which will eventually lead to a cycle of even more orders. In reality, bunching orders together seems to simply lead to a dearth of orders afterwards. The strangest fact in this drama seems to be that both firms have done quite well over the years suggesting that both firms can prosper, or at least could a few years ago. Is this changing?

Before digging deeper, we thought about why some industries have long-term profitability while others do not. For example, why is it that an industry like airlines is so competitive while an industry like cereals is not? Why can some industries migrate to equilibrium profits and others have negative industry-wide profits over time? One could argue that airlines provide more value to society, while cereals are only a minor convenience, so the bottom line of these industries is obviously not a function of importance to humanity. Industry structure itself must play an integral role. In cereals, the giants seem willing to live with each other and do not institute price wars. Overcapacity and despair have plagued airlines with price wars with each firm attempting to maximize utilization by under-cutting competitors (a lose-lose situation for all). Does the growing competitive rivalry in airplane manufacturing mean that a once profitable industry is moving from a cereal to a more airline dynamic; we think so.

The industry is changing, and Boeing and Airbus are the leading catalyst to their own demise.

While articles praised Airbus last year, current articles praise Boeing in the same manner (see BusinessWeek “Takeoff At Last” and New York Times “China Airline Places Big Boeing Order”). What these journalists fail to mention is the most important factor: profitability! The goal of a business is not to collect the most orders, but to provide the best return to shareholders or, in Airbus’ case, to its parent company, EADS. As vanquished internet retailers showed in the late nineties, you cannot make up losses on higher volume. A recent article in the Wall St. Journal has suggested that Boeing is “mortgaging its future selling planes at deep discounts,” while yet another quoted an Air Canada executive saying they received “significant discounts” on their recent order.

The only rationale we can find to defend a volume-focused, cutthroat strategy is that Boeing and Airbus feel that winning the plane wars in 2005 will lead to a monopoly in the future as one firm drives the other out of business. While it is true that Boeing, with its deeply discounted 787 Dreamliner sales, could force Airbus into developing a whole new model rather than continue promoting an inferior revamped A330 (dubbed the A350), this would only give Boeing a short-term lead in the industry. In reality, the probability of one of these firms faltering is slim and even unnecessary since both firms can survive together. Due to the massive government subsidies that each firm enjoys, neither firm is going to vanquish its competitor. In fact, Airbus was created to compete with Boeing; its initial subsidies were intended to help it gain the critical mass necessary to compete. Therefore, their very public confrontation is simply cutting into the bottom line by increasing competition amongst each other. This rivalry surprises us since plane manufacturing on a large scale is essentially an oligopoly. One other explanation could be simple confusion. The use of government subsidies clouds each company’s true profitability. This hinders price leadership or implicit market agreements.

We admit that the fate of Airbus and Boeing are closely linked to an abysmal industry: the airlines. The competition may be so abnormally fierce simply because its consumers, airlines, are hemorrhaging cash at an alarming rate. But, this has always been the case with airlines. The airline industry has had negative industry profits going back as far as the Kitty Hawk. Therefore, the only firms that can really stop the rise in competition are the major players themselves: Boeing and Airbus. In reality, airlines have a distinct incentive to keep these two companies alive and competing against each other; it leads to lower prices and they could badly use lower costs themselves. All this to say, a few orders in a row are not necessarily indicative of a surging plane manufacturer at all, but simply portray the highly competitive nature of an industry that is competing away profitability. By competing so fiercely, both firms are transferring power to airlines.

The firms may want to think about solidifying their own partnerships and providing exceptional service to existing customers. Since airlines have an incentive to keep both firms alive, they should both gain future orders regardless. In the mean time, look for a deluge of orders out of Airbus in the next few months and a slew of articles claiming them as the victors of this lose-lose game, and also expect a slow-down in orders from Boeing in the next few months as well. Maybe if they focused more on profits (i.e. maintaining a win-win oligopolistic industry) and a little less on momentum, they wouldn’t be in such a poor predicament in the first place.

Cement Industry – Differentiation Illusion or High Price Collusion?

2005-05-11T20:30:00.000-04:00

On September 2004, Cemex announced its agreement to acquire RMC Group Plc, the world’s biggest ready-mixed concrete maker and Europe’s leading cement producer. The transaction, worth $5.8 billion will be financed cash and debt by Goldman Sachs and Citigroup. The acquisition increases Cemex sales by over 100%, maintaining its number three position in cement capacity, but giving it a boost No.6 to No.1 in ready-mix volumes. The acquisition which was positively received by analysts was recently completed and approved by the anti-trust authorities on the condition that Cemex divests RMC assets in Tucson-Arizona - less than 0.5% of the acquired company -to avoid unfair competition in this segment. The main concern for the US regulatory agency was a potential “coordinated interaction” between Cemex and the remaining competitors in the market. This worry is in line with alleged accusations against the cement industry and Cemex in particular related to price setting agreements with other producers.

Cemex S.A. was founded in 1931 after the merger of two Mexican cement companies. The RMC transaction is by far the largest acquisition it has ever conducted as part of its expansion strategy. In 1982, the company doubled its exports volume and started implementing an international expansion strategy through acquisitions. Its first move was into Spain, acquiring the two largest cement companies and initiating a multi-market contact structure in the cement industry. Cemex continued acquiring companies or interests worldwide targeting those markets where it could buy close to 100% control on companies that would give it a leadership position of at least a 25% share of the new market. As a consequence, Cemex continued to increase its multi-market contact with other major industry players.

Cemex is by far the fastest growing firm in the industry and it has the highest profitability margins. It has been argued that Cemex expansionist strategy is based on some firm-specific capabilities in terms of cost reduction such as efficient post-merger integration, scale economies and superior technology combined with its expertise in emerging markets. In addition, its geographical diversification helps Cemex to achieve overall more stable cash flows offsetting the cyclical nature of the industry.

Cemex comparative lower costs seem to corroborate to an extent the capabilities abovementioned. Notwithstanding, the price behavior does not correlate as one could expect. In a preliminary paper written by Ghewamat and Thomas at Harvard Business School, the analysis of data for the main world producers of cement seems to support the idea that the largest players’ profitability is rather affected by price than by cost.

Moreover, in general increased margins and prices seem to happen in those markets in which Cemex alone or with the other international firms held an important stake of the market. The strong presence of few of the major firms in the same region seems to be common, for example of the 56 plants acquired in Asia (excluding China), during the period 1996-2002, 38 were located in Indonesia, the Philippines and Thailand which is surprising given that those countries had only 58 of the 391 plants in the region. It can be argued that concentration on specific countries is due to particular characteristics of those countries, to a mimicking strategy by peers or also to a strategy to coordinate prices by working together as a dominant producer. Either way, this joint entry in the market clearly increases multi-market contact.

From as far back as 1959 (Harvard University Press, Imperfect Collusion in the Cement Industry, Loescher) the cement industry has been under scrutiny due to both, the development of factors that facilitate collusion in the industry and to informal and legal complaints against price behavior. From a theoretical stand point, two factors that greatly facilitate collusion, tacit or not, are consolidation of an industry and multi-market contact of the same players. Both characteristics are clearly present in the cement industry today. On one hand, during the past couple decades a chain of mergers and acquisitions triggered a trend of consolidation which the recent Cemex acquisition of RMC significantly reinforces –currently there are about 6 relevant players in the worldwide industry- on the other hand, these few players coincide in most of the markets they participate in.

We believe that the collusion allegation against the industry players and particularly against Cemex, have some ground given that prices have increased despite proven low cost capabilities. Yet, none of the accusations have been proven because industry players have been able to support their claim that quality, service and innovation standards, have continue to develop according to competitive market conditions. Likewise, they have been able to argue that these same characteristics represent valued added that relates to their customers willingness to pay.

In the particular case of Cemex, there are some particular factors which could explain, at least in part, the higher prices with which it leads most of the markets it enters: 1) Its focus on emerging markets allows it to reach smaller consumer by offering smaller sized packaging which normally carry a higher margin due to reduced consumer negotiation power (as per Bloomberg analyst, Thomas Black). 2) The company has managed to create some value for its brand, “de-commoditizing” the product by generating an association between quality and Cemex. 3) Cemex attempts to offer differentiated services to cater specific needs of their customers. For example the “tanda clubs” in Mexico which targeted low income families.

The quandary that this argument brings is that if Cemex prices correspond to an actual premium resulting from some sort of differentiation, this could explain the price differential between Cemex and its competitors. Yet, it would not explain the higher prices that the industry presents as a whole once the biggest players have a substantial share of a market. Whether collusion or coordinated interaction are occurring is still up for debate, what is clear is that for as long as the industry players continue to improve quality and service, they may continue to resort to this as an argument to counteract collusion allegations. It is also clear that more consolidation and more multi-market contact, in any industry, facilitate collusion to a point where it may be impossible to prove it, even if it were to take place.

Leccia, Lopez and Villamil

Sky is falling on GM and VW: First-mover: advantage or disadvantage in the Chinese market

2005-05-11T20:29:00.000-04:00

2005 has not been a good year for General Motors and Volkswagen. They are witnessing their first-mover advantages in China’s vast automobile market rapidly eroding. VW lost half of its market share since 2000 to 20% and GM managed to cling on to the second spot for now with 10%. Sales at VW decreased by two-thirds in the first quarter 2005 and GM’s sales decreased 35% in the first quarter and its overall profits in China declined by 80% to $33 million. New market entrants Hyundai, Honda as well as domestic automaker Chery are boasting increasing market shares and soaring car sales. They are offering smaller and cheaper cars to a population that wants good quality at an affordable price. Hyundai’s unit sales increased by 156% in the first quarter 2005 over the same period last year largely due to the success of its Elantra compact priced starting at $13,600. Honda sold 76% more cars as consumers bought its $10,360 Fit. Meanwhile, domestic automaker Chery’s sales rose 42% driven by the sales of its $3,600 QQ.

There are competing views on these events. Business Week believes that these companies went to China too early. There are no first-mover advantages, or at least they did not build it up correctly. GM formed its Shanghai joint venture in 1997 while Volkswagen arrived in 1984. As first movers, the two companies benefited from high tariffs that kept out imports and allowed them to extract immense profits. In addition, most of the auto sales were made to state-owned companies that were not very concerned about price. However, with these benefits came the iron hand of the Chinese Government, which restricted GM to focus production solely on the expensive Buick Regal, and insisted that Volkswagen develop separate distribution networks for each of its two manufacturing operations. Newer market entrants Honda and Hyundai had far less bureaucracy to manage. Now GM and Volkswagen are moving to improve operations by cutting down costs, introducing smaller cars, and urging more suppliers to start producing in China. Others claim fierce competition is the culprit. Competition is intensifying as capacity in China is expected to increase by 30% this year. Hyundai, Ford, and Nissan are investing billions to increase annual production capacity, add new dealerships, continue market research to offer cars that consumers want, and expand their range of car models.

We believe there are merits in the argument that GM and VW missed opportunities to develop sustainable competitive advantages often afforded to first movers in the market. They did not recognize the need to plan for future capacity growth in the automobile market as well as perform market research to answer the demands of the inevitable birth of the Chinese consumer. Granted there were heavy restrictions imposed by China’s government, however there sees to be no excuse for GM and Volkswagen to have maintained inefficient manufacturing operations, not create more flexible assembly operations. They are responding to these challenges now, investing billions of dollars in capacity and introducing new models with a reactive frenzy.

What does the future hold for these two pioneers in China? This is an extremely important question for these two companies since they depend so much on the Chinese market. To answer this question, we first look at the auto industry in China. The consumers, have a lot of power these days, especially since early 2004 when new government regulations weakened demand to less than supply. There are real risks that the industry will have over-capacity in 2007. Rivalry is fierce. All main automakers in the world, maybe with the exception of the ailing Fiat of Italy, are competing in the market. Excess capacity triggered price wars, which delayed buying decisions as consumers anticipate lower prices. This could be a downward spiral as the prices of raw materials such as steel are rising, forcing automakers to face tightly squeezed margins. Barrier-to-entry is high, but not prohibitive for any major auto company, or indeed some smaller local players. The only upside for the players in the industry is the still heady forecast of the Chinese market. According to one estimate, the market is set to grow by more than three-fold from now to 2014.

Which of these companies will win out in the end? We give our nod to VW over GM for sure. VW, through its 20-year presence in China, is a household brand name, has the highest localization of spare parts, and the most intensive commercial network. They still have a 25% market share, which is not bad in a country of 1.5 billion people. If they can tough out the early competition and maintain a strong brand name for quality they will be able to target the new upper class as it emerges with the Audi models as well as the price conscience consumer in China with it VW brand. For now analysts say the majority of the growth will come from the low-end of the market, where VW has a strong history of serving with such classics as the Golf. Consumers will increasingly demand value for money. The quality image VW has developed and maintained will help it win the battle eventually. GM is much harder to predict. As of right now, it has a big share in the luxury segments with Regal. It has also introduced the Cadillac line. The established relationship with the government will continue to help in the mid-term. The problem is that GM has not been able to defend even its home turf. Without something short of miracle, GM is likely to continue to slide in China.

By: Alexis Collins, Xiaolin Jeff Li, and Victoria Soriano

The Price is Always Right for Luxury

2005-05-11T20:28:00.000-04:00

On May 2nd, a Warburg Pincus and Texas Pacific Group acquired Neiman Marcus, a luxury goods retailer, for a handsome price of $5.1B (a price to earnings ratio over 25). How did a retail chain with only 35 namesake stores justify such a high valuation?

This question is particularly interesting given the current dynamics of the apparel retailing sector. Understanding the high-end retailing environment that Neiman Marcus operates in, and its competitive strategy compared to other players in this sector might help answer this question.

Customers
Neiman Marcus is focused on the ultra-wealthy, high-spending consumer segment. Its top 100,000 customers spend over $1.2B annually, with the average customer spending $11,000. Even more importantly, this is a growing segment in the US, with 1 in every 125 citizens being a millionaire. These customers can be notoriously fickle, desiring not only the best merchandise, but also exceptional service. The good news: they are willing to pay top dollar for it.

Competitor
In the luxury segment, Neiman faces competition from two major players, Saks Fifth Avenue and Nordstrom. Neiman’s continued focus on the high-end customer base, even during the post-9/11 market downturn, has paid off while Saks’ decision to move down-market has hurt its image. Recent restructurings, budget cuts and a general lack of focus put Saks at a disadvantage against Neiman’s strong focus on merchandising and customer-service. However, Saks is turning around and a turn-around at Saks is likely to slow growth at Neiman.

Nordstrom is focused on the same customer base, but its strategy involves creating and promoting its own private brands. While there is some overlap between the store locations for Neiman and Nordstrom, their different strategies result in significant differentiation between the two companies.

Neiman also faces competition from its suppliers like Prada and Gucci, who are opening their own showrooms in the US. However, since these companies are likely to showcase their own products only, Neiman should not be significantly affected by their presence.

Hence we believe that Neiman is in a good competitive environment with room to introduce policies that lock in their customers with Neiman.

Company
Neiman has recognized the needs of its customer base and instituted several policies that build on its competitive advantage:
Exclusivity: Over its 90-year history, it has only opened 35 stores (and 2 Bergdorf Goodman stores). By employing such selectivity, Neiman maintains its aura of exclusivity as well as sales per square foot of $555 versus $350 for Saks.
Shopping Experience: Neiman has converted mere shopping into an exclusive “experience” for its high net-worth customers. Its museum-quality art collections and lavish InCircle members-only fashion shows and events serve to emphasize its brand image.
Employee Training and autonomy: Neiman maintains best-in-class customer service through extensive training and investments in their sales representatives. New employees get 200 hours of training in the first year and 160 hours every year afterwards. Employees are encouraged to cultivate personal relationships with customers. Customers are given coupons to reward exceptional customer service.
Rewards program: The InCircle program, instituted in 1984, integrated branding, customer service and promotions into a customer loyalty strategy is still considered by some to be the best loyalty program ever. The program emphasizes the exclusiveness of shopping at Neiman, and its members account for over 50% of the company’s revenues. The program generates incremental sales, protects against competitive promotions and also encourages new-member referrals. Membership is reserved for the highest of the high-spenders, and members receive “soft” benefits like an 8-night excursion to India. These rewards in turn emphasize the “exclusive experience” image of Neiman Marcus.

Current company policies have provided strong competitive advantages in acquiring and maintaining Neiman’s high-spending customer base. However, the company does face some significant challenges moving forward:
Given its exclusive image, new store openings must be very limited. Opening too many stores may dilute its brand and strain its ability to offer best-in-class customer service and its InCircle rewards. Generating future growth in the US through new store openings will be difficult.
Considering the saturation in the US, Neiman may have to seek growth in international markets where its experience is limited. It would also have to build local operations, usually an expensive and time-consuming task.
Given its turn-around, Saks might re-emerge as a formidable competitor in this market.

Suppliers
Neiman sources its products from a variety of suppliers, none of whom account for a major portion of Neiman’s revenues. Its relationships are currently symbiotic; customers visit Neiman because it offers the suppliers’ brands, as well as superior customer service, and the suppliers see Neiman as a major distribution channel for their products.

Barriers to entry
While the barriers in this market are not very high, Neiman has managed to erect formidable barriers through its InCircle program, it’s well known customer service and its brand that has become synonymous with luxury. We believe that these barriers give Neiman a strong competitive advantage in this market.

Given these facts, we believe Neiman occupies a strong position in this market. By converting shopping into a luxury experience and focusing on customer service, Neiman has managed to foster loyalty in its rich, largely price-insensitive, customer base. Its future growth and success will depend on how well it can leverage its core capabilities to newer, possibly international markets.

Written by: Shatabdi Basu
Sarah Lee

References
http://www.signonsandiego.com/uniontrib/20050211/news_1b11retail.html

http://online.wsj.com/article/0,,SB111507658195922694,00.html?mod=todays_us_marketplace

http://www.aurorawdc.com/ci/000196.html

http://www.crm2day.com/editorial/EpZZklukFZwWYvQQpS.php

Microsoft “Xboxing” With Sony for What Exactly?

2005-05-10T23:31:00.000-04:00

This Thursday, Microsoft will launch their next punch at Sony in an attempt to unseat the latter as the videogame market champion when Microsoft announces its next-generation game console just a few days before Sony makes its announcement. While some analysts believe this to be a straightforward fight for the multi-billion dollar videogame market, others believe this is a war with scope extending well beyond the video game market. As growth of Microsoft’s core personal-computer software slows, are they simply attempting to find new high-growth markets to enter or is there something much greater at stake? Is this a simple case of boldly entering a new market or is this a stalwart defense against a soon to be disruptive technology? While it is quite obvious that Microsoft would love to continue growing, we believe that this move is equally defensive of their competitive advantage as it is an offensive maneuver for growth opportunities. As the line between videogame consoles and home computer technology continues to grow thin – e.g., internet connectedness, computer music play, online transactions – the risk of Microsoft losing relevance increases dramatically (re: lower sales, margin pressure, lower profits).

What is the opportunity?

The overall videogame market has been estimated at over $30 billion per year As of Q3’05, Microsoft’s annualized revenue from its gaming division (Xbox) is close to $2 billion per year with about 17 percent market share in the console space. Assuming they can double or even triple their market share over the next few years, Microsoft may be able to increase revenue to $4-$6 billion. While this is obviously a sizable chunk of revenue, even for Microsoft (>14 percent of current year), there is no guarantee that this market will be that profitable for them. In fact, over the last four years Microsoft has lost and average of $1.2 billion per year.

So why do it? What’s the threat?

If the videogame console replaces the computer as the new centerpiece to the digital home, Microsoft stands to lose relevance in the home computing space. While it is not certain if or when this will happen, and it IS certain that Microsoft is not going to disappear any time soon, the videogame console still represents a huge risk to Microsoft’s titanic cash machine. How big is this cash machine? Microsoft’s fiscal year 2004 net income was over $8B on revenue of close to $37 billion, a 31.6 percent profit margin, and a measly $64 billion in cash on the books. The question is whether there is willingness to lose $1.2 billion a year in the short-term in order to protect over $8 billion per year in the long-term. This is very expensive insurance no doubt, but worth every penny in our opinion.

Hats off to Microsoft:

In the face of analysts and critics who are focusing on the individual battles – namely the gaming division’s drag on profitability, Sony’s product superiority, Xbox360’s launch date – Microsoft’s corporate strategy team is fighting a war to protect their cash machine for the long haul from a potentially disruptive technology. While many analysts are quick to point out Microsoft’s round one misses (their lateness to market, lack of profitability and Sony’s continued dominance in market share), we share Bill Gates’ opinion that they have bought themselves a seat at the table (albeit an expensive one). There were obviously some less than desirable outcomes from the original Xbox launch, but there was also something very important accomplished, namely – a successful entry into an entirely new market (as evidenced by being number two in market share) that not only has the potential to be a big money generator, but also maybe even more importantly, a big money protector.

Microsoft’s entry into the videogame market is textbook corporate strategy for dealing with disruptive technologies. Anticipate/understand a threat and manage the transition by leveraging existing capabilities and market position. Their overall strategy is to have ultimate “control of the digital home” from the computer screen to the television screen and we believe they are in fantastic position to do just that. They got it right with Windows and Office and we know from their launch of Xbox360 that they learned a lot from round one in the videogame console market. Will they pull it off? We think the answer is a resounding yes. Are you willing to bet against them?

Baruah, McGrath, Shelly