Monday, May 30, 2005

How to Save a Sinking Ship

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

Friday, May 27, 2005

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

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)

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?!

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

Thursday, May 26, 2005

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

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

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?”

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

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

Wednesday, May 25, 2005

The Return of the King

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.”

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?

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?

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…

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

Tuesday, May 24, 2005

Consumer Products Industry: Too old to experience growing pains?

The evolution of the consumer products industry occurred during the 20th 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

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 2nd floor of the Gleacher Center? After that, could they please speak with the owners of the parking lot?

Michael Antonelli

Steve Dormanen