Friday, April 29, 2005

Barbarians at the gates of the NYSE

On April 20, the venerable New York Stock Exchange announced a merge agreement with Archipelago, a company unknown to the general public, but well known to the NYSE. Archipelago started operations in 1997. Their goal: establish an electronic trade exchange that would avoid any human interaction in the process of trading securities. In 2001, Archipelago’s CEO Jerry Putnam offered the NYSE an opportunity to work together. The reply from the Big Board was a straightforward no: “We will never use your system”. So, what changed over the last four years to make this deal possible?

A monopolistic game. How do stock exchanges make money? They charge fees to the listing companies and to the people who trade the stocks. What do the final customers want? A fast, cheap and transparent transaction. In this sense, the product offered is basically a commodity. Why are there only a few exchanges in every country? It turns out that the shareholders of the exchanges are the very trading firms who require a platform, the stock exchange, to operate. Once a stock exchange is operating, the barriers to entry are significant: (1) the initial investment is huge, (2) the network effects are difficult to replicate: to sell a stock you need somebody to buy it, the more traders in an exchange, the more valuable it is to trade there.

Global competition. In the domestic markets, competition normally arises in a niche area due to some new financial need. For example, the major domestic competitor of the NYSE is NASDAQ. NASDAQ emerged as a trading platform for start-up companies that did not meet the requirements of NYSE.

Today, additional competition is coming from abroad. One main advantage of the NYSE was its access to financing in a deep market and in US dollars. With the emergence of the Euro area, there is an integrated financial market that can compete with the US in terms of depth and currency stability. Additionally, foreign stock exchanges with innovative products are trying to expand to other countries. For example, Deutsche Boerse has pushed into the U.S. by opening a derivatives exchange in Chicago. To make matters worse, the European exchanges have invested heavily in technology, while the NYSE continues to rely on floor trading.

Leadership change. Why now? The answer is twofold. First, the NYSE probably underestimated the potential threats of other exchanges: “Every company wants to be listed here. Why change?” would summarize their attitude. Second, the former Big Board chief, Dick Grasso, had been there for more than 35 years and was reticent of any change. Merrill Lynch, Goldman Sachs and Morgan Stanley tried to convince Mr Grasso to automate trading for the busiest stocks and were unsuccessful. Grasso’s successor, John Thain is more technically oriented having studied at MIT and managed operations at Goldman Sachs. Addressing the merger at a press conference he stated, “it is clear that we must do more.”

The movement by the NYSE has been followed by a rapid succession of reactions. NASDAQ announced days later intentions to merge with Instinet. On April 25, Mr. Langone a former director of the NYSE stated that the deal was not fair for the “seat owners” of the Big Board and started to meet other Wall Street financiers to put together an offer to buy the NYSE. And to give a conspiracy touch to the whole operation, some analysts highlight the invisible hand of Goldman Sachs: Goldman has interests in both the NYSE and Archipelago and advised both of them during the negotiations. A bad prelude for an institution trying to divest itself of unsavory behavior.

Analysis and Opinion

Four years ago when the NYSE, under Grasso’s leadership, rejected Archipielago’s technology they possibly thought they had an unbeatable positional advantage in the stock exchange industry. They also probably believed that only one leading market could survive in the US and that its company listings, trading volume and network of trading partners gave them an inimitable and unbeatable organization.

New technologies and the rise of alternate playgrounds (e.g. European Union) are changing the competitive rules of this industry. In years past, a company relied on the NYSE and its network to provide adequate financing. But today, as long as a company represents an interesting investment, it need not trade on the NYSE in order to achieve its financing goals. As transaction costs continue to drop, it may even be possible for a company in the future to switch to a new market whenever the need arises. This scenario represents a big threat to the NYSE supremacy.

On the other hand, it is possible that the NYSE is a unique organization with its network of floor traders that provides a superior value to it customers and partners. This vision suggests that NYSE listed companies will not be as well served in new, technically advanced exchanges. The fact that floor trading is not going away expresses managements opinion. Although this could be true in the short run, it is likely in the long run?

Our opinion is that the current positional advantage of the NYSE is only sustainable if they are able to maintain competitive quality (speed and transparency) and pricing (lower transactional costs) for their customers. If NYSE can leverage Archipelago's technology to support these goals, then their customers will be less likely to switch to other markets, thereby allowing NYSE to keep their positional advantage. If they cannot develop these capabilities through the synergies of the two companies, then the NYSE will gradually lose their leading position in the market.

While we cannot determine if the Archipielago deal is the best option for the NYSE, or whether floor trading is ready to change, this merger does look like a move in the right direction. One thing is clear: there is money to be made in the operation, and money is what only matters on Wall Street. The NYSE is right now under a take-over threat. The barbarians are pushing the gates. Will Mr Thain be ready?

Rafael Calderon, Jay Geiger, Joan Gelpi

The War of the Worlds.

In 1792, twenty-four brokers and merchants gathered on Wall Street to sign the Buttonwood Agreement. Thus was formed the New York Stock Exchange – and it hasn’t changed much! It has grown, of course, but consider this: standard parlance on the trading floor requires repeated use of the word “thou”. Even as virtually every stock market in the world has replaced human traders with computers that electronically-match buyers and sellers, the “Big Board” has clung to its archaic ways and doggedly protected its monopoly "specialist" system -- a testament to the enormous political clout of the roughly 480 "specialists" who referee trading.

Why, then, would NYSE CEO John Thain acquire electronic-trading company Archipelago Holdings Inc., and plan to take the merged company public? Does he really expect his stodgy specialists to co-exist with the Archipelago techies while under the transparent roof of a public company? If the trading floor’s days are numbered, can the NYSE realistically survive such creative destruction?

Disregarding the role of Goldman Sachs in the deal, there are a few obvious rationales for Mr. Thain’s action:

· Investors want faster, cheaper execution of their trades, and that has enabled electronic upstarts like Archipelago to quickly build formidable market positions against the NYSE and Nasdaq.

· In teaming with Archipelago, the NYSE will have an electronic-trading platform that will allow it to move into new lucrative markets, including trading options and other derivatives as well as bonds and Nasdaq-listed stocks.

· Next year a new SEC rule will remove longstanding protections extended to slow orders handled manually on the NYSE and give other exchanges a chance to handle them. This rule has forced the NYSE to speed up – Archipelago is its answer.

· By embracing electronics and seeking to go public, the NYSE is attempting to follow in the footsteps of other exchanges like the Chicago Mercantile Exchange, whose stock has soared after going public.

The media’s reaction is almost entirely positive. Even our GSB colleagues state in an earlier blog that “the overall synergy created (by the deal) is more than worth the risk” associated with merging such disparate companies. We agree that the NYSE’s transition to electronic-trading – in whatever form – is necessary due to changes in the competitive landscape. However, we also expect that Mr. Thain’s plan will lead to Wall Street’s version of “The Real World”, as contrasting personalities within the merged company battle wildly for supremacy, in plain view of the public. Here’s why:

· The culture clash: With 213 years of history, the not-for-profit NYSE is one of the oldest institutions in this country. The traders have their own culture and language, and several traders' families have been working there for generations. Yet, Mr. Thain is merging it with a company that was founded by techies in 1996 for institutional traders. Will everyone get along? When employees of Archipelago visited the NYSE in 2001 to suggest the two firms work together, "they looked at us as if we were lepers," says Jamie Selway. "They said they would never use our system."

· The management clash: The combined firm, to be called NYSE Group Inc., will have three co-presidents, including Mr. Thain, who is described as “bookish”, and Archipelago co-founder and CEO Jerry Putnam, who is a brash entrepreneur used to calling his own shots. Mr. Putnam is combative; two former Archipelago partners have filed separate suits against him, and he was previously fired by two trading firms due to disagreements with superiors. Will Mr. Thain and Mr. Putnam be productive together?

· The ownership clash: The NYSE will bring its 1,366 seat holders, which include many of Wall Street's largest firms as well as small businesses owned by families that for several generations have worked at the NYSE. Archipelago's holders are dominated by General Atlantic Partners, a 25-year-old private-equity firm that will maintain a roughly 6% position in the new NYSE Group. How will this diverse group of owners shake out? Which sub-groups will attempt to exert the most influence over the direction of the merged company?

· The knowledge clash: The merger of the floor-based exchange and the online exchange will require the reconciliation of two fundamentally different ways of quoting stock prices, matching orders and executing trades. There has been no explicit statement of whether the companies intend to offer the best of both worlds, or to merely supply a choice of worlds. Mr. Thain insists there will still be a role for the traders, as he envisions a “hybrid market” where investors can choose to have their orders filled quickly on an electronic system or manually on the NYSE floor. Think this through, however. Apparently, the NYSE Group will offer investors a choice between the traditional auction system and an electronic one. Mr. Thain is advocating that the market decide which branch of the new company survives, and to what extent !

Presumably this will all be sorted-out before the merged company goes public! Indeed, these two companies are very highly incompatible. Electronic trading is all about narrowing spreads, while specialist trading is all about making money on them. The revenue generation systems are therefore quite different, as are the individual incentives. Where are the synergies here? With three presidents it seems that the merged company will keep all of the corporate overhead of both companies, and there is very little in the merger that would seem to increase trading volumes, which is how both of the companies make money. Given the inherent lack of synergies, this merger seems to be a case of wishful thinking.

Mr. Thain says he wants the NYSE to be more electronic and to trade more than stocks; he wants to get into the business of trading options, exchange-traded funds and other derivatives. Acquiring Archipelago will perhaps provide the NYSE with a means of accomplishing these goals. In the meantime, you can be certain that this acquisition will provide a lot of fireworks!

Patrick Brickley, Lindsay Lowe and James (Nick) Smith,


Can Sony’s newly anointed Chairman and CEO Howard Stringer revive the Sony Spirit?


ony recently announced a management revamp with Howard Stringer taking over from Nobuyuki Idei as chairman and CEO, and the resignation of seven Directors from the Board, as the current management was believed to be lethargic in their pursuit of innovations and initiatives, Sony’s two core competencies. The 63-year-old Mr. Stringer has the responsibility of developing the strategic linkage between the entertainment and electronics businesses, and furthering the company’s content businesses worldwide. Prior to joining Sony in May 1997, Mr. Stringer worked as a journalist, and later as President at CBS. A native of Wales, Sir Howard received the title of Knight Bachelor in 1999.

Sony is currently undergoing a major restructuring phase as it faces several performance challenges. Sales increased marginally to $72.1B (up 0.3%) and operating profits went down to $0.95B (down 46.6%) during fiscal year 2004. Sony’s core electronics performance deteriorated in fiscal year 2005. The results clearly prove the complexity of the turnaround task of Japan’s best-known electronics company’s new top-management. The new management team will likely have to refocus the electronics business around fewer products and concentrate research and development on more profitable areas. The firm’s concerns in this regard are apparent from the recent initiatives including the joint venture with Samsung and technological advancements in flat panel, LCD and HDTV televisions. The increase in sales of PlayStation software have been offset by a decrease in hardware sales due to price wars from competitors, but the new PlayStation Portable hardware is expected to increase hardware sales. The sales of portable audio equipment are also expected to decline due to a change in the competitive environment (Apple iPods) unless Sony develops new appealing products in this segment. The pictures business had a substantial increase in operating income due to success of “Spider-man” and increase of DVD sales. Despite the downward revision of earnings for this year, Stringer has promised a return to 10% operating margin by March, 2007. This would require quick execution of a strategy to streamline Sony’s operations and cohesively revitalize its diversified business.

Business Description


ony Corporation is one of the world’s leading consumer electronics firm headquartered in Tokyo, Japan and operates in many countries worldwide. It generates revenues through its six business divisions: electronics (63.5%), game (10%), pictures (10%), financial services (7.5%), music (6.5%) and others (2.4%).

Sony is synonymous with innovation, and is credited with several ‘firsts’-- transistor, all-transistor radio, Trinitron Color Television, color video-cassette, The Betamax VCR home use video system, Walkman, CD player, consumer camcorder; 8mm video, and digital VTR. Sony’s growth has come by way of several innovations, diversifications and acquisitions. A SWOT analysis on the firm is as below:


Strong brand presence

Consolidation of operational bases

Internal sourcing of key components

Strategic alliances


Heavy exposure to consumer electronics segment

Weak performance of music division

Decline in revenues from game business



Lithium ion batteries

Broadband market


Strong competition


Pricing pressures in gaming business

Sony’s major competitors include Hitachi, Philips Electronics, Matsushita Electric, EMI Group, DreamWorks SKG, Nokia Corporation, Toshiba and Samsung Corporation

Management Revamp


oward Stringer, currently the Vice Chairman and Sony Group Americas Representative, has been on the board since 1999 and has been managing Sony’s entertainment business. Attention is now focused on potential emphasis on this business under the new management structure. Mr. Idei as CEO was aiming for integration between hardware and content, but under Mr. Stringer the. business will likely be built more around content

In view of the analysts, the new management’s statements that Sony cannot recover without its electronics’ recovery are clearly correct, and they have high expectations that the firm can develop ‘hardware to leverage its content’ and create new markets. Analysts believe that the financial markets are likely to respond positively to the change, since they hold the outgoing management team responsible for the poor performance of Sony’s electronics business in recent years. The big question is about what reforms the new team instigates, how it executes in practical measures, and whether it changes the company’s strategy in a way that has a tangible impact on earnings. Associated risks include major changes of strategy by the new management team.

Managing Diversification


oth internal and external logic of acquiring music business (Sony Music Entertainment) in 1988 and film business (Sony Pictures Entertainment) in 1989 was to seek synergies across the electronics and contents businesses. By the late 1990s, Sony was in a great position to introduce new businesses that combine electronics and entertainment, with nearly one third of asset and revenue coming from its entertainment arms. In fact, Sony’s stock price soared in the year 2000 reaching an all-time high $150 (currently trading in the range of $32 - $42) with such expectation. The rest is history. Sony’s profit and stock price plunged and has not recovered since. Apple has come out with sensational product and service, iTunes and iPod, with SonyConnect (online music service) and Network Walkman only achieving marginal market share.

With its legendary gadget manufacturing and cutting edge designing capabilities, why wasn’t Sony able to create its own “iPod” business? Many point out that Sony’s ownership of contents and its own DRM (digital rights management) technology actually inhibited their ability to launch a universal and easy-to-use online music service and digital music player. Sony was initially reluctant to make other music labels’ songs available on its online service. And its early version of Network Walkman only allowed songs with Sony’s DRM encryption to be downloaded.

While these explanations are persuasive, the strategic decisions were all made by the management team at Sony’s corporate headquarter in Tokyo. Prior to Howard Stringers, all Chief Officers (Executive, Financial, Operating) had no background in contents business. While they were all competent in the electronics business, they did not realize that Sony’s brand does not mean anything in the contents business and failed to capitalize on the first mover advantage to gain an initial market share in the online music and the digital music player business where the network externality effect is high.

Can Sony count on Sir Howard Stringer? With his diplomatic skills and the understanding of the contents business, he is the best bet that Sony has got.

Research Sources

- Interview with an erstwhile Sony Corp employee

- Analyst Reports: Deutsche Bank, Morgan Stanley and Smith Barney Citigroup

- Datamonitor’s latest report on Sony

- Wall Street Journal

- Financial Times

- Business Week online

- Economist.

Submitted by: Shigeru Kusunoki, Pooja Vivek , Atima Bhatnagar.

Unbuckle Your Seat Belts, You Are Now Free To Take On Southwest.

When we look at the airline industry, no longer the first things to mind are the famous tag lines, “Fly the friendly skies” (United) or “Something Special in the Air” (American). Instead, we think about the rising fuel costs, the excess capacity, and of course, the predominance of bankruptcy as the modus operandi. If we do think of a tagline, it is much more likely to be Southwest’s “You are now free to move about the country.” The industry has transformed; the low cost carriers are capturing an increasing share of the market, and consolidation seems inevitable. On April 22nd, America West, the nation’s second largest low cost carrier, confirmed that it is in preliminary conversations with US Airways for a potential merger. America West, with hubs in Phoenix and Las Vegas, focuses on the western region of the United States. US Airways, with hubs in Philadelphia and Charlotte, has a stronghold on the major airports in the eastern part of the United States. A combination of the two airlines would create the nation’s sixth largest airline based on passenger traffic.

Analysts reveal that there are many troubling issues associated with this possible merger. UBS airline analyst Robert N. Ashford offers that although the idea has some merit, the airlines’ abilities to gain the support of their shareholders, their disparate labor unions, and their potential financiers could prove extremely challenging, not to mention the inevitable struggle with federal regulators and GE Capital for deal approval. Furthermore, with fuel prices continuing to skyrocket for the foreseeable future, absorbing much of the available cash, and with both airlines already being extremely leveraged, a required investment of approximately $500 million to consummate the merger may be insurmountable. Other analysts question the rationale behind the deal from America West’s perspective. They doubt the merit of the profitable, well-managed America West, burdening itself with US Airways’ troubles: a second bankruptcy proceeding, an excessively high cost structure, a very poor customer service record, and a fiercely competitive market in the East.

However on a positive note, industry consultant Mo Garfinkle acknowledges that America West has been “boxed in by Southwest, and sees this as a chance to quickly gain a large, national footprint.” He continues by explaining that Southwest is already serving many of the cities in the East, but targets the outlying airports, whereas US Airways is focused on the major airports.

The big question is this – is there room for a low cost regional player in an industry of declining (and mostly negative) profit margins and excess capacity? The answer is “no.” America West needs to branch out from the Western US, and find a home east of the Mississippi. Landing rights are finite assets and are not acquired easily, especially in the restricted airports like La Guardia (New York) and Reagan National (Washington D.C.). US Airways is facing an uphill battle in bankruptcy court, has recently exacerbated its union strife, and is in desperate need of a white knight on a commercial jet. America West needs to compete effectively against the only true national contender in its market niche – Southwest – but must find a more prominent brand name to market. A match made in heaven? Not quite, but this deal is not about finding synergies between the two completely different business models. Instead, it is an opportune moment for America West to buy some cheap “complementary” assets in precisely the landscape it is looking for, with the strong US Airways brand name to boot.

The possible merger may in fact give America West an advantage amongst the low cost carriers, because not only will America West be able to compete on a national scale in major airports, but it will likely be able to extend its services to business customers. Southwest caters to the leisure traveler and the very price sensitive small business traveler, and has in many respects, alienated the “deep pocketed” business traveler by its out-of-the-way airport locations and multiple-stop travel philosophy.

Clearly, there will be significant integration costs and asset rationalization, especially considering the labor union issues and unproductive US Airways management. But again, this is not a story of synergies but is one of assets, and this merger is the only way America West can go head to head with Southwest. The challenge for the America West management team will be to maintain its position as a low cost carrier after combining forces. It needs to stay lean, and will therefore only preserve those tangible and intangible assets which are strategically aligned with its vision. There will be a transition period for America West to successfully convert the fleet and human capital from its original high cost structure. But, America West has a strong, proven management team that has operated its network efficiently, and does the proper due diligence before securing a deal. It walked away from a potential merger with another low cost carrier, ATA Holdings, last year, when it became evident that America West would not be able to obtain the appropriate fleet mix to service its market. US Airways is different, however, in that it has the essential aircraft (Airbuses and 737’s) for the longer, more comfortable non-stop trips.

The airline industry needs a break. America West and US Airways may spark industry consolidation, effectively creating a positive externality on the remaining airlines by decreasing capacity. This capacity reduction will help thwart the perennial ticket price wars, and ultimately lead to increased revenue for each of the airlines. The proposed deal between America West and US Airways can therefore be lucrative both for the industry as a whole and for the two individual airlines. It will be beneficial for America West by allowing it to attack Southwest head on with a national footprint and stronger brand name. US Airways is remunerated by offering shareholders a valuable stake in the “new” America West rather than a potentially worthless stake through liquidation. Although the question of how to finance the deal and gain federal government and creditor approval is essential, if the business plan is aligned, the money will come.

Rob Rosenfeld

Susie Greener

Savyon Amit

Thursday, April 28, 2005

Are You Ready for Some…. Desperate Housewives??

Dun Dun Dun Dun. Howard Cosell. Hank Williams, Jr singing “Are you ready for some football?” For 36 years, they have defined Monday nights for millions of Americans who have grown accustomed to watching Monday Night Football on ABC. Starting in 2006, this will all be but a distant memory. The NFL announced on April 19th a new TV deal that will result in a three network shakeup.

Here is the way the deal broke down: ABC is out of the NFL. They will no longer broadcast the Monday Night Football package which included playoff games and a spot in the Super Bowl rotation. Instead, ESPN will pick up the Monday Night Football rights at a cost of $1.1 billion a year for eight years. In doing so, ESPN is giving up their current rights to the Sunday night game, which will now be broadcasted by NBC at a cost of $600 million a year for six years. Included in NBC’s package are two playoff games and the Thursday season opener, as well as the rights to the 2009 and 2012 Super Bowls.

What was behind the decisions for the three networks?

ABC felt that it did not make financial sense to continue their Monday Night Football deal that resulted in a $150 million loss per year. Ratings had dropped significantly in the last decade, down 21% over the past five years. Monday Night Football had lost its luster due to the addition of more prime time football and the recent trend in parity in the NFL that resulted in meaningless late season games. At the same time, they have had recent success with more traditional entertainment programs like “Desperate Housewives”, and saw a potential to launch such profitable shows on Monday night.

NBC saw something that fit into its new strategy towards sports programming. Ten years ago, the network had broadcast rights for all three major sports: football, baseball, and basketball. They came to the realization that the excessive fees sought by the professional sports leagues did not justify the profit potential, and chose to divest themselves from all three. They decided to take a “wait-and-see” approach and re-enter these markets only when the “price was right”. Apparently, that time is now. The network has fallen from its first place position it held for many years, and is looking for programming like primetime football to directly compete with the other networks. It also sees the NFL as a promotional tool for the rest of the week’s shows.

ESPN’s decision factored in two concerns: maintaining bargaining power with cable companies for their monthly subscriptions, and fending off entry into the cable market of other all-sports programming. ESPN currently has the highest per-subscriber rate at $2.50 a month and had already been facing resistance to these prices before the NFL deal was announced. In addition, there have been rumors that Comcast and News Corporation are planning to launch their own cable sports network, and getting the NFL would be a key asset in making this entry.

NBC’s re-entry into the world of professional football has been viewed favorably by the media and Wall Street analysts. Analysts at Prudential feel that NBC’s exclusive rights to broadcast Sunday Night Football should position the network to profitably rebuild primetime leadership over the next few years. Sunday is traditionally the most-watched night of the week, and currently NBC has no such hit on that night. Demographically, football also makes sense for NBC since it is the perfect counter-programming for ABC’s lineup which is particularly aimed at women.

Furthermore, analysts feel that NBC’s parent company, GE will realize significant synergies as the NFL deal will give them a vehicle to generate additional income cross-selling its products. These include financial services, healthcare and medical services, stadium and team security and lighting and electrical products for stadiums. Nicholas Heymann at Prudential Securities estimates that GE could be looking at roughly $300-$500 million of additional revenue annually based on these synergies.

Analysts have mixed views, however, on whether the deal is good for ABC and ESPN’s parent company, Disney. Although expensive, the deal is a strategically smart move for the company according to CSFB analyst William Drewry. Not only will the deal strengthen ESPN’s dominant cable position, he agrees that this is a necessary roadblock to News Corporation. The high costs will be offset by advertising fees and profit potential from counter programming. JP Morgan analyst Spencer Wang, on the other hand, believes that the deal is very costly, and will result in a net loss for Disney of $96 million based on lower distribution on ESPN when compared to ABC.

We agree with analysts that NBC came out as winners in the deal. The wait and see approach undertaken by NBC has finally paid off, as they entered into the NFL contract at a great price. In addition to the prime time audience captured on Sunday nights, NBC gained the right to switch Sunday night games with CBS and FOX’s afternoon games if they feel a better match-up exists. This problem had plagued ABC’s Monday Night Football and lowered its value. Additionally, the Sunday primetime game sets up the opportunity to create a pre and post game NFL show which would compete directly with ESPN’s popular Sunday night sports programming.

NBC will also be able to charge higher rates for the NFL primetime advertising.
Advertisers have been threatened by the increasing use of recording devices such as Tivo. The NFL provides entertainment that its fans are likely to follow on a day to day basis and watch live, including the commercials.

We also agree that ESPN paid a high price for the Monday Night Football package, but had no choice because of competitive issues. The NFL was able to use News Corporation’s threat of entering the all-sports network arena (a similar strategy to how Murdoch used sports contracts to promote Fox and Sky Network) as a bargaining chip to force ESPN to pay a premium. Bottom line, ESPN’s dominance in the sports entertainment world gives them the power to charge high subscription rates, and losing the NFL might signal a weakness in maintaining this position.

Although the deal is good for everybody involved, the big question is: What does this mean for Hank Williams, Jr?

- Joel Amico, Carol Pinlac, and Jason Rosenthal

Will this Blockbuster Have a Happy Ending?

When deciding to have a quiet evening at home, in the past people drove to their local Blockbuster to rent the newest movie release or curled up in front of the television to watch a classic. Now consumers have many more choices in how they can access their home entertainment content: join an online DVD rental service like Netflix, pick up the remote control and program a cable box to play a movie, purchase a DVD at the local Wal-Mart, download the content from the Web, or continue to drive to their local video retailer. With these new competitive threats and an eroding market, Blockbuster must find a new strategy in order to survive in this evolving and technological fast-changing home entertainment industry.

Blockbuster is the world’s largest video rental chain, with about 9,100 retail stores in 25 countries. The company rents videos, DVDs, and video games at its conveniently located brick-and-mortar video stores. Remaining loyal to its video retail roots, Blockbuster tried to expand its retail presence in 2004 when the company launched a $700 million takeover bid for rival Hollywood Entertainment. The goal of acquiring the #2 US video chain was clearly to gain more market share and increase the already large number of retail outlets by enveloping Hollywood Video’s 2000 stores into its retail family. Blockbuster eventually dropped the Hollywood bid[1] because of an unfavorable antitrust review by the FTC and shareholders’ reactions.

While Blockbuster was distracted with the Hollywood Video bid, the company ignored the creeping threat of online rental company Netflix. Once thought of as a niche player, Netflix has now signed up more than 3 million subscribers including many former Blockbuster customers and made the online DVD market so attractive that Wal-Mart and have entered. Blockbuster initially ignored the Netflix threat because Mr. Antioco, Blockbuster’s CEO, “didn’t think that consumers would want to think days ahead about what movies they [would] want to order.”[2] Mr. Antioco was wrong and Blockbuster missed the first mover advantage and the opportunity to combat Netflix.

With a change of heart, Blockbuster decided to embrace the mail-order DVD service by investing more than $120 million in it. The company has even aggressively lowered monthly subscription prices to undercut Netflix. Consequently, Blockbuster Online has signed up 750,000 customers and claims that it can integrate its operations with the rest of the brick-and-mortar business to get to profit faster than Netflix. Blockbuster has little chance to tempt Netflix subscribers to Blockbuster Online because of relatively high switching costs such as movie order queues, automatic credit card billing, and customized movie suggestions. However, at least Blockbuster is finally reacting to the Netflix threat, responding to customer demands, and diversifying in order to avoid obsolesce.

Blockbuster reacted so strongly to impeding threats that it even abolished lucrative late fees[3]. Customers will be given a one-week grace period to return the product. After that grace period, the customer will automatically be billed for the price of the product minus the rental fee. Blockbuster management claims that the new “no-late-fees” policy resulted in an increase in rental transactions and retail sales in test markets.

Unfortunately, while customers responded well to this new initiative, analysts and shareholders have been less than enthusiastic. Late fees contribute to some $250 to $300 million in operating income and Blockbuster expects to spend $50 million in advertising. The most vocal critic of Blockbuster’s initiatives is Carl Icahn, who amassed 8.6% of the voting stake in Blockbuster last year (and quite a bit of Hollywood Video stock). Icahn claims that the company’s management is on an irresponsible spending spree. He demanded that Blockbuster stop the extravagant capital expenditures and instead pay shareholders $300 million of its cash flow in dividends. Even our fellow Competitive Strategy peers agreed that Blockbuster’s management was trying to increase the company’s growth through unsustainable tactics and diverging from its core competencies. They further supported Icahn’s demands for a cash harvest[4].

We disagree with both our Competitive Strategy classmates as well as Carl Icahn. Exhibit 1 shows one of Blockbuster’s competitive strengths: A bargaining power over suppliers. Blockbusters’ cash inflow and outflow seem significantly mismatched. Blockbuster’s inventory remains on hand for about 70 days. After Inventory is sold, 11 days elapse before cash is collected from customers. Yet suppliers are not paid until 195 days after inventory is purchased, meaning that Blockbuster has huge bargaining power over its suppliers. The bargaining power over suppliers allows Blockbuster to generate 114 days of “Free Money.” This vendor driven financial system enabled Blockbuster to invest in business without paying cost of capital. However, this vendor driven finance system has a pitfall: Blockbuster must keep cash at hand so that it can pay back suppliers. Therefore, Blockbuster should not pay a big dividend to shareholders. Instead, it can maximize shareholder value by using cash to reinforce its competitive advantages and further invest in future growth strategies; for example, using cash for buying-back shares and use this treasury stock for future potential M&A.

In addition to high bargaining power over suppliers, Blockbuster’s competitive advantages include convenient store locations, variety in entertainment selection, and a strong brand name. Thus far Blockbuster’s strategies of eliminating late fees and an online DVD rental service reinforce its competitive advantages. These initiatives help combat the immediate threat of Netflix and counter the erosion of the video rental retail market. Unfortunately, these solutions are not necessarily sustainable for growth as most industry experts believe that the online DVD rental is a passing fad soon to hit extinction when cable’s on-demand solution and downloading content from the Internet become more popular.

Blockbuster should take advantage of the evolving technology and the new fragmented Internet and on-demand markets. Learning from the Netflix mistake, Blockbuster can be the first mover in this market and create high switching costs to consumers to produce entry barriers against competitors. By investing in technology, the company can provide downloadable entertainment content to consumers. Similar to Apple’s iTunes, can serve movies, games, and other entertainment to consumers over the Internet. Consumers can have the opportunity to rent content (by placing a time stamp on the content and setting expiration dates) or purchase content at a discounted price compared to retail since packaging and promotional costs are reduced. Blockbuster’s high bargaining power over suppliers will help the company convince entertainment companies to provide content to consumers over the Internet. Its strong brand name and a reputation for variety and convenience will convince consumers that is another great place to get their home entertainment. Downloading content over the Internet is even more appealing than cable on-demand because it has more variety and convenience to consumers.

Blockbuster’s recent strategic initiatives coupled with an investment in emerging technology should help the company remain a dominant player in the home entertainment industry, utilize its competitive advantages, and ease shareholders’ concerns over reckless spending. While it may not guarantee a happy ending, this plan certainly avoids complete extinction.

Abigail Akzin
Naomi Nakagawa
Natalie Yu
[1] “Blockbuster Drops Hollywood Bid,” Joe Flint, The Wall Street Journal, March 28, 2005.
[2] “At Blockbuster, New Strategies Raise Tensions Over Board Seats,” Martin Peers, The Wall Street Journal, April 18, 2005.
[3] “Blockbuster Drops Late Fees,”, December 14, 2004.
[4] “Block-Busted,” Suzanne Davidkhanian, Keith Guerrini, Yvette Nicholas, April 21, 2005

Valero leverages the “Perfect Storm” in sour crude refining; will it be wiped out?

Valero Energy announced plans Monday to acquire Premcor as part of a deal that would create the largest refiner of crude oil in North America. With Premcor, Valero will gain four more refineries for combined output of 3.3 million barrels per day or 19.6% of total U.S. refining capacity, giving it top U.S. market share for refined products.
Unique in the industry, Valero has focused since the early 1980’s on one simple strategy: refining sour oil, which has high sulfur content and sells at a lower price compared to sweet crude. Investing in sour crude processing capacity has reaped greater rewards for Valero as sweet crude oil prices have risen in the last two years to more than $55 per barrel. Currently, sour crude oil sells at a discount of as much as $20 per barrel for some grades. Gasoline and diesel prices are based on the higher priced sweet crude prices.
Because many of its competitors do not have the technology to refine heavy and sour grades of oil, Valero has a distinct competitive advantage – it pays less for crude oil than many other refiners do. It buys cheaper grades of oil and refines them into high quality derivatives like gasoline.
The current market environment for Valero’s business is ideal: the number of refineries in the U.S. has declined from 325 in 1981 to 149 at present, leading to low inventories which keeps margins high. At the same time, U.S. refiners have seen rising demand spurring historic gains in fuel prices, while the discount of sour crude versus sweet is near historic highs, maximizing Valero’s margins.
In an interview Monday, CEO William Greehey explained, “There’s $350 million, at least, of synergies that are involved. Their assets fit well with our system. This is a tremendous deal for Valero shareholders and Premcor shareholders.” He believes that the trend of high discounts from sweet to sour crude will continue: demand is exceeding refining capacity growth and capacity is getting tighter, thus world reserves of heavier sour crude – Valero’s specialty -- will be used to meet increasing demand. Some analysts suggest that spreads will likely trend narrower. Greehey’s response: “As demand picks up, discounts will widen. We’re not concerned.”
Analysts have several reasons to be positive. Margins are high because of high and increasing demand with little reason to expect that to change. In addition, competitors should have trouble building equivalent technology within the next two years.
Ann Kohler, analyst for IRG, said, “We believe the fundamentals for the refining sector remain outstanding, particularly for those companies, like Valero, with sophisticated refining hardware capable of processing less expensive sour and heavier grades of crude.” Merrill Lynch analyst Andrew Fairbanks, despite having downgraded the stock recently, noted that the deal “fits well with the company’s refining margin outlook and strategy to grow its capacity in an environment where demand is expected to exceed capacity increases.”
Fairbanks continues: “Synergies of $350 million are targeted and backed up with identifiable projects. Reduced administrative costs and refinery yield improvements make up the bulk of the increase, which is sensitive to refining margins.”
Still, there is at least one influential group of bears on the deal: the credit agencies. S&P cut Valero to one level above junk and placed it on negative credit watch, reflecting “concerns that refining margins could weaken considerably.”
In fact, the firm plans to pay off the debt linked to the acquisition within two years, not leaving much room for error. For this reason, UBS analyst Stewart Morel downgraded Valero from “buy” to “hold.”
Moody’s noted that Valero paid a higher price than other recent refinery acquisitions. Jay Saunders at Deutsche Bank commented, “Valero is paying up for Premcor…and the rest of the refiners win with a high benchmark valuation for refineries.” Ultimately, Valero is paying over twice what comparable deals have gone for: $9 million per daily barrel compared with recent deals of $4 million.
Saunders at Deutsche summarizes his view: “We see strategic enhancement for Valero, with size and quality into strong margins, but significant risk on the price and timing, as Valero could be buying within a year away from the top of the market.” Light-heavy spreads are at all-time highs.
From a competitive standpoint, Morningstar says, “We think adding sour crude capacity will be at the top of many refiners’ project lists. Although doing so is capital intensive, there are few barriers to adding sour crude capacity. When competition intensifies, Valero’s wide margins will disappear.”
So the questions remain. Will the competition expand competitive sour refining capacity? Will margins narrow between sour and sweet crude? Will demand growth slow? These legitimate concerns posed by analysts have been used as criticisms of the deal. To us, $350 million in synergies seems low compared to spending $8 billion on Premcor at twice the value of comparable deals. Valero has extremely cyclical performance; profits will decline rapidly when and if discounts on sour crude shrink and refined product prices decline. We question the advantages of scale as a competitive advantage in a commodity business. Finally, the history of Valero is one of cautious, slow acquisitions of sour refineries for bargain basement prices. This was great when margins were small in this industry which they did for the past 20 years. To suddenly pay such an extreme value for Premcor strikes us as pure empire building, not strategic enhancement of competitive advantage or shareholder value.
Authors: Patrick Brickley, Lindsay Lowe, James Smith

Will the Berries get squished?

Will the Berries get squished?

Blackberries, the mobile email devices made by Research In Motion (RIM), have become immensely popular among business users. In the past year the number of subscribers grew by 50% to almost 3 million. RIM is the leading mobile e-mail provider and has grown to the third largest PDA manufacturer with 18% market share. This success has not gone unnoticed however. As the Wall Street Journal reported on April 25th telecom giants such as Nokia, Motorola and Samsung, and tech behemoth Microsoft are now trying to muscle into the attractive wireless e-mail market. For a while analysts have been warning that RIM may not be able to sustain its position with new competitors entering the market. Now the attack of the BlackBerry killers seems to have started, will the Berries get squished?

In the past RIM has successfully competed with many smaller rivals in a niche market. Now the wireless e-mail market has grown to a substantial size, it enters a new and more competitive stage. Currently mainly business professionals use the technology, but consumers are about to adopt it. Analysts are extremely optimistic about the booming all-in-one handset industry. However, in a market that is the crossroad of mobile phones, camera’s, MP3 players, PDA’s and online services many players battle for dominance and the fight is going to be fierce. Overall, analysts are optimistic about RIM’s future. While analyst James Faucette makes cautious forecasts based on slower replacement expectations, S&P analyst Kenneth Leon is convinced RIM has a solid strategic position. For sure, RIM has reached a turning point where it must adapt its strategy to the changing market structure.

In the last months RIM has already taken several steps to fight competition on different fronts. In response to the e-mail enabled mobile phones from manufacturers like Nokia, Motorola and Samsung and the extended PDA’s like PalmOne’s Treo, RIM has launched new and very competitive phone-email-data handhelds. As for now, RIM seems to stay ahead of the pack. However, as in any other consumer electronics market, the competition for the handheld devices will be very tough and destroy margins.

On the software front, new e-mail and mobile operating software developers like Good Technology and Visto are building device independent software. The acceptance of an open mobile e-mail platform poses a serious threat to the existence of the BlackBerry platform. To counter this threat, RIM has licensed its BlackBerry platform to Nokia and Siemens. However, this license is far from the creation of a standard.

And then there is Microsoft. The industry heavyweight eyes mobile technology as an area of strategic growth. While RIM and Microsoft signed an agreement on April 21st that will enable enterprise instant-messaging applications on the BlackBerry platform, Microsoft had already signed a licensing deal in March with Symbian, a Nokia-backed mobile operating system developer. The goal of the Microsoft-Symbian deal was to combine the mobile operating system with the e-mail software to capture a larger share of the wireless e-mail market. On top of that, Microsoft is expected to release later this year a newer version of its own mobile operating system with extensions for e-mail. The dance with partner Microsoft might become dangerous for many players that want to get into mobile e-mail.

While giants may be entering, BlackBerry is far from gone. RIM has a large customer base with strong recurring revenues that will not easily change providers due to high switching costs. With an installed base of over 40.000 BlackBerry servers at business customers, RIM has locked in organizations that cannot switch overnight or afford huge service disruptions. As a consequence current users will only consider devices compatible with their existing infrastructure and unless the incumbents offer more value than a phone-email-PDA BlackBerry, there is no incentive to switch.

Additionally, RIM has teamed up with many carriers across the globe. The carriers sell the BlackBerry products and services, creating growth for both the carrier and RIM. These alliances remain indispensable in the growth strategy for mobile e-mail as the sale of the device comes with a subscription to a carrier’s data network service. To strengthen its position RIM has recently announced several partnerships with some of the largest international phone companies including StarHub in Singapore, Turkcell in Turkey and Radiomovil in Mexico. On top of its partnerships, RIM has the expertise of running the network, a capability CEO Mike Lazaridis considers a competitive advantage.

RIM is also looking to further differentiate its products by customization and partnerships with Internet and content providers. RIM partnered with EarthLink to enable enhanced HTML wireless browsing in an attempt add EarthLink customers to its base and increase customer retention through “sticky” applications. For business users RIM enables access to CRM applications.

BlackBerry has a firm strategic position with a solid and locked-in customer base, strong partnerships, innovating products and very good financial results. The mobile e-mail market is still only in its early stages of growth and there is a lot to change. RIM now faces a classic technology-industry problem where young companies that launch popular products may not be the long-term winners. As often seen with new technologies, eventually only one standard dominates. The key to RIM’s success is the ability to outline or quickly adopt the industry standard for mobile e-mail, in which ‘partner’ Microsoft will lead the dance. If RIM’s management proves to be a good dancer, the Berries won’t be squished.

Coulembier, Grony and Iyer

Project Barbell or Project Dumbbell?

Floundering east coast-based airline US Airways is in serious talks with west coast carrier America West Airlines about a prospective merger. This is not the first time the twice-bankrupt carrier has looked to merge: talks with United stalled in July of 2001 when blocked by the U.S. Department of Justice. Now US Airways is shopping again: according to the New York Times, “…the chairman of US Airways, David G. Bronner told The Associated Press…that the airline had approached several carriers about a merger, but discussions with America West had progressed the farthest.”
Although the merger faces many hurdles, “it could prove the first step in a long-awaited new wave of consolidation of the embattled airline industry,” according to the Wall Street Journal. The deal would create the sixth-largest airline in the United States, just ahead of rival Southwest. Indeed, if US Airways and America West merge, they will do so in an attempt to create a beefed-up discount airline, one that offers amenities like first class and airline clubs, but that would compete head on with Southwest. This raises the old question about Southwest, one of very few profitable U.S. airlines: is it possible to copy its model, and thus its success? If US Airways and America West succeed in emulating Southwest, they will be the first in a long line of aborted efforts to do so. But it is unclear whether the merger would create an entity with all of the synergies and reinforcing capabilities that make Southwest thrive.
There are many potential benefits that could be realized through this merger. According to the Wall Street Journal article on April 21st, many feel that these mergers are inevitable and “could trigger a long-awaited industry shakeout.” Larry Kellner, chief executive of Continental Airlines, Houston states that these talks are “another sign that the industry's going to continue to evolve over the next two years,” and that Continental also intends to "keep our eyes on the marketplace."
One of the most obvious benefits to the US Airways and America West merger is the opportunity to combine two airlines that have hubs in very different areas of the country. They would be able to offer many more choices of routings and flight paths. Especially for US Airways, who has felt the crunch from competitor Southwest Airlines in its major hubs of Philadelphia and Charlotte, the Wall Street Journal states “A merger would allow it (US Airways) to expand its stunted route network and grow to the West, where it offers very few flights.” America West is also facing similar problems on the opposite coast, “For its part, America West is hemmed in by Southwest at its hubs in Phoenix and Las Vegas, and needs places outside its Western U.S. territory to grow and use new airplanes it has on order.” With America West’s reputation for low costs among the carriers, and the combined hubs of the two airlines, “Together they would be a full-service but low-cost operator with a credible national network.”
This touches upon another area that will be helped by the potential merger. Also, according to US Airways bankruptcy proceedings, “bankrupt airlines are allowed to get out of unprofitable aircraft leases, reducing costs and capacity”, Business Week, “Takeoff for Airline Mergers?” This would allow US Airways to cancel certain leases of their own, with the knowledge that they could make up the difference with the new planes on order to America West mentioned in the paragraph above.
Another main area of concern to the airline industry is of course the severe overcapacity that is currently plaguing the skies. This leads to too many filled seats at a cost that most airlines simply can’t afford. The overcapacity problem could also be controlled to a certain extent through the merger. According to the article on April 21st, “if the airlines end up cutting some routes or service in the deal, that could be an answer to the overcapacity problem that has kept fares in the U.S. airline industry too low for most carriers to make money.”
There are three main risks to a potential merger between America West and US Airways. Mergers between airlines involve negotiating with rival unions which tends to be costly, as well as integrating incompatible fleets of planes, complex routes, employees and systems. According to UBS analyst, Robert Ashcroft, “We believe airline mergers work best when buyer is big and powerful (as AWA is not) and target is small and puny (US Airways is weak but over twice the size of AWA).” The two airlines have very few overlapping routes, as US Airways is concentrated on the East coast and America West is concentrated on the West coast, with neither of them offering many transcontinental flights, hence the project is referred to internally as “Project Barbell”. This would be favorable to antitrust regulators, however, it provides few opportunities to consolidate operations. If anything, this deal creates duplicate costs rather than cost savings.
Another concern for investors is that neither America West nor US Airways has sufficient financial resources to take US Airways out of bankruptcy without outside capital. According to the Wall Street Journal, outside investors would have to contribute $500 million to complete the deal. General Electric, the biggest creditor of both airlines, would have to approve the deal as well, which could potentially increase its exposure to credit risk. The federal government, which granted loan guarantees to both airlines after Sept. 11, 2001, would also need to approve the merger, as well as other creditors, the bankruptcy court and America West shareholders. According to Business Week, the fear among industry followers and potentially shareholders is that America West will be weighed down by US Airways problems, such as high costs, complaints about poor customer service and a fiercely competitive market on the East coast.
The third risk of the merger is the threat of competing against Southwest. According to CreditSights analysts, Southwest has a dominant presence on the East coast, namely Philadelphia, and they have made their latest move to start flights in Pittsburg. Southwest also has a bigger presence in Las Vegas and a dominant position in California, as well as more transcontinental flights when compared to America West. CreditSights says Southwest never stands still in the face of a threat, as seen in its fight to bid for the assets of bankrupt ATA Airlines over AirTan. Lastly, UBS analyst Robert Ashcroft also said “We’d expect Southwest to apply maximum pressure to a merged entity, perhaps even before a merger.”
Given the many risks of this merger mentioned above, a successful outcome seems improbable. US Airways is a sinking ship desperately seeking a partner; it has approached many other airlines about a potential merger. Why should America West, who showed profitable results in the fourth quarter of 2004, be brought down with this ship? US Airways has been in bankruptcy twice in the past two years, and this deal will only increase costs and distract management of both airlines from the issues at hand. America West should reconsider this risky proposition and instead capitalize on its recent progress. Perhaps as an airline consultant for R.W. Mann & Co. states, a better name for this deal would be “Project Dumbbell”.

By: Tara Duhan, Michelle Fedunyszyn, Katherine Palmer

Wednesday, April 27, 2005

Fasten Your Seatbelts: Turbulence Ahead for US Air & America West

Recently confirmed rumors that US Airways and America West Airlines are involved in merger talks has sparked some discussion about how wise a move that would create the nation’s 6th largest airline will prove to be. With the industry just now showing signs of life after nearly 4 years mired in turmoil, this is the first sign of M&A activity in the U.S. market since UAL Corp’s United Airlines flirted with US Airways back in 2000. This potential deal wouldn’t face quite the uphill battle United saw; the resulting airline would barely beat out Southwest for that 6th spot (a combined United/USAir venture would have handled 27% of all domestic air travel).

This chatter is clearly a result of the record fuel costs, empty seats, and ticket-price wars that have virtually eliminated margins for most major airlines. The level of competition and excess capacity makes survival difficult; the thought of a deal that could remove capacity and lead to increased fares is obviously a pleasant one for analysts and investors watching the situation. A merger could allow the two airlines to eliminate redundant equipment, gates and (possibly) personnel across their networks. Those in favor of the merger further cite the little route overlap between the two airlines and the availability of exit funding for the bankrupt US Air should they find a partner. They could right-size their fleet through a little-known codicil of the bankruptcy code that would allow US Air to ditch some of their current airplane leases. Though it is possible to read the initial press and come away with a fairly positive impression, the picture isn’t necessarily so rosy.

As recently as early 2001, pundits were warning against potential over-consolidation in the U.S. air travel industry. Idle for some time, these naysayers are suddenly back in fashion. Airlines are hugely complex entities, with shareholders, employees (whose pension plans tend to own large chunks of stock and whose unions can often dictate company policy), and other “investors” able to exert significant power on management. Then there are the fleets. US Airways (including US Airways Express) sports 13 different planes across its fleet, America West has 6 (with only some overlap in airframe and engine types). These figures don’t compare favorably to the airline everyone seems to have in their sights, Southwest, who operates 417 planes that are all variations of the venerable Boeing 737. Increasing fleet complexity leads to increased maintenance and pilot costs, and has a subtle but significant logistical effect – when flight crews have to be matched to the planes they are rated to fly, the airline loses flexibility.

The market doesn’t seem to like the idea either; America West (NYSE: AWA) lost 6.4% on the day the rumors started. US Airways’ bulletin board issue (OTC BB: UAIRQ.OB) isn’t even worth talking about. Given that US Airways is banking on this deal as a guarantee for the last USD 100 million in exit financing, some wonder how they would fund the huge integration program that would follow any agreement. There is also the hidden cost of frequent flyer programs. The 4 million or so America West frequent flyers would gain access to the entire Star Alliance network; the pent-up demand for free flights could choke profits as flyers exploit the newfound range of their program.

Southwest, thought by many to be the primary target of the new airline, doesn’t think much of the idea. With no discernable braggadocio, SWA CEO Gary Kelly mentioned that the merger “doesn’t really change the competitive landscape as we see it.” This, coming from the incumbent 800-lb gorilla of the growing discount air market, may turn out to be quite prophetic. Taking two struggling airlines (struggling, in spite of AWA’s recent quarterly profit) and mashing them into what would ultimately be the nation’s largest discount carrier might not be what the doctor ordered.

The 9/11 attacks on the World Trade Center and the Pentagon obviously changed the way airlines operate; United Airlines and AMR’s American (both lost planes and crew in the attacks) have flagged, and the subsequent decline in passenger traffic has sent shockwaves through the industry. But players have largely ignored M&A activity as a potential road to profitability, more than likely because the Air Travel Stabilization Board (ATSB) has kept these languishing airlines afloat with loans and subsidies (between them, US Airways and America West took out USD 1.5 billion in loans). GE Capital Aviation Services is equally at fault. They’re currently US Airway’s largest creditor and have “gracefully” extended terms that at the same time keep the airline flying and paying more over longer periods of time. Unlike other industries, where market forces dictate the size and number of players, the U.S. has a number of airlines that just shouldn’t be.

Even the counter-argument has flaws; proponents of the ATSB (and even GE’s “benevolent” actions) say that if they hadn’t acted, the consumer would bear the brunt in the form of service degradation. The fact of the matter, however, is that if US Airways were to exit the market, other players would fill the void in service they left behind. Efficient markets don’t tend to stand idly by and watch players’ failures without presenting new opportunities for profit to those who are most fit to claim it.

A combined airline flying under the US Airways livery would certainly present some opportunity to take capacity out of the skies in the short term. However, someone will have to figure out how they’ll jump the huge hurdles that currently look pretty steep (in the form of approvals from two unions, the ATSB, GE Capital, and the bankruptcy court overseeing US Airways reorganization) and come up with new solutions for fleet management and route optimization. If they succeed, however, and fuel prices pull back from their current, absolutely insane levels, airlines might return to service differentiation – rather than pricing – as a source of competitive advantage. And we might see pillows on our next flight.

J. C. Groon
Kevin Hardy
Amrit Sahasranamam

Super Size Me!

On January 27th, 2005, Deustche Boerse AG (DB), operator of the Frankfurt-based stock exchange by the same name, formalized its bid of 530 pence per share for the London Stock Exchange (LSE). With this move, DB crystallized a process that began in 2000 and started a competition that could shape the future of European exchanges

In 2000, the two exchanges agreed in principle to merge, but those plans went awry as LSE was forced to fight off Stockholm Stock Exchange’s hostile takeover. The goal then as it was recently, was to create a pan-European exchange that would lead the continent in listed companies, IPOs, trading value and liquidity.

Additionally during 2000, the competitive landscape changed, signaling the start of a race to build Europe’s largest and strongest exchange. The Amsterdam, Brussels and Paris Stock exchanges merged to form Euronext, instantly creating the 2nd largest exchange by market capitalization in Europe (LSE 1st and DB 3rd). Two years later, Euronext merged with the Lisbon exchange and acquired the London International Financial Futures Exchange, the main UK derivatives exchange.

Against this backdrop, Deutsche Boerse’s bid for LSE was an aggressive play to stay competitive in Europe. Both DB and LSE are single country exchanges with no existing cross-trading tie-ups with other exchanges. DB publicly stated that their intent was to create the preeminent international exchange that offered one-stop shopping for securities trading in Europe (together they oversee ~ 40% of European stock market capitalization and 30% of all listed European companies). DB has a net income of slightly over 5 times that of the London bourse, but London offers more international companies, more liquidity and more IPOs. DB could use revenues from these sources to lower costs on trading and other fees for its trading participants.

Additionally, DB hoped that by joining with LSE, creating Europe’s largest exchange, other exchanges would look first to join with it when consolidation became inevitable. Also, DB wanted to use this tie-up to compete in the UK’s lucrative derivatives market through Eurex, the derivatives exchange it jointly operates with the Swiss Exchange.

LSE, however, felt DB’s offer did not represent the value of the combined company, given all the synergistic advantages that would be created by the merger, and twice rejected DB’s offer. LSE then invited Euronext to the discussion table in an attempt to encourage competitive pricing for its shares, hoping for an offer price of between 600 to 700 pence per share.

Faced with limited success of its offers, in late February, DB announced that it was considering a hostile bid for LSE. This created shareholder backlash among some of the funds that owned shares of DB. Shareholders wanted DB’s huge cash position distributed back to themselves in dividends or buybacks and not to be used in a takeover attempt that could decrease shareholder value. Faced with growing discord among some of its major shareholders, DB withdrew its offer for LSE in early March, however, saying it would re-enter the bidding process should another exchange make an offer for LSE close to the offer presented by DB.

Consensus abounds that any merger with LSE is set to rule the exchange landscape in Europe. Size is critical to survival as smaller regional exchanges opt to join the market leader when they consider consolidation. LSE and its partner would dwarf other exchanges in Europe and practically guarantee themselves as the first choice partner when smaller exchanges merge.

DB contends that the synergies created by a merger with LSE would amount to 100M€- 25M€ for cross selling revenue synergies and 75 M€ for cost synergies from operating from a single trading platform. However, analysts believe those estimates are overly optimistic, especially the revenue synergies. Furthermore, they state that since Euronext is more familiar with cross-boarder trades and has a business model that offers more synergistic opportunities, it is a better tie-up option. Analysts do not believe that DB’s strategy of using LSE’s equities trading position and Eurex’s technical experience with derivatives trading, to launch a market in FTSE and single stock UK-derivatives will work. Some say Euronext’s control of LIFFE and LIFFE’s liquidity will prove too significant a barrier for DB to gain any immediate foothold in the industry, such as it experienced in the US market.

Synergies of a DB-LSE merger do exist, mainly from the cost reduction of operating on a single platform. Revenue synergy from cross-selling is a less compelling argument. First, the national turnover in the UK derivatives market needed to support these synergies is hampered by stricter regulations in the UK than in Germany. Second, Euronext controls most of the derivatives trading liquidity through LIFFE causing difficulty for DB’s introduction of new products to steal market share.

In spite of these issues, DB should merge with LSE. First, Euronext is not better suited as a partner due to its cross-border trading experience. Before they merged in 2000, the three exchanges that make up Euronext were far more provincial than DB or LSE. DB can learn about cross-boarder selling as fast, if not faster, as those exchanges did. Second, as seen in the mergers among exchanges in Japan during the 90s and the recent merger between NYSE and Archipelago, the industry is consolidating. These consolidations occurred with exchanges that controlled the largest trading volume and value in the market. If DB wants to be an international exchange, built up through regional mergers within Europe, they need to be the largest European exchange offering the most liquidity, highest trading volume and value.

But how should they merge? Acquisition is the best option for DB. Along with being the largest exchange in a particular market, comes considerable buyer power. If DB’s management is concerned with creating long-term shareholder wealth for its current shareholders, it needs this power to control its future in a consolidating environment. Acquiring LSE will be a significant drain on DB’s cash position, but the long-term value is found in controlling strategy for the group and positioning itself to compete as an international exchange.

By Dan McKelvey, Jit Tan, and Jessica Zysk