Strategic Management: Concepts and Cases [3 ed.] 1119563135, 9781119563136

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Strategic Management Third Edition

Strategic Management Concepts and Cases

Third Edition

JE FF DYER

ROBERT JENSEN

Brigham Young University, Marriott School

Brigham Young University, Marriott School

PAUL GODFREY

DAV ID BRYCE

Brigham Young University, Marriott School

Brigham Young University, Marriott School

EDITORIAL DIRECTOR EXECUTIVE EDITOR PRODUCT DESIGNER EDITORIAL ASSISTANT SENIOR MARKETING MANAGER SENIOR CONTENT MANAGER SENIOR PRODUCTION EDITOR SENIOR DESIGNER COVER CREDIT

Michel MacDonald Lisé Johnson Wendy Ashenberg Cecilia Morales Anita Osborne Dorothy Sinclair Elena Sacarro Thomas Nery B&M Noskowski/E+/Getty Images

This book was set in 9.5/12.5 Source Sans Pro at Lumina Datamatics, Inc. printed and bound by Quad Graphics. The cover was printed by Quad Graphics. Founded in 1807, John Wiley & Sons, Inc. has been a valued source of knowledge and understanding for more than 200 years, helping people around the world meet their needs and fulfill their aspirations. Our company is built on a foundation of principles that include responsibility to the communities we serve and where we live and work. In 2008, we launched a Corporate Citizenship Initiative, a global effort to address the environmental, social, economic, and ethical challenges we face in our business. Among the issues we are addressing are carbon impact, paper specifications and procurement, ethical conduct within our business and among our vendors, and community and charitable support. For more information, please visit our website: www.wiley.com/go/citizenship. Copyright © 2020, 2018, 2016 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate percopy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website http://www.wiley.com/go/permissions. Evaluation copies are provided to qualified academics and professionals for review purposes only, for use in their courses during the next academic year. These copies are licensed and may not be sold or transferred to a third party. Upon completion of the review period, please return the evaluation copy to Wiley. Return instructions and a free of charge return shipping label are available at www.wiley.com/go/returnlabel. If you have chosen to adopt this textbook for use in your course, please accept this book as your complimentary desk copy. Outside of the United States, please contact your local representative. ISBN: 9781119563143 The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct. Library of Congress Cataloging-in-Publication Data Names: Dyer, Jeff (Professor of strategy), author. Title: Strategic management : concepts and cases / Jeff Dyer, Brigham Young University, Marriott School, Paul Godfrey, Brigham Young University, Marriott School, Robert Jensen, Brigham Young University, Marriott School, David Bryce, Brigham Young University, Marriott School. Description: Third edition. | [Hoboken] : Wiley, [2020] | Includes index. Identifiers: LCCN 2019047716 (print) | LCCN 2019047717 (ebook) | ISBN 9781119609827 (paperback) | ISBN 9781119563136 | ISBN 9781119609803 (adobe pdf) | ISBN 9781119563143 (epub) Subjects: LCSH: Strategic planning. Classification: LCC HD30.28 .D9223 2015 (print) | LCC HD30.28 (ebook) | DDC 658.4/012—dc23 LC record available at https://lccn.loc.gov/2019047716 LC ebook record available at https://lccn.loc.gov/2019047717 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

About the Authors JEFF DYER (Ph.D., UCLA, 1993) is the Horace Beesley Professor of Strategy at the Marriott School, BYU, where he serves as Chair of the Department of Organizational Leadership and Strategy. Before joining BYU, Dr. Dyer was a professor at the University of Pennsylvania’s Wharton School, where he maintains an adjunct professor position and continues to teach Executive MBAs. Dr. Dyer has considerable consulting experience, having spent 5 years working as a strategy consultant and manager at Bain & Company, where he consulted with such clients as Baxter International, Kraft, Maryland National Bank, and First National Stores. Since then he has been a consultant, speaker, or trainer for a variety of companies, including Adobe, AT&T, Cisco, General Electric, General Mills, Gilead Sciences, Harley-Davidson, Hewlett Packard, Intel, Johnson & Johnson, and Sony. Dyer is the only strategy scholar in the world to have published at least six times in the Harvard Business Review and six times in Strategic Management Journal, the top academic journal in the strategy field. In 2012, he was ranked the world’s #1 “most influential” management scholar among scholars who completed their Ph.D.s after 1990. This ranking, published in Academy of Management Perspectives, was based upon an equal weighting of academic citations (academic influence) and non-“.edu” Google searches (business influence). His book The Innovator’s DNA is a business bestseller and has been published in 13 languages, and his new book, The Innovator’s Method, has already hit top 10 business bestseller lists. PAUL C. GODFREY (Ph.D., Washington, 1994) currently serves as the William and Roceil Low Professor of Business Strategy in the Marriott School of Management at Brigham Young University. Paul teaches classes to BYU undergraduates, as well as MBA and Executive MBA students. He was honored in 2013 with the Marriott School’s Teaching Award, and in 2017 with the school’s research award. His research has appeared in the Academy of Management Review, the Strategic Management Journal, the Journal of Business Ethics, and the Journal of Management Inquiry. He has recently published a book on eliminating poverty with Stanford University Press. He has also co-edited two other books and served as a special issue editor for two academic journals. He currently serves as Associate Academic Director of the Economic Self-Reliance Center at the Marriott School. He currently consults with a

variety of for-profit and not-for-profit organizations. Paul received his MBA and Ph.D. degrees from the University of Washington and a Bachelor of Science degree in Political Science from the University of Utah. ROBERT J. JENSEN (Ph.D., Wharton, 2006) is an associate professor of Strategy and International Business and is a Whitman Faculty and Peery Research Fellow at the Marriott School of Management, Brigham Young University. He received his Ph.D. from the Wharton School, University of Pennsylvania. He has published in many of the top management journals including Strategic Management Journal, Organization Science, Management Science, and the Journal of International Business Studies. His professional awards include the McKinsey & Company/SMS Best Conference Paper prize, honorable mention, a finalist for the Blackwell Best Dissertation Prize from the Academy of Management, as well as the William H. Newman Best Paper from a Dissertation award, and runner up for the Booz Allen Hamilton/SMS Ph.D. fellowship. His work was honored as the best paper published in Competitiveness Review in 2009 and his papers have been selected seven times for the best paper proceedings of the Academy of Management. His research interests include leveraging knowledge assets through transfer and replication including the problems of overcoming the stickiness, or difficulty, of such transfers. He also researches the boundaries of the firm in extreme locations such as the Bottom of the Pyramid including the rise of hybrid organizations in such locations. He is also currently working on a study of the factors, both student, faculty, and course content factors, that impact student success in management classes, particularly in online settings, and which professor characteristics and routines can best be replicated in that medium. DAVID J. BRYCE (Ph.D., Wharton, 2003) is Associate Professor of Organizational Leadership and Strategy at the Marriott School of Management and has been an adjunct Associate Professor of Management at the Wharton School where he has taught strategy in the MBA program for executives. David earned a Ph.D. in strategy and applied economics from the Wharton School and is author on a number of thought-leading articles for senior executives, including articles in the Harvard Business Review. He conducts research in the area of corporate strategy and has published in top academic journals such as vii

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Management Science and Organization Science. For more than 20 years, he has served as consultant on important strategic challenges to executives of start-ups, mid-market companies, and major corporations, including Eli Lilly, Prudential, Procter & Gamble, Microsoft, Johnson & Johnson, and the LG Group. He has worked with clients on enterprise strategy,

new market entry, branding, pricing, positioning, and growth. He has also conducted many strategy-oriented leadership training sessions over the past 10 years within the Fortune 50, including extensively at Microsoft. Prior to his academic career, he held partner, vice president, and other senior positions at several global management consulting firms.

Preface Why does the world need another strategy textbook? The answer is that we simply have not been able to find a textbook that we felt fully met the needs of our students. What are those needs? First, we wanted to write a textbook that would engage students’ interest using numerous practical examples and tools that would help them actually do analysis to answer key strategic questions. For example, leading firms and strategy consulting firms have tools to teach strategists how to actually conduct a “5 Forces” analysis, calculate a scale or experience curve, or conduct a net promoter score analysis. We wanted to provide those tools. We also wanted to create interactive learning tools that would connect with a new generation of learners. This meant we needed to provide interactive digital learning experiences such as the “white board” animated videos that we have created to support our textbook. When students are more engaged, they learn more—and they enjoy it more! Not surprisingly, this increases student satisfaction with the course and the professor. As we looked at how we could create an enjoyable and engaging strategy course learning experience, we realized as an author group that we were somewhat uniquely qualified to create that type of experience. Why? Because we collectively have over 13 years of full-time management consulting experience at top consulting firms. Why does this matter? Because we have practical experience applying strategy concepts and tools to real companies—practical experience that we have embedded in this textbook. Perhaps just as important, we know how to write to a management audience, having published three books targeting a practitioner audience, seven articles in Harvard Business Review, and another four articles in Sloan Management Review. Perhaps most important is the fact that we’ve tested the text, cases, video animations, and strategy tools with large groups of business students at BYU and Wharton over the past 10 years—with remarkable results. Average student satisfaction ratings have been 6.6/7.0 across multiple instructors for strategy courses using our materials. The bottom line is that we see better student satisfaction and higher teaching ratings because of using this material. In just the past year, we have class tested Strategic Management at over 40 institutions with over 900 students. In exit surveys, 76 percent of students rated the experience as positive or very positive. A few of their quotes are in the margin below.

Key Course Differentiators Because this is a strategy book, we should tell you that our strategy in writing this book is to offer unique value. The key differentiators of this book can be summarized with the acronym TACT—Text, Animated Executive Summary Videos, Cases, and Tools. Text. Each of our chapters is written in an accessible Harvard Business Review style with lots of practical examples, and each chapter is roughly 20 percent shorter than the chapters of the average strategy textbook. You can assign the whole chapter (not just a few pages) and feel confident that your students will not perceive it as a waste of time. This is not to say that we haven’t included core strategy concepts, frameworks, and theories. They are all there. Animated Executive Summary Videos. In WileyPLUS each chapter is accompanied by at least one 8–10 minute animated video that brings the content to life. Today’s students love to learn through interactive technology, and student response to our animated videos has been positively off the charts. Research shows that student recall increases by more than 15 percent when material is presented with a white board animation versus a typical talking head lecture.1 These animated videos allow you to 1 Study by Richard Wiseman. Available at http://www.sparkol.com/blog/how-scribe-videos-increase-your-studentslearning-by-15/

MY FAVORITE ASPECT WAS THE EXAMPLES USED TO EXPLAIN THE CONCEPTS. IT REALLY HELPED ME UNDERSTAND THE MATERIAL. –BILL BOCHICCHIO, STUDENT, VILLANOVA UNIVERSITY THE WHITEBOARD ANIMATIONS WERE VERY ENTERTAINING AND HELPED EXPLAIN SOME OF THE CONCEPTS IN REAL LIFE SITUATIONS. –CAMERON LANDRY, STUDENT, MCNEESE STATE UNIVERSITY

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flip the classroom. When students view the videos before class, they get the core concepts in a memorable way. Then you have more time to discuss questions and help them deeply understand and synthesize the concepts and tools. In WileyPLUS, we also provide strategy in your career videos that will help students tie what they are learning to the workplace and decipher how strategy affects their current and future career plans. This brings a new level of relevance to the study of strategy. THE CASES WERE MY FAVORITE PART—UNDERSTANDING REAL WORLD EXAMPLES HELPED PUT THINGS INTO PROPER PERSPECTIVE. – PHILIP SIEKMANN, STUDENT, PENNSYLVANIA COLLEGE OF TECHNOLOGY

I LIKED THE EXAMPLES AND THEIR OVERALL RELEVANCE. I ALSO LIKED THE STRATEGIC TOOLS AND THE EXPLANATIONS. –DAVID GRANTHAM, STUDENT, KENNESAW STATE UNIVERSITY

I FOUND IT TO BE A VERY EASY READ. IT WAS ONE OF THE FEW BUSINESS TEXTBOOKS THAT I ENJOYED READING WHICH MADE LEARNING EASIER AND MORE FUN. –TAYLOR LEE, STUDENT, SAN JOSE STATE UNIVERSITY

Cases. We will admit that differentiating cases isn’t easy, but we think we’ve done a few things to make using our cases easier. Our cases offer new, shortened, and updated “classic” cases on familiar companies (e.g., Walmart, Coke and Pepsi, Intel, Southwest, Nike, etc.). If you build your course around these cases, you’ll experience very low switching costs moving to our book. We’ve also written cases on companies and topics that millennials gravitate to such as Tesla, Uber, Facebook, ESPN, Amazon, skype, Samsung, and the AT&T-Apple alliance. We also provide brief Case Notes and PowerPoint presentations to summarize key take-aways for each case. Tools. Almost every chapter will offer a “Strategy Tool” to teach students how to apply a theory, framework, or concept. Students will feel like they have learned how to do something—actually conduct analysis that will help with strategic decisions. Some of these tools are used in Fortune 500 companies and in strategy consulting firms such as Bain, BCG, and McKinsey when they do strategy analysis for clients. For example, the book shows the student how to assess the attractiveness of an industry, how to calculate and use scale or experience curve, how to create a net promoter score to assess whether a differentiation strategy is working, and how to decide whether to “make” versus “buy.” Many of the end-of-chapter cases integrate the strategy tool into the case so you can easily have students apply the tool as they analyze the case. Our students tell us that these tools help them feel that they are acquiring useful analytical skills to help them in making strategic decisions. We think the combination of well-conceived and executed Text, Animated Executive Summary Videos, Cases, and Tools can dramatically improve student satisfaction with your strategy course. Indeed, a random sample of strategy professors who reviewed our text book preferred it over their current textbooks by almost 4:1. That’s a pretty powerful endorsement. So, does the world need another strategy text? We answer “yes,” and we offer one that provides students with a well-designed, engaging, and learning-rich combination of TACT: Text, Animated Executive Summary Videos, Cases, and Tools. We’ve also found that when our students enjoy their courses, we enjoy teaching much more.

What’s New in Edition 3? When you open the book, you’ll see much that’s new, from new color schemes to layouts. There’s more that’s new, however, than just cosmetics; we’ve taken time to respond to feedback from users of the first edition, sharpened our ties to the overarching framework of our book, and provided new updates and cases. Let’s look at each of these in turn: User Feedback. While we continue to get rave reviews for the second edition, we also received some very insightful critique. We’ve heard feedback that some of our models don’t mesh well with other readings strategy faculty use. As a result, we’ve updated Chapter 3 to eliminate confusion around the company diamond model and the strategy diamond many faculty use. We’ve continued to polish the Strategy and Your Career sidebars, and we created a set of videos in WileyPLUS with the authors answering frequently asked questions about strategy careers. Sharper Focus. We approach strategy—the search for competitive advantage—as the answer to four critical questions: Where should we compete? Why do we win with customers? How do we deliver unique value to win with customers? How will we win over time, or sustain our competitive advantage? Several chapters now include a

PREFACE

specific section that details new thinking about the answers to these four questions. For example, we explore the idea that “where you compete” is less at the industry level and more at the “job-to-be-done” level. We also discuss new thinking that suggests unique value is less about cost versus differentiation and more about cost and differentiation—meaning that companies are increasingly offering differentiated products at a lower price. We have created five new video animations that instructors can use to illustrate this new thinking in a way that is easy for students to understand. New Content and Cases. We’ve updated a number of chapter opening vignettes. In Chapter  9, for example, we replaced Lincoln Electric with Huawei, the Chinese telecom giant that has expanded into making smartphones to compete directly with Apple and Samsung around the globe. In Chapter 10, we now introduce the chapter content with a case on “voice wars,” highlighting the emerging battle between personal digital voice assistants like Alexa, Google, and Siri. In the third edition, we’ve updated a number of existing cases in our library and have added cases on Facebook and the 2016 election, ESPN, EcoLab and Vivint Smart Home. We continue to write new cases in between each edition to keep the companies fresh and give instructors new material. Similar to our case library, our animation library will continue to grow. You’ll soon see new “tool” animations on how to solve a business problem and how to present a business solution. If you are a current user of our book, let us say “Thank You!” for your support and your wonderful feedback. If you are thinking about adopting our text, we’d encourage you to give our total offering (text, animations, cases, PowerPoints, tools) a very serious look. This edition keeps all that was great about the first edition—an approachable text that helps students understand and use real-world strategy tools to supplement strategy models—and builds on those strengths to offer a text that better meets your needs, emphasizes a simple framework to help students see an overarching vision of strategy, and content that builds on the latest and greatest strategic moves by companies.

Instructor Resources Companion Website. The Strategic Management Website at http://www.wiley.com/ college/dyer contains myriad tools and links to aid both teaching and learning, including resources listed here. Teaching Notes. The Teaching Notes offer helpful teaching ideas. They offer chapterby-chapter text highlights, learning objectives, chapter outlines, and answers to endof-chapter material. Case Notes. Written for each case presented with Strategic Management, each Case Note includes a brief case summary, learning objectives for the instructor, learning outcomes for the students, and a brief teaching plan with questions and answers. In addition, we’ve provided a matrix showing alternative teaching approaches for each case. Test Bank. This comprehensive Test Bank contains over 100 questions per chapter. The multiple-choice, fill-in, and short-essay questions vary in degree of difficulty. All questions are tagged with learning objectives, Bloom’s Taxonomy categories, and AACSB Standards. The Computerized Test Bank allows instructors to modify and add questions to the master bank and to customize their exams. In addition, a Respondus Test Bank is available for use with learning management systems. PowerPoint Presentation Slides. This robust set of slides for chapters and cases can be accessed on the instructor companion site. Lecture notes accompany most slides. A set of slides without lecture notes is available on the student companion site. Practical Application Guide. This brief manual, authored by Sheri B. Schulte, University of Akron, provides an introduction to a “flipped classroom” approach of teaching

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Strategic Management. It contains practical exercises linking to key topics throughout the text. Each exercise is accompanied by facilitator’s instructions, questions for classroom discussion and follow up, and suggested answers.

WileyPLUS WileyPLUS is a research-based online environment for effective teaching and learning. WileyPLUS builds students’ confidence because it takes the guess-work out of studying by providing students with a clear roadmap: what to do, how to do it, if they did it right. Students will take more initiative so you’ll have greater impact on their achievement in the classroom and beyond.

WileyPLUS for Instructors WileyPLUS enables you to: • Assign automatically graded homework, practice, and quizzes from the chapters, cases, animations, and test bank. • Track your students’ progress in an instructor’s grade book. • Access all teaching and learning resources, including an online version of the text, and student and instructor supplements, in one easy-to-use website. These include animated executive summary videos, additional cases, teaching notes, and full-color PowerPoint slides. • Create class presentations using Wiley-provided resources, with the ability to customize and add your own materials.

WileyPLUS for Students In WileyPLUS, students will find various helpful tools, such as an ebook, animations, videos, additional cases, a virtual Career Center, and flashcards.

Acknowledgements Writing a book is a daunting task, and we’ve had much help in this process. We thank our colleagues in the Academy for years of interactions too numerous to mention, but each of which enlarged our view and clarified our understanding of how to teach strategy most effectively. Thanks to our colleagues and our students at BYU and the Wharton School for their excellent feedback on drafts of our book. Their insightful comments on the text, animations, cases, and tools brought gaps and holes to light that we would have missed. Thank you to James Aida, Preston Alder, David Benson, Jared Brand, Tyler Cornaby, Caleb Flint, Mark Hansen, Michael Hendron, Bryson Hilton, Chad Howland, Benjamin King, David Kryscynski, Jake Lundin, Christian Mealey, Matthew Moen, Kyle Nelson, Lee Perry, Erin Pew, Zachary Sumner, David Thornblad, Joseph Woodbury, and Bryant Woolsey for their research and assistance writing the cases. And, thank you to Sheri Schulte for contributing the Practical Application Guide. We gratefully acknowledge the advice, cooperation, wisdom, and work of the team at John Wiley who shepherded this book from its inception to its publication. Executive Editor Lisé Johnson, Product Designer Wendy Ashenberg, and Senior Marketing Manager Anita Osborn have all taught us about the process of bringing such a massive undertaking to fruition. Their professionalism has enriched the content of the book and our own lives, and their patience with us as we moved through the process has been inspiring. In addition, we’d like to thank the remainder of the team at Wiley: Thomas Nery, Elena Sacarro, Dorothy Sinclair, and Cecilia Morales. Finally, we’d like to thank the numerous reviewers who have contributed valuable time and incredible feedback:

Reviewers A D Amar, Seton Hall University Al Lovvorn, The Citadel Amad Hassan, Morehead State University Amit Shah, Frostburg State University Barry VanderKelen, California Polytechnic State University, San Luis Obispo Brian Boyd, Arizona State University Brian Connelly, Auburn University Carla Jones, Sam Houston State University Charles Wainwright, Belmont University Chip Baumgardner, Penn College Christopher Penney, Mississippi State University Dali Ma, Drexel University Daniel Marrone, Farmingdale State College David Boss, Ohio University David Hover, San Jose State University Dean Frost, Bemidji State University Don Okhomina, Fayetteville State University Don Stull, Texas Tech University Donna Galla, American Military University Edward Ward, St. Cloud State University

George Puia, Saginaw Valley State University Ghoreishi Minoo, Millersville University Herve Queneau, Brooklyn College Hugh O’Neill, University of North Carolina Ismatilla Mardanov, Southeast Missouri State University James Fiet, University of Louisville James Spina, University of Maryland Jamie Collins, Sam Houston State University Jeff Gutenberg, Geneseo, The State University of New York John Guarino, Averett University John Keifer, Ohio University John Lipinski, Middle Tennessee State University John Morris, Oregon State University John Walker, Iowa State University Jorge Walter, Portland State University Joseph Goldman, University of Minnesota Joshua Aaron, East Carolina University Joy Karriker, East Carolina University Kalyan Chakravarty, California State University, Northridge Kimberly Goudy, Central Ohio Technical College Konghee Kim, St. Cloud State University Kristal Davison, University of Mississippi Kristin Backhaus, SUNY New Paltz xiii

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Linda Edelman, Bentley University Lucas Hopkins, Middle Georgia State University Luke Cashen, Nicholls State University M. Nesij Huvaj, University of Connecticut Melissa Waite, Brockport, The State University of New York Meredith Downes, Illinois State University Michael Hennelly, West Point Michael McDermott, Northern Kentucky University Mike Montalbano, Bentley University Mitchell Adrian, McNeese State University Patricia Norman, Baylor University Paula Weber, St. Cloud State University Peter Pinto, Bowling Green University Quentin Fleming, University of South Carolina Ram Subramanian, Stetson University Richard Kernochan, California State University, Northridge Roman Nowacki, Northern Illinois University Tatiana Manilova, Bentley University Tim Holcomb, Florida State University Timothy Gubler, University of California, Riverside Uma Gupta, Buffalo State, The State University of New York William Forster, Lehigh University William Hayden, SUNY Buffalo William Norton, Georgia Southern University Yanli Zhang, Montclair State University Focus Group Participants Mitchell Adrian, McNeese State University Frances Amatucci, Slippery Rock University of Pennsylvania Elsa Anaya, Palo Alto Community College Bindu Arya, University of Missouri, St Louis Koren Borges, University of North Florida Kalyan Chakravarty, California State University, Northridge Larry Chasteen, University of Texas, Dallas William Forster, Lehigh University Dean Frost, Bemidji State University Anne Fuller, California State University, Sacramento Donna Galla, American Military University Lucas Hopkins, Middle Georgia State University Dawn Keig, Brenau University Vance Lewis, University of Texas, Dallas Sali Li, University of South Carolina John Lipinski, Middle Tennessee State University Cindy Liu, Cal State Polytechnic University Daniel Marrone, Farmingdale State College Don Okhomina, Fayetteville State University Michael Provitera, Barry University Herve Queneau, Brooklyn College Timothy Rogers, Ozarks Tech Community College Veronica Rosas-Tatum, Palo Alto Community College Mark Ryan, Hawkeye Community College Stephen Takach, University of Texas, San Antonio Beverly Tyler, North Carolina State University Edward Ward, St. Cloud State University James Weber, St. Cloud State University Carol Young, Metropolitan State University

Wiley Technology Summit Participants Lakami Baker, Auburn University Brent Beal, University of Texas, Tyler Larry Chasteen, University of Texas, Dallas Dean Frost, Bemidji State University Stephen Hallam, University of Akron David King, Iowa State University Donald Kopka, Towson University Marie Milena Loubeau, Miami Dade College Don Okhomina, Fayetteville State University Thomas Shirley, San Jose State University Thomas Swartwood, Drake University Class Testers Mitchell Adrian, McNeese State University Rajshree Agarwal, University of Maryland, College Park Francis Amatucci, Slippery Rock University Jeff Bailey, University of Idaho Lakami Baker, Auburn University Chip Baumgardner, Penn College Brent Beal, University of Texas, Tyler Gregory Blundell, Kent State University, Kent John Buttermore, Slippery Rock University McKay Christensen, Brigham Young University Daniel Connors, Providence College Dean Frost, Bemidji State University James Glasglow, Villanova University David Gras, Texas Christian University John Guarino, Averett University Uma Gupta, Buffalo State University Stephen Hallam, University of Akron John Hopkins, Clemson University Paul Hudec, Wisconsin School of Engineering David King, Iowa State University Donald Kopka, Towson State University David Kryscynski, Brigham Young University Martin Lewison, Farmingdale State College George Mason, Providence College Stuart Napshin, Kennesaw State University Scott Newbert, Villanova University Roman Nowacki, Northern Illinois University Don Okhomina, Fayetteville State University Paulo Prochno, University of Maryland, College Park Rhonda Rhodes, Cal Poly Pomona William Ritchie, James Madison University Douglas Sanford, Towson University Ben Shaffer, University of Wisconsin, Milwaukee Lois Shelton, California State University, Northridge Thomas Shirley, San Jose State University Richard Smith, Iowa State University Roger Strickland, Santa Fe College Thomas Swartwood, Drake University Ram Subramanian, Montclair State University Xiwei Yi, University of Houston, Downtown Yuping Zeng, Southern Illinois University, Edwardsville

ACKN OW LE D G EMEN TS

Student Focus Group Participants Rachel Abel, Auburn University William Annan, Villanova University Andrea Arbon, Brigham Young University Vincent Arrington, McNeese State University Brian Basili, Villanova University Kelly Becker, Clemson University Cody Brackett, Iowa State University Doreen Compher, The University of Akron Lincoln Eppard, Iowa State University Laura Eppley, Kent State University Hannah Gay, University Wisconsin, Milwaukee Yuliya Gitman, Drake University Laura Jones, University of Texas at Tyler Daniel Larsen, Iowa State University Tyler Look, Auburn University Miranda Matuke, Bemidji State University

Michael Minocchi, Kent State University Monica Ghadiyaram, Virginia Tech Moriah Mitsuda, Brigham Young University Ashley Mueller, University Wisconsin, Milwaukee Rebeka Perkins, Santa Fe College Zaineb Sehgal, University of Texas at Tyler Bryttan Thompson, Iowa State University Mythy Tran, Santa Fe College Taylor VanDevender, McNeese State University Corrie VanDyke, Clemson University Kelsey Vetter, Iowa State University Christopher Wahl, Drake University Courtney Weiner, Towson University Stew Williamson, Brigham Young University Sarah Wright, The University of Akron Lynn Wu, Virginia Tech

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Brief Contents vii

CA S E 03B

ESPN in 2019: A Network in Search of a Solution C-37

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CA S E 04

Southwest Airlines: Flying High with Low Costs C-41

CA S E 05

Harley-Davidson: Growth Challenges Ahead C-56

CA S E 06

Ecolab and the Nalco Acquisition: Sustainable Advantage Through Shared Values C-68

CA S E 07

Nike: Sourcing and Strategy in Athletic Footwear C-78

CA S E 08

AT&T and Apple: A Strategic Alliance C-87

CA S E 09

Samsung: Overtaking Philips, Panasonic, and Sony as the Leader in the Consumer Electronics Industry C-100

CA S E 10

Tesla Motors: Disrupting the Auto Industry? C-114

11 Competitive Strategy and Sustainability 194

CA S E 11

Smartphone Wars in 2013

12

Implementing Strategy 215

CA S E 12

13

Corporate Governance and Ethics 233

Lincoln Electric: Aligning for Global Growth C-137

14

Strategy and Society 249

CA S E 13

ICARUS Revisited: The Rise and Fall of Valeant Pharmaceuticals C-145

CA S E 14

Safe Water Network: Mastering the Model at Dzemeni C-156

ABOUT THE AUTHORS PREFACE

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ACKNOWLEDGEMENTS

1

What Is Business Strategy? 1

2

Analysis of the External Environment: Opportunities and Threats 17

3

Internal Analysis: Strengths, Weaknesses, and Competitive Advantage 44

4

Cost Advantage 61

5

Differentiation Advantage 79

6

Corporate Strategy 98

7

Vertical Integration and Outsourcing 117

8

Strategic Alliances 133

9

International Strategy 152

10

Innovative Strategies That Change the Nature of Competition 177

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GLOSSARY INDEX

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C-124

C AS E 01

Walmart Stores: Gaining and Sustaining a Competitive Advantage C-1

CA S E 15

Facebook at a Crossroads: Russian Interference in the 2016 Election C-169

C AS E 02

Coca-Cola and Pepsi: The Shifting Landscape of the Carbonated Soft Drink Industry C-12

CA S E 16

CVS in 2015: From Neighborhood Pharmacy Provider to Healthcare Company C-182

C AS E 03A

ESPN in 2015: Continued Dominance in Sports Television? C-25

CA S E 17

Uber Technologies Inc. C-192

ADDITIONAL CASES CAN BE FOUND IN WILEYPLUS

Contents ABOUT THE AUTHORS PREFACE

vii

ix

ACKNOWLEDGEMENTS

xiii

1 What Is Business Strategy?

1

What Is Business Strategy? 2 Competitive Advantage 3 The Strategic Management Process 4 What Information and Analysis Guides Strategy Formulation? 7 Mission 8 External Analysis 8 Internal Analysis 9 How Are Strategies Formulated? 10 Strategy Vehicles for Achieving Strategic Objectives 10 Strategy Implementation 11 Who Is Responsible for Business Strategy? 12 Who Benefits from a Good Business Strategy? 13 Summary 14 Key Terms 14 Review Questions 15 Application Exercises 15 References 15

2 Analysis of the External

Environment: Opportunities and Threats 17

Determining the Right Landscape: Defining a Firm’s Industry 19 Five Forces that Shape Average Profitability Within Industries 21 Rivalry: Competition Among Established Companies 21 Buyer Power: Bargaining Power and Price Sensitivity 24 Supplier Bargaining Power 25 Threat of New Entrants 26 Threat of Substitute Products 28 Overall Industry Attractiveness 29 Where Should We Compete? New Thinking About the Five Forces and Industry Attractiveness 30 How the General Environment Shapes Firm and Industry Profitability 31

Complementary Products or Services 33 Technological Change 33 General Economic Conditions 34 Demographic Forces 35 Ecological/Natural Environment 35 Global Forces 36 Political, Legal, and Regulatory Forces 36 Social/Cultural Forces 36 Summary 37 Key Terms 37 Review Questions 37 Application Exercises 38 Strategy Tool 38 References 42

3 Internal Analysis: Strengths,

Weaknesses, and Competitive Advantage 44

The Value Chain 46 The Resource-Based View 47 Resources 47 Capabilities 47 Priorities 49 Creating a Sustainable Competitive Advantage: The VRIO Model of Sustainability 49 Value 50 Rarity 50 Inimitability 50 Organized to Exploit 53 Assessing Competitive Advantage with VRIO 53 The Competitive Advantage Pyramid: A Tool for Assessing Competitive Advantage 54 Gathering Data for the Competitive Advantage Pyramid Analysis 55 Using the Competitive Advantage Pyramid 56 Summary 58 Key Terms 58 Review Questions 58 Application Exercises 59 References 59

4 Cost Advantage

61

Economies of Scale and Scope 63 Ability to Spread Fixed Costs of Production 63 Ability to Spread Nonproduction Costs 63

xviii

CON TENTS

Specialization of Machines and Equipment 64 Specialization of Tasks and People 64 Evaluating Economies of Scale: The Scale Curve 65 Economies of Scope 66 Learning and Experience 67 The Learning Curve 67 The Experience Curve 67 Experience Curves and Market Share 69 How Strategists Use the Scale and Experience Curves to Make Decisions 70 Proprietary Knowledge 72 Lower Input Costs 72 Bargaining Power over Suppliers 72 Cooperation with Suppliers 73 Location Advantages 73 Preferred Access to Inputs 74 Different Business Model or Value Chain 74 Eliminating Steps in the Value Chain 74 Performing Completely New Activities 74 Revisiting Tata 75 Summary 75 Key Terms 76 Review Questions 76 Application Exercises 76 Strategy Tool 76 References 77

5 Differentiation Advantage What Is Product Differentiation? 80 Sources of Product Differentiation 81 Different Product/Service Features 81 Quality or Reliability 83 Convenience 83 Brand Image 85 How to Find Sources of Product Differentiation 85 Customer Segmentation 85 Mapping the Consumption Chain 88 Building the Resources and Capabilities to Differentiate 91 New Thinking: Achieving Low Cost and Differentiation 92 Assessing Differentiation Performance 93 Strategy in Your Career: What Is Your Unique Value? 94 Summary 94 Key Terms 95 Review Questions 95 Application Exercises 95 Strategy Tool 95 References 96

79

6 Corporate Strategy

98

Corporate Versus Business Unit Strategy 99 Creating Value Through Diversification 100 Levels of Diversification 100 Value Creation: Exploit and Expand Resources and Capabilities 101 The Eight Ss 102 Destroying Value Through Diversification 106 Methods of Diversification 108 The Acquisition and Integration Process 109 Making the Acquisition 109 Integrating the Target 109 Summary 113 Key Terms 114 Review Questions 114 Application Exercises 114 References 115

7 Vertical Integration and Outsourcing

117

What Is Vertical Integration? 118 The Value Chain 119 Forward Integration and Backward Integration 119 Three Key Reasons to Vertically Integrate Capabilities 120 Coordination 121 Control 123 Dangers of Vertical Integration 124 Loss of Flexibility 124 Loss of Focus 125 Advantages of Outsourcing 126 Dangers of Outsourcing 128 Summary 129 Key Terms 129 Review Questions 129 Application Exercises 130 Strategy Tool 130 References 131

8 Strategic Alliances

133

What Is a Strategic Alliance? 134 Choosing an Alliance 135 Types of Alliances 137 Nonequity or Contractual Alliance 137 Equity Alliance 138 Joint Venture 138 Vertical and Horizontal Alliances 138

120

CONTENTS

Ways to Create Value in Alliances 140 Combine Unique Resources 140 Pool Similar Resources 141 Create New, Alliance-Specific Resources 142 Lower Transaction Costs 142 The Risks of Alliances 143 Hold-Up 143 Misrepresentation 143 Building Trust to Lower the Risks of Alliances 143 Building an Alliance Management Capability 146 Improves Knowledge Management 146 Increases External Visibility 146 Provides Internal Coordination 147 Facilitates Intervention and Accountability 147 Summary 148 Key Terms 148 Review Questions 148 Application Exercises 149 Strategy Tool 149 References 150

9 International Strategy

152

The Globalization of Business 153 Why Firms Expand Internationally 155 Growth 155 Efficiency 156 Managing Risk 157 Knowledge 157 Responding to Customers or Competitors 158 Where Firms Should Expand 158 Cultural Distance 159 Administrative Distance 160 Geographic Distance 161 Economic Distance 161 How Firms Compete Internationally 162 Multidomestic Strategy—Adapt to Fit the Local Market 163 Global Strategy—Aggregate and Standardize to Gain Economies of Scale 165 Arbitrage Strategy 166 Combining International Strategies 167 How a Firm Gets into a Country: Modes of Entry 168 Exporting 168 Licensing and Franchising 168 Alliances and Joint Ventures 169 Wholly Owned Subsidiaries 170 Choosing a Mode of Entry 171 Summary 171 Key Terms 172 Review Questions 172 Application Exercises 172

xix

Strategy Tool 173 References 174

10 Innovative Strategies That Change the Nature of Competition

177

What Is an Innovative Strategy? 178 Incremental Versus Radical Innovation 179 Categories of Innovative Strategies 181 Reconfiguring the Value Chain to Eliminate Activities (Disintermediation) 181 Low-End Disruptive Innovations 182 High-End/Top-Down Disruptive Innovations 184 Reconfiguring the Value Chain to Allow for Mass Customization 185 Blue Ocean Strategy—Creating New Markets by Targeting Nonconsumers 185 Create a Platform to Coordinate and Share Private Assets 186 Free Business/Revenue Models 187 Hypercompetition: The Accelerating Pace of Innovation 189 Innovation and the Product/Business/Industry Life Cycle (S-Curve) 190 Introduction Stage 190 Growth Stage 190 Maturity Stage 191 Decline Stage 191 Summary 192 Key Terms 192 Review Questions 192 Application Exercises 192 References 193

11 Competitive Strategy and Sustainability

194

Understanding the Competitive Landscape 195 Strategic Groups and Mobility Barriers 195 Strategy Canvas 197 Evaluating the Competition 199 What Drives the Competitor? 200 What Is the Competitor Doing or Capable of Doing? 200 How Will a Competitor Respond to Specific Moves? 200 Using Game Theory to Evaluate Specific Moves 201 Principles of Competitive Strategy 205 Know Your Strengths and Weaknesses 205 Bring Strength Against Weakness 205 Protect and Neutralize Vulnerabilities 205 Develop Strategies That Cannot Be Easily Copied 206

xx CON TE N TS

14 Strategy and Society

Competitive Actions for Different Market Environments 206 Competition Under Monopoly 206 Competition Under Oligopoly 207 “Perfect” Competition 208 Dynamic Environments 210 Sustaining Competitive Advantage 210 Summary 212 Key Terms 212 Review Questions 212 Application Exercises 213 Strategy Tool 213 References 213

12 Implementing Strategy

215

Alignment: The 7 S Model 217 Strategy 217 Structure 217 Systems 219 Staffing 219 Skills 219 Style 220 Shared Values 220 Strategic Change 222 The Three Phases of Change 223 The Eight Steps to Successful Change 224 Measurement 227 Line of Sight 227 Summary 230 Key Terms 230 Review Questions 230 Application Exercises 231 References 231

13 Corporate Governance and Ethics

Strategy and Social-Value Organizations 250 The Tools of Strategy and the Creation of Social Value 251 External Analysis and the Value Net 251 Internal Analysis: Resources and Capabilities 253 Cost Leadership, Differentiation, and Innovative Strategies 253 Corporate Strategy and Alliances 254 Implementation and Governance 254 Strategy and Social Change 255 Corporate Social Responsibility (CSR) 255 CSR and Firm Performance 256 Social Entrepreneurship 256 Types of Social Entrepreneurship 257 Skills of Social Entrepreneurs 258 Challenges in Social Entrepreneurship 259 Summary 261 Key Terms 261 Review Questions 261 Application Exercises 261 References 262 264

GLOSSARY INDEX

269

CA S E 01

Walmart Stores: Gaining and Sustaining a Competitive Advantage C-1

CA S E 02

Coca-Cola and Pepsi: The Shifting Landscape of the Carbonated Soft Drink Industry C-12

CA S E 03A

ESPN in 2015: Continued Dominance in Sports Television? C-25

CA S E 03B

ESPN in 2019: A Network in Search of a Solution C-37

CA S E 04

Southwest Airlines: Flying High with Low Costs C-41

CA S E 05

Harley-Davidson: Growth Challenges Ahead C-56

CA S E 06

Ecolab and the Nalco Acquisition: Sustainable Advantage Through Shared Values C-68

233

The Purposes of the Corporation 234 The Shareholder Primacy Model 235 The Stakeholder Model 236 Governance: Boards and Incentives 238 The Board of Directors 239 Compensation and Incentives 240 Corporate Ethics 241 Corporate Culture and Ethics 243 Creating an Ethical Climate 244 Summary 246 Key Terms 246 Review Questions 246 Application Exercises 247 References 247

249

CONTENTS

xxi

C ASE 07

Nike: Sourcing and Strategy in Athletic Footwear C-78

CA S E 13

ICARUS Revisited: The Rise and Fall of Valeant Pharmaceuticals C-145

C AS E 08

AT&T and Apple: A Strategic Alliance C-87

CA S E 14

Safe Water Network: Mastering the Model at Dzemeni C-156

C AS E 09

Samsung: Overtaking Philips, Panasonic, and Sony as the Leader in the Consumer Electronics Industry C-100

CA S E 15

Facebook at a Crossroads: Russian Interference in the 2016 Election C-169

CA S E 16

CVS in 2015: From Neighborhood Pharmacy Provider to Healthcare Company C-182

CA S E 17

Uber Technologies Inc. C-192

C AS E 10

Tesla Motors: Disrupting the Auto Industry? C-114

C AS E 11

Smartphone Wars in 2013

C AS E 12

Lincoln Electric: Aligning for Global Growth C-137

C-124

ADDITIONAL CASES CAN BE FOUND IN WILEYPLUS

CHAPTER 1 What Is Business Strategy? LEARNING OBJECTIVES Studying this chapter should provide you with the knowledge to: 1. Define business strategy, including the importance of competitive advantage, the four choices that are critical to strategy formulation, and the strategic management process.

3. Discuss how strategies are formulated and implemented in order to achieve objectives. 4. Explain who is responsible for, and who benefits from, good business strategy.

2. Summarize the information that the company’s mission and thorough external and internal analysis provide to guide strategy.

STANCA SANDA/Alamy Stock Photo

Strategy at Apple

In 2000, Apple Computer held a loyal customer base but was limping along as a relatively minor player in the personal computer market. Launched by Steve Jobs and Steve Wozniak, Apple was one of the pioneers in the industry. Unlike other PC makers that relied on Microsoft’s operating system and application software, Apple wrote its own operating system software and much of its application software, which was known as being easy to use. In fact, Apple was the first to introduce software on a low cost personal computer with drop-down menus and a graphical user interface that allowed customers to easily complete a task, such

as dragging a file to the trash to delete it. However, Apple’s investment in unique software led to high-priced computers and created files that were originally incompatible with those of Microsoft’s Windows operating system and Office software suite. As a result, Apple rarely achieved more than about a 5 percent share of the computer market.1 That all changed in 2001, however, when Apple entered an entirely new market with the launch of an MP3 portable music player called the iPod. Apple’s MP3 player was not the first on the market. A company called Rio had offered an MP3 player for a couple of years before iPod’s entry into the market. But iPod quickly took market share from the Rio, for three primary reasons: 1. iPod had a mini hard drive that allowed it to hold 500 songs, as opposed to the roughly 15 songs the Rio could hold using flash memory. 2. iPod was the first to introduce a “fly wheel” navigation button—the round button that was easy to use and allowed users to quickly scroll through menus and songs. 3. iPod was backed with Apple’s name and an innovative design.2 These advantages helped iPod quickly move to industry leadership, despite the fact that an iPod cost 15 to 25 percent more than a Rio.3 At the time the iPod was launched, it was difficult for most consumers to access digital downloads of songs legally. Initially, the iPod was snapped up only by a relatively small group of users, mostly

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teenagers and college students, who were illegally downloading songs through Napster and other free downloading sites. Apple recognized that to grow the market for iPods, it needed to help consumers legally access songs to play on their iPods. As a result, Apple developed software called iTunes, allowing customers to legally download songs. One main reason iTunes was able to provide legal downloads before its competitors was because Steve Jobs, as CEO of both Apple and Pixar (the animation movie production company), understood that music companies, like movie companies, were concerned about people pirating their products. So Apple worked with the music companies to sell songs that had been digitized using software that prevented customers from copying the songs to more than a few computers. iTunes was designed to be easy to use with the iPod. Customers now could easily and legally access songs simply by connecting their iPods to their computers and letting the software do the rest. Even a technologychallenged grandparent could do it.4 But Apple wasn’t done with its music player strategy. Apple’s experience in the computer business was that other companies could make similar products, often at lower prices. Indeed, while Apple and IBM were the pioneers of the personal computer industry and dominated it during the early years, lower-priced competitors such as Dell, Hewlett-Packard, Lenovo, and ASUS eventually came to dominate the market. Apple realized it needed to prevent easy imitation of its

business strategy A plan to achieve competitive advantage that involves making four inter-related strategic choices: (1) markets to compete in; (2) unique value the firm will offer in those markets; (3) the resources and capabilities required to offer that unique value better than competitors; and (4) ways to sustain the advantage by preventing imitation. competitive advantage When a firm generates consistently higher profits compared to its competitors. market The industry, customer segment, or geographic area that a company competes in. unique value The reason a firm wins with customers or the value proposition it offers to customers, such as a low cost advantage or differentiation advantage or both.

music offering. So it created proprietary software called Fairplay that restricted the use of music downloaded from iTunes to iPods only. That meant consumers couldn’t buy a lower-priced MP3 player and use it with iTunes because it was incompatible. If they wanted to use a different MP3 player, they would have to download and pay for music a second time.5 Now Apple has bundled an MP3 player into the iPhone, which makes it move convenient for customers because they don’t have to carry two devices. To top it off, Apple did something that no other maker of computers, music players, or any other electronic device company had done. It opened its own stores to sell Apple products. This required that Apple learn how to operate retail stores. The Apple Stores helped Apple create a direct link to its customers, making it easier for consumers to learn about and try out Apple products—and get their products serviced. As a result of Apple’s strategic initiatives, it has built a very secure market position in music players, currently holding over 70 percent of that market.6 But the battle isn’t over. Amazon has entered the industry, offering music buyers unrestricted use of its songs with a subscription to Amazon Music Unlimited. Moreover, other competitors offering music via subscription include eMusic, Pandora.com, and Spotify. Users can listen to any song they want for a small monthly subscription fee. The $17 billion music industry is so large that it will continue to attract new competitors who want to dethrone Apple.

How did Apple enter the music industry and within 10 years become the dominant seller of both songs and music players? How did Pandora, a start-up, succeed in the music industry while former giant Sony (maker of the Walkman and Discman) struggled? For that matter, why is any company successful? Understanding the series of actions taken by Apple to achieve a dominant position in the online music business will go a long way toward understanding business strategy—a company’s dynamic plan to gain, and sustain, competitive advantage in its markets. In this chapter, we’ll help you get started by answering some basic questions. We begin with the most obvious: “What is a business strategy?”

What Is Business Strategy? The word strategy comes from the Greek word strategos, meaning, “the art of the general.” In other words, the origin of strategy comes from the art of war, and, specifically, the role of a general in a war. In fact, there is a famous treatise titled The Art of War that is said to have been authored by Sun Tzu, a legendary Chinese general. In the art of war, the goal is to win—but that is not the strategy. Can you imagine the great general Hannibal saying something like, “Our strategy is to beat Rome!” No, Hannibal’s goal was to defeat Rome. His strategy was to bring hidden strengths against the weaknesses of his enemy at the point of attack—which he did when he crossed the Alps to attack in a way that his enemies did not believe he could. He achieved an advantage through his strategy. In similar fashion, a company’s business strategy is defined as a company’s dynamic plan to gain and sustain competitive advantage in the marketplace. This plan is based on the theory its leaders have about how to succeed in a particular market. This theory involves predictions about which markets are attractive and how a company can offer unique value to customers in those markets in a way that won’t be easily imitated by competitors. This theory then gets translated into a plan to gain competitive advantage. This plan must be dynamic to

What Is Business Strategy?

3

respond to new information that comes as customers, competitors, and technologies change. Apple’s theory of how to gain a competitive advantage in the music download business was to create cool and easy-to-use MP3 players and smartphones that could easily—and legally— download digital songs from a computer through the iTunes store. Apple sought to sustain its advantage by making it difficult for competitor MP3 players or phones to download songs from the iTunes store. The Apple Stores contributed to Apple’s advantage by providing a direct physical link to customers that competitors couldn’t match. In this particular instance, Apple’s plan to gain, and sustain, competitive advantage worked. But there have been other times, such as with the Apple Newton Message Pad (the first handheld computer that Apple sold as a personal digital assistant), that Apple’s approach to gaining and sustaining competitive advantage did not work. Sometimes strategies are successful and sometimes they are not. Strategies are more likely to be successful when the plan explicitly takes into account four factors: 1. Where to compete, or the attractiveness of a market or customer segment in the targeted markets 2. How to offer unique value relative to the competition in the targeted markets 3. What resources or capabilities are necessary to deliver that unique value 4. How to sustain a competitive advantage once it has been achieved The goal of the strategic plan is to create competitive advantage. First, let’s examine the goal.

Competitive Advantage What exactly do we mean when we use the term competitive advantage?7 In the sports world, it is usually obvious when a team has a competitive advantage over another team: The better team wins the game by having a higher score. The ability to consistently win is based on attracting and developing better players and coaches, and by employing strategies to exploit the weaknesses of opponents. In the business world, the scoring is measured by looking at the profits (as a percentage of invested capital) generated by each firm. We describe the most common ways of measuring profits in Strategy in Practice: Measuring American Home Products’ Competitive Advantage. Just as in sports, where an inferior team may outscore a superior team on a given day, it may be possible for an inferior company to outscore a superior company in a particular quarter, or perhaps even a year. Competitive advantage requires that a firm consistently outperform its rivals in generating above-average profits. A firm has a competitive advantage when it can consistently generate above-average profits through a strategy that competitors are unable to imitate or find too costly to imitate. Above-average profits are profit returns in excess of what an investor expects from other investments with a similar amount of risk. Risk is an investor’s uncertainty about the profits or losses that will result from a particular investment. For example, investors suffer a lot of uncertainty (and, hence, risk) when they put their money into a start-up company that is trying to launch products based on a new technology, such as a solar power company. There is much less risk in investing in a stable firm with a long history of profitability, such as a utility company that supplies power to customers who have few, if any, alternative sources of power.9 Many organizations work to achieve objectives other than profit. For example, universities, many hospitals, government agencies, not-for-profit organizations, and social entrepreneurs play important roles in making our economy work and our society a better place to live. These organizations do not measure their success in terms of profit rates, but they still use many of the tools of strategic management to help them succeed (see Chapter 14). For these organizations, success might be measured using tangible outcomes such as the number of degrees granted, patient health and satisfaction measures, people served, or some other measure of an improved society. The primary source of a company’s competitive advantage can come from several areas of its operations. For example, the diamond company De Beers has an advantage that comes from paying lower costs for its diamonds than other companies do, because De Beers owns its own

above-average profits Returns in excess of what an investor expects from other investments with a similar amount of risk.

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Strategy in Practice Measuring American Home Products’ Competitive Advantage To see which firms in an industry are most successful, we typically compare their return on assets (ROA), a calculation of operating profits divided by total assets, or their return on equity (ROE), which is operating profits divided by total stockholders’ equity. The company that consistently generates the highest returns for its investors, in terms of ROA or ROE, wins the game. For example, from 1971 to 2000, the pharmaceutical company American

Home Products averaged 19 percent ROA, compared to competitor American Cyanamid’s 7 percent. American Home Products’ ROA was higher than American Cyanamid’s every year for 30 years. This is evidence that during this time period, American Home Products had a competitive advantage over American Cyanamid.8 American Home Products’ advantage over American Cyanamid has frequently been attributed to its ability to develop more blockbuster drugs (through more effective research and development) and to quickly get those drugs to market through a larger and more effective sales force.

20 18

Operating Profit (ROA %)

16 14 12 10 8 6 4 2

American Cyanamid

Pfizer

Upjohn

Schering Plough

Eli Lilly

Bristol Myers Squibb

Merck

American Home Products

0

Profitability of Different Firms in the Pharmaceutical Industry Source: Annual reports; 1973–1992.

strategic management process The process by which organizations formulate a plan and allocate resources to achieve competitive advantage that involves making four strategic choices: (1) markets to compete in, (2) unique value the firm will offer in those markets, (3) the resources and capabilities required to offer that unique value better than competitors, and (4) ways to sustain the advantage by preventing imitation.

diamond mines. Competitive advantage can also come from different functional areas within the company. Biotechnology pioneer Genentech’s advantage comes primarily from research and development that has produced several blockbuster drugs; Toyota’s advantage in automobiles has come primarily from its manufacturing operations (known as the Toyota Production System); Procter & Gamble’s advantage in household products comes largely from its sales and marketing, and Nordstrom’s advantage as a retailer comes largely from its merchandising and service.

The Strategic Management Process The processes that firms use to develop a strategy can differ dramatically across firms. In some cases, executives do not spend significant time on strategy formulation, and strategies are often based only on recent experience and limited information. However, we propose that a better approach to the formulation of strategy is the strategic management process outlined in Figure 1.1. The strategic management process for formulating and implementing strategy involves thorough external analysis and internal analysis. Only after conducting an analysis of the company’s external environment and its internal resources and capabilities are a firm’s

What Is Business Strategy?

5

Mission

External Analysis

Internal Analysis

• Industry structure • Opportunities/threats [Chapter 2]

• Resources and capabilities • Strengths/weaknesses [Chapter 3]

Strategy Formulation Cost Advantage [Chapter 4]

Differentiation Advantage [Chapter 5]

Corporate Strategy [Chapter 6]

Vertical Integration [Chapter 7]

Strategic Alliances [Chapter 8]

Dynamic Strategic Actions

Disruptive Business Models [Chapter 10]

Competitor Interaction/ Game Theory [Chapter 11]

Business Level Strategies

Strategy Vehicles

International Strategy [Chapter 9]

Strategy Implementation Strategy Implementation [Chapter 12]

FIGURE 1.1

Governance and Ethics [Chapter 13]

Social Value Organizations [Chapter 14]

The Strategic Management Process

executives and managers able to identify the most attractive business opportunities and formulate a strategy for achieving competitive advantage. The central task of the strategy formulation process is specifying the high-level plan and set of actions the company will take in its quest to achieve competitive advantage. After the plan for creating competitive advantage is created, the final step is to develop a detailed plan to effectively implement, or put into action, the firm’s strategy through specific activities. The focus of the strategic management process should be to make four key strategic choices, as shown in Figure 1.2: 1. Which markets will the company pursue? A company’s markets include the high-level industry and specific customer segments in which it competes and its geographic markets. 2. What unique value does the company offer customers in those markets? This is the firm’s value proposition, the reason the company wins with a set of customers.10 3. What resources and capabilities are required? What does the company need to have and know how to do so that it can deliver its unique value better than competitors, and exactly how will the company deliver its unique value through an implementation plan?11 4. How will the company capture value and sustain a competitive advantage over time? Firms need to create barriers to imitation to keep other companies from delivering the same value.

external analysis Examining the forces that influence industry attractiveness, including opportunities and threats that exist in the environment. internal analysis The analysis of a firm’s resources and capabilities (its strength and weaknesses) to assess how effectively the firm is able to deliver the unique value (value proposition) that it hopes to provide to customers.

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FIGURE 1.2

Markets to Pursue

• What industry, customer segment, and geographic markets are most attractive as business arenas?

Unique Value to Offer

• What value proposition will offer unique value relative to competitors in the areas of cost or differentiation or both?

Resources and Capabilities to Develop

• What resources and capabilities are required in order to deliver that unique value better than competitors?

Sustaining Advantage

• How to create barriers to imitation to prevent other companies from offering that same value?

Four Key Strategic Choices in Strategic Management

Markets One of the first decisions a company must make is where to compete or which markets it will serve. Leaders must choose the industries a company competes in and the specific customer segments or needs it will address (the focus of Chapter 2) within those industries. For example, before iPod, Apple competed only in the computer industry. Its product markets included desktop and laptop computers. Launching iPod and iTunes took Apple into the music industry. Later, when Apple launched the iPhone, it entered the cell phone business. Apple targets the high-end customer segments within its industries. Its customers want the latest in technology, see themselves as innovators, appreciate design and elegance, and are not price sensitive. It is also important to select geographic markets to serve. Apple competes on a worldwide basis, which allows it to spread heavy research and development costs across its many geographic markets. By contrast, Walmart started by focusing on rural markets, which allowed it to offer lower prices than the “mom and pop” retail stores in small towns.12 Unique Value cost advantage An advantage that a firm has over its competitors in the activities associated with producing a product or service, thereby allowing it to produce the same product at lower cost.

differentiation strategy An advantage a firm has over its competitors by making a product more attractive by offering unique qualities in the form of features, reliability, and convenience that distinguish it from competing products.

After a company chooses the markets in which to compete, it then attempts to offer unique value in those markets. This is often referred to as a company’s value proposition, or the value that it proposes to offer to customers. Companies typically try to achieve a competitive advantage by choosing between one of two generic strategies for offering unique value: low cost or differentiation. Companies such as Walmart, Ryanair, Taco Bell, and Kia attract customers by being cost leaders, offering products or services that are priced lower than competitor offerings. A firm that chooses a low-cost strategy (the focus of Chapter 4) focuses on reducing its costs below those of its competitors. Key sources of cost advantage include economies of scale, lower-cost inputs, or proprietary production know-how. A firm that chooses a differentiation strategy (the focus of Chapter 5) focuses on offering features, quality, convenience, or image that customers cannot get from competitors. Apple’s unique value is offering iPods (music players), iPhones (smartphones), and iPads (tablets) that are well designed, innovative, easy to use, and have features that competing products don’t have (“there’s an App for that”). In similar fashion, Starbucks wins through differentiation by offering multiple blends of high-quality coffee in convenient locations. The traditional answer to offering unique value is to be either a low-cost (low-price) provider or a differentiator. In fact, strategy professor Michael Porter, whose five forces analysis will be introduced later in this chapter, has cautioned that trying to do both simultaneously

What Information and Analysis Guides Strategy Formulation?

can result in being “stuck in the middle”—meaning that by trying to do both, companies don’t effectively do the job of either low price or differentiation. Increasingly, however, companies are finding ways to deliver on both low cost and differentiation.13 Does Amazon beat brickand-mortar stores because of price or differentiation (e.g., convenience)? Does Uber beat taxis because of price or differentiation (e.g., convenience)? The answer, of course, is both. Some companies have discovered ways to simultaneously offer both low price and a differentiated product—which turns out to be a powerful source of competitive advantage (see “New Thinking: Achieving Both Cost and Differentiation Advantages” at the end of Chapter 5).

Resources and Capabilities Delivering unique value requires developing resources and capabilities (the focus of Chapter 3) that will allow the company to perform activities better than competitors. Indeed, perhaps the most critical role of the strategist is to figure out how to build or acquire the resources and capabilities necessary to deliver unique value. Resources refer to assets that the firm accumulates over time, such as plants, equipment, land, brands, patents, cash, and people. Elon Musk is a key resource for Tesla because his reputation as a successful innovator allows the company to raise the large sums of money Tesla needs for product development at a low price. Capabilities refer to processes (or recipes) the firm develops to coordinate human activity to achieve specific goals. To illustrate, Starbucks has key resources that allow it to succeed through differentiation, including its Starbucks brand, its retail store locations, its recipes to produce different coffee blends, and even some patents to protect those recipes. Its capabilities include its processes to roast coffee beans for the best flavor, create new coffee blends, design stores with great atmosphere, and find optimal store locations. These resources and capabilities have allowed Starbucks to deliver unique value to customers, thereby helping the company outperform other coffee shops within the coffee retailing industry. The development of key resources and capabilities needed to deliver unique value should be part of the company’s strategy implementation plan. The strategy implementation plan involves the company developing a set of processes (capabilities) within each function (e.g., R&D, operations, sales, service, HR, etc.) that align with the unique value the company hopes to offer. For example, because Walmart’s unique value is “low prices,” every function of the company is focused on how it can perform its activities at the lowest possible cost. Strategists also have learned that it is helpful to align the firm’s structure (organization design), staffing (people), skills (capabilities/processes), systems (e.g., information and reward systems), and shared values and style (its culture) with its strategy for offering unique value (implementation is discussed in detail in Chapter 12). Sustaining Advantage

By being the first to offer music downloads through its easyto-use iTunes software, Apple encouraged its customers to store their entire music libraries on iTunes. Designing iTunes so that it wouldn’t easily download songs to other music players helped Apple to prevent competing MP3 players from taking market share from iPod. Of course, Apple’s brand image and its Apple Stores also prevent competitors from easily imitating its products and services. These actions helped Apple capture and sustain the value it created.

What Information and Analysis Guides Strategy Formulation? As Figure 1.1 shows, the earliest steps in the strategic management process involve analyses and choices that later result in the formulation and implementation of a company’s strategy. These choices are made within the context of the company’s mission and only after an analysis of the external environment and internal organization.

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What Is Business Strategy?

Mission mission A company’s primary purpose that often specifies the business or businesses in which the firm intends to compete—or the customers it intends to serve.

A company’s mission outlines the company’s primary purpose and often specifies the business or businesses in which the firm intends to compete—or the customers it intends to serve. People in business often use the terms mission, vision, or purpose somewhat interchangeably. For our purposes in this book, we will use the term mission to refer to the primary purpose of the organization. Most business firms start with a mission, even if it isn’t formally stated. For example, Starbucks founder Howard Schultz got the idea to introduce coffee bars to America when he visited Italy and experienced the great coffee and convenience of Italian espresso bars. His external analysis of the coffee shop industry in the United States led him to believe that there was an opportunity to bring an exceptional coffee experience to America. Schultz once said American coffee was so bad it tasted like “swill.” He discovered café latte when visiting an espresso bar in Verona, Italy, and thought, “I have to take this to America.”14 So he launched Starbucks, a company that offered higher-quality coffee than traditional coffee shops and included many varieties at a premium price. In essence, Starbucks started with a mission to bring high-quality coffee to the masses in the United States. As companies grow and develop formal mission statements, these statements often define the core values that a firm espouses, and are often written to inspire employees to behave in particular ways. Starbucks formalized its mission as follows: Our mission: to nurture and inspire the human spirit—one person, one cup, and one neighborhood at a time.15 It then proceeds with the statement: Here are the principles of how we live that every day— which is followed by a set of principles or values designed to guide employee behaviors. Even after it has been formalized, however, a company’s mission is still open to interpretation, as Strategy in Practice: Apple’s Evolving Mission shows.

External Analysis

SWOT analysis Strategic planning method used to evaluate the strengths, weaknesses, opportunities, and threats involved in a business.

External analysis is critical for addressing the first strategic choice: Where should we compete? External analysis involves (1) an examination of the competition and the forces that shape industry competition and profitability, and (2) customer analysis to understand what customers really want. The combined results of external analysis with internal analysis of the firm are often summarized as a SWOT analysis. SWOT is an acronym for Strengths, Weaknesses, Opportunities, and Threats.16 External analysis is particularly useful for shedding light on the latter two: opportunities and threats.

Industry Analysis One of the central questions for the strategist is to determine which markets or industries to compete in. The fact of the matter is, all industries are not created equal. To illustrate, between 1992 and 2006, the average return on invested capital in US industries ranged from as low as zero to more than 50 percent.17 The most profitable industries include prepackaged software, soft drinks, and pharmaceuticals. These industries are more than five times as profitable as the least profitable industries, which include airlines, hotels, and steel. This does not mean that a steel or airline company cannot be successful or profitable (Southwest Airlines has been quite profitable18), but it does mean that the average profitability of all firms in these industries is low compared to other industries. This makes the challenge of making money in these low-profit industries even greater. Why are some industries more profitable than others? Strategy professor Michael Porter developed a model for conducting industry analysis called the Five Forces that Shape Industry Competition.19 Understanding the five forces that shape industry competition is one of the starting points for developing strategy, and will be discussed in detail in Chapter 2. This framework helps managers think about what the company can do to increase its power over suppliers and buyers, create barriers to other firms looking to enter the market, reduce the threat of substitute products or services, and reduce rivalry with competitors.

What Information and Analysis Guides Strategy Formulation?

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Strategy in Practice Apple’s Evolving Mission When Steve Jobs and Steve Wozniak launched Apple in 1976, their primary purpose was to make great computers that people loved to use. Twenty-four years later, Apple was still essentially a computer company when it launched the iPod, a device that took the company into the music industry. But did you know that Apple was not the first computer company to make a small, handheld MP3 player with a mini-hard drive that could store your entire music library? That honor goes to Compaq (later acquired by HP). Compaq developed an MP3 player before Apple, but the company decided this was not an industry and product market that it wanted to enter. Compaq decided not to pursue the MP3 business because it saw its mission as being a computer maker, and music players fell outside of that mission. Instead of refining the design and launching its MP3 player on the market, Compaq sold the technology to a Korean company. In contrast, Apple decided that this product market was not outside its mission. Apple’s decision was influenced by its external analysis. Apple looked at the multibillion-dollar music business and quickly

realized that no company was offering legal digital downloads—so the market was wide open because of the challenges of protecting the files from easily being copied. Apple’s leaders also considered its internal capabilities. Unlike Compaq—which only made computer hardware but not software—Apple had vast experience at writing software for Apple computers. It also had far greater design expertise than Compaq. In fact, the company had long been hailed for the cutting-edge designs of the iMac and some of its other computers. Apple decided to channel its internal capabilities at writing software to navigate an MP3 player. Apple’s software engineers came up with the innovative “flywheel” design for navigating the iPod. Likewise, it channeled its design capabilities toward designing a product that was elegant and small enough to fit in your pocket. As a result of formulating a strategy to enter the MP3 player market—and subsequently the iPhone, iPad, and Apple Watch— Apple’s mission has broadened. The company no longer focuses on just being a computer maker. In fact, in 2007 it changed its name from Apple Computer Inc. to Apple Inc. to reflect this change in its mission.

Customer Analysis

External analysis also involves an analysis of customers or potential customers, notably an analysis of their needs and price sensitivity. In particular, the strategist can make better decisions about how to offer unique value by considering groups of customers who all have similar needs. This is called customer segmentation analysis.20 For example, in the automobile industry, some customers want cars that are very stylish, powerful, luxurious, and packed with technology and gadgets. These customers are the focus of companies such as Porsche, MercedesBenz, BMW, and Lexus. Others want trucks with the capacity to haul heavy items and move easily over rough terrain. These customers are the focus of the truck divisions of Chevy and Ford. Still others want economy cars for basic transportation—the focus of Hyundai and Kia. External analysis should enlighten managers about the competitive forces that influence the profitability of particular markets and industries, as well as opportunities and threats. In addition, it should shed light on what customers want and what they are willing to pay to have their needs met.

price sensitivity The degree to which the price of a product or service affects consumers’ willingness to purchase the product or service. segmentation analysis Dividing up customers into groups or segments based on similar needs or wants.

Internal Analysis Whereas external analysis focuses on a company’s industry, customers, and competitors, internal analysis focuses on the company itself. Internal analysis completes the SWOT by focusing on strengths and weaknesses. More formally, internal analysis involves an analysis of the company’s set of resources and capabilities that can be deployed—or should be developed—to deliver unique value to customers. We discuss internal analysis in greater detail in Chapter 3. In the 1980s, the resource-based view of the firm, also known as the resource-based model, was developed to explain why some firms outperform other firms within the same industry.21 Why does Nucor make money in the steel business when most of its US competitors do not? Why does Southwest fly high in the air travel business while most of its competitors are (financially) grounded? The resource-based model assumes that each company is a collection of resources and capabilities (also referred to as competencies) that are deployed to deliver unique value.22 Firms that don’t have the resources and capabilities that are necessary to implement the strategies they are contemplating may need to improve, change, or possibly create them in order to offer unique value to their customers. This is where resource allocation becomes an important dimension of strategy. After a company decides how it hopes to offer unique value, it must allocate the resources necessary to build those resources or capabilities. For example,

resource-based review of firm Determining the strategic resources available to a company.

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after Target realized that it could not compete directly on prices with Walmart, it allocated additional resources to move “upmarket.” This involved investing heavily in a trends department, a new mix of higher-quality products, relationships with designers, more expensive suburban retail locations, and significant TV advertising to get the message out to customers.

How Are Strategies Formulated? Formulating a strategy involves selecting which actions the company will take to gain and sustain competitive advantage. Remember, competitive advantage requires that the company do all of the following: • Provide unique value to a set of customers in the appropriate markets. • Develop a set of resources and capabilities that allow the company to deliver that unique value to customers better than competitors. • Sustain the competitive advantage by figuring out how to prevent imitation of the chosen strategy.

corporate strategy Decisions about what markets to compete in, made by executives at the corporate level of an organization. business unit strategy Decisions about how to gain and sustain advantage, made at the manager level for each standalone business unit within a company. functional strategy Decisions about how to effectively implement the business unit strategy within functional areas like finance, product development, operations, information technology, sales and marketing, and customer service.

strategy vehicles Activities and strategic choices—such as make versus buy, acquisitions, and strategic alliances—that influence a firm’s ability to enter particular markets, deliver unique value to customers, or create barriers to imitating its product.

A company will also need to formulate, and then implement, strategy at three different levels of the organization: corporate, business unit (product), and functional. Corporate strategy refers to decisions that are made by senior corporate executives about where to compete in terms of industries and markets. For example, Amazon’s corporate executives made the decision to use its Kindle to enter the electronic reader/tablet business where it would face new competitors such as Apple. Similarly, Amazon’s launch of Amazon Web Services—a business that provides web hosting, cloud storage, and marketplace software—was made at corporate headquarters by the corporate management team. Business unit strategy is made at the level of the strategic business unit—standalone business units in a company that typically have their own profit and loss responsibility. Amazon’s online discount business would be considered one business unit, whereas Kindle and Amazon Web Services would be different business units. The general manager of each business unit addresses the questions we’ve identified regarding how to gain and sustain advantage in that particular market. Finally, within each business unit are different functions such as product development, operations, information technology, sales and marketing, and customer service. A functional strategy should align with the overall business unit strategies to effectively implement the business unit strategy (see Figure 1.3).

Strategy Vehicles for Achieving Strategic Objectives In many instances, firms rely on a few key strategy vehicles to help them enter attractive markets and build the resources and capabilities necessary to deliver unique value. These strategy vehicles include such things as diversification, acquisitions, alliances, vertical integration, and international expansion. In some cases, a firm may choose to grow by diversifying, adding to its products or opening a new line of business. Acquisition is a strategy vehicle used for growth and diversification or to acquire key resources. For example, when Apple acquired NeXT Computing, the late Steve Jobs’s start-up, Apple acquired the operating system that became OSX—and the acquisition brought Steve Jobs back to Apple.23 More recently, Apple acquired SIRI, a company that made voice recognition and search software that was the technology behind SIRI (pronounced sir’-ee), Apple’s personal assistant on the iPhone. Sometimes companies decide to access new resources and capabilities through a strategic alliance—an exclusive relationship with another firm—rather than through acquisition. For example, Apple teamed up with AT&T in an alliance to launch the iPhone in the United States. AT&T put huge promotional dollars behind the iPhone—and paid Apple 10 percent of its revenues from each iPhone subscriber—in order to be the exclusive distributor of iPhones for the first five years.

How Are Strategies Formulated?

Corporate Strategy (Where to compete)

Business Unit 1 Strategy (How to compete)

R&D Strategy (How to implement)

Business Unit 2 Strategy (How to compete)

Operations Strategy (How to implement)

Marketing Strategy (How to implement)

Identifies where to compete in terms of Provides guidance for industries and managing and allocating markets resources to distinct business units

Identifies what unique value to offer (cost or differentiation) and Provides a plan how to deliver it to achieve competitive advantage

H.R. Strategy (How to implement)

Strategies and tactics of the functional areas should align with and implement the overall business unit strategy. FIGURE 1.3

Multiple Levels of Strategic Analysis

Vertical integration, or the make–buy decision, is also a vehicle for achieving objectives.24 For example, when Apple decided to move into retailing by establishing Apple Stores, the company made a decision to “make” stores that sold their own products, rather than simply “buy” the retailing services of stores run by other companies, such as Best Buy or Walmart. Finally, companies may use international expansion as a vehicle to achieve economies of scale, access key resources, or learn new skills. Indeed, some companies use international expansion as a primary source of competitive advantage. These strategy vehicles—discussed in detail in Chapters 6 to 9—are important tools that strategists use to achieve key strategic objectives.

Strategy Implementation The final step in the strategic management process is to implement the strategy that was chosen during the strategy formulation phase. Strategy implementation occurs when a company adopts a set of organizational processes that enable it to effectively carry out its strategy. Effective implementation typically requires the following: 1. The functional strategies within the company—research and development, operations, sales and marketing, human resource management—are well aligned with delivering the unique value identified in the overall strategy. Implementation is generally more successful when a company can measure how effectively functional activities are being performed to support the overall strategy. 2. The organization’s structure, systems, staff (people), skills (processor capabilities), style, and shared values (culture) are designed to facilitate the execution of the strategy. This is the McKinsey 7 S framework, which is useful for creating the alignment necessary to ensure effective implementation. We discuss how companies can effectively create alignment with their strategy—or change the organization to align with a new strategy—in Chapter 12. The Strategy in Practice: Walmart Functional Strategies Implement the Overall Strategy feature describes some of the actions that Walmart has taken to ensure that its functional activities align with and implement the overall business unit strategy.

strategy implementation The translation of a chosen strategy into organizational action so as to effectively implement the activities required to achieve strategic goals and objectives.

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Strategy in Practice Walmart Functional Strategies Implement the Overall “Low Cost” Strategy When a company has a clear strategy regarding how it plans to offer unique value, or “win” with customers, this helps guide the implementation of the overall strategy within each of the different business functions. As we’ve discussed, Walmart’s strategy is to win by being a cost leader in its markets. Walmart’s functional areas support that strategy in a number of ways:25 • Walmart’s human resource management strategy focuses on keeping labor costs as low as possible.  Walmart pays relatively low wages and has few layers of management, which minimizes labor costs. Walmart also has a nonunion stance and once even closed a store in Canada when the workers tried to unionize.26 Managers have small offices with inexpensive furniture, and

when they travel, they stay at inexpensive hotels and frequently share a room. • Walmart’s information technology and operations areas also focus attention on cost reduction.  Walmart has invested in information technology to lower the costs of communicating with thousands of suppliers and to provide suppliers with real-time data on what products are selling, at what price, in what store. • Walmart purchasing department negotiates aggressively with suppliers. Walmart uses its tremendous buying power to get the lowest prices on products from its suppliers. It also offers a product mix that appeals to price-sensitive customers. • Marketing does price checks at competitors.  The goal of the marketing staff is to ensure that Walmart’s prices are always as low, if not lower, than competitors.

To ensure successful implementation, the organization should have clear metrics, or ways to measure whether or not the plan is being implemented. In Chapter 12, we provide a strategy tool, our version of the balanced scorecard, which suggests some useful metrics that functional area leaders, and the CEO and top management team, can use to determine how effectively strategies are being implemented.27

Who Is Responsible for Business Strategy? strategic leaders Organizational leaders charged with formulating and implementing a strategy with the objective of ensuring the survival and success of an organization. deliberate strategy A plan or pattern of action that is formulated through a deliberate planning process that is then carried out to achieve the mission or goals of an organization.

emergent strategy A plan or pattern of action that develops and emerges over time in an organization despite a mission or goals.

Strategic leaders are typically the leaders of an organization who develop strategy through the strategic management process. These leaders are responsible for not only formulating strategy, but also for explaining the strategy in a way that employees will understand—and in a way that will motivate employees to execute it. Chapter 13 explains the role the board of directors and the top management team play in formulating and implementing strategy. Theorist Henry Mintzberg refers to strategies that are developed by management, using the strategic management process shown in Figure 1.1, as “intended” or “deliberate” strategies.28 Deliberate strategies are implemented as a result of careful analysis of markets, customers, competitors, and a firm’s resources and capabilities. Target’s move to upscale discount retailing came after it concluded that it could not compete with Walmart on costs and prices. So it created a trends department, created partnerships with high-end fashion designers (e.g., Oscar de la Renta) and stores (Neiman Marcus), offered a higher-end mix of products, and built stores in more affluent suburban areas as opposed to rural towns. Target’s strategy to become Tar-zhay was the result of a deliberate strategic plan. Emergent strategy is a strategy that was not expressly intended in the original planning of strategy. Strategies that emerge when leaders recognize and act on unexpected opportunities that occur through serendipity, such as ideas from people within the organization, are called emergent strategies.29 Apple’s transformation from a computer company to a company known mostly for its music players and cell phones was the result of a strategy that emerged after the introduction of the iPod. The iPod opened up opportunities—such as the iPhone and iPad— that the company’s senior executives did not necessarily foresee. Successful companies typically have strategies that are partly deliberate, due to effective strategic planning processes, and partly emergent, due to a willingness to respond to changes in the external environment and to ideas that come from within the organization. That is why a strategy needs to be a plan to gain and sustain advantage. In a successful company, everyone in the organization has some responsibility for understanding the company’s strategy and for offering ideas to improve the company’s strategic position.

Who Is Responsible for Business Strategy?

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Ethics and Strategy The Price Companies Pay to Stay Competitive One of the central ethical challenges facing the strategist is making decisions designed to deliver unique value to customers. A decision could, for example, focus on providing low costs to customers but it might result in reduced value for other stakeholder groups. Over the past few years, an increasing number of US companies have shut down US facilities and fired American workers as they have shifted their activities overseas to save money. For example, IBM laid off more than 1,200 employees in New York and Vermont because their jobs could be done more cost effectively in “Brazil, India, and now China.”32 In similar fashion, HP announced layoffs of 500 customer service workers in Arkansas due to global restructuring, the term often used to describe a company’s plan to fire workers and move activities from one location to another.33 And Eaton, a 101-year-old Cleveland-based manufacturer of electronic components, moved its corporate address to Ireland, where the top corporate tax rate is 12.5 percent versus 35 percent in the United States. These are only a few

of the many examples of organizations making difficult decisions in order to stay competitive. But at what price? In each of these instances, the company’s leaders are responding to customer demands (lower prices) and shareholder demands (higher profit returns). But in doing so, they are neglecting employee demands (job retention) and community demands (taxes provide community benefits). Some may question whether it is ethical to fire employees and avoid US taxes in order to better meet the desires of customers and shareholders. Others will argue that if the company does not keep its customers and shareholders happy, employees will eventually lose their jobs anyway because the company will not be cost competitive, and companies that go bankrupt cannot pay taxes. The challenge of meeting the sometimes-competing needs of various stakeholder groups is one that is constantly faced by a company’s leaders. A typical response is to prioritize stakeholders’ needs—with customers and shareholders needs coming first—and take strategic actions that best meet their needs. But actions that take unduly from employees and communities to compensate customers and shareholders are viewed by many as unethical.

Who Benefits from a Good Business Strategy? Every organization has a set of stakeholders to whom it is accountable—and who therefore can influence business strategy. Organizations have four primary stakeholder groups: 1. Capital market stakeholders (shareholders, banks, etc.)

stakeholders Those who have a share or an interest in the activities and performance of an organization.

2. Product market stakeholders (customers, suppliers) 3. Organizational stakeholders (employees) 4. Community stakeholders (communities, government bodies, community activists)30 There is a lively debate that will be discussed in Chapter  13 about which of these four stakeholder groups is the most important and should be the primary beneficiaries of successful business strategies. Some people believe that shareholders (owners of the company) are the most important. Others make the case that customers, employees, governments, or communities should be the primary beneficiaries of business activity. In the United States, shareholders typically receive highest priority, but each stakeholder group can influence the strategic decisions that are made by a company. Sometimes, different stakeholder groups have conflicting views as to the appropriateness of different strategic decisions. Imagine that your company can lower its product costs by closing down your plants in the United States and moving production to China, where labor is cheaper. This will require firing many of your US employees. Both the employee stakeholder group and community stakeholder groups in the cities where your plants are located will perceive this move as negative, and they will try to stop the company from making this decision. However, shareholders and customer stakeholder groups may applaud this decision. It could increase profits for shareholders and lower prices for customers, or both. Because of conflicts like this, companies need to make sure their strategic actions follow accepted ethical standards for business activity. In the ideal situation, a firm has such an effective business strategy that it generates above-average profit returns. Above-average returns allow companies to not only meet the expectations of shareholders, but also satisfy the expectations of other suppliers of capital, product-market, organizational, and community stakeholders. Since stakeholders influence, and are influenced by, strategic decisions made by a company’s management team, it is important to understand and consider the needs of different stakeholder groups when making strategic decisions.31

shareholders Owners of a company.

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Strategy in Your Career Understanding business strategy and the strategic management process is important for at least two reasons: 1. When you start your own company or are the president or general manager of a department or division within a company, your primary job will be to formulate and implement an effective business strategy. Even as a junior person in your company, by understanding basic strategy principles you will be more effective at developing and implementing ideas that are consistent with, and support, your business unit’s overall strategy. Being able to understand and contribute to your firm’s strategy may lead to earlier promotions as you stand out from your peers.

2. Understanding strategy will help you evaluate the strategy of companies you choose to work for. An effective strategy can give a company competitive advantage over its rivals. Companies with competitive advantage typically provide superior advancement opportunities, higher pay, and greater job security than companies without any competitive advantage. In summary, understanding the strategic management process—as well as the concepts that are fundamental to the formulation, and implementation, of strategy—will likely be very helpful as you pursue a successful career in business.

Summary • A company’s business strategy is defined as a plan to achieve competitive advantage. Formulating a strategy involves making four key choices: (1) what markets or industries the company will pursue, (2) what unique value to offer the customer in those markets, (3) what resources and capabilities will allow the firm to deliver that unique value better than competitors, and (4) how the company will sustain its advantage and prevent imitation of its strategy by competitors. • The strategic management process involves the selection of a company mission as well as external and internal analyses that contribute to the formulation of a company’s strategy. A company’s mission outlines the company’s primary purpose and scope of activity. External analysis involves an analysis of the company’s current (or potential) markets or industries to understand the environmental factors that influence a firm’s profitability. Internal analysis involves an analysis of the company’s set of resources and capabilities (or new ones that need to be developed) that can be deployed to create competitive advantages. • These analyses contribute to the formulation of a company’s strategy. After the plan for creating competitive advantage is created,

the final step is to develop a plan to effectively implement the firm’s strategy. • Every organization has a set of stakeholders to whom it is accountable—and who therefore can influence business strategy. The four primary stakeholder groups are capital market stakeholders (shareholders, other suppliers of capital like banks), product market stakeholders (customers, suppliers), organizational stakeholders (employees), and community stakeholders (communities, government bodies). • The chief executive officer and vice presidents of the different business functions are ultimately responsible for a company’s strategy. They are often assisted by a VP of strategic planning (chief strategy officer), who may lead a planning staff, or in some cases by a management-consulting firm. Good strategic leaders, however, will seek information and ideas from anyone in the company. • You need to understand business strategy because (1) it will give you the tools to more effectively evaluate, and contribute, to the strategy of the company that employs you; and (2) it will give you the knowledge you need to evaluate the strategy of organizations you may want to join.

Key Terms above-average profits 3 business strategy 2 business unit strategy 10 competitive advantage 2 corporate strategy 10 cost advantage 6 deliberate strategy 12 differentiation strategy 6 emergent strategy 12

external analysis 4 functional strategy 10 internal analysis 4 market 2 mission 8 price sensitivity 9 resource-based review of firm 9 segmentation analysis 9 shareholders 13

stakeholders 13 strategic leaders 12 strategic management process strategy implementation 11 strategy vehicles 10 SWOT analysis 8 unique value 2

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References 15

Review Questions 1. Why is it important for you to understand business strategy? 2. How would you describe or define strategy? 3. What are the four choices that are part of strategy formulation? 4. What are the two generic strategies, or primary ways, in which companies attempt to offer unique value relative to competitors? 5. Who is ultimately responsible for a company’s strategy? Who does this individual (or individuals) call on for help in formulating strategy for the firm?

6. According to Michael Porter’s “five forces” model, why do some firms earn higher profits than other firms? 7. What are resources and capabilities, what is the difference between them, and why do firms need to assess them? 8. What are three keys to the successful implementation of a company strategy? 9. Who are the four primary stakeholder groups that influence strategic decisions in a company?

Application Exercises Exercise 1: Examine the Business Strategy of a Company 1. Identify a company you would like to learn more about that seems to have a competitive advantage (earns above-average profit returns). 2. Gather data about the strategy of that company, using public sources such as the company website or its annual reports, public articles, and your own experience. 3. Identify the mission statement of the company, if it has one. How does this mission statement guide the behavior and actions of people in the company? 4. What markets or industries does the company focus on? Does this differ from competitors in any particular way? 5. What unique value does it try to offer to customers? Why do most of its customers pick its products over those of competitors?

6. Try to identify any resources or capabilities this company has that help it offer unique value. This is the most difficult step in the assignment, because companies often try to hide their sources of competitive advantage. Exercise 2: Amazon is an online discount retailer that has successfully entered other businesses, such as electronic devices with the Kindle, Kindle Fire, and Echo as well Amazon Web Services. Read what you can about Amazon’s entry into these new businesses, and try to explain: 1. why you think they chose to compete in those markets, 2. their unique value is in those markets—why they win with customers; 3. what resources and capabilities they possess that enable them to succeed in the new markets; and what new capabilities they need to develop; and 4. what makes it hard for competitors to imitate their offerings.

References 1 S. Levy, Insanely Great: The Life and Times of Macintosh, the Computer that Changed Everything (New York: Penguin Books, 1994).

S. Levy, The Perfect Thing: How the iPod Shuffles Commerce, Culture, and Coolness (New York: Simon and Schuster, 2006). 2

D. Yoffie, Apple Computer 2005 (Cambridge, MA: Harvard Business School Press, 2005). 3

E. Smith, “Can Anybody Catch iTunes?” The Wall Street Journal (Nov. 27, 2006), pp. 41 +. 4

P. Kafka, “How Are Those DRM-free MP3s Selling?” Silicon Alley Insider (2008), www.alleyinsider.com/2008/3. 5

http://www.afterdawn.com/news/article.cfm/2009/09/09/ipod _market_share_at_738_percent_225_million_ipods_sold_more _games_for_touch_than_psp_nds_apple. 6

For more discussion about competitive advantage, see J. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17(1) (1991): 99–120. R. Reed, “Causal Ambiguity, 7

Barriers to Imitation, and Sustained Competitive Advantage,” Academy of Management Review 15 (1) (1990): 88–102. M. E. Porter, Competitive Advantage, 2nd ed. (New York: The Free Press, 1998). T. C. Powell, N. Rahman, and W. H. Starbuck, “European and American Origins of Competitive Advantage,” Advances in Strategic Management, 27 (2010): 313–351. 8

For a discussion of risk versus uncertainty, see F. Knight, Risk, Uncertainty, and Profit (Chicago: Houghton Mifflin Co., 1921). According to Knight, though the distribution of outcomes may be very wide, risk is possible to measure, whereas uncertainty is immeasurable; even the possible distribution of outcomes is unknown. 9

See M. Porter, “What Is Strategy,” Harvard Business Review (November– December 1996): 61–78.

10

See B. Wernerfelt, “A Resource-Based View of the Firm,” Strategic Management Journal 5(2) (1984): 171–180. Also see Barney, 99–120.

11

See http://www.dailymail.co.uk/news/article-1394087/Is-end-Mom-Pop -stores-Mini-Wal-Mart-express-stores-coming- town-near-you.html.

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C. L. Hill, “Differentiation or Low Cost or Differentiation and Low Cost: A Contingency Framework,” Academy of Management Review 13  (3) (1988): pp. 401–412. J. Dyer, D. Bryce, and P. Godfrey, “Strategy 2.0: New Answers to Strategy’s Big Questions,” Brigham Young University Working Paper (2017).

13

H. Shultz, Pour Your Heart Into It: How Starbucks Built a Company One Cup at a Time (New York: Hyperion, 1997).

14

15 See http://www.starbucks.com/about-us/company-information /mission-statement.

The technique of SWOT analysis is credited to Albert Humphrey. For more information see T. Hill & R. Westbrook, “SWOT Analysis: It’s Time for a Product Recall,” Long Range Planning 30 (1) (1997): 46–52. doi:10.1016/S0024-6301(96)00095-7. J. Scott Armstrong, “The Value of Formal Planning for Strategic Decisions,” Strategic Management Journal 3 (3) (1982): 197–211.

16

Harvard Business Review, HBR’s 10 Must-Reads on Strategy (2011), http://books.google.com/books?id=aI-UUMi7jpsC&pg=PA48&lpg=P A48&dq=1992+to+2006+average+return+on+invested+capital&sour ce=bl&ots=Od-2BgCcJe&sig=c9BVKyhhl8tvBJDGPwOwb-K9IAM&hl= en&sa=X&ei=B5SeUYGFOaPiiAL5h4HQDw&ved=0CDEQ6AEwAQ#v= onepage&q=1992%20to%202006%20average%20return%20on%20 invested%20capital&f=false.

17

18 J. Mouawad, “Pushing 40, Southwest Is Still Playing the Rebel,” New York Times (November 20, 2010),” http://www.nytimes.com/2010/11/21 /business/21south.html?pagewanted=all&_r=0.

M. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard Business Review (January 2008): 79–93.

19

For an overview of customer segmentation see D. Goldstein, “What Is Customer Segmentation?” Mind of Marketing (May 2007), http://www .mindofmarketing.net/2007/05/customer-segmentation-why-exactlydoes.html. Also see C. Christensen and M. Raynor, The Innovator’s Dilemma, Chapter 3 for a discussion of segmenting customers based on product attributes, demographics, or “job-to-be-done.” Also see C. Christensen, “Integrating Around the Job to Be Done,” Harvard Business School Press (2010), Module note. N9-611-004.

20

21 This is often called the resource-based view of the firm within the field of strategic management. See Wernerfelt, 171–180, and Barney, 99–120.

See G. Hamel and C. K. Prahalad, “The Core Competence of the Corporation,” Harvard Business Review (May–June, 1990). 22

23 See D. E. Dilger, “Apple’s 15 Years of NeXT,” Apple Insider (December 21, 2011), http://appleinsider.com/articles/11/12/21/apples_15_years_of _next.

See Business Dictionary, “Make or Buy Decision,” http://www .businessdictionary.com/definition/make-or-buy-decision.html.

24

P. Ghemewat, S. Bradley, and K. Mark, “Wal-Mart Stores in 2003,” Harvard Business Review (September 2003).

25

S. Berfield, “Walmart vs. Union-Backed OUR Walmart,” Bloomberg Businessweek (December 13, 2012), http://www.businessweek.com /articles/2012-12-13/walmart-vs-dot-union-backed-our-walmart. 26

27 R. S. Kaplan and D. P. Norton, “The Balanced Scorecard—Measures that Drive Performance,” Harvard Business Review (February 1992).

H. Mintzberg, The Rise and Fall of Strategic Planning (New York: The Free Press, 1994).

28

K. Moore, “Porter or Mintzberg: Whose View of Strategy Is the Most Relevant Today?” Forbes (March 28, 2011), http://www.forbes.com /sites/karlmoore/2011/03/28/porter-or-mintzberg-whose-view-of -strategy-is-the-most-relevant-today/.

29

R. E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman, 1984).

30

J. Harrison and R. E. Freeman, “Stakeholders, Social Responsibility, and Performance: Empirical Evidence and Theoretical Perspectives,” Academy of Management Journal 42 (5) (1999): 479–485.

31

A. Kelly. “IBM Layoffs: Computer Company Cuts Thousands of Jobs as Part of Restructuring Plan.” International Business Times (June 12, 2013), http://www.ibtimes.com/ibm-layoffs-computer-company-cuts -thousands-jobs-worldwide-part-restructuring-plan-1304949.

32

L. Jones and L. Turner. “Update: HP to Lay Off 500 in Conway,” Arkansas Business (July 8, 2013), http://www.arkansasbusiness.com/article/93433 /reports-hewlett-packard-to-lay-off-500-in-conway?page=all. 33

CHAPTER 2 Analysis of the External Environment: Opportunities and Threats LEARNING OBJECTIVES Studying this chapter should provide you with the knowledge to: 1. Explain the importance of correctly identifying and choosing a firm’s industries and markets. 2. Identify and measure the five major forces that shape average firm profitability within industries to evaluate the overall attractiveness of an industry.

4. Discuss situations in which entry into both attractive and unattractive industries follows “new thinking” rather than conventional wisdom. 5. Identify the factors in the general environment that affect firm and industry profitability.

3. Discuss how understanding the five forces that shape industry competition is useful as a starting point for developing strategy.

Tim Boyle/Getty Images News/Getty Images

State Farm Adjusts to a Changing World George Jacob “G. J.” Mecherle founded the State Farm Mutual Automobile Insurance company in 1922. Mecherle’s company targeted small-town and rural farmers as policy holders with a new value proposition: lower premiums. Insurers of the automobiles (still a relatively new innovation in the 1920s) based their policy premiums on payouts and accident claims by urban drivers. Mecherle realized that rural customers, his target, had a far different driving profile than auto owners in larger cities: They had far fewer opportunities for accidents and thefts. State Farm based its premiums on this lower incidence of risk.1 The company expanded into the life insurance market in 1929 and opened a homeowners line in 1935. By 1942 the company had become the nation’s largest auto insurer, a title it still holds today.2 The Good Neighbor (taken from State Farm’s famous jingle written by Barry Manilow) wrote just shy of $42 billion worth of premiums in 2016, gobbling up 18 percent of the US market. Importantly, State Farm’s $42 billion in the auto market represented 65 percent of its total Property and Casualty (P&C) revenue of almost $65 billion. The company’s 65,000 employees and 19,000 agents collected over $17 billion in homeowners premiums.3 The

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company’s auto line is almost 8 times its life insurance revenue, and 60 times its sales of health insurance products.4 State Farm is the market leader in the auto and homeowner lines of business with over 81 million US policy holders and commands just over 10 percent of the market, 40 percent greater than Berkshire Hathaway’s 6 percent and more than double Allstate’s 4.9 percent. For State Farm, P&C is the 800 lb. gorilla. You might think of P&C insurance as a sleepy business with known risks and very slow growth. You’d be wrong. P&C insurers have seen, and continue to see, changes in their industry that require innovation and new business models. The rise of the “gig” economy and ridesharing companies like Uber or Lyft present one challenge. Most of these drivers carry passengers in their personal vehicles; when they pick up a rider, their car is no longer a “personal” vehicle, it becomes a “livery” or commercial-use vehicle. Personal auto policies don’t cover livery uses, and drivers lose their coverage. Rideshare companies established bare-bones, low-cost policies to insure drivers, and State Farm created flexible insurance to provide better coverage. When a driver engages the App, State Farm’s policy (called a rider) continues their personal coverage while their vehicle is in “livery” mode. State Farm survived, and profited from, the advent of ride sharing. Services like Airbnb or Vacation Rental by Owner create similar problems for State Farm policy holders. When an Airbnb guest arrives, the home ceases to be a personal dwelling and becomes a “short-term rental” used to make a profit. State Farm, like most other insurers, won’t cover most claims when a private dwelling gets used for most business activities. Homeowners insurance provides two types of coverage: property and liability. Coverage remains in force for most weather related property damage, but policies don’t cover damage caused by short-term renters (e.g., if guests host a party at the house that ruins furniture or floors). Personal liability—say a guest slips on the stairs, breaks a leg, and sues the homeowner for medical costs—also falls outside most policies, leaving the renter, or host, on the hook for costs. To date, State Farm has not developed a short-term rental policy to respond to these changes.5 The rise of the gig or sharing economy signaled changes in how policy holders (customers) behave. Climate change represents another challenge for P&C insurers. Rising oceans mean that waterfront properties, and coastal cities in general, face greater risk of weather-related damage. In humid climates, rising average temperatures spawn more powerful hurricanes,

tornadoes, and typhoons. In dry climates, warmer air increases the risk of brush and forest fires. The net result for State Farm: greater risk of property damage, both in the number of properties damaged and higher claim amounts. State Farm, and all property insurers, continue to struggle with how to respond. For example, in 2018 California experienced the worst fire in the state’s history—the Mendocino Complex Fire—and 16 other fires that caused extensive property damage and loss of life.6 For 2017 and 2018, loss claims for these wildfires exceeded $23 billion. Some insurers refuse to cover at-risk homes, while others have seen the claims rise by 20 percent.7 Strategy makers at State Farm have to decide more than just prices for coverage; they have to determine whether or not to compete in an increasingly risky homeowners market. As described in Chapter 1, strategy involves crafting a plan to create competitive advantage—and superior profitability—in particular markets. This plan, however, is shaped by the landscape in which the firm competes. A firm’s external environment provides both opportunities—ways of taking advantage of conditions in the environment to become more profitable—and threats—conditions in the competitive environment that endanger the profitability of the firm.8 Successful firms have a deep understanding of their environment and constantly scan the horizon to see opportunities and threats as they emerge.9 One of the key threats a strategist must understand and cope with is the environment in which their firm operates. In this chapter you’ll learn about the forces that shape that environment, from the specific industry the firm competes in to the larger, macroeconomic environment of competition. State Farm competes in what has traditionally been a very stable industry; however, changes among its customers, suppliers, competitors, potential entrants, and substitute products all combine to create turbulence in its markets. Together, all five forces define an industry’s structure and shape the competitive interactions—and profitability—of companies within that industry. Even though industries might appear to differ significantly, the principles that determine the underlying drivers of profitability are often the same. Outside forces, like a changing climate, help determine the ultimate attractiveness of industries such as homeowners insurance. This chapter will help you to recognize the major threats and opportunities that make up the competitive landscape, both the industry forces and general macroeconomic forces that drive industry attractiveness—and profitability.

As described in Chapter 1, strategy involves crafting a plan to create competitive advantage— and superior profitability—in particular markets. This plan, however, is shaped by the landscape in which the firm competes. A firm’s external environment provides both opportunities—ways of taking advantage of conditions in the environment to become more profitable—and threats— conditions in the competitive environment that endanger the profitability of the firm.10 Successful firms have a deep understanding of their environment and constantly scan the horizon to see opportunities and threats as they emerge.11 One of the key threats a strategist must understand and cope with is competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s direct

Determining the Right Landscape: Defining a Firm’s Industry

competitors. Nokia was so focused on Microsoft as its key competitor in the 3G operating system industry, and Motorola and Ericsson as its cell phone competitors, that it failed to effectively prepare for Apple’s entry into the industry. Competition for profits goes beyond established industry competitors to include four other forces that shape industry attractiveness and profitability: customers, suppliers, potential entrants, and substitute products. Together, all five forces define an industry’s structure and shape the competitive interactions—and profitability—of companies within that industry. Even though industries might appear to differ significantly, the principles that determine the underlying drivers of profitability are often the same. The global cell phone industry, for instance, appears to have nothing in common with the highly-profitable soft drink industry or the low-cost airline industry (i.e., Southwest and JetBlue). But to understand industry competition and profitability in these and other industries we must analyze the same five forces. This chapter will help you to recognize the major threats and opportunities that make up the competitive landscape, both the industry forces and general macroeconomic forces that drive industry attractiveness—and profitability.

Determining the Right Landscape: Defining a Firm’s Industry The first strategic decision that most firms must make is to select the industry, and markets, in which it will compete. The Strategy in Practice feature discusses the US government’s classification of industries. A firm’s industry also determines which customers and which competitors will be part of the firm’s landscape. The landscape is typically defined by: (1) the industry (or industries) in which a firm competes, and (2) the product and geographic markets within that industry that the firm targets. For example, Nokia competes primarily in the cellular telephone manufacturing and operating system industries. Within the cellular telephone manufacturing industry, Nokia targets multiple product markets by selling a range of handsets, from high-end smartphones to inexpensive basic phones. The company also targets multiple geographic markets, focusing mainly on Europe and developing economies in the Middle East and Africa. Be careful about assuming that it is obvious which industry a company competes in. For example, it seems obvious that Barnes & Noble competes in the book retailing industry and Microsoft competes in the computer software industry. However, it may be less obvious that those aren’t their only industries. In addition to operating systems, Microsoft also makes the X-Box gaming system, so it competes in the gaming console industry as well as the PC operating system industry. Barnes & Noble sells an e-reader, the Nook, that combines electronic books with computer hardware. Amazon.com, Barnes & Nobles’ main book retailing competitor, not only sells books and the Kindle e-Reader, but also sells web services competing with Microsoft and a wide range of products online as a discount retailer competing with Walmart. Firms must choose which markets to compete in, with many large firms choosing to compete in several at the same time. If managers do not properly define and understand their industry, they may be vulnerable to unseen competitors. For example, Nokia defined itself primarily as a mobile handset manufacturer. As a result, managers failed to see computer hardware companies like Apple and web search companies like Google becoming potential competitors—or potential partners. (Nokia now uses Google’s Android operating system on its smartphones.) Their focus on preventing Microsoft from creating a dominant position in the mobile operating system industry caused them to overlook Apple, a company that has consistently been the leader in innovative,

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Strategy in Practice How the US Government Defines Industries One tool that helps to define industries is the North American Industry Classification System (NAICS), a series of codes generated by the US government.12 These codes (formerly referred to as SIC codes, for Standard Industrial Classification) vary from two to seven digits, becoming more narrow with increasing numbers of digits. Table 2.1 provides the NAICS codes for State Farm. At the highest level the company competes in the Finance and Insurance sector, which includes banking, investment, and insurance companies. It’s a broad industry, but the three-digit code narrows State Farm’s industry to insurance. The four-digit level describes the extent of State Farm’s business model. The five-digit level captures the company’s different product lines and the six-digit level provides more detail about its casualty and property lines.

TA B L E 2 . 1

NAICS codes can be useful not just for helping to define an industry but also for determining who the primary competitors and stakeholders are, although in fast-changing industries, the NAICS can sometimes lag behind changing technologies or changing customer demands. As we’ve seen, State Farm has to figure out a new segment of buyers, people sharing their cars and homes with others, which is not yet reflected in the NAICS lines of business. The choice of industries is important because not all industries are created equal. The profits of an average firm in some industries are substantially higher than profits of an average firm in other industries. Figure 2.1 shows the return on equity for a variety of industries over a ten-year period. As you can see, the industry in which a firm competes has a direct bearing on the profits earned by that firm.

NAICS Codes for State Farm

Code

Classification

52

Finance and Insurance

524

Insurance Carriers and Related Activities

5241

Insurance Carriers

52411

Direct Life, Health, and Medical Insurance Carriers

52412

Direct Insurance (except Life, Health, and Medical) Carriers

524126

Direct Property and Casualty Insurance

5242

Agencies, Brokerages and Other Insurance Activities

52421

Insurance Agencies and Brokerages Varying Profitabilty of US Industries, 2018

60% 50% 40% Return on Equity

30% 20% 10%

FIGURE 2.1

Tobacco

Renewable Energy

Apparel

P&C Insurers

Home builders

Average

Soft Drinks

Airlines

Wireless providers

–10%

Online Retailers

0% Railroads

20

Varying Attractiveness of US Industries, 2018

Source: Data from various sources, compiled by Aswan Damodoran, NYU Stern School of Business. Available at http:// pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html.

Five Forces that Shape Average Profitability Within Industries

21

user-friendly operating systems for a variety of platforms.13 At the time Apple didn’t make phones, while Microsoft had announced plans to start making them. Because of how Nokia defined their industry, it was easy for them to overlook Apple, a non-phone manufacturer. Truly understanding an industry often begins by taking a customer-oriented view. Rather than identifying the industry based on the product or service they produce (such as cell phone handsets), firms should think carefully about the job that products do for customers. What need does a product fill? Understanding customer needs can be very helpful in defining the boundaries of an industry. If two firms have products that do the same job for customers— that meet similar customer needs—then those two firms can be considered part of the same industry. For instance, companies that meet the need for communication by manufacturing mobile handsets, as opposed to mobile ham radios (long-range walkie talkies), compete in the same industry.14 In the case of cell phones, changing customer needs broadened the boundaries of the industry, from primarily manufacturing hardware to including mobile operating systems and applications that allowed phones to do far more jobs for customers than just place a phone call. This led to new competitors for Nokia, including Apple and Google.

Five Forces that Shape Average Profitability Within Industries Michael Porter, a well-known strategy professor at Harvard, identified five forces that shape the profit-making potential of the average firm in an industry. As shown in Figure 2.2, those five forces are (1) rivalry, (2) buyer power, (3) supplier power, (4) threat of new entrants, and (5) threat of substitute products. The strength of each of these five forces (known as Porter’s five forces15) varies widely from industry to industry. For instance, in the semiconductor industry, the threat of substitutes is almost nonexistent, while in the carbonated soft drink industry it is a significant threat. A careful analysis of the five forces is a powerful way for firms to discover the threats and opportunities in their environments. We provide a tool at the end of this chapter to help you conduct a careful analysis of an industry’s five forces. There are three basic steps involved in using the five forces analysis tool: • Step 1: Identify the specific factors relevant to each of the five major forces. We describe the factors that contribute to each of the five forces in the next five sections of this chapter. • Step 2: Analyze the strength of each force. To what extent is it shaping the industry’s attractiveness? The appendix at the end of the book lists several sources where you might find the data you need to analyze each of the five forces. • Step 3: Estimate the overall strength of the combined five forces to determine the general attractiveness of the industry, the profit potential for an average firm in the industry. Instructions for steps 2 and 3 are at the end of the chapter. Step 1, the factors relevant to each of the five forces, is discussed next.

Rivalry: Competition Among Established Companies Competition in an industry is sometimes referred to as war, with each company deploying as many weapons in its arsenal as possible to gain greater profits. Because there are typically a limited number of buyers, each firm’s profits often come at the expense of other firms in the industry. Each move by a firm provokes countermoves among competitors, resulting in a constantly shifting competitive landscape populated by winners and losers. (Chapter 11 explores how successful firms manage that shifting landscape by planning for the countermoves of their rivals.) Firms’ moves and countermoves can take many forms, including sales and promotions, better quality or service, a wider variety of products, or lower prices. Not surprisingly, these types of moves increase rivalry—the intensity with which companies compete with each other

rivalry Competition among firms within an industry. Typically this involves firms putting pressure on each other and limiting each other’s profit potential by attempting to gain profits and/or market share. substitute A product that is fundamentally different yet serves the same function or purpose as another product. threats Conditions in the competitive environment that endanger the profitability of a firm. opportunities Ways of taking advantage of conditions in the environment to become more profitable. attractiveness of an industry The degree to which an average firm in the industry can earn good profits.

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NEW ENTRANTS

BUYER POWER

COMPETITOR RIVALRY

SUPPLIER POWER

SUBSTITUTES

FIGURE 2.2

Analyzing Major Threats and Opportunities: The Five Forces Industry Analysis Tool

Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 86, 1 (January 2008), pp. 80–86.

for customers—which tends to squeeze the profit margins of most firms in an industry. Rivalry among firms in an industry—for either rational or irrational reasons—is such an important determinant of profitability that it is shown at the center of Figure 2.2. The following seven factors are critical to understanding the intensity of rivalry in an industry: 1. The number and size of competitors 2. Standardization of products 3. Costs to buyers of switching to another product 4. Growth in demand for products 5. Levels of unused production capacity 6. High fixed costs and highly perishable products 7. The difficulty for firms of leaving the industry

The Number and Relative Size of Competitors The more competitors there are in an industry, the more likely that one or more of them will take action to gain profits at the expense of others. Economists call an industry with a lot of competitors a fragmented industry. In a fragmented industry, it is difficult to keep track of the pricing and competitive moves of multiple players. The large number of firms responding to one another tend to create intense rivalry. The same is true of the relative sizes of competitors. If firms are approximately the same size, they tend to be able to respond, or retaliate, strongly to moves by rival firms. Industries that are concentrated, as opposed to fragmented, have far fewer competitors and tend to be dominated by a few large firms. In these industries, rivalry is typically much less intense. Smaller competitors do not have the capability to respond to actions taken by large firms, and the few large competitors are more aware of each other and less likely to risk actions that may result in price wars. Relatively Standardized Products Differentiated products, ones that boast different features or better quality, tend to engender loyalty in customers because they meet

Five Forces that Shape Average Profitability Within Industries

23

customer needs in unique ways. When products are standardized, or commodity-like, buyers are less loyal to a particular brand and it is easier to convince them to switch brands. A rider may be fiercely loyal to his or her Harley-Davidson motorcycle, for example, but willing to buy several different brands of gas for the Harley. Firms that sell standardized products—manufactured products or materials that are interchangeable regardless of who makes them, like bolts and nuts, rubber, plastics, or commodities such as coal, crude oil, salt, or sugar—often have to compete by offering sales, rebates, or lowering prices. Price wars increase rivalry and decrease profits.

Low Switching Costs for Buyers Switching costs include any cost to the customer for changing brands. Switching costs for buyers are related to the degree of product standardization. For a computer user, changing operating system or word processing software would entail considerable switching costs because the user would need to (1) convert files to the new software, and (2) learn how to use the new software. Switching from an iPod to another MP3 player might require music lovers to move all of their music files from iTunes to a different music software. In contrast, most of us can change our brand of gum or candy bar without any switching costs. The lower the switching costs, the easier it is for competitors to poach customers, thereby increasing industry rivalry. Switching costs are a fundamental part of not just rivalry but also the other four forces: 1. Buyer power: If customers, or buyers, can easily switch firms, then buyers have increased power. 2. Supplier power: If firms can’t switch suppliers easily, then suppliers have increased power. 3. New entrants: If buyers can easily switch to new companies attempting to enter the industry, there is a greater threat of new entrants. 4. Substitutes: If buyers can switch to substitute products without much difficulty, firms face an increased threat from those substitutes.

Slow Growth in Demand for Products or Services

When demand is increasing rapidly, most firms can grow without taking existing customers from competitors. When growth slows, however, firms can become desperate. They may try to increase their sales volume by attracting customers from their competitors through sales promotions, price discounts, or other tactics.16 Of course, competitors then respond with their own sales promotions and price cuts, thereby increasing industry rivalry. Consider the flat-screen television industry. When large, flat-panel displays were first introduced, prices were high. They remained that way for years while industry growth exploded. As flat-panel manufacturers anticipated slower growth, from 18 percent in 2010 to 4 percent in the first half of 2011, they dropped prices by more than 25 percent in the last quarter of 2010 in a bid to gain what market share they could from their competitors.17

High Levels of Unused Production Capacity Unused production capacity is expensive. Firms typically try to produce at or near their full production capacity so that they can spread the fixed cost of factories, machinery, and other means of production across more units. In fact, they may try to produce more product than the market demands, in order to use their capacity completely. However, when more is produced than is demanded in the market, firms often have to drop their price or risk having unsold product. This has frequently been the case in the automobile industry. During an economic downturn, automakers offer price cuts, rebates, and special sales incentives to buyers so that they don’t have significant unused production capacity or lots of older-model cars left to sell when new ones are produced. High Fixed Costs, Highly Perishable Products, High Storage Costs Industries that produce or serve products in these three categories sometimes find themselves with a supply of products that they have to sell quickly or take large losses on. For example, airlines operate with high fixed costs. Most of the cost of a flight is in the airplane, the fuel, and the pilot and flight attendants. It is not in the cost of serving an additional passenger. The marginal

switching costs Barriers that help keep buyers using the same supplier by imposing extra costs for switching suppliers.

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cost of adding an additional passenger is truly only peanuts (and a drink). If it appears that a scheduled flight is going to have few passengers, an airline may be tempted to discount steeply in order to fill as many seats as possible. The variable cost of an additional passenger is very little, so selling a seat for less would not cost the airline money, but leaving it empty would mean the airline has fewer passengers over whom to spread its fixed costs. Firms that sell highly perishable products, such as fruits or vegetables, face similar problems. As food nears the date when produce will spoil, grocery chains often steeply discount it rather than lose the sale completely. Products with high storage costs exhibit the same characteristics. If firms have an oversupply and are forced to store the product, they may discount the price to avoid storage costs. In all three cases, steep discounting leads to increased rivalry as competitors are forced to respond with discounts of their own or be left with losses while others recoup their production costs.

High Exit Barriers In some industries, companies don’t exit even when they aren’t making a lot of money. Most often, they stay because they have made investments in specialized equipment that can’t be used in any other industry. For example, steel blast furnaces are very expensive and cannot be used in any industry other than steelmaking. If the firm exits the steel industry, its blast furnaces lose most of their value. Another barrier to exit is labor or government agreements that make it difficult to close a plant. Emotional ties to employees or a business can also lead to less than rational decisions by top management to stay in business.

Buyer Power: Bargaining Power and Price Sensitivity supplier A firm that provides products that are inputs to another firm’s production process.

When buyers have sufficient power, they can demand either lower prices or better products from their suppliers, thereby hurting average profitability of firms in the supplier industry. The two primary situations in which buyers have high power are when buyers hold a stronger bargaining position than sellers and when buyers are price-sensitive. The strength of a buyer’s bargaining power or price sensitivity can be affected by a number of factors. When firms understand what causes buyers to have power over their industry, they have a better chance of countering that power.

Buyer Bargaining Power Four key factors influence the degree to which buyers have bargaining power over their suppliers. We already discussed two of these factors—buyers’ switching costs and demand—because they are also factors in rivalry among firms. The two remaining factors are the concentration and size of buyers and the threat that buyers can backward integrate: • Number, or concentration, and size of buyers: Buyer concentration reflects the law of supply and demand. If there are few buyers but many sellers, then the sellers must compete more strongly for buyer business. Sellers in this situation are likely to give concessions to make the sale. Likewise, the larger the number of buyers, compared to sellers, the more likely sellers are to increase the level of competition in order to gain buyers’ business. For example, farmers, as suppliers to the frozen-food industry, are not very concentrated. The three largest farmers account for only about 1 percent of all food produced and sold. Frozenfood makers, however, are concentrated. The top four (Nestlé, Schwan, ConAgra, and H.J. Heinz) accounted for nearly half (48.6 percent) of total market share in their industry in 2010.18 This means that frozen-food manufacturers, as buyers, have a great deal of power over farmers. A farmer who needs the business of the big four frozen-food makers in order to sell this year’s crop may be willing to accept a lower price in order to secure their business. backward integration A firm purchases one or more of its suppliers in order to make a product itself rather than buying it from another firm.

• Credible threat of backward integration: In some cases, a buyer can exert pressure over suppliers by threatening them with backward integration, meaning they will make the product themselves. For example, one way Walmart keeps prices low for consumers is by threatening to expand its Sam’s Choice store brand products into additional categories if manufacturers of other branded products don’t meet Walmart’s pricing demands.

Five Forces that Shape Average Profitability Within Industries

Buyer Price Sensitivity In general, when buyers are more price-sensitive, they are more likely to exert pressure on suppliers to keep prices low. Buyers exert pressure not just through price negotiation but also through more comparison shopping and a greater willingness to switch suppliers. Buyer price sensitivity tends to increase in the following situations: • Buyers are struggling financially: When companies, or consumers, are struggling financially, they are more likely to be price-conscious and to look for less expensive sources of supply. If many of an industry’s buyers are in the same situation, there is a cap on what suppliers can charge. • Product is significant proportion of buyer’s costs: Buyers tend to care more about getting a good price when the product they are buying creates a large part of the costs of their own production (or their budget, if the buyers are the end consumers). If the product is only a small part of their cost structure, buyers are less likely to bother negotiating or comparison shopping. For instance, end consumers are less likely to do extensive comparison shopping for a gallon of milk than they are for a home or car. Likewise, auto manufacturers are less likely to pressure suppliers of electrical wiring for price cuts than suppliers of steel or engine components. • Buyers purchase in large volumes: When buyers purchase in large volumes, they typically expect to get breaks in price. In essence, the buyer is taking a risk by being willing to buy large amounts at once rather than smaller amounts over time. • Product doesn’t affect buyers’ performance very much: If a product is very important to the quality of the buyers’ end product, then buyers tend not to be very price conscious. For instance, when Nokia had the most innovative handsets on the market, many cellular phone carriers, like Verizon and T-Mobile, were willing to pay whatever Nokia charged in order to be able to offer Nokia phones to their customers. However, if suppliers’ products don’t affect buyers’ quality or performance very much, then buyers are much more likely to be price conscious. For instance, the plastic casing on tablet or laptop computers doesn’t enhance the performance of the computers very much; it doesn’t drive sales to the end consumer. As a consequence, PC manufacturers are likely to shop around for price discounts on plastic casings in ways that they might not for the microprocessors that run the computers. • Product doesn’t save buyers money: If a product saves buyers money, they tend not to be very price-conscious when purchasing it. These types of products can be anything from machinery in manufacturing industries that replaces highly skilled, costly labor to inexpensive, overseas labor that replaces more expensive labor or machinery in countries such as the United States. If a product does not save buyers money, however, buyers are as likely to be price conscious as they are with other types of products they buy.

Supplier Bargaining Power The factors that increase the bargaining power of suppliers are very similar to those that increase the bargaining power of buyers. In this case, however, the firms are not customers but suppliers, those from whom your industry purchases inputs. When supplier industries have strong bargaining power, they can charge higher prices, which tends to decrease average profitability in a buyer’s industry. As firms understand the factors that give suppliers power, they may be able to make decisions that decrease that power.

Number, or Concentration, and Size of Suppliers As with buyer concentration, supplier concentration also follows the law of supply and demand. If there are few sellers but lots of buyers in an industry, then the buyers have to compete to get the products that they want, often paying higher prices to get sufficient supply. Likewise, the larger the number of sellers compared to the buyers, the less likely buyers are to pay the price that sellers are demanding.

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For instance, ARM, a designer of semiconductor chips for smartphones, has, for years, controlled upwards of 95 percent of the market for its product,19 resulting in a highly concentrated supplier industry dominated by one large firm. As a consequence, Nokia, or any other smartphone handset manufacturer that wants a sufficient supply of chips, and wants the highquality chips that won ARM its market share in the first place, has to buy from chip manufacturers who license from ARM. ARM has sufficient power that it can, to a large degree, set the price for its product. Suppliers who charge more often squeeze the profits of buyers, who may not be able to pass additional costs through to their customers. In fact, ARM’s rise to power in the mobile semiconductor chip industry is a major contributor to Nokia’s current difficulties. Nokia cannot charge enough for its low-cost handsets to make a good profit after paying for expensive ARM chips.

forward integration A firm goes into the business of its former buyers, rather than continuing to sell to them.

Credible Threat of Forward Integration

In some cases, a supplier can exert pressure over its buyers by threatening them with forward integration, doing what its buyers do, if the buyers don’t offer price concessions. A good example of this is Google and its decision to forward integrate into the smartphone handset industry by manufacturing its own phones.20 Google also licenses its Android operating system to other handset makers, such as HTC and Samsung. Google’s ability to forward integrate, even if they don’t sell many phones, gives Google power over those handset makers. When there is a credible threat of forward integration, buyers are often willing to take a cut in profit by paying higher prices, rather than risk losing the supply altogether and creating a new rival (if the supplier hasn’t already forward integrated).

Threat of New Entrants

barriers to entry The way organizations make it more difficult for potential entrants to get a foothold in the industry.

As previously shown in Figure 2.1, not all industries are created equal. Industries in which the average firm is making good profits can often be targets, enticing firms from outside those industries to enter. Likewise, quickly growing industries are often attractive, which increases the incentive for outside firms to enter those industries. One of the important tasks for strategists is to identify firms that might enter their industries. New entrants pose a double hazard. First, they typically are anxious to gain market share.21 Unless the industry is growing quickly, that market share must come at the expense of existing firms. Second, new entrants bring new production capacity, which tends to drive prices down unless demand is growing faster than the increase in supply. New entrants mean greater rivalry, so existing firms often try to discourage new entrants by building barriers to entry. The higher the barriers to entry, the more difficult it is for potential entrants to get a foothold in the industry, and the more likely that they are to quit or choose to not enter in the first place. Likewise, incumbent firms, those already in the industry, often signal new entrants that they are likely to retaliate by slashing prices, increasing advertising, or other competitive moves that help the established firms hold on to their market share. If the threats of retaliation are perceived as credible, potential entrants might decide to stay away. It is essential for firms to understand the barriers to entry that already exist in their industry and to consider ways of increasing them. Existing firms may also want to build new barriers. Firms that are considering going into an industry can use an analysis of the barriers to entry in the target industry to help them determine how likely they are to succeed if they attempt to enter.

Economies of Scale, Experience, or Learning

These types of economies occur when the cost per unit of production (the cost for producing each individual product or service) decreases as a firm produces more. Typically, these economies come from mass manufacturing methods, discounts through purchasing in high volumes, employees becoming quicker and better at production, and being able to spread the fixed costs of production machinery, R&D, advertising, and marketing across more units.22 Chapter 4 will explore these three types of cost advantages in greater detail. In essence, lower costs allow the firm either to lower its price, perhaps in retaliation for a new firm entering the market, or to maintain its price while earning more profits than competitors.

Five Forces that Shape Average Profitability Within Industries

When economies of scale, experience, or learning exist in an industry, new firms will be at a cost disadvantage. New firms are not likely to have as much market share as existing firms, so they will not produce as much and can’t achieve the same economies as existing firms. Some firms may not be able to lower their prices sufficiently to match incumbent firms’ prices. Other new entrants may match incumbent prices, but earn smaller profit margins than the incumbents. The higher the economies of scale, the greater the barrier to entry and the easier it is for the larger incumbent to pose a credible threat of retaliation. If conditions change so that cost savings from these economies become smaller, the barrier diminishes. For example, from the late 1980s until the early 2000s, the cell phone handset manufacturing industry possessed high economies of scale. Nokia produced millions of handsets per year during this time and had the lowest costs of its competitors. Consequently, the number of firms in the industry was relatively stable during this period. However, the invention of flexible manufacturing processes, coupled with the rise of low-cost, highlyskilled labor in China in the mid-2000s, lowered the cost savings that could be achieved from high levels of production and allowed thousands of new Shanzhai manufacturers to successfully enter the industry.

Other Cost Advantages Not Related to Scale

Incumbent firms might have cost advantages relative to new entrants for a variety of reasons besides economies of scale. These include the following: 1. Patents or proprietary technology, such as those that exist in the pharmaceutical industry 2. Better locations, a deterrent to firms wishing to enter markets where Starbucks is dominant, for example 3. Economies of scope, less expensive costs per unit created by bundling different types of products. For example, Procter & Gamble has low-cost marketing and distribution costs, compared to firms that manufacture only one type of product, because P&G ships dozens of different types of products to the same retailers. (See Chapter  4 for a more detailed explanation of economies of scope.) 4. Preferential access to critical resources, such as raw materials or access to distribution networks. For example, Chinese makers of lithium ion batteries have government-protected access to sources of rare earth elements, raw materials that are necessary for battery production. In many industries, new entrants face high barriers in the cost of building a dealer network or recruiting retailers to sell their products. With a limited number of potential dealers and retailers, new entrants often find themselves having to cut prices, and profit margins as well, to secure access to distribution. As with economies of scale, it is important for firms to track whether barriers are rising or falling. An expiring patent or the advent of an innovative distribution channel, such as the Internet, has the potential to radically change the strength of barriers related to cost advantages.

Capital Requirements

It costs money to enter a new industry. Not only do potential entrants often need capital to build a factory or store, but they may also have to invest in R&D to generate viable products, build inventory, undertake sufficient advertising and marketing to take market share from incumbent firms, and have sufficient cash on hand to cover customer credit. Anything that increases the start-up costs will reduce the pool of possible entrants. For instance, the computer semiconductor chip industry, dominated by Intel, makes a very complex product. New entrants would need to spend years of R&D before they had a viable product and could make their first sale. The high capital requirements needed for long periods of R&D limit the number of entrants to those with enough financial or other resources to enter. However, firms that already have made R&D investments in similar products, such as semiconductor chips for mobile phones, could lower the capital costs associated with entering the computer semiconductor industry. It is likely no coincidence that ARM, the maker of mobile semiconductor chips, is one of only a few successful entrants into Intel’s industry in the last 30 or more years.

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Network Effects network effects Growth in demand for a firm’s product that results from a growth in the number of existing customers.

In some industries, network effects increase the switching costs for customers, making it more difficult for new entrants to take business from incumbent firms. When network effects are in operation, the greater the number of people using products from a given firm, the greater the demand grows for that firm’s product. For example, the more people who use a particular social networking site, the more customers want to continue to use the site, and the more new customers are likely to try it. A new entrant wanting to compete with Facebook is at a distinct disadvantage, because most of their potential customers’ “friends” are likely to be on Facebook, making it less likely that they will be willing to switch to a new social media site. For new entrants to compete with a firm like Facebook they have to be innovative enough to attract large numbers of users quickly, creating their own network effect.

Government Policy Restrictions

Finally, government policies may make it more difficult to enter a market or even restrict a market completely to new entrants. For instance, governments often raise the costs of entry by requiring bonding, licenses, insurance, or environmental studies before a firm can enter an industry. New entrants will have to use capital that might have been used for R&D, production, or advertising to meet those requirements. When competing across international borders, additional regulations, such as trade restrictions and local content requirements, may be applied to try to limit foreign competition. In some industries, such as hairstyling, the requirements might be fairly minimal, but in others, such as oil refining, they can become so onerous that most new firms cannot overcome the barrier.

Threat of Substitute Products A substitute is a product that is fundamentally different yet serves the same basic function or purpose as another product. One of the primary problems for the strategist in assessing substitutes is determining what is a substitute and what isn’t. It involves determining the boundaries of an industry, as we addressed earlier in the chapter, and then scanning other industries to find products that might serve the same basic functions. For instance, e-mail is a substitute for telephone messages, faxed documents, or documents delivered via the post office. All four are ways of delivering messages. Similarly, fruit juice is a substitute for any number of other drink products, including coffee, wine, and soda. Generally, something can be considered a substitute if it serves the same function, such as quenching thirst, but does so with a different set of characteristics. If the product has the same basic characteristics and is made using the same general set of inputs, it would be considered part of rivalry, rather than a substitute. For instance, competitor brands serving the same basic need, such as Apple’s iPhones and Samsung’s smartphones running Google’s Android operating system, are rivals, not substitutes. In general, substitutes put downward pressure on the price that firms in an industry can charge. For instance, streaming video across the Internet is a substitute for watching movies in the theater. Even if you had the only movie theater in an area, you could not charge whatever price you wanted to. As your price rose, more customers would switch to streaming video. If the price difference is enough, customers will stream even though the quality is lower and they have to wait weeks or months before the movie leaves the theater and is available online. For some industries, such as newspapers, the low price of the substitute—in this case, free news on the Internet—can be disastrous, creating such a low cap on the prices they can charge that many firms go out of business. The factors that determine the intensity of a threat of substitutes include the awareness and availability of substitutes and their price and performance compared to an industry’s products.

Awareness and Availability Sometimes customers aren’t readily aware that substitutes exist. The threat increases when substitute products are well known. This is particularly true if there are strong brands among the substitute products. Likewise, if the substitute product is just as easy for customers to obtain as the industry’s products are, it is more of a threat. If the substitute is difficult to find or acquire, the threat is diminished.

Overall Industry Attractiveness

Price and Performance

A significant part of the customer decision to switch to substitutes will concern the price and performance trade-offs. As we discussed earlier in the chapter, customers are more likely to switch to a substitute if the costs of switching are low. The price of the substitute itself also factors into customers’ decisions. If substitutes are cheaper than products from another industry, the threat is higher. Likewise, if the performance of substitutes is similar or better, the threat is higher. The closer the substitute is in performance, the less flexible a seller can be with price. For instance, many newspapers have seen steep declines in circulation as Internet news has gained in quality. The Wall Street Journal, however, has not declined in circulation over the same time period because online substitutes for serious business news have not increased in quality nearly as fast as for other types of news.

Overall Industry Attractiveness Understanding the five forces that shape industry competition is useful as a starting point for developing strategy. Indeed, managers often define competition too narrowly, as if it occurred only among direct competitors. Yet competition for profits goes beyond direct rivals to include buyers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within an industry. Every company should know what the average profitability of its industry is and how that has been changing over time. The five forces help explain why industry profitability is what it is—and why it might be changing. Attractive (profitable) industries are those where firms have created power over buyers and suppliers, created barriers to entry to reduce the threat of new entrants, and minimized the threat of substitutes while keeping rivalry to a minimum. Even inefficient, relatively poorly run companies can earn superior profits under such conditions. At the other extreme are unattractive industries. Firms in these industries are consistently pressured by buyers and suppliers alike. They face high rivalry, easy entrance for new competitors, and many well-positioned substitute products. Under these conditions, only the most efficient, well-run companies are able to turn a profit. Each of the five forces can be analyzed to determine how, and the degree to which, it contributes to industry attractiveness. We provide a strategy tool at the end of this chapter for analyzing each force. After doing an analysis of each force, these can be combined to develop a detailed picture of what is driving the overall profitability—the attractiveness—of the industry. Few industries will rate high (attractive) or low (unattractive) on all forces. A significant threat from just one or two of the five forces is often sufficient to destroy the attractiveness of an industry. For example, many firms in the auto industry have struggled to be profitable over the last decade. This industry, however, has relatively low buyer and supplier power, no real threat of substitutes, and a moderate threat of new entrants. Rivalry, however, has been fierce, with constant excess production capacity and price discounting. Sometimes, it only takes one of the five forces to be unattractive to make an industry struggle. When many of the five forces are unattractive, firms face great challenges maintaining profitability. However, understanding each force and how it is influencing profitability helps managers know where to focus in dealing with those challenges. Moreover, a company strategist who understands that competition extends well beyond existing rivals will perceive wider competitive threats and be better prepared to address them. At the same time, thinking comprehensively about an industry’s structure can uncover opportunities to improve performance on each of the five forces, thereby becoming the basis for distinct strategies that yield superior performance. One thing to keep in mind is that the five forces are subject to change. Each of the five forces can be altered by actions taken by firms inside or outside the industry. For instance, Google built the Android operating system, even though it gives it away for free, to increase the number of suppliers for its search engine, thus decreasing the supplier power that Apple might have earned had it been able to dominate the smartphone industry. A good strategist always has her eye on actions and trends that might change any of the five forces in her industry. Not all of those trends come from actions taken by firms close to the industry. Some come from the general environment. These are discussed in the next section.

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Where Should We Compete? New Thinking About the Five Forces and Industry Attractiveness Strategists have long argued that where you compete is the starting point for strategic analysis. The traditional answer to this question has been to use the five forces model we just studied to compete in attractive (i.e., profitable) industries or markets characterized by high bargaining power over suppliers and buyers, low threats of substitutes or new entry, and low rivalry. This traditional argument is reflected in the recent best seller Playing to Win, by prominent strategists A. G. Lafley and Roger Martin, who argue, “Porter’s five forces help define the fundamental attractiveness of an industry and its individual segments.”23 We agree that the five forces model describes the kind of industry or market you’d like to create or compete in, and it remains an excellent model that firms all over the world use to keep tabs on the industry and markets they compete in and to get guidance about what tactical moves they can make to increase profitability in their industry. Executives, however, have to choose markets to compete in before they enter. This is where new thinking turns the five forces a bit upside down. Traditionally, you would give executives the advice to enter industries or markets that are rated “attractive” by the five forces. But the success of their choice to enter is determined almost completely by the unique value the firm hopes to offer and the resources and capabilities (these concepts will be covered extensively in Chapter 3) it has to deliver that unique value. Thus, whether a market is attractive may depend more on what the entrant can offer to that market rather than the structural characteristics of the market. To use a popular idiom: “Beauty is in the eye of the beholder.” Or, in other words, unattractive markets according to traditional industry analysis may be quite attractive to the right kind of entrant. By almost any measure of attractiveness, the automobile industry is not an attractive industry to enter. Entry barriers are enormous, bargaining power over customers is minimal, rivalry is high, and average profitability is quite low. No wonder there hasn’t been a successful US-based company entrant since Chrysler in 1925. Yet in 2008, during the Great Recession while the US government was bailing out GM and Chrysler to the tune of $80 billion24 Tesla, a California-based firm, entered anyway. They entered an unattractive industry at the depths of its unattractiveness—typically, a foolhardy strategic decision. Tesla entered the automobile market with the Roadster, a pricy, beautifully designed, battery electric (BEV) sports car. They followed with the Model S and Model X—both targeted at wealthy individuals with a penchant for fast cars and a desire to reduce carbon emissions and US dependence on foreign oil.25 Within nine years of entry, by February 2017, Tesla had generated a market value of more than $44.6 billion—double that of Chrysler and closing in on the 114-year-old Ford26—all in an “unattractive” industry. Where successful companies choose to compete doesn’t depend so much on the historical profitability or structural attractiveness of the market. Rather, it is fundamentally tied to what unique value they can offer, what capabilities they have, and whether they can prevent imitation (all concepts covered more fully in Chapter 3). For industries that are not attractive from a five-forces perspective, successful entry requires offering a unique value proposition with unique resources and capabilities. If you use an approach that mimics what incumbents are doing, your profits will be poor—just like incumbents. Nucor entered the unattractive steel industry, but did so in a radically different way. It used Mini-Mill technology and sourced scrap steel, rather than the traditional enormous steel production plants using iron and coke as their raw materials. Nucor was, and is still, able to produce steel at a much lower cost and to be highly profitable at a time when many US steel manufacturers have gone out of business.27 Markets that are unattractive from a five-forces perspective can still be attractive to new entrants—but only when they offer unique value.

How the General Environment Shapes Firm and Industry Profitability 31

On the flip side, it is also important to understand that attractive markets from a five-forces perspective are typically unattractive for new entrants. In an article for Harvard Business Review (see “Strategies to Crack Well Guarded Markets”), we reported that, on average, new entrants into highly profitable (attractive) markets were 30 percent less profitable than new entrants into unattractive markets (i.e., in general, it is easier for new entrants to make money in unattractive industries than attractive ones).28 The reason? Barriers to entry made it difficult for the new entrant to establish itself. So, on average, an attractive market (from a five-forces perspective) is actually the least attractive market for a new entrant. But wait. We also found that when new entrants did achieve profitability in the most attractive markets, they were four times as profitable as the average profitable entrant elsewhere. For example, the beverage industry has historically been a high-profit industry (indeed one of the most profitable)—but one with high barriers to entry. So according to the logic we’ve been discussing, it should be an unattractive market for new entrants. Walmart, however, decided to enter anyway—offering consistently low prices with its Sam’s Choice brand. We won’t spell out exactly how Walmart did it because those barriers to entry are part of the Coca-Cola and Pepsi case that is a companion to this chapter. Suffice it to say that Walmart was able to overcome each element of the barriers to entry that Coca-Cola and Pepsi had painstakingly erected over decades. By figuring out how to circumvent the entry barriers, Walmart was able to grab almost 5 percent share in an attractive market, indeed in one of the most attractive markets from a five-forces perspective. The point is that if firms figure out how to circumvent the barriers to entry into an attractive market, it can be profitable even if they aren’t able to enter with a particularly unique value proposition (Sam’s Choice Cola isn’t all that unique). Finally, we’ve learned that industries as we’ve historically defined them (e.g., automobiles, medical equipment, computers, cell phones, etc.—think about the NAICS codes we covered at the beginning of this chapter) are becoming somewhat irrelevant as it relates to finding attractive markets to compete in (it is not irrelevant to understanding the dynamics of an industry you are already in). In deciding where to compete (i.e., which markets to enter), it is helpful to be as specific as possible rather than using broad generalities such as industries as they have historically been defined. In fact, as Harvard business professor Clayton Christensen has suggested, you compete at the “job to be done” level (if you truly understand the functional, emotional, and social needs of your customer segment, the task of offering unique value becomes much easier).29 Tesla started in the automobile industry by targeting wealthy individuals who loved fast cars but also had a desire to be green. Customers purchased a Tesla not just because it solved a functional need (transportation, rapid acceleration/speed) but also an emotional need (“I want a green world”) and a social need (“I want to be part of the Tesla community and want others to know about my social consciousness”). Now Tesla has added in-home battery charging stations and roof-mounted solar panels for homes. So from a historical perspective, Tesla is now in the roofing segment of the home construction industry as well as being in the automobile industry. One could say that Tesla is in the energy industry at a very high level—which is true. But it has expanded into roof tiles and battery-charging stations to do a particular job for a very specific segment of customers: provide a convenient one-stop shop for clean energy at home and on the road for individuals who want a green world.30 When the industry is defined at the “job to be done” level, it then makes it easier to identify what other companies are also trying to do at that specific job (competitors) and what substitutes exist for that job.

How the General Environment Shapes Firm and Industry Profitability To determine the landscape that a firm competes in, it isn’t enough to only understand the five forces that directly affect an industry. The general environment also needs to be understood, as it can affect firms in a variety of ways,31 including affecting the shape of each of the five industry forces. A simple way to think about the general environment is to break it down into eight

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categories. Strategic managers in the best companies are focused on each of these categories, looking for trends that might lead to new opportunities or threats. This is illustrated in Figure 2.3: • Complementary products or services • Technological change • General economic conditions • Population demographics • Ecological/natural environment • Global competitive forces • Political, legal, and regulatory forces • Social/cultural forces Developments in each of the eight categories shown in the outer ring have the potential to shape and change the general landscape for any specific industry. Each category can affect an industry’s dynamics, which are shown by the area within the center circle, altering any or all of the five forces. You should always keep in mind that an industry’s five forces are not static. The five forces are subject to change and may change, even radically, if elements of the general environment change. When you are examining the general environment, it is important, then, to not just get a picture of what things look like today but to analyze trends and the direction each category is headed toward tomorrow. Remember, as well, that this analysis is industry specific. You want to know how each of the eight categories is going to affect the industry you are studying, rather than how it might affect a single firm. Both levels of analysis can be useful. But at this stage you want to know how the general environment might affect the five forces, potentially giving you advance notice of what is going to change in your industry and a chance to plan accordingly.

THE GENERAL ENVIRONMENT Complimentary Products/Services

NEW ENTRANTS

Social/Cultural Forces

Political/Legal/ Regulatory Forces

Global Forces

BUYER POWER

COMPETITOR RIVALRY

Technology Change

SUPPLIER POWER

SUBSTITUTES

Ecological/Natural Environment FIGURE 2.3

Trends in Opportunities and Threats in the General Environment

General Economic Conditions

Demographics

How the General Environment Shapes Firm and Industry Profitability 33

The relative importance of each of the general environmental factors differs from industry to industry. In the fast-food industry, social forces, such as a shift toward healthier eating, are likely to significantly alter the threat of substitutes, but technological change doesn’t play as large a role. In the motorcycle manufacturing industry, demographics play a key role, as many industrialized nations experience an upward trend in the average age of the population, but changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting in fewer people riding because of their age rather than a societal shift in the perception of motorcycles. Managers need to develop a deep sense of which environmental factors are strategically relevant to their own industries.32 Managers need to understand not only which factors have the largest impact on their industry right now, but also which factors are likely to change in the future, so that they can adapt their firms’ strategies to changing conditions.

Complementary Products or Services Complementary products or services are those that can be used in tandem with those in another industry. For example, video gaming hardware and software, or smartphone operating systems and Apps, are complementary sets of products. When two complements are used together, they are worth more than when they are used apart. Complementary pairs or groups (also called ecosystems) of products can be found in many places, not just in the technology sector.33 Gas stations and roads are complements to automobiles, and piping is a complementary product to natural gas. Trends in complementary industries have the potential to radically alter—for better or worse—the landscape in which firms compete. Take the rise of application software (Apps), for instance. In the 1990s, Microsoft created tools for software designers. By doing so, Microsoft lowered the barriers to entry in the application software industry, a complementary industry to operating systems. Apple made it even easier to enter the App industry by releasing segments of its operating system code, creating even more new entrants and sparking the rise of single-purpose, inexpensive Apps for mobile computing devices. Now, customers at Apple’s App store can choose from hundreds of thousands of Apps for their iPhones. The number of new entrants in the App industry is actually increasing the barriers to entry in the smartphone operating system industry. It would be difficult for a new mobile operating system to come on the scene and compete with Apple or Android. Even powerful Microsoft has experienced challenges entering the mobile operating system business even though it had a head start over Apple and Google.34 For many industries, changes in complementary products are one of the most important trends to keep an eye on. Some consider them significant enough that they even refer to them as a sixth force among the five industry forces.35

Technological Change Technological change within an industry has the potential to radically reshape a firm’s landscape, and sometimes society with it. Technological changes can include new products, such as smartphones; new processes, such as hydraulic fracturing (fracking), which has dramatically increased the output of the natural gas industry; or new materials, such as lithium batteries, which make electric automobiles possible. In many industries, the pace of technological change has accelerated over the last couple of decades.36 Managers find it increasingly important to consistently scan the environment to locate potential new technologies that might affect their industries.37 Early adopters are often able to gain greater market share and earn higher profit margins than those who are late to adopt, suggesting the importance of incorporating new technologies early. Not only can technology change the nature of rivalry in an industry by giving some firms an upper hand in gaining market share, but it can sometimes lower barriers to entry. For instance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such as steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new technology for smelting steel called the electric arc oven allowed new firms, such as Nucor, to enter

complementary products or services Products or services that can be used in tandem with those from another industry.

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the industry with only one-tenth the capital investment that would have been needed to start a traditional steel firm. Perhaps the technological change that has affected the threat of new entrants in the greatest number of industries in the last 20 years is the Internet. Some have suggested that the next giant wave of technology change, one we are in the middle of experiencing, is wireless communication, like smartphones, which allow individuals to connect to and from anywhere and anyone at any time; and the coming 5G wireless revolution, which promises to allow those connections to occur at speeds that truly allow connection to and from anything and anyone, at anytime, and from anywhere no matter how much data is being transmitted.38

General Economic Conditions Changing macroeconomic forces can also have a large impact on industries. The state of an economy can affect a region or nation and, subsequently, the ability of the average firm in an industry to be profitable. Analyzing the economic environment typically involves measuring the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or deflation. The appendix provides a list of sources where you can find information on these economic indicators.

Economic Growth

How quickly, or slowly, an economy is growing has a direct impact on most firms’ bottom line. Economic expansion tends to improve customer balance sheets, lower price sensitivity, and increase the growth rate in an industry, as customers purchase more, easing rivalry. For example, a number of African nations, such as Nigeria and Kenya, have experienced solid levels of economic growth in the last few years.39 As a consequence, a growing percentage of the population has sufficient disposable income to afford products like automobiles and cell phones. Companies providing products like these in Africa have experienced a boom in customer demand.40 The reverse is also true. When an economy slows down, industry growth rates slow, customers are more price sensitive, and suppliers are also likely to be struggling and pursuing ways of increasing profits—at the expense of firms in your industry, if they have the power to do so.

Interest Rates

Interest rates particularly affect rivalry by increasing or decreasing the demand for an industry’s products. This is particularly true for expensive items like housing, cars, and even education, which often require customers to take out loans to purchase. For example, the housing boom experienced in the United States and Europe in the early 2000s was fueled by low-interest-rate loans, sometimes below 4 percent, when the average mortgage interest rate in the previous decade had been above 6 percent. When interest rates are low, industry growth rates increase and rivalry decreases. When interest rates are high, the opposite can occur. In addition, interest rates affect the cost of capital. When interest rates are low, many firms can afford to invest in new assets. As interest rates increase, new investments become more difficult. As a result, firms sometimes engage in price wars as a strategy for gaining market share when rates are high, rather than investing in R&D and new product development.

Currency Exchange Rates Currency exchange rates reflect the value of one country’s currency in relation to the currency from another country. Exchange rates can have a large impact on the prices that customers pay for products from firms in other countries, directly affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss franc appreciated 65 percent against the US dollar, making Swiss products 65 percent more costly in the United States, even though the cost of production hadn’t changed at all. Nestlé, a Swiss firm, was particularly hard hit. It either had to decrease its profit margin to cover the extra cost or increase its prices substantially, risking fewer customers buying its products. Inflation

A significant, consistent rise in prices, known as inflation, can create many problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year (low

How the General Environment Shapes Firm and Industry Profitability 35

inflation), then next year that product will cost $1.02. If it is higher, though, say 30 percent, which is not unheard of around the world, the product would cost $1.30 next year and $1.63 the year after that, doubling the cost in three years. Inflation or deflation, if they are high enough, can make it hard for firms to plan investments. Inflation tends to decrease overall economic growth, increasing rivalry and possibly buyer and supplier power and the threat of substitutes. When firms can’t predict what price they will be able to get for a particular product, investments in new product development become riskier. When inflation is high, many industries experience increases in price competition, rather than development, as a means of gaining market share.

Demographic Forces Demographic forces involve changes in the basic characteristics of a population, including changes in the overall number of people, the average age, the number of each gender or ethnicity, or the income distribution of the population.41 Because demographic changes involve basic shifts in the product and geographic markets that firms target, demographic changes are always accompanied by opportunities and threats. Even though demographics often change slowly, they fundamentally reshape the landscape, so good strategic managers have a firm understanding of demographic trends. The appendix contains a list of readily available sources for demographic information. Some sources, such as the World Bank, contain hundreds of different demographic indicators. Over the last 50 years, the size of the world’s population has more than doubled, from around 3 billion to more than 7 billion people. Projections suggest that the Earth’s population could reach 9 billion by 2040.42 Each new individual is a potential new consumer, suggesting that growth rates of many industries will increase over time. However, increases in consumption resulting from population growth also mean that supplies of raw materials (such as the rare-earth metals terbium and europium currently used in flat-panel displays43) are likely to decrease. Furthermore, the world population isn’t spread evenly over all nations. The enormous populations of China and India account, to a large degree, for the number of firms that have set up operations in those countries. The average age of the population within a nation can also have a tremendous effect on some industries. In Japan, for instance, more than 20 percent of the population is over age 65. In the United States, this won’t occur until around 2040.44 The robotics industry has already felt this shift. Japanese companies like Honda have invested tens of millions of dollars in robots for home use, including walk-assist robots that help seniors with weakened muscles remain ambulatory when they would otherwise need to use a wheelchair.45

Ecological/Natural Environment The natural environment can also be a source of change for many industries. In some cases, this involves changes to the physical environment such as increasing shortages of key inputs like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas). More often, though, current trends in the natural environment involve changes in the public’s perception of how business affects the environment. From global warming to clean air and water, the public in many countries—including developing economies like China—are demanding that firms be more proactive in protecting the environment. Many firms have responded by implementing green initiatives. Although some of these may be for public relations purposes only many firms have established serious goals. For instance, Procter & Gamble has goals to use 30 percent renewable energy to power its plants by 2020. By 2014, 7.5 percent of its energy needs were already met by renewable energy. They have also promised to reduce their energy consumption, water usage, greenhouse gas emissions, and waste by 20 percent by 2020. They have already reduced them by 8 percent by 2014.46 If consumers truly care about the environment, then actions like these increase rivalry as competitors are forced to respond in kind.

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Global Forces Global forces also play a large role in shaping many industries. Over the last 50 years, as communications and transportation technologies have undergone a revolution, trade barriers among nations have fallen dramatically. Many countries, from South Korea and Taiwan, to China and India, to Brazil and South Africa, have enjoyed remarkable economic growth and a rising standard of living. These changes have caused firms from many countries to expand operations and begin producing and selling across national borders. We will examine global forces and strategies for capitalizing on them in greater detail in Chapter 9.

Political, Legal, and Regulatory Forces Political, legal, and regulatory forces are those that arise from the use of government. When new laws are passed, they may alter the shape of an industry and influence the strategic actions that firms might take.47 For example, the federal Affordable Health Care Act, enacted in 2009, mandated that health insurance companies insure everyone, including those with preexisting conditions. This changed the cost structure of the insurance and healthcare industries, resulting in consolidation and less rivalry, as inefficient firms either went out of business or were acquired by more viable firms. In the United States, following the Great Recession of 2008– 2009, the Federal Reserve required banks to keep larger amounts of cash on hand to cover potential mortgage-related losses. One consequence of this regulation was less lending to small businesses, erecting entry barriers in many industries and changing the nature of rivalry in industries with many small firms. Because political processes, laws, and regulations have the potential to shape and constrain industries, managers should analyze and understand the impact of new laws and regulations and decide how to respond. The Affordable Health Care Act, for example, required firms with over 50 employees to provide health insurance for their workers, or face fines. Because the law also provided for health insurance exchanges through which uninsured people could buy their own insurance, some firms dropped employee health insurance as a benefit. Their managers have determined that the fines their companies face would be cheaper than the current premiums for health insurance. Of course, laws can provide opportunities as well as threats. For instance, laws in many countries and states in the United States that require electricity providers to obtain a percentage of their electricity from renewable sources have resulted in a boom in demand for wind turbines and solar panels. Because of the potentially far-ranging effect of laws and regulations, many firms and industries strategically lobby government in an attempt to influence the lawmakers to enact legislation favorable to their industries.

Social/Cultural Forces Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes are so fundamental that they often affect the other six general environmental forces, shaping the overall landscape in which firms compete. For instance, changing cultural norms about health have resulted in laws against sodas being sold in schools and lawsuits against fast-food retailers such as McDonald’s for marketing “unhealthy” food to children. Like the other environmental forces, however, social forces can create opportunities if a firm happens to be among the first to act on changes in values and attitudes. For instance, Facebook helped to change social norms about connecting to friends and family. It reaped enormous profits for being among the first to capitalize on the change in social networking. Social forces are different, sometimes radically so, in different countries. Firms that compete in a global industry must understand differences among consumers in each country they serve. For example, the collectivist orientation of many people in China results in a general belief that the well-being of the group is more important than that of the individual and a related norm of open information sharing.48 This open-sharing norm allows a greater acceptance of product knockoffs and software pirating than many people are comfortable with in countries that tend to have individualist orientations, such as the United States.

Review Questions 37

Summary • One of the primary decisions that firms need to make is which industry, or environment, they are going to compete in. Defining a firm’s industry correctly is important because it helps managers to identify their competition. One tool for helping to define an industry is the NAICS codes produced by the US government. • Not all industries are equally attractive. Five major forces determine the attractiveness of an industry, defined as the profitability of the average firm in the industry. These forces are rivalry, buyer power, supplier power, threat of new entrants, and threat of substitute products. • Good managers develop a deep understanding of the effect of each of the Five Forces on industry attractiveness. Such an understanding allows them to take strategic action to influence the five forces in a positive way for their firm and industry. Misunderstanding the nature of the five forces can lead to decisions that destroy industry profitability.

• New thinking suggests that for potential entrants the conventional wisdom needs to be re-examined. Rather than suggesting that new entrants should always look for industries that are attractive, for new entrants who possess unique value, entering an unattractive industry can be much more profitable than entering an attractive industry. But if you don’t possess that unique value you can still enter attractive industries if you completely understand the barriers to entry and can overcome each one. • Eight general environmental factors can affect the profit potential of a firm: complementary products or services; technological change; general economic conditions; demographic forces; the ecological/ natural environment; global forces; political, legal, and regulatory forces; and social/cultural forces. Changes in any of these eight factors can create additional opportunities and threats and often shape the five industry-specific forces.

Key Terms attractiveness of an industry 21 backward integration 24 barriers to entry 26 complementary products or services 33

forward integration 26 network effects 28 opportunities 21 rivalry 21

substitute 21 supplier 24 switching costs 23 threats 21

Review Questions 1. Why is it important for a firm to accurately determine what industry it is in?

not hold? Besides the examples used in the book, can you think of any other examples?

2. How should a firm decide what industry it is in?

11. Can you identify some of the eight general environmental factors that might be important for the personal care industries that Procter & Gamble participates in, such as shampoo, dish and laundry detergents, toothpaste, and cough medicine, to name a few? Please feel free to use the Internet to get more information about Procter & Gamble. The appendix also has a guide about how to gather information about the eight general environmental trends. If your professor assigns this question as part of a larger project, you may find the appendix to be very useful as a starting point.

3. What are the five major industry forces? How do they shape average profitability in an industry? 4. What factors determine the intensity of rivalry? 5. Which type of industry has more rivalry, fragmented or concentrated, and why? 6. Explain what happens to buyer power when buyers have increased price sensitivity. 7. Explain what it means for suppliers to have a credible threat of forward integration. 8. What factors determine the intensity of the threat of new entrants? 9. What are substitutes? Can you name any substitutes for the laptop most of your classmates are using? What about substitutes for watching your university play football on Saturdays? 10. Under what conditions does the traditional advice concerning entering attractive markets and staying away from unattractive ones

12. How does each of the eight general environmental factors influence industry profitability? Take your time in answering this one and examine how at least one general environmental factors affects each of the five forces (you can use a different environmental factor for each of the five forces). 13. What are the elements of a complete external analysis?

38

CH A PT E R 2

Analysis of the External Environment: Opportunities and Threats

Application Exercises Exercise 1: Practice evaluating the industry five forces using the strategy tools presented in this chapter and using the cola industry case included in your textbook. Read the case, Coca-Cola, Pepsi, and the Shifting Landscape of the Carbonated Soft Drink Industry. 1. Use the strategy tool presented in this chapter, along with data from the case, to evaluate: a. The intensity of rivalry within the cola manufacturing industry (where Coca-Cola and Pepsi are prominent firms). Is rivalry high, medium, or low? b. The intensity of supplier power within the cola bottling industry (where Coca-Cola and Pepsi are prominent suppliers). Is supplier power high, medium, or low? 2. Where sufficient data aren’t available, use qualitative evidence to evaluate the strength of a particular factor. Whether there is sufficient data or not, fill in the explanation/data line of each strategy tool where the data can be found and/or a summary of your logic. 3. Which industry is likely to be more attractive: cola manufacturing or bottling? Why? Use your analysis to back up your claim.

Exercise 2: Practice evaluating the five forces, using the strategy tools presented in this chapter. 1. Use either an industry that your professor assigns to you or pick an industry of your choice. 2. Use a five-forces tool that your professor assigns to you (or one of your choice) to evaluate that force within the industry you are

analyzing. Be prepared to either hand in your completed analysis, using the tools from Figures 2.3–2.9, or show and explain it in class.

Exercise 3: Analyze the effects of the general environment on an industry of your choice. 1. Identify an industry you would like to learn more about. Ideally, you should be able to gather sufficient information on this industry to thoroughly analyze the impact of the general environment on industry profitability. Although information is available for a wide variety of industries, this exercise will be easier if you choose an industry that has been written about consistently in the business press. In order to manage the volume of data required for a thorough analysis, your instructor might want you to focus solely on the home country of the largest firms in the industry (unless most firms earn a majority of their profits from abroad). 2. Use data from a variety of sources, including those listed in the appendix, in your analysis. 3. Try to identify the major effects of each of the eight factors (complementary products; technological change; general economic conditions; demographic forces; ecological/natural environment forces; global forces; political, legal, and regulatory forces; and social/cultural forces) on industry profitability. 4. Identify and predict any short-term to medium-term changes in any of the eight factors that might alter average profitability in the industry. Address how those changes will affect industry profitability in the future. 5. As part of the analysis, consider how the general environmental factors may affect each of the five industry forces (rivalry, buyer power, supplier power, threat of new entrants, and threat of substitutes).

Strategy Tool Evaluating Industry Attractiveness Using Porter’s Five Forces Model Understanding the five forces and their effect on the landscape that a firm competes in is a cornerstone of successful strategic analysis. Figures 2.4 through 2.9 are general analytical tools used by a number of Fortune 500 firms to evaluate the intensity of the five forces in an industry, either their own or one they are thinking about entering.48 These tools essentially help to quantify the ideas that we have already discussed in this chapter. In practice, top management often implicitly understands the dynamics of the five forces and might not personally use the tools presented here to map out the strength of each force and its overall effect on industry profitability. However, a number of Fortune 500 firms use these tools in their strategic planning departments to provide rigor to the strategic analyses and recommendations they present to top management. Although the tools might appear complicated, they distill the concepts from this chapter, allowing a relatively simple, yet comprehensive and detailed analysis of the five forces. You can look for the data to complete these analysis tools in the sources listed in the appendix at the end of the book. Many of the

indicators in these analysis tools are objective numbers that you can obtain from various data sources. Others are more subjective; they require a logical argument for the level—low, medium, or high—that you choose. Even for more subjective indicators, however, data from various sources, for instance, articles in the business press, can take the guesswork out of doing a five-forces analysis. To use the tools, for each separate item, put an X in the box that most accurately reflects the data you have gathered on your industry. For some boxes this is a range of data, for instance, 60 to 70 percent combined market share in the rivalry tool. If the correct number is anywhere within the range, put an X in the appropriate box. Cite your data source and/or explain the logic of your placement underneath each item. Your answer for some rows of boxes will be an average of more than one item. For instance, in the rivalry tool, the degree of industry standardization is the average of the four items below it. After filling out each item, you will use the columns. Each column is assigned a number, 1 through 5. The columns will help you to find the correct answer for elements that have subsets to them. For instance, in the rivalry worksheet, you need to determine whether the degree of industry product standardization is low, medium, or high. The low,

Strategy Tool medium, and high are encased in boxes, letting you know that this is a major concept, while the rows that are not in boxes will help determine the answer to the major concept. You also should notice that each row of boxes lines up with a number to the left. Each number is a major concept that you will use to determine the overall level of whichever force you are measuring, in this case, rivalry. So, to determine the degree of standardization, you will use data and/or logic to put an X on the right answer (according to your data) for each of the four rows underneath Product Standardization. Now the columns come into play. Notice that each X that you placed falls under one of the columns. Each column has a number 1 through 5. Add up the placement of your Xs and then divide by the number of rows you were using (in this case there were four) to determine whether Product Standardization is high, medium, or low. For example, if the answer, according to your data and/or logic, for the four rows under Product Standardization was (1) 5%–10%, (2) 50%, (3) Med, and (4) Med (each of these four items was in column 3), you would add these together (3+3+3+3), getting the number 12. You would then divide by the number of rows you were using (4) and end up with the number 3. That tells you to put an X in the row of boxes for Product Standardization that is in column 3, which would be medium. If the sum for the four rows doesn’t divide evenly by 4, round the decimal to the nearest whole number to see which column your X should go in. So, if instead of 12 our total was 15, we still would

FIGURE 2.4

divide by 4 rows, returning the number 3.75. This means we would put our X under column 4, meaning that Product Standardization is between medium and low. To get the value for the overall intensity of each force, you will first add the values from the boxes with Xs in them (the major concepts, i.e., that have a row of boxes and a number next to them on the left side of the worksheet). The values come from the columns. So you would look down each column and see if a box has an X in it. If all the boxes are in Column 1, we would get a 6 for the rivalry worksheet because there are six major concepts. If all of the boxes were in column 5, we would get a 30 (6 x 5 = 30). After you have a total from adding the numbers of each box, which you obtained from the column it is in, you divide that number into the number of major concepts (6 for rivalry) times the number of columns (5). For the rivalry worksheet, the total number possible is 30. Suppose the sum of all of the major concepts (found in the boxes, each one under a numbered column) for your analysis is 15. Using those two numbers, you have 30 divided by 15 = 2. You would then place your answer for the Overall Intensity of Rivalry (the row at the very bottom) under column 2, resulting in Rivalry that is relatively competitive (halfway between fiercely competitive and neutral). As with the subconcepts, always round your answer to the nearest whole number. If you got a 1.6 or a 2.4, you still would put your final X under column 2. And now that you know how to use the worksheets, go and do great work!

Strategy Tool—Evaluating the Intensity of Rivalry (mark an × in the appropriate box

for each factor)

1. Number and Relative Size of Competitors • Top 4 competitors’ combined industry market share

1

2

3

4

5

70%

Explanation/Source of Data:

2. Degree of Industry Product Standardization

High

Med.

Low

(take the average of the bullet points below)

• Difference between competitors in price of similar products

15%

100%

75%

50%

25%

0%

Explanation/Source of Data:

• What % of industry’s products are sold at discount? Explanation/Source of Data:

• Customers’ ability to recognize brands from industry

Low

Med.

High

Low

Med.

High

Explanation/Source of Data:

• Degree of switching costs Explanation/Source of Data:

3. Industry Growth Rate Explanation/Source of Data:

5%

4. Unused Industry Production Capacity • % of industry wide production capacity currently in use Explanation/Source of Data:

5. Degree to which firms have high fixed costs or products have high storage costs or are perishable

100%

High

Med.

Low

High

Med.

Low

Explanation/Source of Data:

6. Extent of Exit Barriers Explanation/Source of Data:

Overall Intensity of Rivalry (take the average of the major factors, items numbered 1 through 6)

39

Fiercely Competitive

Neutral

Mildly Competitive

40

CH A PT E R 2

Analysis of the External Environment: Opportunities and Threats

FIGURE 2.5 Strategy Tool—Evaluating the Intensity of Buyer Power (mark an × in the appropriate box for each factor)

1. Buyer Industry Bargaining Power (take the average of the bullet points below)

• Buyer concentration (top 4 buyers as a % of total industry volume sold to buyers)

1

2

High >70%

3

4

Med. 60–70%

50–60%

5 Low

40–50%

50%

30–50%

20–30%

5–20%

50%

30–50%

15–30%

5–15%

70%

60–70%

50–60%

40–50%

30%

20–30%

10–20%

5–10%

>5%

5%

Explanation/Source of Data:

• Difference between suppliers in price of similar products Explanation/Source of Data:

• Importance of suppliers’ brands to the end consumer

High

Med.

Low

High

Med.

Low

High Power

Neutral

Low Power

Explanation/Source of Data:

3. Possibility of Supplier Forward Integration Explanation/Source of Data:

Overall Intensity of Supplier Power (take the average of the major factors, items 1 through 3, above)

Strategy Tool FIGURE 2.7 Strategy Tool—Evaluating the Intensity Threat of New Entrants (mark an × in the appropriate box for each factor)

1. Incumbent Firms’ Cost Advantages (take the average of the bullet points below)

• Size of scales economies: measured as the slope of the scale curve (see Chapter 4 for how to calculate this)

1

2

Low >95%

3

4

Med. 85–95%

80–85%

5 High

70–80%

>70%

Explanation/Source of Data:

• Size of investment in plant and machinery required to enter industry

Small

Med.

Large

Small

Med.

Large

Low

Med.

High

Explanation/Source of Data:

• Size of investment in marketing needed to match incumbent brand awareness Explanation/Source of Data:

• Degree to which incumbents employ property rights, like patents, to protect their market share Explanation/Source of Data:

• Market share required to break even

40%

Explanation/Source of Data:

Low

Med.

High

Weak

Neutral

Strong

Low

Med.

High

• Degree to which network effects affect buying decision Explanation/Source of Data:

Low

Med.

High

• Cost for entrants to comply with government regulations

Low

Med.

High

Low

Med.

High

2. Other Incumbent Firm Advantages (take the average of the bullet points below)

• Strength of incumbents’ brands (how influential in customer purchase decision?) Explanation/Source of Data:

• Size of switching cost for incumbents’ customers Explanation/Source of Data:

Explanation/Source of Data:

3. Additional Considerations (take the average of the bullet points below)

• Profitability of average incumbent

>15%

10–15%

5–10%

0–5%

5%

3–5%

1–3%

0–1%

250 cc)

Honda Price Experience Curves25

Source: Company annual reports.

The numbers, however, told a different story. The three Japanese heavyweights, Honda, Yamaha, and Suzuki, controlled a dominating 85 percent of the US market.27 Moreover, it was clear that Honda wasn’t content with just being the lightweight bike leader and intended to continue introducing heavier models into the markets it had developed. But, with no competition from the Japanese in the heavyweight market (650 cc motorcycles and larger), Harley essentially ignored its emerging competitors. Harley went public in 1965, and in a friendly takeover, the company was acquired by American Machine and Foundry (AMF), which had been looking to expand its portfolio into leisure goods. AMF recognized the growth potential of the motorcycle market and wanted a slice of the profits. When asked about AMF’s decision to acquire Harley-Davidson, then CEO of AMF, Rodney Gott, explained, “There was a motorcycle craze. You could sell anything you could

Harley’s Redemption

produce. We wanted to meet [this] demand.”28 But there was a problem: Harley-Davidson’s production techniques were outdated. Each Harley-Davidson motorcycle was essentially crafted by hand, using job-shop production techniques, and required detailed attention from a skilled workforce. However, hiring and training a skilled workforce took more time and money than AMF was willing to expend. As a result, AMF added less-skilled workers to the assembly line and expanded production from 15,475 units in 1969 to 70,000 units in 1973. But the increase in output came with a significant drop in motorcycle quality.29 When asked to describe the deterioration of the Harley brand, Richard Teerlink, the firm’s CFO during the time of the increase in production, explained, “In the early ‘80s, Harley’s reputation for reliability and quality had fallen as steeply as its market share, which had dropped from 100% of the domestic market to a low of 23%. Brand new Harleys sitting on the dealership floor had to have cardboard put down beneath them to sop up the leaking oil.”30 The drop in quality soon extended to a drop in the brand’s reputation, and Harley-Davidson bikes earned the nickname “Hardly Drivable.” However, the bad news for Harley didn’t stop with nicknames. In 1975, Honda introduced its first 1000 cc motorcycle, the highly anticipated heavyweight Goldwing, which brought with it the most sophisticated technology for a heavyweight bike at the time. Furthermore, the Goldwing offered consumers a quiet alternative to the loud Harley, and it did so with better reliability at a lower price. Consequently, Goldwing sold almost 100,000 units in the first four years. Although an excellent penetration in the heavyweight bike segment, it amounted to only a small fraction of the more than 5 million motorcycles Honda was selling worldwide at the time. Slowly, more Japanese heavyweight bikes entered the market, and to Harley-Davidson’s horror, its market share in the heavyweight segment dropped. Harley now faced a daunting situation—poor product quality drove away nontraditional customers at the same time that its traditional customers were switching to Japanese motorcycles. It appeared as if Harley was headed for bankruptcy.

Harley’s Redemption By 1980, amid mounting competition, AMF decided to sell Harley-Davidson to Harley CEO Vaughn Beals and a small group of Harley-Davidson managers. However, Beals was only able to raise a small portion of the $81 million buyback price and took on the rest as debt.31 With Harley’s profitability already down, the highly leveraged buyout obligated the new owners to pare down costs by decreasing motorcycle production and laying off employees. The move was a major blow to company morale, but by this point Harley-Davidson was simply trying to survive. In order to avoid financial disaster, Harley needed to improve product reliability and get production costs in line with its Japanese competitors. As Beals explained, “Harley-Davidson’s production system was basically flawed. In this system, we gave the worker responsibility for quantity, not quality. Then we set up a whole police force for quality and a battalion of accountants to measure errors made in production.”32 Referring to some of the differences in quality between Honda and Harley-Davidson, experts explained that “only 5 percent of Honda’s motorcycles failed to pass final quality inspection,” while “over 50 percent of Harley’s failed the same test.”33 Moreover, compared to its Japanese competitors, Harley was producing subpar bikes less efficiently. According to Harley-Davidson’s internal estimates at the time, overall Japanese productivity was more than 30 percent greater than at Harley-Davidson.34 To understand how the Japanese manufacturers produced motorcycles at such a high level of quality and quantity, Tom Gelb, Harley’s senior vice president for operations at the time, along with a group of other senior Harley managers, arranged a tour of Honda’s Ohio plant. Of that experience, Gelb explained, “The [Honda] assembly line was neat and uncluttered—unlike our operation, where the line was always littered with parts and material. There was minimum

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Harley-Davidson

paperwork, and things flowed very smoothly.”35 One reason for Honda’s smooth flow surprised the Harley executives. Unlike Harley’s expensive and inefficient computerized inventory system, the Japanese employed noncomputerized just-in-time (JIT) production methods that required far less buffer inventory for both work-in-process (WIP) and finished motorcycles. Furthermore, Honda built each bike to order, instead of building for inventory.36 Jeffrey Bleustein, Harley’s senior vice president for parts and accessories, admitted, “[The Japanese] . . . were just better managers . . . and they understood how to do manufacturing a hell of a lot better, with less inventory and much higher quality.”37 Beals realized that, in order for Harley to survive, it needed to dramatically change its manufacturing system—and fast. To give the company some time to implement these changes, Harley sought tariff protection, a fee imposed on a foreign company’s product that increases its price in the marketplace, from the US government. Fortunately for Harley, in 1983, the International Trade Commission granted the American manufacturer a five-year protection tariff on heavyweight (above 700 cc) motorcycles imported from Japan.38 With no time to waste, Harley went to work and took three steps to improve its production and quality. First, line workers were encouraged to contribute to the decision-making process. Workers were required to participate in the newly formed quality circles that were made directly responsible for improving motorcycle quality. Second, a materialsas-needed (MAN) program, the company’s version of Honda’s JIT inventory control practices, was implemented to free up much-needed cash by reducing work-in-process (WIP) inventory. It was hoped that lowering the inventory levels would make quality problems more apparent and force employees to take action. Third, under SOC [statistical operator control], employees were taught to see how quality problems developed and how they could be traced and corrected during the production process.39 As a result of the changes to the manufacturing process, Harley’s productivity and reliability improved dramatically. The new system reduced WIP inventory by 75 percent and lowered scrap and rework by 68 percent. Moreover, the increased efficiency was accompanied by an increase in labor productivity of more than 50 percent, and the reliability of Harley-Davidson motorcycles improved substantially. It took some time, but Harley’s newfound ability to produce higher quality bikes at lower cost resonated with customers. The improved motorcycles led to a growth in Harley’s US revenues of more than 80 percent during the next five years and an increase in operating profits of $59 million.40 As proof of Harley’s comeback and an indicator of a bright future, the company went public for the second time in a well-received IPO in 1989. To celebrate, Harley initiated a motorcycle parade down Wall Street.41

HOG Heaven In the late 1980s, Harley-Davidson began to recover, but it hadn’t proved its potential for sustainable growth in revenues and profitability. The change in leadership brought with it a number of improvements for getting Harley bikes up to par with competitors. Furthermore, more efficient processes in manufacturing helped improve the motorcycles while cutting costs. Dealerships also worked hard to provide a better buying experience for customers. But even though these changes helped Harley get back on its feet, they weren’t enough to make the company compete effectively. To do that, the American manufacturer decided to refocus its marketing campaign on what it meant to own a Harley-Davidson. Despite the shattering of the company’s reputation for quality, some key pieces of Harley’s identity were kept intact. For example, the bike was still considered to be a symbol of Americana and American manufacturing. After all, it was the bike of choice for celebrities Elvis Presley and James Dean. In short, owning a Harley-Davidson motorcycle still had the aura of rugged American individualism. As CEO Jim Ziemer explained, “One of the main

Philip Goodier/Alamy Stock Photo

HOG Heaven C-63

EXHIBIT 4

The Harley Davidson Experience

things that gives us an edge over the competition is that we sell more than just motorcycles and related products—we sell a complete experience” (see Exhibit 4).42 Leveraging this competitive advantage, Harley developed several ad campaigns that depicted riders living the “complete experience.” In one Harley commercial, a group of bikers pulls up to a rural gas station where a man, visibly impressed by the motorcycles, is filling up his car. As one of the bikers starts to fuel his bike, the man says, “Nice Harley.” The biker responds with “thanks,” and he continues to concentrate on filling up his tank. The guy at the car adds, “Yeah, I was going to get one of those myself but, uh, spent the sixty-four-ninety-five on a killer dinette set.” The biker looks up at the driver with an expression of incredulity. A woman biker who overhears the conversation also stares in disbelief. The man at the car continues, “It was tough, ya’ know. Harley or dinette set—Harley or dinette set.” There is a pause as both the bikers stare at the man, who halfheartedly admits, “Went with the dinette set.”43 This commercial and others like it that Harley aired presented a powerful question to the viewer: Who are you and what do you want out of life? Another part of the complete experience that Harley emphasized was bike customization, which helped riders express their rugged individualism. The “Build Your Bike” feature on Harley-Davidson’s website offered different combinations of rims, seats, bags, and other features, that a customer could fit on several unique bike styles. After the bike was ordered, dealers and salesman had catalogs with almost 900 pages of additional add-on options from which the enthusiast could select to further customize.44 The customization process became so popular that Harley-Davidson offered customers financing up to 60 percent above the price of a base-model motorcycle through its own financing program, Harley-Davidson Financial Services (HDFS).45 The Harley-Davidson biker culture encouraged motorcyclists to further customize and show off their bikes at the Harley-Davidson community fun rides and rallies each year. In order to support the Harley-Davidson culture and community Harley sponsored the development of numerous enthusiast and social groups. The most popular of these groups was the Harley-Davidson Owners Group (HOG). Formed in 1983, the HOG was created to encourage riders to become more involved with other local Harley owners and in motorcycling events, including state rallies, anniversary celebrations, and scavenger “touring” hunts.46 In 30 years, the HOG grew to more than 1 million members, making it the world’s largest motorcycle

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Harley-Davidson

enthusiast organization.47 The cost of membership includes owning a Harley and paying for a HOG membership, which ranges from a $25 annual fee with limited benefits to $120 for three years with full benefits, including roadside assistance, magazines, touring guides, and access to all rallies. HOG chapters organize rallies, fun rides, charity support, and other events that reinforce a sense of community and identity among riders. In describing how HOG has influenced Harley’s success, an article in BusinessWeek said the following: [T]he real buzz comes from the 886,000 members of the company-sponsored Harley Owners Group. They are the ones who organize rides, training courses, social events, and charity fund-raisers. They pore through motorcycle magazines and wear the Harley-branded gear to feel more like rugged individualists and outlaws when they take to the road on weekends. A quarter of a million of them descended on Milwaukee last Labor Day to celebrate the brand’s centennial. No wonder more than half of new Harley sales are to current customers who are trading up. The brand is self-reinforcing.48 Members of the HOG organized local communities of riders and made sure there was a culture of buying up Harley paraphernalia. Historically, HOG members spent an average of 30 percent more on the Harley-Davidson gear compared to other Harley owners. However, that gear was not limited to motorcycle parts for customization. It also included accessories such as leather jackets, key chains, lampshades, Christmas tree ornaments, and even a special edition Barbie. Harley owners were willing to buy almost anything with the Harley logo on it. Harley-Davidson decided to start licensing its brand aggressively in the mid-1980s when Clyde Fessler, then the company’s vice president for business development, saw that Harley needed to give people access to the Harley experience whether they owned a bike or not.49 Fessler launched a successful licensing strategy campaign and created the Harley-Davidson Motorclothes line, which enabled enthusiasts to benefit from the Harley experience more often and increased brand awareness.III As a result, the bar and shield logo became the company’s most valuable asset. By 2016, the Harley bar and shield logo, a symbol of American individualism, was the 80th most valuable global brand, with an estimated value of $5.5 billion.50 Fessler recognized the need to protect Harley’s brand image, and as a result, the company’s licensing department developed strict guidelines. First, after submitting a proposal and design of what the final product would look like, the licensee was required to get Harley-Davidson approval to create a prototype. After receiving approval, the merchandiser was then required to send a sample of the product and await final approval. When final approval was given, the merchandiser could then produce its branded product, but it was responsible for advertising and distributing the product across the dealer network. Lastly, Harley collected royalties for each sale—typically in the range of 10 percent to 30 percent. Licensing its brand has proven to be an extremely profitable way for Harley to grow revenues. Indeed, revenue from licensing sales made up roughly 25 percent of Harley-Davidson profits in 2012.

Looking for Growth: International Markets Throughout its storied history, Harley Davidson had been a US-centric company with the majority of its sales coming from the United States. Critics have argued that Harley hasn’t moved fast—or effectively—enough overseas, either to establish low-cost factories or to find new customers.51 These criticisms come despite the fact that Harley has expanded sales to 70 countries around the world. However, less than 20 percent of Harley’s sales come from outside of the United States.

The Harley-Davidson Motorclothes line accounts for an average of $210 million in revenue every year.

III

Looking for Growth: International Markets

It wasn’t really until 2000 that Harley looked to expand its footprint into international markets because the US market had matured. However, while international markets seemed to be a potentially attractive way to grow, Harley found international expansion to be quite challenging. Harley’s entry into mainland China, for example, illustrates the company’s challenges. Harley-Davidson’s entry into China started in the Hong Kong market in 1995 and served as a launching pad for entry into mainland China, which occurred 10 years later with a dealership in Shanghai. However, it quickly became apparent that Harley’s heavyweight bikes would have a tough time selling in the country. Sean Jiang, managing Harley-Davidson director for China, described some of the problems: Regulations make it difficult for consumers to buy and ride motorcycles—mostly because it is difficult to get a license plate. Plus, China has a compulsory scrap policy that dictates all bikes must be scrapped after 11 years. China’s regulations were set some 20 years ago when conditions were quite different. The smaller bikes that were mass produced then were generally of poor quality. Road conditions and traffic management were also poor. The bikes caused safety, traffic, and pollution problems. These bans still remain in effect today, even though motorcycle quality, road conditions, traffic management, and rider profiles have all changed.52 The regulations that made selling Harley’s heavyweight bikes a challenge were only part of the company’s uphill battle to sell motorcycles in China. Import duties in China could add 30 percent to the sticker price on a new Harley, and shipping could add an additional 5 percent to 10 percent to the bottom line.53 For example, in 2013, the Touring Ultra Classic Electra Glide, which cost $21,800 in the United States, started at 340,000 Yuan ($53,000) in China. This high price limited the motorcycles’ potential customer pool to the wealthy. As Jiang explained, “Because of the import structure and high pricing, our customers here have a much higher disposable income.”54 The price problem was made more complicated because of the availability of less-expensive substitutes. Honda, which has had a long presence in China, sold 1.29 million units in China in 2010, compared to Harley, which sold only 268 motorcycles in the same year. Put another way, 2010 saw more Harleys sold in one Milwaukee dealership than all of China.55 To help mitigate this problem, Harley turned to diplomacy in order to promote the brand and reduce import tariffs. During a tour of China, Wisconsin Governor Scott Walker participated in Harley-Davidson’s 110th anniversary celebration to help promote the brand.56 He met with President Xi Jinping to mediate for the American manufacturer amid political accusations of unfair trade practices. However, the meeting made little difference, and Harley continued to face high tariffs and competition from several wellknown Chinese manufacturers such as Lifan and Loncin (each of which produced more than 1 million units). Jiang noted: In 2010, China produced 27 million motorcycles, 99 percent of which were small, easily affordable bikes—such as mopeds—used for basic transportation. Only a couple of domestic manufacturers make models with engines sizes up to 600 cc. For comparison, Harley-Davidson’s smallest engine is 800 cc, and ranges up to a very large 1,600 cc. The concept of heavyweight leisure motorcycles is not yet understood in China. There’s no infrastructure, wholesale or retail financing, insurance, or roadside assistance, as compared to China’s more mature auto industry. Because the segment isn’t yet established, consumers in China have little awareness of heavyweight motorcycling as a leisure activity.57 In addition to the challenges associated with regulations and price, Harley had to figure out how to help customers in China and other international markets appreciate the Harley brand and the value associated with being part of the Harley community. In 2006, as part of that effort, Harley launched the first HOG chapter in Beijing, China, and progressively sponsored numerous rides and rallies through its 11 Chinese dealerships. With these initiatives, Harley hoped to gradually gain traction in the large Chinese market. As the company looked to expand into new markets and customer segments, Harley continued to focus on ways to help potential customers understand the meaning of owning a Harley-Davidson motorcycle.

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C-66

Harley-Davidson

Riding into the Unknown Under the June supermoon, a group of bikers cruised the open road in the southern Utah desert under the collective thudding of their Harley Davidson V-twin engines. These friends were united years ago by their mutual love for riding and adventure. Ever since their first exhilarating ride together, they meet at least once a year and go on a new trek, making lifelong memories on the journey. Suddenly, as the twilight appears on the eastern horizon, an incoming telephone call appears on the bike’s dashboard. The rider looks down to see who’s calling—it’s his boss. The biker with a subtle grin uses the thumb-operated joystick to toggle from “Answer” to “Ignore” and goes back to his joy ride. That scene, taken from a Harley-Davidson commercial, is part of the largest newmodel launch in Harley-Davidson’s history: “Project Rushmore.”58 The launch involved eight new motorcycles with dramatic shifts in both technology and feel—areas that traditional Harley riders might consider sacrilege to change. But to Harley, these changes were far overdue. Critics claimed that Harley was too dependent on older white males and wasn’t diversifying its owner base quickly enough. Nor was Harley keeping up with Asian competitors, such as Honda and Kawasaki, in quality or productivity.59 As part of the transformation, the new bikes were designed to vibrate less and included gadgets more technologically advanced than those on any bike Harley had previously produced.60 Beyond Project Rushmore, in early 2017 CEO Matt Levatich announced that Harley had plans to offer 50 new models in the next five years in order to drive sales. “The success we saw with the launch of the Milwaukee-Eight engine is a sign of the innovation we have in place. We are confident our 2018 line will also help sales,” said Levatich. “I have never been more excited about the products in our pipeline.”61 Despite Levatich’s optimism, many analysts questioned whether more new models would be enough to help Harley overcome the challenges the company faced, such as attracting nontraditional riders and growing in international markets. Would higher quality and more technologically advanced motorcycles open new doors to future growth? Was it a good idea for Harley to focus more on product attributes such as quality and technology, areas where competitors had historically been stronger? Moreover, could the Harley brand and product transcend US culture to connect with new customers in international markets? Was it worth the investment? Finally, had Harley maximized its opportunities to grow by licensing its brand to merchandisers? Or could the company grow by expanding into other product categories beyond motorcycles? These questions, and others, faced Levatich and his team as they looked for ways to keep Harley growing.

References B. Tuttle, “The Harley-Davidson Surprises: Touchscreens, Voice Control and Women Bikers,” Time Business & Money (September 3, 2013), http://business.time.com/2013/09/03/the-harley-davidson-surprises/. 1

Interbrand, “Best Global Brands 2013,” Interbrand, http://www .interbrand.com/en/best-global-brands/2013/Harley-Davidson. 2

Harley-Davidson, Inc., 10-K Annual Report, 2012.

3

Harley-Davidson, “Investor Relations: Demographics,” Harley-Davidson USA (2013), http://investor.harley-davidson.com/phoenix.zhtml?c=87981 &p=irol-demographics.

4

5 6 7

Ibid. Ibid. Harley-Davidson internal research, September 2007.

R. L. Nolan and S. Kotha, Harley-Davidson: Preparing for the Next Century (Cambridge, MA: Harvard Business School, 2006), p. 3. 8

A. Taylor III, “The Hurdles at Harley-Davidson,” CNN Money (October 3, 2012). 9

Harley-Davidson, “H-D Timeline,” Harley-Davidson Museum, http:// www.harley-davidson.com/en_US/Content/Pages/HD_Museum/explore /hd-timeline.html. 10

Ibid.

11

Ibid.

12

Ibid.

13

Nolan and Kotha, p. 2.

14

Ibid.

15

References C-67 Harley-Davidson, “H-D Timeline.”

16

Ibid.

17

Ibid.

18

Nolan and Kotha, p. 2.

19

E. T. Christiansen and R. T. Pascale, Honda (A) (Cambridge, MA: Harvard Business School, 1983), p. 1. 20

Ibid., p. 2.

21

Ibid., p. 3.

22

Advertising Age (December 2, 1965).

23

Christiansen and Pascale, p. 2.

24

Christiansen and Pascale, p. 7.

25

Forbes (September 15, 1966).

26

Christiansen and Pascale, p. 2.

27

P. C. Reid, Well Made in America: Lessons from Harley-Davidson on Being the Best (New York, NY: McGraw-Hill, 1990), p. 6. 28

Nolan and Kotha, p. 4.

29

Reid, p. 6.

30

Nolan and Kotha, p. 5.

31

43 Harley-Davidson. “Dinette Set.” Television advertisement. Carmichael Lynch, directed by Tom De Cerchio, 2004.

Harley-Davidson Company, Harley-Davidson Genuine Motor Parts & Accessories 2014, 2014.

44

Interview with Rick Story, Dealer Manager at Harley Davidson’s Lindon, Utah, dealership.

45

Harley-Davidson, “H-D timeline.”

46

C. Denove and J. D. Power IV, Satisfaction: How Every Great Company Listens to the Voice of the Customer (2007), p. 195.

47

“Cult Brands,” BusinessWeek (August 1, 2004).

48

G. Rifkin, “How Harley Davidson Revs Its Brand,” Strategy+Business (October 1, 1997). 49

R. Clifton, J. Simmons, and S. Ahmad, Brands and Branding; The Economist Series 2nd Edition (New York, NY: Bloomberg Press, 2004).

50

A. Taylor III, “The Hurdles at Harley-Davidson,” CNN Money (October 3, 2012).

51

P. M. Miller, “Harley-Davidson in China,” China Business Review (January 1, 2012).

52

K. Inoue, ed., “Harley-Davidson in China Encounters Barriers of Entry for Two Wheels: Cars,” Bloomberg News (September 18, 2011).

53

Reid, p. 18.

54

Nolan and Kotha, p. 5.

55

Ibid.

56

32 33 34

Reid, p. 4.

35

Nolan and Kotha, p. 5.

36

Reid, p. 15.

37

Harley-Davidson, “H-D Timeline.”

38

Ibid. Ibid.

J. Harper, “China Has Harley-Davidson Fever, Thanks to Gov. Scott Walker,” The Washington Times (May 17, 2013). P. M. Miller, “Harley-Davidson in China,” China Business Review (January 1, 2012).

57

J. Fogelson, “Project RUSHMORE: 2014 Harley-Davidson Motorcycles,” Forbes (September 3, 2013).

58

Nolan and Kotha, p. 6.

59

Statistics quoted from Reid.

60

39 40

Nolan and Kotha, p. 6.

41

Harley-Davidson Company, Code of Business Conduct, p. 26.

42

Taylor.

“Rushmore Bikes Lead to Positive Q3 for Harley-Davidson,” Powersports Business (October 22, 2013).

61 http://www.bizjournals.com/milwaukee/news/2017/01/31/harley -davidson-plans-50-new-models-over-next-five.html.

CASE 6 Ecolab and the Nalco Acquisition Sustainable Advantage Through Shared Values Doug Baker, CEO of Ecolab since 2004, turned his chair away from the desk and looked out over the St. Paul, Minnesota, skyline. In his 10 years at the helm of the Minnesota cleaning and sanitation firm, he had transitioned the company from a premier provider of cleaning, sanitation, and hygiene supplies to a leader in environmental sustainability. No action he took had been more significant than Ecolab’s 2011 acquisition of Nalco, the nation’s leading industrial water treatment and management firm. Baker’s task on this spring afternoon in 2015 was to finalize his presentation for the upcoming board meeting. He needed to provide an assessment of the success of the Nalco acquisition. As he looked out on a beautiful Minnesota spring day, he pondered two questions: First, with a little more than three years since the deal closed, how successful had the acquisition really been, and second, what key learnings did he want his team to remember as they considered future acquisitions?

Ecolab Historical Origins The Ecolab that Doug Baker headed looked remarkably different from, and yet very similar to, the company founded by Merritt J. (M. J.) Osborn in 1923. Osborn worked as a travelling salesman and noticed that the hotels he stayed in had to take rooms out of service for up to two weeks every time they cleaned the carpets. Osborn developed a carpet cleaner—Absorbit—that cleaned carpets in less time and with less water, meaning that rooms would be out of commission for a much shorter time. Although customers paid more for Absorbit, their total cost of cleaning—factoring in labor, water usage, and downtime—would be lower.1 Osborn named his company Economics Laboratory (EL). “Economic” because it saved customers time, labor, and material costs, and “Laboratory” because the products were backed by laboratory research. In 1924, EL introduced Soilax, an easy-to-use and measure dishwashing detergent that set EL on the path of market leadership in the category. In 1928, Osborn rolled out a line of Soilax dispensers and other dishwashing equipment; EL became a provider of dishwashing solutions, not just soap. Over the next nine decades the company developed and followed a rather simple business model: identify a pressing customer problem in cleaning and sanitation, and develop a scientific solution that would save customers labor, maintenance, downtime, and equipment costs. Customers would pay a premium for the company’s products because their lower total cost of using the EL system would more than make up for the costs of the products and regular on-site service provided by EL. EL hired technical people as field representatives, and a core tenet of Osborn’s philosophy was that EL staff should “know more about the cleaning processes of that

C-68

Ecolab

industry than anyone else, including the customer.”2 Economics Laboratory sales and field service representatives would also be on call 24/7 to respond to customer challenges or problems with an EL system. This high level of customer service and support also justified the company’s price premium. EL entered the dairy industry in the early 1950s. Poor cleaning practices and limited refrigeration capabilities meant that milk had a useful shelf life of only three days, leading to significant waste in the industry. EL bought a dairy equipment supplier, Klenzade Products, in 1961. Klenzade had pioneered a clean-in-place (CIP) system that allowed dairies to avoid the costly and time-consuming process of dismantling their entire production line to clean the system. EL combined its cleaning and sanitation expertise with Klenzade’s core technology to roll out an improved CIP system for dairies, and eventually a variety of food and beverage customers. Doug Baker would note a half-century later that EL was the company that probably made the single biggest contribution to milk shelf life with its clean-in-place technology.3 EL continued to innovate and build out strong market positions in the consumer and institutional and light industrial (“I&I”) cleaning and sanitation business: food and beverage production, food service (restaurants and cafeterias), healthcare, and hospitality. In 1986 EL changed its name to Ecolab and began to shift its identity. The “eco” now stood for ecology and environment, while the “lab” continued the focus on science and technology.4 The following year the company sold its consumer dishwasher detergent business to focus solidly on serving its I&I businesses. Ecolab remained true to the original philosophy of M. J. Osborn through its emphasis on hiring and training technical experts who could help business customers solve problems and provide ongoing 24/7 service.

Ecolab in the Twenty-First Century When Doug Baker assumed the role of president and CEO of Ecolab in 2004, the company had just broken $4 billion in sales, had created a division specifically to grow its healthcare business, and enjoyed a strong international presence.5 Ecolab had rolled out a two-prong strategy a decade earlier: Circle the Customer, Circle the Globe. Circle the Customer described the process of finding an increasing number of customer-centric solutions for unique customer problems; Ecolab realized that “while we are only a very small part of our customers’ cost to operate, because we ensure their ability to operate and protect their brand equity, we impact a large part of their P & L.”6 Circle the Globe meant that Ecolab would follow its customers as they expanded in international markets and continue to provide trusted solutions and support. The company Baker inherited continued to evolve. In 2002 the company launched its EcoSure business, an assessment, evaluation, and training service that expanded the company’s offerings from a focus on “end-of-use” cleanliness and sanitation to “beginning-ofuse” product safety and “in-use” process integrity. Ecolab won the 2006 Black Pearl Award for Corporate Excellence in Food Safety and Quality, presented by the International Association of Food Protection (IAFP). The award recognized Ecolab’s contribution in enhancing food safety and employee awareness and knowledge through its efforts.7 The award came at the same time as Ecolab began hearing from its customers that their businesses environments were shifting: Being a maker of high-quality and/or low-cost products and services was no longer enough; customers desired that these products and services be produced and delivered in a sustainable way that conserved, preserved, and reused natural resources wherever possible. As a steward of much of their customers’ use of chemicals and solvents, and the water and waste that accompanied those products, Ecolab realized that its ability to help customers on their path to sustainability was both a business necessity and a tremendous opportunity for growth.

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C-70

Ecolab and the Nalco Acquisition

The Move to Sustainability Christophe Beck, then executive vice president of the company’s institutional businesses, explained that “the essence of sustainability is the fundamental proposition that you improve business performance at a lower cost as you reduce the use of natural resources. It’s a win, win, win proposition.”8 The customer, Ecolab, and the environment would all win through sustainable solutions. As Ecolab’s leaders looked toward the future as a company focused on sustainability, they instinctively looked to the past for guidance. Beck, Baker, and other members of the executive team realized that eight decades earlier, M. J. Osborn had created a company and a philosophy consistent with the modern notion of sustainability. Ecolab’s focus on lowering a customer’s total cost of operation built on a foundation of reducing the overall quantity of resources used, natural and human, that went into cleaning and sanitizing work, and minimizing the waste produced in the process. For its customers, sustainability may mean radical changes in the way they did business, but for Ecolab sustainability meant more of a change in messaging and tone since the DNA of sustainability had been hard wired in the company from its founding. As the company reframed the business conversation with its customers around sustainability, new opportunities for growth appeared. Sam Hsu directed Ecolab’s operations in China from 2007 to 2012. When he arrived, customers, including Chinese government officials, viewed the company as a seller of commodities. Hsu began talking about Ecolab’s capabilities in food safety and sustainability. The message resonated with officials in the midst of planning for the 2008 Olympic Games and the associated challenges of feeding visitors and athletes in a very high-profile setting. Ecolab staff worked with several government ministries to define new, and import existing, global standards for food safety and security. Ecolab became a central participant in a coalition of government officials, industry associations, public health interests, and media representatives. By 2010, its focus on food safety and sustainability had transformed Ecolab from a seller of soap to a trusted advisor and business partner.

The Nalco Acquisition Ecolab shifted its strategic position and messaging to focus on sustainability, but the company continued on its historical trajectory of creating innovative systems to solve customers’ toughest problems. The company also enjoyed leadership positions in its core sanitation business with 35 percent of sales in food services and 25 percent in food and beverage production; the other 40 percent of Ecolab’s sales came from its healthcare segment (15%), hospitality (10%), and its other, smaller market segments (15%).9 Exhibit 1 displays Ecolab’s selected income statement from 2008 to 2014. By early 2011, the company had developed a strong competency in antimicrobial products and delivery systems for infection control, a mission critical issue for its healthcare business, but also important to food and beverage and hospitality customers. Twenty years earlier, when talking with customers about their operating needs, Ecolab was told water treatment was a critical need for its institutional, food and beverage, and commercial laundry customers, all of whom had large water treatment needs. It was at that point the company realized the criticality of water and water management to sanitation, hygiene, and infection control for its customers and Ecolab set up to build a global capability in water treatment. The executive team realized that Ecolab now needed more competence and skill in water treatment and management; Ecolab wasn’t, but needed to be, “masters of water.”10 The question was how to become a master of water, and Ecolab had two options: Build the capability internally or buy the competence through an acquisition. Ecolab attempted to build a water business through smaller acquisitions but had been unable to build the critical scale need to serve its global customers. Angela Busch, senior vice president for corporate development, explained that as the team investigated the water market, Nalco was the market leader and that “you can try to build Nalco 2 [which you can never do because they are the masters of water], or maybe you could buy them.” After some discussion the team realized “you can’t out Nalco Nalco,” and Ecolab executives began to explore an acquisition.

The Nalco Acquisition

EXHIBIT 1

C-71

Selected Financial Data: Ecolab

All Numbers in Millions 2014

2013

2012

2011 (Pro Forma)

2011 (Actual)

2010

Net Sales

$14,280.50

$13,253.40

Cost of Goods Sold

($7,679.10)

General, Selling, and Administrative

($4,577.60)

2009

2008

$11,838.70

$11,283.90

$6,798.50

$6,089.70

$5,900.60

$6,137.50

($7,161.20)

($6,483.50)

($6,126.40)

($3,475.60)

($3,013.80)

($2,978.00)

($3,141.60)

($4,360.30)

($3,920.20)

($3,920.60)

($2,438.10)

($2,261.60)

($2,174.20)

($2,257.20)

($68.80)

($1 71.30)

($145.70)

($19.80)

($131.00)

($7.50)

($67.10)

($25.90)

$1,955.00

$1,560.60

$1,289.30

$1,256.70

$753.80

$806.80

$681.30

$712.80

($256.60)

($262.30)

($276.70)

($74.20)

($59.10)

($61.20)

($61.60)

Combined Income Statement (Abbreviated)

Special Gains (Charges) Operating Income Interest Expense Income Tax Expense Net Income

($476.20)

($324.70)

($311.30)

($216.30)

($216.60)

($201.40)

($202.80)

$1,222.20

$973.60

$701.30

$463.30

$531.10

$418.70

$448.40

$3.93

$3.16

$2.35

$1.91

$2.23

$1.74

$1.80

$2,721.90

$2,663.30

$2,660.80

$448.50

$449.40

$469.30

$3,170.40

$3,007.40

$2,787.90

Net Income per Common Share Diluted Segment Information Net Revenue US Cleaning and Sanitizing US Other International Global Industrial

$4,886.70

$4,742.80

$4,762.20

$4,623.30

$2,036.60

Global Institutional

$4,314.50

$4,152.50

$4,063.20

$3,852.00

$3,852.00

Global Energy

$4,283.30

$3,427.30

$2,275.40

$1,882.20

$100.50

$750.30

$709.30

$736.30

$701.40

$701.40

Other

Data for 2008–2010 taken from 2010 10-K filing, https://investor.ecolab.com/~/media/Files/E/Ecolab-IR/ Annual%20Reports/2010-annual-report.pdf Data for 2011–2012 taken from 2013 10-K, https://investor.ecolab.com/~/media/Files/E/Ecolab-IR/ Annual%20Reports/2013-annual-report.pdf Data for 2013–2014 taken from 2014 10-K, https://investor.ecolab.com/~/media/Files/E/Ecolab-IR/ Annual%20Reports/2014-annual-report.pdf

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Ecolab and the Nalco Acquisition

Nalco Nalco’s Business Operations The National Aluminate Corporation came into being through the 1928 merger between two Chicago suppliers of sodium aluminate, a chemical for treating water to prevent fouling and scaling in boilers and other industrial applications. The Chicago Chemical Company sold sodium aluminate to industrial plants, and the Aluminum Sales Corporation sold the chemical to railroads for use in locomotive boilers. The company became the Nalco Chemical Company in 1959, a name change that reflected a business that concerned itself with all types of industrial water treatment challenges and had a strong presence in the manufacturing, mining, nuclear energy, oil and gas, and pulp and paper industries.11 After an accident at Union Carbide’s chemical plant in Bhopal, India, in 1984, business leaders and government authorities became more concerned with safety as a business issue, and by the mid-1990s Nalco found itself moving beyond chemicals to help its customers meet increasingly stringent regulatory requirements—health, safety, and water use—while providing cost-efficient solutions. For example, Nalco helped Mobil Oil develop and deploy a system for treating oil tanker sludge that recycled the sludge for other uses, saving the company money as it no longer had to dispose of hazardous wastes or buy separate inputs.12 Suez Lyonnaise, the French water giant, purchased Nalco in 1999 for $4.1 billion, valuing Nalco at 24 percent above its trading price.13 Suez hoped the acquisition would solidify its position as the world’s largest water treatment company; however, the acquisition failed to create value. Suez competed in the municipal water segment, which had a different sales cycle, buying process, and value proposition than Nalco’s industrial business, and the companies created few meaningful synergies. Cultural differences between European and American business cultures also created difficulties for merging the two companies. Suez sold Nalco to a consortium of private investors in September 2003 for $4.35 billion.14 That consortium, Blackstone Group, Apollo Management, and Goldman Sachs Capital Partners, began to recoup their investment in January 2004 when the company issued $445.8 million in high interest notes, with all of the proceeds going to the consortium. Nalco did an IPO in the fall 2004, raising $800 million for a 40 percent interest in the company, with consortium members receiving $544.5 million of the IPO proceeds. To fund the company, Nalco ballooned its total debt to $3.37 billion by the end of summer 2005, putting sustained pressure on cash flow and net income.15 Exhibit 2 provides data on Nalco’s financial performance prior to the Ecolab merger.

Nalco: Technology and Markets While the company’s balance sheet became impaired, Nalco’s position as the undisputed market leader in industrial water treatment provided the company with a stable cash flow stream to manage its debt. In 2004, the company brought to market a new, patented water management system, 3D TRASAR™. The three D’s stood for Detect, Determine, and Deliver. In Detect, the automated system continuously checked input and system-wide water for impurities, changes in the chemical composition of water, or minerals that would cause scaling. The system then automatically Determined the remedial cocktail of treatment chemicals to restore water quality, and Delivered those without human intervention.16 3D TRASAR technology allowed Nalco to charge its customers a price premium compared to bulk chemical suppliers, which customers willingly paid because 3D TRASAR lowered their total operating costs through higher quality input and production water, less system downtime and maintenance through automation, and longer asset life due to reduced scaling and other impurities. 3D TRASAR also allowed Nalco to sell additional services, such as an electronic control and monitoring service that allowed Nalco to become, in essence, the manager of its customers’ water. Nalco’s 7,500 technical sales and support staff provided the expertise that backed up the 3D TRASAR system and offered customers easily accessible technical and business support.

Nalco

EX HIB I T 2

Selected Financial Data: Nalco Corporation

All Figures in Millions, Except per Share 2010

2009

2008

$4,250.50

$3,746.80

$4,212.40

Water services

$1,809.60

$1,636.30

$1,919.00

Paper services

$755.20

$683.50

$778.00

Net sales

Energy services

$1,685.70

$1,427.00

$1,515.40

($3,672.80)

($3,342.90)

($4,224.60)

Cost of product sold

($2,336.70)

($2,040.90)

($2,381.80)

Selling, administrative, and research expenses

($1,285.40)

($1,206.30)

($1,246.50)

Total operating costs and expenses

Amortization of intangible assets

($43.20)

($47.90)

($56.80)

Restructuring expenses

($2.60)

($47.80)

($33.40)

Gain on divestiture

$0.00

$0.00

$38.10

Impairment of goodwill

($4.90)

$0.00

($544.20)

Operating earnings (loss)

$577.70

$403.90

($12.20)

Interest expense

($231.90)

($254.50)

($258.80)

Income tax expense

($103.30)

($67.80)

($54.50)

$201.70

$67.90

($334.60)

$1.41

$0.44

($2.44)

Net Earnings (Loss) Earnings per common share Diluted

Data taken from 10-K filing https://www.sec.gov/Archives/edgar/data/1298341/000119312511047634/d10k.htm 2008 segment data http://getfilings.com/sec-filings/100226/Nalco-Holding-CO_10-K/

3D TRASAR helped Nalco grow its revenues within the industrial segment, and its sales mix in 2010 came from Energy (40% of revenue), Industrial and Manufacturing (31%), and Pulp and Paper (18%). Overall, Nalco was the recognized market leader in global industrial water treatment with 28 percent of the market, three times larger than GE Water, its closest competitor. Nalco was named “water company of the year” in 2004, and the company became the nation’s—and the world’s—leader in innovative water management. Emilio Tenuta, Nalco’s first director of sustainability, noted that after the award customers came to Nalco with a new request: They wanted more than just water treatment; they wanted Nalco to help them conserve water and become more sustainable in their water use. Tenuta developed the notion of eROI to help Nalco service staff and their customers understand the business value of sustainability. Nalco helped customers improve their sustainability and profitability by working in five areas: • Safety: Nalco products, services, and systems helped create cleaner, safer and healthier operating environments for employees and customers. • Water: Nalco solutions conserve water and optimize water quality. • Energy: Nalco solutions save energy by enabling more efficient operations, or help produce more energy by uncovering new oil and gas reserves. • Waste: Efficiency, recycling, and reuse solutions helped keep waste out of landfills. • Assets: Products and services such as 3D TRASAR improve asset use and lengthen asset life. By 2011, sustainability had become an essential element in Nalco’s strategy. Their customers loved Nalco’s systems for their quality and cost-reducing properties, and that Nalco helped reduce their overall environmental impact. Nalco products helped a number of their clients land a spot on prestigious indexes, such as the Dow Jones Sustainability Index. Customers began to see that Nalco offered “sticky” solutions, ones that reduced costs and improved reputation over a number of years.17

C-73

C-74

Ecolab and the Nalco Acquisition

E XH I B I T 3

Ecolab Share Price, July 18–22, 2011

Date

Open

Volume

July 22, 2011

51.6335

11746873

July 21, 2011

51.3177

12081296

July 20, 2011 (Announcement date)

49.4043

23175092

July 19, 2011

47.7603

1225653

July 18, 2011

49.3393

1364653

Source: https://www.macrotrends.net/stocks/charts/ECL/ecolab/stock-price-history.

Announcing the Acquisition Ecolab announced its intention to purchase Nalco on July 20, 2011. Ecolab agreed to pay $38.80 per share for Nalco, a 32 percent premium over Nalco’s trading price. Seventy percent of the deal would be in stock, with Ecolab trading its own shares for Nalco’s outstanding stock (0.7005 shares of Ecolab for each Nalco share outstanding, for a total of $3.8 billion). The other 30 percent of the purchase price would be a cash payment, for a total of $1.6 billion. Ecolab would also assume Nalco’s $2.7 billion debt load. Exhibit 3 shows how the market reacted to the announcement. Baker attributed the steep penalty for the Nalco offer to two factors. First, over his tenure Ecolab had focused on small, “bolt-on” acquisitions representing minor extensions of Ecolab’s reach;18 the Nalco deal was the largest of Baker’s career, and investors seemed to wonder if the two companies could be combined to create strategic value. Second, Baker felt that investors assumed that Ecolab must be in trouble, and hence overvalued, if they were making a play for a company like Nalco.19 The executive team believed that the merger would create substantial value. On the strategy side, Angela Busch noted that “buying Nalco was like finding our long-lost brother,” and bringing him home would help the combined family grow and prosper. Busch’s and Baker’s internal numbers saw the acquisition as accretive to Ecolab shareholders and pressed ahead. Their analysis also projected initial run-rate cost synergies of $150 million a year: $50 million in savings in general and administrative costs, and $100 million from supply chain efficiencies.20 They were subsequently raised to $250 million. In terms of its acquisition strategy, the Nalco acquisition represented the fulfillment of a 20-year quest to offer a premium global water treatment solution. It represented a significant pivot, a large acquisition that could catapult Ecolab into new market spaces. The ultimate test for any acquisition, according to Angela Busch, is “are we the right owners for them[?] How will they benefit us? How will we benefit them?” Baker and the executive team knew that creating value through this acquisition would require careful premerger integration planning and successful postmerger execution, and so he and his team went to work.

Premerger Acquisition Planning Baker and his team began planning for the Nalco acquisition with four assumptions that guided their decision making: 1. Neither Nalco nor Ecolab would be the same after the merger. Changes were inevitable, and the role of planning and premerger work represented an effort to guide and direct many of those changes. Proactivity beat reactivity. 2. Ecolab had to watch out for the “conquerors mindset” so common in acquisitions: “Our company bought yours and so we must be better than you.” In this case, Ecolab was buying on the premise that Nalco was, in water treatment, a better company; Nalco had probably forgotten more about water treatment than Ecolab knew. 3. The Nalco merger (not “acquisition”) would be a “best of” combination, where the best practices of either company would be adopted going forward. The goal was to build something truly great and unique, not protect turf or play power games.

Nalco

4. Synergies are like an annuity. Wall Street would forgive and forget the costs of implementation as a one-off expense but would love the recurring value of cost and revenue synergies. Ecolab and Nalco needed to spend whatever was required to realize those synergies as quickly as possible.21 Baker created an integration team that drew key people from each company. Half the team came from Ecolab, with Christophe Beck at the head, and half from Nalco, initially with Stewart McCutcheon and then with Mary Kay Kaufmann, a senior vice president, leading that contingent. This leadership team eventually created 28 separate project teams to consider every part of the business, from overall mission and vision, through product and technology development, including back-end business operations.22 Christophe Beck and Mary Kay Kaufmann laid out their vision for the teams; they positioned the merger as about something bigger than a financial or operating exercise. This was a chance to build something really great for the companies and their customers, a company that blended water mastery with its sanitation and hygiene mastery. They prioritized their work and goals. The first task was to win the hearts and minds of both companies’ employees through their broad vision. Next, the team would focus on creating customer synergies and revenue growth. Finally, the team would think about cost synergies. Looking back, Beck explained the wonderful cultural opportunity the merger presented: Culture is usually one of the top two or three reasons why mergers fail. In our case we had the chance to have a similar business model built around service, supported by technology, chemistry and information. On the other hand Ecolab was more of a Sales culture whereas Nalco was more of a Technical / Engineering one. I think we managed to combine the strength of both to create who we are today. A sales culture with solid technological expertise. We also leverage safety as a great Nalco strength that would not only make the company better but protect its most important assets, it’s people.23 Emilio Tenuta found himself on one of those 28 teams, the one concerned with creating a new vision for the combined company around sustainability. This group identified four pillars of strategic focus for the combined company: clean water, safe food, abundant energy, and healthy environments. Each needed attention and solutions as mega trends in each pillar could endanger future global economic growth and the livelihoods and quality of life for billions of people. The new Ecolab would possess knowledge, skills, and systems that could ensure positive outcomes for people and the planet. The teams working on product and technological integration hoped to showcase the value of the combined companies, and they soon chose to focus on three Winning as One (WAO) projects that would surprise and delight customers and investors. The first new product sought to integrate Nalco’s 3D TRASAR system with Ecolab’s clean-in-place (CIP) technology used in food and beverage processing plants. This project required significant innovation to combine 3D TRASAR’s continuous monitoring system into CIP’s batch processing logic. CIP depends on expensive and sophisticated cleaning systems that do not require disassembly of the plant’s equipment, and the team figured out how to use 3D TRASAR to monitor the cleaning system’s performance. This ensured that the “right” chemistry (the right amount to properly clean and sanitize, without waste) flowed through the CIP system, which improved both the efficiency and effectiveness of CIP in the plant. The second project entailed transferring Ecolab’s advanced chemical knowledge to 3D TRASAR. Nalco used liquid chemicals in 3D TRASAR, which created extra costs, difficulties of operations (space requirements, changeovers, maneuvering the heavy weight of the barrels of chemistry to the application site in the plants or buildings), and safety issues (liquids spill). Ecolab had learned how to make concentrated chemical bricks that eliminated the water in the product to deal with challenges of its healthcare and hospitality customers, and the team developed hard brick versions of Nalco liquids. Engineers created a “lock and key” feature for 3D TRASAR, where the chemical bricks were formed into a shape that would only fit in the appropriate 3D TRASAR port. 3D TRASAR customers would reduce cost (solids are cheaper to produce and transport than liquids) and space requirements, and improve safety for their own employees.

C-75

C-76

Ecolab and the Nalco Acquisition

The third project worked to leverage Ecolab’s competence in antimicrobial treatments for use in Nalco’s markets. The eventual use case the team settled on was adding antimicrobials to Nalco’s treatment systems for oil field hydration and water use. Microbial fouling contributes to impeded flow of oil and gas at the well head, as well as early corrosion of well heads, pipelines, and storage tanks.24 Antimicrobials that Ecolab developed for healthcare customers would now be delivered in tanker trucks in oil fields around the world. The acquisition closed on November 30, 2011, and each of these WAO products entered the market shortly thereafter. The projects had the intended effect; customers and employees of both companies saw the value-creating potential of the combined company. Each project boosted short-term revenue and provided a platform for further cross selling. Sales for the new Ecolab in the oil and gas industry, for example, grew 21 percent during the fiscal year 2012. The success of the Nalco integration in oil and gas laid the groundwork for Ecolab’s late 2012, $2.2 billion acquisition of Champion, another complementary merger that expanded Ecolab’s position in the energy market from nothing in 2010 to $4.2 billion by 2014.

Conclusion As Baker turned his gaze back toward his desk and presentation draft, he realized he faced a wonderful problem: how to summarize in a brief presentation to the board the many metrics of financial and strategic success from the Nalco acquisition. Ecolab’s market capitalization had almost tripled between the merger announcement date ($11.8 billion) and the close of 2014 ($32.51 billion), for a total return to shareholders of 100 percent on the capital invested in the two mergers.25 He could also look to changes in Ecolab’s share price, found in Exhibit 4. Should E XH I B I T 4

Monthly Share Prices

Date

S&P Open

Ecolab Open

Date

S&P Open Ecolab Open

6/30/2011

1307.64

51.54

3/31/2013

1562.86

74.75

7/20/2011

1328.66

49.40

4/30/2013

1593.58

78.91

7/29/2011

1300.12

46.28

5/31/2013

1652.13

80.77

8/31/2011

1213.00

49.50

6/28/2013

1611.12

81.59

9/30/2011

1159.93

45.14

7/31/2013

1687.76

89.55

10/31/2011

1284.96

50.70

8/30/2013

1638.89

87.55

11/30/2011

1196.72

53.12

9/30/2013

1687.26

93.36

12/30/2011

1262.82

53.83

10/31/2013

1763.24

101.59

1/31/2012

1313.53

56.68

11/29/2013

1808.69

102.34

2/29/2012

1372.20

57.02

12/31/2013

1842.61

99.87

3/30/2012

1403.31

58.19

1/31/2014

1790.88

95.24

4/30/2012

1403.26

59.84

2/28/2014

1855.12

102.09

5/31/2012

1313.09

59.82

3/31/2014

1859.16

102.92

6/29/2012

1330.12

63.37

4/30/2014

1877.10

100.57

7/31/2012

1385.27

61.11

5/30/2014

1920.33

104.39

8/31/2012

1400.07

60.58

6/30/2014

1960.79

104.90

9/28/2012

1447.13

61.22

7/31/2014

1965.14

105.55

10/31/2012

1410.99

65.49

8/29/2014

1998.45

110.19

11/30/2012

1415.95

67.69

9/30/2014

1978.21

112.15

12/31/2012

1402.43

66.94

10/31/2014

2001.20

106.04

1/31/2013

1501.96

68.25

11/28/2014

2074.78

109.35

2/28/2013

1515.99

73.23

12/31/2014

2082.11

102.13

Source: Ecolab Data: https://www.macrotrends.net/stocks/charts/ECL/ecolab/stock-price-history S&P 500 Data: https://finance.yahoo.com/quote/%5EGSPC/history?period1=1311141600&period2 =1420009200&interval=1d&filter=history&frequency=1d.

References C-77

he also include growth in revenue, operating earnings, and net income? In terms of strategic success, which elements of the acquisition should he emphasize to the board? For Baker, the most pressing question involved learning: What had Ecolab learned through the Nalco process that would help with other acquisitions in the future? Ecolab had a strong history of not resting on past success; from M. J. Osborn’s days forward the company had tried to leverage the learning from current success into future growth.

References 1 Ecolab, “Celebrating 75 Years of History,” internal company document, 1998, p. 5–6.

“Celebrating 75 Years,” p. 10.

2

Interview with Doug Baker, October 30, 2017.

3

“Celebrating 75 Years,” p. 46.

4

Data on sales from Ecolab’s 2004 Annual Report, https://investor .ecolab.com/~/media/Files/E/Ecolab-IR/Annual%20Reports/2004 -annual-report.pdf, accessed July 6, 2018. Data on other business moves from the Ecolab Fact Book, https://investor.ecolab.com/~/ media/Files/E/Ecolab-IR/documents/ecolab-factbook-final.pdf 5

Quotation taken from Ecolab website, https://investor.ecolab.com /investor-story/business-model, accessed July 6, 2018. 6

“Suez Sells Nalco for $4.35 Billion,” Water World, September 4, 2003, https://www.waterworld.com/articles/2003/09/suez-sells-nalco-for -435-billion.html, accessed July 7, 2018.

14

J. P. Miller, “Nalco Awash in Debt as Returns Flow to Buyers,” Chicago Tribune, August 28, 2005, http://articles.chicagotribune.com /2005-08-28/business/0508280230_1_nalco-buyout-firms-buyout -deals/2, accessed July 7, 2018. 15

See https://www.ecolab.com/nalco-champion/offerings/3d-trasartechnology-for-cooling-water, accessed 31 July 2019.

16

The above paragraphs use data from an interview with Emilio Tenuta, October 11, 2017.

17

Bush.

18

Baker.

Ecolab Fact Book.

19

Interview with Christophe Beck, October 12, 2017.

20

Ecolab merger with Nalco, internal presentation, July 20, 2011.

21

7 8 9

Beck.

10

Nalco Chemical Corporation History, Funding Universe, http://www .fundinguniverse.com/company-histories/nalco-chemical-corporation -history/, accessed July 7, 2018. 11

Nalco History.

12

“Suez Buys Nalco for $4.1 Billion,” CNN Money, June 28, 1999, http:// money.cnn.com/1999/06/28/worldbiz/suez/, accessed July 7, 2018.

13

Estimates found in the Ecolab merger with Nalco. Baker. Tenuta.

22

Beck, comments on the case, August 2, 2018.

23

Information on microbial fouling can be found at https://www .luminultra.com/industry/upstream-oil-gas/, accessed July 10, 2018.

24

Data on market cap taken from Y-charts (ycharts.com) and a search of “Ecolab (ECL), market cap.” Data collected July 2018.

25

CASE 7 Nike Sourcing and Strategy in Athletic Footwear Nike, Inc. is the world market share leader in athletic footwear, with 44 percent of the world market, compared to only 30 percent for Adidas/Reebok (see Exhibit 1). The Nike brand alone is valued at $10.7 billion—the most valuable brand among sports businesses. Many high-profile athletes and sports teams around the world are sponsored by Nike, with endorsers donning  the highly recognized “swoosh” logo and the trademark “Just Do It.” But Nike wasn’t always the world leader. In fact, when Nike launched its first product in 1972, Adidas was the worldwide leader in athletic footwear sales, and Converse was the most recognized US athletic footwear brand. Adidas, the German shoe and sports apparel giant, was known for making high-performance shoes and held the dominant market share position. Adidas could not have imagined that, by 1992, Oregon-based upstart Nike would overtake it as the world’s leading athletic footwear company. Moreover, Nike didn’t just surpass Adidas in market share. It also consistently generated profitability ratios that were 50–100 percent higher than Adidas (see Exhibit  2 and Exhibit  3 for selected financial data). For example, in 2010, Nike’s operating profits-to-sales ratio was 10.1 percent compared to 6.7 percent for Adidas. How did Nike, a small startup, leap past Adidas and Converse to emerge as the world leader in athletic footwear in just 20 years? What was unique about the company’s strategy, and what lessons does the Nike story hold for other companies hoping to be the leaders in their industries? Finally, now that competitors, especially new ones such as Under Armour, understand Nike’s path to leadership, how can Nike stay on top?

EXHIB IT 1

Global Athletic Footwear Sales and Market Share by Major Brand (Estimated in millions of dollars at wholesale)

Company

2016

2013

% in 2013

Nike

19,871

14,539

44%

Adidas

10,135

9,379

ASICS Skechers

3,563

New Balance

% in 2010

2005 sales

2000 sales

10,332

41%

7,300

5,562

29%

7,354

29%

4,064

3,424

2,314

7%

1,631

7%

877

628

1,846

6%

2,007

8%

1,006

675

2,390

7%

1,780

7%

1,550

1,100

—

217

1%

509

223

K-Swiss

2010 sales

Under Armour

1,011

299

1%

127

1%

na

na

Reebok

1,766

1,913

6%

1,599

6%

2,718

2,102

—

—

—

—

—

—

*

Converse

**

*Reebok was purchased by Adidas in February 2006 **Converse was purchased by Nike in July 2003 Source: Company annual reports; Privco.

C-78

209

Nike

EX HIB I T 2

Nike, Inc., Financial Performance, 2000–2016 (Year ended May 31; millions of dollars)

2016

2013

2010

2005

2000

1995

$19,871

$14,539

$10,332

$7,300

$5,562

$3,554

Apparel

9,067

6,820

5,037

3,879

2,699

897

Equipment

1,496

1,405

1,035

825

328

Total Rev

30,507

25,313

19,014

13,740

8,995

4,761

SG&A

2,606

1,210

Revenues Footwear

–

10,469

7,780

6,326

4,222

Demand Creation

3,278

2,745

2,356

1,601

Operating Overhead

7,191

5,035

3,970

2,621

19

(3)

6

5

45

24

Income Tax

863

808

610

648

340

250

Net Income

3,760

$2,485

$1,907

$1,212

$579

$400

Europe

7,315

5,415

5,042

4,282

2,351

980

Asia Pacific

4,654

3,244

2,624

1,897

955

516

14,764

10,387

6,696

5,129

5,017

2,998

Interest

Geo. Segment Rev

North America

*2005 Europe data also includes Middle Eastern and African sales *Total geo revenues will not add up to total revenues due to other sources of revenue that Nike has Source: Nike Annual Reports.

EX HIB I T 3

Adidas Group Financial Performance, 1995–2016 (millions of euros)

2016

2013

2010

2005

2000

1995

10,135

6,873

5,389

2,978

2,509

1,790

Apparel

7,476

5,813

5,380

2,798

2,159

1,528

Hardware

1,681

1,806

1,221

860

1,167

131

Net Sales

19,291

14,492

11,990

6,636

5,835

3,500

8,263

6,133

5,046

2,573

2,012

1,095

70

68

88

158

94

47

Income Tax

439

344

238

2,221

140

43

Net Income

1,019

839

567

383

182

245

Sales Footwear

Operating Expenses Interest Expense

Net sales by region

(millions of euros)

North America

4,051

3,362

2,805

1,327

1,906

767

Latin America

1,736

1,575

1,285

398

171

91

Asia/Pacific

4,244

3,861

2,972

1,460

875

307

Europe

5,787

5,694

4,928

3,451

2,860

2,335

*In Euros, millions *1995 results given in millions of Deutsche Marks Source: Adidas Annual Reports.

C-79 79

C-80

Nike

Nike’s Origins Nike was founded in 1962 as Blue Ribbon Sports by University of Oregon track athlete Phil Knight and his coach Bill Bowerman. The company initially operated as a distributor for Japanese shoe maker Onitsuka Tiger (now ASICS), making most of its sales at track meets, out of Knight’s automobile. But the relationship between the two companies started to deteriorate in 1970, and Knight and Bowerman were ready to make the jump from being a footwear distributor to designing and manufacturing their own brand of athletic shoes. So, Bowerman and Knight designed their own track shoes and had them manufactured in low-cost Asian plants. Bowerman created a “waffle iron” design that improved traction while keeping the shoes extremely light. Bowerman and Knight selected a logo to put on the shoe, known internationally as the swoosh, which was created by a graphic design student, Carolyn Davidson, from Portland State University. Davidson was originally paid $35 for the logo design. (Knight later gave Davidson an undisclosed amount of Nike stock and a diamond ring with the swoosh engraved.) Then, in May 1971, Blue Ribbon changed its name to Nike after the Greek goddess of victory. The new Nike line of footwear debuted in 1972, just in time for the US Track and Field Trials in Eugene, Oregon. Early models of Nike’s track shoes were primarily used by track athletes at the University of Oregon. Fortunately for Nike, one of those Oregon athletes was Steve Prefontaine, a middleand long-distance runner who became a prominent track star. Prefontaine competed in the 1972 Olympics and once held the American record in seven different distance track events from the 2,000 meters to the 10,000 meters. Prefontaine’s success catapulted Nike into the spotlight and jump-started the company’s sales. Building on this momentum, Nike started to design shoes for other track stars and prominent athletes in other sports. The late 1970s and early 1980s saw sprinter Carl Lewis, marathon runner Joan Benoit, and tennis star John McEnroe sporting Nike shoes. The company hit the jackpot in the late 1980s when it signed basketball superstar Michael Jordan to an endorsement contract. Nike’s Air Jordan sneakers, promoted by the player himself, were a huge winner in the basketball shoe segment of athletic footwear. The success of Air Jordan, and the entire Nike line, was helped by the “Just Do It” advertising campaign developed and launched by ad agency Wieden+Kennedy in 1988. The company hit the jackpot again in the late 1990s after signing golfing phenom Tiger Woods to an endorsement contract. Leveraging Woods’s popularity, Nike not only entered the golf shoe market but also golf equipment and apparel. Even before Nike signed Woods, it was firmly ensconced as the leading athletic footwear company in the world. Nike’s dramatic success in overtaking Adidas in such a short period of time was typically attributed to its successful and memorable marketing campaigns featuring well-known athletes. Although marketing has undoubtedly been critical to Nike’s success, the company’s ability to produce cutting-edge shoe designs that have attracted endorsers is sometimes overlooked. Nike made significant investments in shoe design, starting with running shoes and then branching out to tennis, basketball, soccer, golf, and other shoes for specific uses. Each year, Nike launched more than 100 new designs of different types of shoes. This practice stimulated new customer purchases by creating the desire to have the very best shoe possible to maximize performance. It also increased the overall size of the market as customers bought shoes for specific sports, often having as many as 5–10 different types of athletic footwear in their closets. Nike’s decision to keep its focus on product design and marketing, and not manufacturing, is another little-understood factor that has influenced its success. The company chose not to produce any of its own shoes, preferring instead to hire independent suppliers in Asian countries such as South Korea, Taiwan, China, and Indonesia. These suppliers built high-quality shoes to exact specifications and delivered them according to precise delivery schedules. They helped Nike keep costs down because Asian labor was cheap and plentiful. This was in sharp contrast to the labor costs at many of the Adidas shoe-manufacturing facilities in Europe (mostly Germany) where labor costs were significantly higher. By outsourcing the production of its shoes to foreign suppliers, Nike was able to focus all of its attention and resources on shoe design and marketing. Nike’s choices regarding which activities to conduct internally, and, thus, which activities to outsource to suppliers, played a critical role in propelling it to the top of its industry.

Nike’s Sourcing Practices

Nike’s Sourcing Practices Nike’s use of Asian suppliers dates back to its humble beginning. The allure of low-cost labor in Asia was what initially attracted the attention of Phil Knight. An accountant by training, Knight had noticed the success of Japanese cameras in the 1950s against higher-priced German models, and he thought the same approach could work in the athletic footwear industry, where the leading brands (Adidas and Puma) were German.1 Nike’s advantage in athletic footwear came, in part, from creating cutting-edge designs that could be manufactured at low cost. Each year Nike’s designers created more than 100 new shoe styles and colors. The company then sent designs to its Asian suppliers, which would develop and test prototypes. After these prototypes were approved, the blueprints were ready to be sent out to bid to suppliers.2 Nike was known to constantly look for the supplier that could provide the lowest cost production for its shoes. According to Jeffrey Ballinger, an Asian-American Free Labor Institute (AAFLI) representative, Nike’s strategy is to pit six factories against each other and have them compete for orders based on who produces the cheapest shoe.3 An estimated cost breakdown of a 1995 Nike athletic shoe (the Pegasus running shoe) is presented in Exhibit 4. As seen in Exhibit 4, only about 15 percent of the cost of Nike shoe production was labor costs. This was significantly lower than the labor costs required to manufacture a shoe in Europe. In order to avoid dependence on a small number of suppliers, Nike cultivated working relationships with numerous manufacturers spanning a number of different countries. For example, large suppliers in China or Indonesia rarely produced for just one athletic shoe firm. A single plant might be producing Nike shoes in the same plant with Reebok or Converse production lines. Because of the low labor costs in Asia, by the mid-1990s, virtually all US athletic footwear companies relied on overseas manufacturing. There were a few exceptions, with one of the most notable being New Balance Athletic Shoe Inc., which operated four US plants and held a relatively small share of the US market. It focused on a niche market of customers interested in more-varied width sizing. Not surprisingly, employees at New Balance’s US plants earned considerably more than their Asian counterparts. For example, hourly wages in US plants for apparel manufacturing averaged $8.16 compared to only $.25 in China and $.28 in Indonesia (See Exhibit 5 for a comparison of textile and apparel wages in selected markets for 1993 and 2007). In the Brighton, Massachusetts, plant, for instance, employees earned a base wage of $7.50 per hour, or between $8 and $12 per hour with benefits factored in.4 With such high labor costs, New Balance was unable to profitably produce shoes that retailed for less than $50.5 New Balance later moved the majority of its shoe production to Asia. Nike was well aware that production costs varied from country to country and could change over time as a result of changing labor costs and exchange rates. For example, in 1988, Nike purchased 66 percent of its shoes from suppliers located in South Korea. Wage rates grew rapidly

EX HIB I T 4

Estimated Cost Breakdown of a Nike Athletic Shoe, 1995

Labor

$2.75

Materials

$9.00

Rent

$3.00

Duties

$3.00

Shipping

$0.50

Supplier’s operating profit

$1.75

Total cost of sales:

$20.00

Approximate average wholesale price

$35.50

Average price at retail

$70.00

Source: J. Ballinger and C. Olsson, Behind the Swoosh (Sweden: Global Publications Foundation, 1997).

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E XH I B I T 5

Country

Hourly Labor Costs for Production Workers in the Textile and Apparel Industry—Selected Countries, 2007

Hourly Labor Cost—Textile (in US$)

Hourly Labor Cost—Apparel (in US$)

2012*

2007

1993

2012

2007

1993

24.17

18.58

11.61

24.09

15.29

8.13

3.4

1.81

2.93

2.92

1.32

1.08

35.56

14.32

35.49

13.25

17.22

China (PRC)

2.1

0.8

0.36

1.26

0.71

0.25

Indonesia

1.08

0.39

0.43

na

0.35

0.28

South Korea

8.22

8.41

3.66

8.78

2.71

Philippines

2.1

0.97

0.78

0.87

0.53

Taiwan

9.46

4.68

5.76

4.39

4.61

North America United States Mexico Europe Germany

20.5

Asia

16.6 na 9.2

*2011 data for Indonesia, South Korea, China, Taiwan, and the Philippines. 2012 textile data for the Philippines and Taiwan is the average manufacturing wage. Source: Bureau of Labor Statistics, OECD, Institute of Global Labour and Human Rights, ILO Department of Statistics, Werner International, Eurasia Group, Deloitte.

in the 1980s and early 1990s in South Korean factories, with wages going from less than $1.00 per hour in 1980 to $3.66 by 1993. The Korean Ministry of Labor reported that workers in shoe factories earned an average of $24.40 per day in 1990, compared to just $9.71 per day in 1986. As a result, Nike’s imports from South Korean suppliers dropped to 42 percent by 1992 and to less than 10 percent by the end of the 1990s, and employment in Pusan, South Korea’s shoemanufacturing center, fell from nearly 500,000 in 1990 to 120,000 by 1993. As wages increased, many Korean suppliers moved factories to lower-wage countries, such as Indonesia, so that they could be cost-competitive when bidding on contracts from Nike or other athletic footwear companies. Not only did changing wage rates influence the cost competitiveness of suppliers, but so did exchange rates. In the late 1990s, during the Asian financial crises, the costs to manufacture athletic footwear changed significantly from year to year, depending on a country’s currency relative to the dollar. China, for example, pegged the RMB to the dollar to ensure a more stable currency. In contrast, Indonesia let its currency float, and within a two-year period, the exchange rate changed from roughly 4,000 rupiahs to the dollar to more than 10,000 rupiahs to the dollar. That allowed Nike to get more for its dollar by purchasing shoes and other materials from Indonesian suppliers than they could from suppliers in China. As a result, during the time period when the rupiah lost value to the dollar, Indonesian suppliers were more cost competitive and had a cost advantage when bidding for Nike shoe contracts. As a result of the changing wage and exchange rates, Nike had a truly global supplier network that it could draw upon for its shoe production. This allowed the company to shift production as necessary to plants in different countries that could provide the lowest-cost shoes at the moment. Nike was able to achieve this without building its own plants or making the investments necessary to develop a world-class manufacturing capability in shoes. Nike’s practice of using a competitive bidding process was not without criticism, however. As suppliers worked to keep costs low and win the bids, some believed that Nike used exploitive labor practices and that the company should bear responsibility for the actions of its suppliers. In the 1990s, Nike executives often deflected these accusations, arguing that Nike did not own or operate its suppliers’ factories. Neal Lauridsen, Nike’s vice president for Asia, said, “We don’t know the first thing about manufacturing. We are marketers and designers.”6

Nike’s Quest for Growth Opportunities

And John Woodman, Nike’s general manager in Jakarta at the time, further explained, “They are our subsuppliers. It’s not within our scope to investigate [allegations of labor violations].”7 Nike executives noted that the organization was a positive economic force within many emerging economies in Asia and provided thousands of jobs for people who probably wouldn’t be working otherwise.

Industry Changes Affecting Nike: 1994–2000 The market for branded athletic footwear continued to grow between 1994 and 2000, but at a slower rate. After nearly two decades of explosive growth, a slowdown was expected. By 1994, the average athletic shoe purchaser in the United States owned three pairs.8 Faced with slowing US demand, Nike looked for new places and unique ways to grow. International sales were emphasized during this period, and Nike made steady inroads into European and Asian markets. The company also expanded into sports apparel and other footwear products, including hiking shoes and upscale men’s shoes with the acquisition of Cole Haan. Nike continued to invest in product design, seeking lighter, more durable, and even more comfortable models. Competitors were never far behind. Reebok, for example, refined its Pump technology, which filled the shoe’s upper with air, claiming it provided superior support and comfort. It also introduced GraphLite, which offered a graphite-composite structure in the arch that replaced part of the sole and reduced the weight of the shoe up to 10 percent. To further increase demand, Nike and Reebok, in particular, increased their investments in innovative product designs. Nike continued to rely on the endorsements of famous athletes, including Michael Jordan and Kobe Bryant, in its television campaigns. Reebok followed suit, signing endorsers such as Shaquille O’Neal, Allen Iverson, and Yao Ming. Competition began to heat up in the late 1990s as US growth slowed and Adidas shifted the bulk of its shoe production from Europe to Asia. Following Nike’s lead, Adidas used the savings that resulted from lower-cost shoe production on marketing and high-profile endorsers. New Balance also increased its competitiveness by shifting roughly 70 percent of its shoe production to China. Both Adidas and New Balance increased their global shares of athletic footwear at this time, but Reebok’s share fell. Nike was able to slowly grow its market share in athletic footwear during the late 1990s, but the overall growth in the US market dropped to half the rate of growth that took place in the 1980s. In 1999, Nike’s sales dropped by 8 percent over its prior year’s sales, highlighting the need for the company to look for even more innovative ways to grow.

Nike’s Quest for Growth Opportunities As growth in the athletic footwear market slowed in the late 1990s, Nike looked to extend its product lines into other sports equipment and apparel. Although Nike’s core products had always been athletic shoes, the company decided to expand by manufacturing and selling equipment for golf, tennis, soccer, baseball, bicycling, volleyball, wrestling, and even auto racing. The company was very successful in developing and selling a line of golf apparel and equipment—notably golf balls and clubs—endorsed by Tiger Woods. In 2000, Nike signed Woods to a 5-year, $105 million contract. It was the largest endorsing deal ever signed by an athlete at that time. Woods’ endorsement has been credited with playing a significant role in helping the Nike Golf brand transform from a start-up golf company in the late 1990s to a leading golf apparel company in the world and a major player in the equipment and golf ball market, where it competes effectively with Titleist, Callaway, and Taylor Made. Nike looked for similar opportunities in other sports categories and started making equipment and apparel for many other sports. As it did with its shoes, Nike outsourced the manufacturing of its apparel and sports equipment to a variety of suppliers throughout the world. Indeed, using outside suppliers became even more important because of the wide variety

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of manufacturing that needed to be done for Nike—from shoes, to golf clubs, to volleyballs. Outsourcing production allowed Nike to move quickly into new product categories because it didn’t have to acquire the knowledge about how to actually make the products that it designed and marketed. During the late 1990s and early 2000s, Nike was more aggressive about moving into apparel and other sports equipment than its major competitors, Adidas and Reebok, were. This helped Nike grow at a much faster rate than Adidas and Reebok. For example, Nike Golf was estimated to be generating roughly $600 million in sales by 2007, while Adidas and Reebok generated insignificant sales from golf apparel and products. Nike’s product category expansions during this time period also helped offset the slowing growth in sales of athletic footwear. Indeed, from 2000 to 2010, Nike’s sales grew from $9.0 billion to more than $19.0 billion.

Outsourcing Challenges: New Balance’s Experience Although Nike’s experience with outsourcing was generally positive, such was not the case for all of its competitors. In early 2000, New Balance experienced a problem with a supplier that created concerns for all of the major makers of branded athletic footwear. Scores of deeply discounted New Balance shoes began showing up in stores from England to Australia.9 One of New Balance’s former Chinese suppliers, run by Taiwanese businessman Horace Chang, was continuing to produce and sell New Balance shoes. Chang had been a major supplier to New Balance, as well as a distributor of New Balance’s shoes in China. However, New Balance and Chang had a falling out when the company vetoed Chang’s proposed strategy for China—selling larger volumes of low priced shoes in China. The company felt that Chang’s strategy would dilute its brand image. When New Balance shoes made by Chang’s plants began appearing in cut-rate shops for as little as $20, it enraged New Balance’s legitimate retailers, who were trying to sell the same shoes for as much as $60. Although attempting to compete directly with Reebok, Adidas, and Nike, New Balance was being relegated to the bargain bin. New Balance quickly sued Chang in the United States and did everything in its power to prevent “unlawful” New Balance shoes from being sold. With the help of China’s State Administration of Industry and Commerce, Chang’s warehouses were raided and more than 100,000 pairs of New Balance shoes were confiscated. Buoyed by signs of increased brand protection by Chinese authorities, New Balance filed a suit in Shenzen against Chang. However, in February of 2002, a Chinese judge ruled against New Balance. Instead of recognizing that New Balance had revoked its sales agreement with Chang, the judge cited an older document with Chang’s manufacturing company, in which New Balance suggested that Chang’s factory could manufacture the shoes until 2003. New Balance’s painful experience caused Nike and other sports footwear and apparel companies to rethink their strategy of outsourcing products to suppliers from emerging economies. Each company reevaluated its sourcing strategy and began to think of ways to ensure that it did not experience the problems that New Balance did.

Nike’s Response to Industry Outsourcing Challenges During the 1990s, Nike frequently faced criticism for sourcing its shoes from Asian suppliers that had used questionable labor management practices. The concerns included unsafe working conditions, working laborers too many hours at low pay, and using child labor. Nike executives often deflected these accusations, arguing that Nike did not own or operate its suppliers’ factories. But that started to change in 2000 when Ceres, a nonprofit organization advocating

Nike’s Hurdles

for sustainability leadership (including the rights of workers and safe working conditions), convinced Nike and other multinational organizations to follow a specific set of corporate responsibility principles.10 In 2000, about the same time that New Balance was experiencing trouble with its Chinese supplier, Nike took actions to incorporate social responsibility into its overall business strategy and to respond to criticisms of its subcontracting practices. In November 2000, Nike formally endorsed a set of Ceres principles that advocated for socially responsible practices. These principles included minimizing risks to employees, offering safe products and services, and immediately informing the public about any aspect of the company’s operations that could pose a threat to the environment, health, or safety. Nike admitted that it had not been as vigilant as it could have been when it came to monitoring working conditions at suppliers. Dusty Kidd, Nike’s vice president for corporate responsibility, commented, “We hope that through this engagement with Ceres, we can advance our work in environmental and social issues.”11 As part of its effort to endorse and follow Ceres principles, Nike launched its Transparency 101 program, which focuses on reducing risks to employees, offering safe products and services, and informing the public in a timely manner about issues that could pose a threat to workers’ health or safety. By monitoring supplier factories in each country where Nike operates, this program ensures that the practices in each are in line with the company’s code of conduct. To launch the program, in February 2001, Nike—in cooperation with Reebok—commissioned an independent auditor to look into labor conditions at a factory in Mexico that manufactured products for the two companies. When the report was completed, the company made the auditors’ report available on the company website. As part of its Transparency 101 program, Nike continues to investigate and report on factory conditions worldwide and ensures that they are following Ceres principles. With regard to meeting the challenge of offering “safe products and services,” Nike is continuing its efforts to phase out PVC and other potentially harmful chemicals in its products. On the issue of “informing the public,” Nike says that it publishes its findings on factory conditions as they become available, and it recalls products that might pose a health hazard to consumers. As a result of these actions, Nike has been recognized for making strides in corporate social responsibility. Fortune magazine ranked Nike No. 1 in the apparel industry on its annual list of “America’s Most Admired Companies” in 2012. Similarly, the Far Eastern Economic Review (FEER) ranked Nike among its top-ten best multinational corporations in Asia for corporate leadership and corporate responsibility leadership. FEER noted that, in the previous year, Nike had improved in almost every category.12 Nike is also listed as one of the 226 companies recognized for sustainability efforts on the Dow Jones Sustainability Index. According to some observers, Nike’s increased interaction with key suppliers regarding social issues has deepened and improved relationships with those suppliers who have demonstrated they are committed to following Nike’s code of conduct.

Nike’s Hurdles Nike’s success during the past 30 years has been nothing short of spectacular. However, Nike’s leaders realized that the company would have to overcome some major challenges if it hoped to continue its growth trajectory. For example, in 2005, Adidas announced that it would acquire Reebok for $3.8 billion. The combined Adidas Group had revenues of $13.3 billion in 2006 and offered a wide range of products that would allow it to challenge Nike for global supremacy (Nike’s revenues were roughly $14 billion at the time). Adidas CEO Herbert Hainer noted that the combination of Adidas and Reebok accelerated the Adidas Group’s growth and options in the global athletic footwear, apparel, and equipment markets. The new Adidas Group would benefit from a wider range of products and brand identities, and an even stronger presence across teams, athletes, events, and leagues. In particular, Reebok’s strong position in North America was thought to complement Adidas’s strong international profile. North America represents

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approximately 50 percent of the global sporting goods market, and with the acquisition of Reebok, the Adidas Group’s North American sales more than doubled to US $3.9 billion, threatening Nike’s worldwide dominance. But perhaps more threatening was the emergence of Under Armour, a new competitor that was stealing Nike’s thunder as the industry innovator. Under Armour initially launched with sports apparel, notably a compression T-shirt built from microfibers that wicked moisture and kept athletes cool and dry. Building on the success of its apparel business, Under Armour entered the athletic footwear business in 2006 and signed NBA star Steph Curry as a key product sponsor. But perhaps most disconcerting for Nike was Under Armour’s announcement that it was planning to manufacture its athletic footwear at its huge Lighthouse Innovation Lab using robots.13 Under Armour hoped to succeed where others had failed: automate the process of building a high-quality shoe. In the past, high-quality shoes required lots of labor and hand stitching, which is why the industry, led by Nike, had outsourced shoe production to low-wage countries. But with new emerging production technologies, Under Armour was determined to build a high-quality shoe in the United States and bypass the challenges associated with outsourcing shoes to China. According to Business Insider, Under Armour’s production process is “full of mind-blowing technology” including “a machine that molds the toes of sneakers, a lightning-fast laser cutter called the Lectra that is programmed to slice fabric in a way that generates the least amount of waste possible . . . and a machine that can apply glue to 2,400 pairs of shoes in eight hours—a task that would normally require a 200-person production line.”14 These, and other innovations, had allowed Under Armour to leap past Nike on Forbes’ list of most innovative companies. Nike now faced additional challenges and decisions related to its future strategy with regard to the production of its shoes. Nike already faced challenges of growing in emerging markets— especially China—where growth continued to be threatened by subcontractors selling unlawful Nike “knockoff” shoes. Nike’s leaders knew it needed to develop a strategy to expand in China (now the world’s largest shoe market) without fueling the growth of unlawful “knockoff” shoes. But now it faced the possibility that Under Armour could enter those markets with shoes that were not produced by subcontractors. Thus, Under Armour might not face the same problems of unlawful “knockoff” shoes being sold in the market. These new challenges hit Nike as it faced fewer growth opportunities in its home market of North America (footwear unit growth has been less than 1 percent during the last five years) because Nike had already entered most sports apparel and equipment categories. Nike’s top management team knew it had built a strong position as the worldwide leader in the athletic footwear and branded sports apparel industries, but also knew that it faced major challenges in securing Nike’s financial future.

References 1

P. Rosenzweig, “International Sourcing in Athletic Footwear,” Harvard Business School Case 9-394–184.

“1992 Footwear (Athletic) Market,” Sporting Goods Manufacturing Association.

M. Clifford, “Spring in Their Step,” Far Eastern Economic Review (November 5, 1992), p. 57.

9 “For New Balance a Surprise: China Partner Became Rival,” Wall Street Journal (December 19, 2002).

2

Ibid.

3

D. E. Lewis, “Delicate Balance: Running Shoe Company Weighs Commitment to Manufacturing in Urban American Against Efforts to Organize Its Boston Workers,” Boston Globe (February 23, 1993). 4

5 J. Finegan, “Surviving in the Nike/Reebok Jungle,” Inc. (May 1993), p. 102. 6

M. Clifford, “Spring in Their Step,” op. cit., p. 57.

7

A. Schwartz, “Running a Business,” op. cit., p. 16.

8

http://www.ceres.org/.

10

http://www.iisd.org/business/viewcasestudy.aspx?id=81.

11

Ibid.

12

http://www.businessinsider.com/under-armours-new-innovation -lab-features-robots-that-make-sneakers-and-we-went-inside -2016-6/#the-lighthouse-is-located-inside-a-former-garage-in-port -covington-an-area-south-of-baltimores-city-center-its-a-10-minute -drive-from-the-main-campus-1 13

Ibid.

14

CASE 8 AT&T and Apple A Strategic Alliance Randall Stephenson, CEO of AT&T, sat at his desk in January 2011 during a moment of quiet reflection. Verizon Wireless had just announced it would offer the Apple iPhone beginning in a few weeks. AT&T had been the sole carrier of the iPhone since its launch to the market in June 2007, and the strategic alliance between AT&T and Apple that had existed for almost five years would soon end. Stephenson and the AT&T leadership team were now in a position to evaluate whether the Apple alliance had helped AT&T achieve its objectives—and to consider what might happen going forward given that AT&T would no longer be the exclusive service provider for the iPhone. At the inception of the alliance, AT&T was looking to rebrand itself as a wireless phone carrier. Apple was designing the iPhone and looking for the optimal way to launch it into the new smartphone market. The two companies ultimately decided that combining their resources and capabilities in a strategic alliance centered on the iPhone would help both companies achieve their strategic objectives. But now that the alliance was over, the AT&T leadership team needed to look to the future to determine what other strategic initiatives—including other potential alliances or acquisitions—would provide the best vehicles for helping the company achieve its strategic objectives.

The History of AT&T The American Telephone and Telegraph Company (AT&T) was founded in 1885 by Alexander Graham Bell after his invention of the telephone. After a merger with the Bell telephone company in 1900, AT&T became the main phone company in the United States. In 1913, AT&T also became a government-sanctioned monopoly of the telephone market, as a result of the Kingsbury Commitment. (Essentially, the company was allowed to be a monopoly “provided [AT&T] is independent, intelligent, considerate, thorough and just.”1) The government agreed to allow AT&T’s monopolistic operation after the company agreed to allow independents to interconnect to the long distance network under certain conditions and to abstain from acquiring companies if the ICC2 objected. For decades afterwards, AT&T continued to be the only truly nationwide phone company, and it continually had to walk a fine line between being a monopoly and acting like one. Litigation in the 1970s ultimately led to the breakup of the AT&T Bell System in 1982, resulting in AT&T divesting itself of its local telephone operations while still maintaining its long-distance network. The seven new regional Bell operating companies (RBOCs), also called Baby Bells, were Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis, Southwestern Bell, and US West. Although these Baby Bells remained independent for many years, all were acquired over the years as the industry consolidated into a few players. Major acquisition events are summarized in Exhibit 1. C-87

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E XH I B I T 1

Major Acquisition Events of Baby Bells

Original Baby Bell

Acquisition By

Year

Ameritech

SBC (now part of AT&T Inc.)

1999

Bell Atlantic

Verizon Communications

2000

BellSouth

AT&T Inc.

2006

NYNEX

Bell Atlantic

1996

Pacific Telesis

SBC (now part of AT&T Inc.)

1997

Southwestern Bell (later SBC)

Acquired AT&T Corp., became AT&T Inc.

2005

US West

Qwest, and later Century Link

2000, 2011

The breakup of AT&T led to a new era of competition among the Baby Bells, AT&T, and new entrants into the telecommunications industry. Long distance over local telephone service became an intensely competitive business. Having started from a monopoly position, AT&T would inevitably see its market share fall, and it did—from 90 percent in 1984 to about 50 percent a dozen years later. As a result of new competition and new technologies (primarily fiber optic transmission), prices plummeted by more than 40 percent over the next five years, and volume exploded. In 1984, AT&T carried an average of 37.5 million calls per average business day. In 1989, the equivalent volume was 105.9 million, and in 1999, it was 270 million. In the 1990s, the growth of computers, and then the emergence of the Internet, led to an increasing number of customers wanting to send data, rather than voice, over wired and wireless networks.3 AT&T, along with other long-distance providers, was looking for new ways to offer services that would meet these new customer demands.

The History of AT&T Wireless In 1981, AT&T estimated that the total US market for cellular phone users would be about 900,000 by the start of the twenty-first century, and thus, it was not a compelling market for it at the time. However, McCaw Cellular Communications, founded in 1987, saw cellular technology as a huge opportunity and was a savvy pioneer in the emerging mobile phone market. McCaw quickly outpaced the growth of the Baby Bells through a series of acquisitions and spectrum license purchases, and it became the single largest cellular spectrum owner by 1990, with licenses in most major US cities (spectrum licenses were necessary because cellular technology used spectrum as the vehicle for routing calls). Cellular phone technology became an increasingly important alternative to landlines as the technology was more widely adopted throughout the 1980s and early 1990s. At this point, McCaw’s focus turned from acquiring licenses to servicing the network and signing up customers in what was now a maturing technology on the cusp of explosive growth. In order to handle the customer side of the business, McCaw turned to AT&T for technology. With AT&T’s help, McCaw introduced SS7 signaling technology across its entire network, allowing it to effectively tie its network together and to provide customers with the ability to “roam” away from their home network where they were subscribed. They called the new system “Cellular One.” In 1992, AT&T purchased one-third of McCaw for $3.8 billion. At the time, McCaw had two million Cellular One subscribers and was generating $1.75 billion in annual revenue. AT&T’s previous predictions of total wireless users were way off the mark, but now the company was ready to jump into the growing industry. In 1994, AT&T purchased the rest of McCaw Cellular for $11.5 billion, creating AT&T Wireless Group under AT&T Corp.4 At the time, AT&T Wireless was the second largest cellular carrier in the United States thanks to the Cellular One user base, and by the end of 1997, it grew to

The History of Apple

become the largest cellular provider. However, the cellular industry began to consolidate, and by 1999 and 2000, Verizon Wireless and Cingular Wireless became the first and second largest national carriers, respectively. AT&T Wireless became a separate company from AT&T Corp. in 2001, and it continued to expand its operations until, in 2003 and 2004, the Federal Communications Commission (FCC) mandated that AT&T allow customers to port their phone numbers to other carriers. AT&T Wireless experienced a mass exodus of many customers who were fed up with years of poor service. When the new process for porting numbers in or out of its system was poorly implemented, AT&T Wireless only accelerated the exodus of customers. The AT&T Wireless management team received so much criticism that the company eventually agreed to accept bids to be acquired in early 2004.5 In 2004, Cingular Wireless won the bid and acquired AT&T Wireless for $41 billion, nearly double the company’s recent trading value. Cingular, headed by CEO Stan Sigman, was a joint venture between two Baby Bells; 40 percent owned by BellSouth and 60 percent owned by SBC Communications, Inc. Six months after the merger, the AT&T Wireless brand was retired by Cingular. According to a pre spin-off agreement, the name AT&T Wireless and the use of the AT&T name in wireless phone service would revert to AT&T Corp. The brand would be brought back about a year later after SBC Communications, Inc. completed a merger with AT&T Corp. in 2005, at which time SBC renamed itself “AT&T Inc.” In December 2006, the new AT&T acquired Bellsouth, just as the negotiations with Apple commenced. Randall Stephenson took over as CEO of the new AT&T in June 2007 and was the leader as the strategic alliance with Apple was finalized. “This is a once-in-a-lifetime moment to change how the public views AT&T as a wireless company,” said Stephenson, “and to change internally how we view AT&T as a wireless company.”6 After the acquisition of Bellsouth, AT&T changed the name of its wireless branch, Cingular, to “AT&T” and rolled it out as part of the alliance with Apple.7 “I don’t care if you have to go to every store in America and get a paper bag and paint a globe on it and put it over the signage in each store. We’re going to launch this under the AT&T brand,” Stephenson remembers telling his team. “And it was the smartest thing we ever did, because AT&T became synonymously branded with that Apple product [iPhone] at that moment in time.”8

The History of Apple Apple Computer was incorporated on January 3, 1977, by founders Steve Jobs and Steve Wozniak. Apple Computer launched several computer models, including the Apple II in 1977, which introduced VisiCalc, a spreadsheet program that was one of the first “killer apps.”9 The Apple III was released in 1980 to compete with IBM and Microsoft in the business-computing market, followed by the Apple Lisa in 1983 and the Macintosh in 1984, two of the first personal computers to use a graphical user interface or GUI. The Macintosh debut was heralded by the now famous “1984” Super Bowl XVIII commercial directed by Ridley Scott, which depicted an Orwellian “1984” world that is changed by the introduction of the Macintosh. The Macintosh, in combination with LaserWriter and PageMaker, kept Apple growing and ushered in the desktop publishing market.10 In 1985, Jobs resigned from Apple Computer. The board of directors had removed him from his managerial duties following a power struggle with then CEO John Sculley, who had been hired two years earlier.11 Jobs founded NeXT Inc. later that same year. Between 1986 and 1997, Apple Computer continued to release numerous new computers, including the Macintosh Portable in 1989 and the PowerBook in 1991 with upgrades to its OS. However, following the flops of several consumer-targeted products, such as digital cameras, portable CD players, speakers, video consoles, and TV appliances, Sculley was replaced as CEO by Michael Spindler in 1993. Spindler continued as CEO until 1996 when he was replaced by Gil Amelio, after Apple experienced a significant decline in revenues and profits.12 After several failed attempts at improving the Mac OS, Amelio decided to acquire NeXT Inc., bringing Jobs

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back to Apple Computer as an advisor. In 1997, Amelio was ousted as CEO by the board of directors, and Jobs became interim CEO. A year after Jobs returned as CEO, Apple Computer released the iMac, which was commercially popular and successful. The iMac integrated notable new design aesthetics and technology, selling nearly 800,000 units in the first five months.13 During the next several years, Apple Computer acquired several companies to complete its iLife suite, which included iMovie, GarageBand, iPhoto for consumers, and Final Cut Pro for professionals. In 2001, Apple Computer opened its first Apple Retail Stores and introduced the wildly successful iPod, which sold more than 100 million units by 2007. To complement the iPod and provide an even better user experience, Apple introduced the iTunes Store in 2003. During the period between 2003 and 2006, the price of Apple Computer’s stock went from about $7 per share to more than $80 per share.14 At this point, Apple began to seriously consider entering the smartphone market. The company had partnered with Motorola to release the Motorola ROKR in 2004, which was carried exclusively by Cingular and used iTunes software to play iTunes songs. However, Apple executives felt the design and execution (controlled primarily by Motorola and Cingular) were clunky.15 In 2005, Apple engineers were working on touchscreen technology for a tablet PC and were convinced that they could use the same technology for a smaller device. Moreover, the new processor chips were fast and efficient enough to power a combined phone, computer, and iPod device in a single mobile device. Apple saw the success of BlackBerry and the rising demand for phones that used data and the Internet. As mobile phones became more integrated with other applications (such as music), Apple could see that the iPod business would be negatively affected because of increased competition from phones. Apple was looking for its next big product and thought that the smartphone market was where the company needed to be, but only on its own terms.

Terms of the Strategic Alliance Jobs referred to telecom operators as “commodities” who would never understand the web and entertainment the way Apple did. Apple was trying to buck the “rules” of the cellphone industry and maintain complete control of the design and marketing of its first cellphone. In order to maintain complete control, Apple considered creating the device and buying excess capacity from existing carriers to service the device themselves. This was what Virgin had done when it launched Virgin Mobile (though Virgin didn’t try to design its own phone).16 But this option would require substantial investment and would put Apple into direct competition with the major carriers: Verizon, AT&T, Sprint, and T-Mobile. So Apple decided to explore the option of partnering with one of the major carriers. Ideally, Apple was looking for a partner that could help fund the development of the iPhone but would grant Apple full control of the development and design. Apple also wanted a partner with a large retail network that would be effective at selling the iPhone. This meant that AT&T and Verizon were prime targets. In addition, Apple wanted a partner that would give it a percentage of the annual service bill for iPhone users (anticipated to be roughly $1,000 per year). Finally, Apple didn’t want to provide long-term exclusivity to any one carrier. AT&T (called Cingular before 2005) was a top candidate because its wireless data network was the largest wireless data network available at the time, reaching 270 million people worldwide—about 50 million more than the next largest wireless network.17 However, according to at least one industry expert, AT&T was a “sclerotic mess of assets” with a future that lay in “a glitchy, hodgepodge cellular network cobbled from deals past.”18 As its voice business continued to fade fast because of fierce competition and price wars, AT&T had a large incentive to grow its wireless business—and add more data customers through expanded smartphone use. AT&T was looking for a competitive advantage in the wireless market and to fully transition its brand into that of a wireless company. In early 2005, Jobs pitched his idea to then Cingular Wireless chief executive Stan Sigman. They agreed to explore the idea further. Cingular’s global network for mobile communications

Launch of the iPhone with AT&T

(GSM) technology was the standard in much of the world, and so Cingular was a logical choice as a partner for Apple. Jobs also shopped his idea around to other wireless industry titans, including Cingular’s main competitor Verizon Wireless in the middle of 2005, but negotiations fell through. Verizon balked at the notion of cutting out its big retail partners, such as Circuit City, which would not be allowed to sell the phone. Verizon also hesitated because Apple wouldn’t allow Verizon to sell content such as music and videos through its proprietary V Cast service.19 With Verizon out of the picture, Apple’s talks with Cingular accelerated. The wireless company couldn’t pass up the chance to usher in the smartphone era with Jobs, who had reinvented the computer and the music industry. Secret negotiations that began with Cingular executives in February 2005 took over a year to complete, ending with the company that had been renamed AT&T. Stan Sigman, CEO of AT&T Wireless, and his team were taken with the idea of the iPhone, but it was difficult to convince everyone to change so much of the existing phone carrier business model and to concede to Jobs’ demands.20 Forbes reported, “Trust was a big part of the story behind AT&T’s deal with Apple. ‘I told people you weren’t betting on a device,’ recalls AT&T CEO Randall Stephenson. ‘You were betting on Steve Jobs.’”21 The official details of the agreement are proprietary, but a number of them have been released or publicly acknowledged. Main points are summarized below: • AT&T would be the exclusive carrier of iPhone for five years, while Apple would get millions of dollars from AT&T to support development of the iPhone. • AT&T would get 10 percent of iPhone sales in AT&T stores, while Apple would get $10 per month of AT&T iPhone subscriber’s bill. • AT&T would get a thin slice of iTunes revenues, while Apple would get control of design, manufacturing, and marketing. Although Jobs was notoriously secretive about the iPhone before its announcement, even with AT&T executives, those who did get to see it before the public were enthusiastic. Sigman called the iPhone “the best device I have ever seen.”22 In return for five years of exclusivity, roughly 10 percent of iPhone sales in AT&T stores, and a thin slice of Apple’s iTunes revenue, AT&T had granted Jobs unprecedented power.23 He had cajoled AT&T into spending millions of dollars and thousands of hours to create a new feature, a so-called visual voicemail, and to reinvent the time-consuming in-store sign-up process.24 AT&T’s wireless data network would become a differentiator. Voellinger, VP of telecom consultancy Telwares, said the AT&T–Apple alliance was really about content. “They are not going to pull users with speed,” he says. “They will do it with content and because of the content, it should be very successful.”25 With Apple’s design prowess and AT&T’s network services, the iPhone was poised to revolutionize the wireless smartphone industry.

Launch of the iPhone with AT&T Tremendous excitement surrounded the iPhone launch in North America on June 27, 2007. In March 2007, AT&T had more than 1 million inquiries for the device on its website. An AT&T store sales representative in Manhattan reported receiving hundreds of phone calls per day and at least another hundred inquiries from people who walked into the store asking how they could get their hands on an iPhone.26 Owners of the iPhone said they loved using their device to surf the Internet, download content, stream music and videos, and send and receive email, as well as talk on the phone. AT&T discovered that its data network demand predictions were far too low, causing huge strains on the network resulting in spotty coverage and customer service headaches. Since 2007, traffic on AT&T’s network has doubled each year, and, according to an AT&T FCC filing in 2011, mobile data volume surged 8,000 percent from 2007 to 2010, which included data used on iPods and iPads.27 Apple contributed to coverage problems as well. The original iPhone shipped with glitches in its communications software that led to dropped calls.28

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When AT&T complained to Apple about iPhone users’ data demands, it was met with resistance. AT&T requested that Apple take measures to help throttle back user data traffic, for example, by limiting YouTube videos to Wi-Fi only or by cutting off after a minute. AT&T argued that there was no point in offering features that carriers couldn’t support. However, Apple engineers and marketers weren’t interested in cooperating. “We consistently said ‘No, we are not going to mess up the consumer experience on the iPhone to make your network tenable.’ They’d (AT&T) always end up saying, ‘We’re going to have to escalate this to senior AT&T executives,’ and we always said, ‘Fine, we’ll escalate it to Steve and see who wins.’ I think history has demonstrated how that turned out.”29 Meanwhile, AT&T customers were upset with the limited coverage and service on the EDGE network, especially in cities such as New York and San Francisco where iPhone users were more densely populated than they were in other markets. This created numerous PR headaches for AT&T because its reputation became increasingly associated with an unreliable network. AT&T’s service glitches became fodder for competitors such as Verizon.30 AT&T responded to the increased demand by spending $115 billion from 2007–2012, acquiring additional spectrum and building its network to meet customer demand. Speaking in an interview in 2009, AT&T Chief Technology Officer John Donovan said, “Nobody is in the same boat we’re in. We’re shaping the landscape for the whole industry, and I relish the opportunity to be the first to figure it out. . . . We’re solving problems for the world in how to deal with these loads.”31

Assessing the Impact of the Strategic Alliance As the alliance reached the end of its five-year life, both AT&T and Apple had the opportunity to assess whether it had achieved its strategic objectives.

Impact on AT&T AT&T’s key objectives with the partnership were to attract more subscribers and to rebrand itself as a wireless company. Analysts predicted the iPhone would sell about 8 million units by the end of 2008, but in reality, that number was larger. There were 1.4 million units sold globally in 2007, and in the years 2008–2011, the number of units sold were 11.6 million, 20.7 million, 40.0 million, and 72.3 million, respectively,32 with approximately 85 million total in the United States during that same period.33 AT&T reported roughly 53 million iPhone account activations in the United States from 2007 to 2011 (see Exhibit 2). From the launch of the iPhone in June 2007 to

Time EXHIBIT 2

AT&T iPhone Activations (2007–2011)

*Compiled from AT&T Inc. Financial Review 2007 – 2011

Q4 2011

Q3 2011

Q2 2011

Q1 2011

Q4 2010

Q3 2010

Q2 2010

Q1 2010

Q4 2009

Q3 2009

Q2 2009

Q1 2009

Q4 2008

Q3 2008

*Q1 2008

Q4 2007

*Q2 2008

Number of iPhone Activations for AT&T

8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Q3 2007

# of Activations (in millions)

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Assessing the Impact of the Strategic Alliance

January 2012, AT&T’s market share of wireless phone subscribers (among the top four companies) went from 36 percent to 39 percent. The 3 percent share increase translated into roughly 3.2 million additional subscribers at the beginning of 2012. Verizon Wireless also gained subscribers during that time period, going from 36 percent to 41 percent. Sprint was the big loser, with its market share of subscribers dropping from 27 percent to 17 percent (see Exhibit 3).34 Following the launch of the iPhone 3G (second generation) in 2008, AT&T began subsidizing iPhones. The original $599 price tag was too expensive for the majority of consumers, and Apple dropped the price down to $199 with a 2-year contract and a slightly higher monthly data plan fee. AT&T executives were willing to pay this subsidy because they saw that iPhone users were more lucrative due to their increased data usage, and they believed the new pricing would lead to mass adoption.35 Indeed, AT&T ended up getting nearly twice the average revenue per user (ARPU) per month from iPhone users. According to Apple Inc. in 2010, AT&T’s iPhone ARPU36 was $95 compared to $50 for the top three carriers.37 Additionally, turnover (churn levels) for these subscribers was significantly lower than it was for other smartphone customers.38 Starting in February 2011, Verizon was able to start selling iPhone activations, followed by Sprint in October 2011. Despite speculation that AT&T iPhone activations would drop off quickly after the company lost exclusivity, activation activity for AT&T was 17.5 million iPhones in 2011. Verizon was 10.8 million, and Sprint came in at 1.8 million. That trend continued in the first quarter of 2013. AT&T activated 4.8 million iPhones while Verizon activated 4.0 million.39 The iPhone remains AT&T’s most popular phone, and it garnered about 73 percent of the company’s smartphone subscribers in 2012. The AT&T wireless segment’s financial performance steadily increased from 2006 to 2007, with the Cingular merger and the introduction of the iPhone. By 2012, sales had passed $66 billion. AT&T’s market value also increased during that time, from $183.5 billion to $227 billion, but it dropped back down to $188 billion by the end of 2012 (See Exhibit 4).

Impact on Apple The iPhone cost an estimated $150 million to develop over 30 months.40 According to Apple court case documents, it spent $647 million on advertising the iPhone in the United States from 2007 to 2011.41 However, these costs were more than covered by the estimated $10 per month charge for each iPhone in the contract with AT&T.42 In fact, in just 2011, the final year of the agreement, AT&T reported 17.5 million iPhone activations, which would have generated roughly $2.1 billion in annual profit. With 53 million cumulative iPhone activations in the first five years, Apple would have generated roughly $5–$6 billion in AT&T service revenue profits over the life of the agreement. EX HIB I T 3

Company

Subscriber Share for the Four Largest Wireless Carriers (2006–2012)

2006

2007

2008

2010

2011

2012

60

70.1

77

85.1

95.5

103.2

107

Market Share*

36%

38%

38%

38%

38%

39%

38%

Verizon

59.1

65.7

80

91.2

102.2

108.7

115.8

Market Share

35%

35%

39%

41%

41%

41%

41%

Sprint

45.8

45.4

42.9

39.94

44.5

46.6

47.8

Market Share

27%

25%

21%

18%

18%

17%

17%

T-Mobile

2.9

4

5.4

6.6

8.2

9.3

8.9

Market Share

2%

2%

3%

3%

3%

3%

3%

AT&T

2009

*Market share among the top four national players included here, not across the entire wireless market; does not include local wireless players (e.g., Cricket Wireless). Source: Company 10k SEC filings. Subscriber counts include prepaid and postpaid retail customers.

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AT&T and Apple

EXHIB IT 4

Selected Financials for Apple, AT&T, Verizon, Sprint, and T-Mobile (2006–2012)

APPLE INC. (in millions)

2006

2007

2008

2009

2010

2011

2012

$19,315

$24,006

$37,491

$42,905

$65,225

$108,249

$156,508

13,717

15,852

24,294

25,683

39,541

64,431

87,846

5,598

8,154

13,197

17,222

25,684

43,818

68,662

712

782

1,109

1,333

1,782

2,429

3,381

2,433

2,963

3,761

4,149

5,517

7,599

10,040

Operating income

$2,453

$4,409

$8,327

$11,740

$18,385

$33,790

$55,241

Mac sales

$7,375

$10,314

$14,276

$13,859

$17,479

$21,783

$23,221

iPod sales

7,676

8,305

9,153

8,091

8,274

7,453

5,615

iPhone and related sales

0

123

1,844

13,033

25,179

47,057

80,477

iPad and related sales

0

0

0

0

4,958

20,358

32,424

$65.70

$103.94

$163.57

$120.22

$229.39

$342.18

$526.71

Number of shares (000s)

855,263

872,329

888,326

899,806

915,970

929,277

939,208

Market value (in millions)

$56,193

$90,672

$145,301

$108,175

$210,119

$317,979

$494,687

2006

2007

2008

2009

2010

2011

2012

$37,537

$42,684

$49,174

$53,504

$58,500

$63,215

$66,763

Cost of services and sales

15,057

15,991

Selling, G&A

11,446

12,594

6,462

7,079

6,025

6,043

6,497

6,329

6,873

$4,527

$7,020

$15,257

$13,830

$15,257

$15,604

$15,594

60.0

70.1

77.0

85.1

95.5

103.2

107.0

$625.62

$608.90

$638.62

$628.72

$612.57

$612.55

$623.95

$75.45

$100.14

$198.14

$162.51

$159.76

$151.20

$145.74

2006

2007

2008

2009

2010

2011

2012

Total operating revenues

$38,043

$43,882

$49,332

$62,131

$63,407

$70,154

$75,868

Cost of services and sales

11,491

13,456

15,660

19,749

19,245

24,068

24,490

Selling, G&A

12,039

13,477

14,273

17,848

18,082

19,579

21,650

4,913

5,145

5,405

7,030

7,356

7,962

7,960

$9,600

$11,795

$13,994

$17,505

$18,724

$18,527

$21,768

59.1

65.7

80.0

91.2

102.2

108.7

115.8

Revenue/Sub

$643.71

$667.91

$616.65

$681.26

$620.42

$645.39

$655.16

OI/Sub

$162.44

$179.53

$174.93

$191.94

$183.21

$170.44

$187.98

Net sales Cost of sales Gross margin Research and development Selling, G&A

Average stock price

AT&T (in millions) Wireless operating revenue

Depreciation & amortization Operating income Subscribers (millions) Revenue/Sub OI/Sub

*Operating expenses were consolidated after 2007.

VERIZON (DOMESTIC WIRELESS) (in millions)

Depreciation & amortization Operating income Subscribers (millions)

Assessing the Impact of the Strategic Alliance

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SPRINT (in millions)

2006

2007

2008

2009

2010

2011

2012

$35,115

$34,700

$30,427

$27,786

$28,597

$30,301

$32,355

Cost of services & products

12,854

13,635

13,644

13,929

15,253

16,964

18,922

Selling, G&A

10,572

11,151

10,047

8,659

8,813

9,070

9,286

$2,428

$9,914

$6,776

$5,198

$4,531

$4,267

$4,147

45.8

45.4

42.9

39.9

44.5

46.6

47.8

$766.70

$764.32

$709.25

$695.69

$642.63

$650.24

$676.88

$53.01

$218.37

$157.95

$130.15

$101.82

$91.57

$86.76

2008

2009

2010

2011

2012

Service & equipment revenue

Depreciation & amortization Operating income Subscribers (millions) Revenue/Sub OI/Sub

9,086

*Depreciation & amortization were consolidated after 2006.

T-MOBILE (in millions)

2006

2007

Service & Equipment Revenue

$1,547

$2,236

$2,752

$3,481

$4,069

$4,847

$5,101

Cost of services and sales

922

1,245

1,562

2,004

2,318

2,913

2,930

Selling, G&A

244

352

447.582

567.73

622

644

697

Depreciation & amortization

135

178

255

378

450

539

641

$237

$460

$468

$535

$719

$748

$824

2.9

4.0

5.4

6.6

8.2

9.3

8.9

$533.41

$558.93

$509.54

$527.35

$496.26

$521.22

$573.18

$81.81

$115.03

$86.62

$81.10

$87.67

$80.38

$92.58

Operating income Subscribers (millions) Revenue/Sub OI/Sub

Source: Apple, AT&T, Verizon, Sprint, and T-Mobile Annual Reports, 2006–2012.

Manufacturing costs for the iPhone have been estimated to be roughly $290, and the average selling price has been approximately $600,43 giving Apple 50 percent profit margins, before covering other operating expenses such as advertising, service, and general and administrative expenses.44 Advertising costs were roughly $8 per customer ($647 million in advertising spread across 85 million customers) during the first five years. Depending on actual service costs, general and administrative expense allocations, and the actual bill of material component costs, Apple earned between $225 and $325 per iPhone. At $225 per phone multiplied by 85 million phones, Apple’s profits from iPhones during the 5-year period would be roughly $19.1 billion. With these profits, Apple became the largest mobile handset vendor in the world by revenue in 2011, surpassing longtime leader Nokia.45 Sales of the iPhone continue to come primarily through AT&T and other third-party retail outlets. In 2012, the 250 Apple stores sold approximately 21 percent of iPhones, while AT&T sold 28 percent and Verizon 26 percent. These numbers indicate that consumers still prefer to go to the carrier to purchase their iPhone, as opposed to the Apple store where they purchase the majority of other Apple devices, including Macs and iPads.46 Part of this trend may also be because of the accessibility of AT&T or Verizon stores. The value of Apple’s brand and its stock skyrocketed after the launch of the iPhone. Apple’s Interbrand ranking (a comparison of global brand recognition and value) went from thirtyninth ($9.1 billion) in 2006 to first ($98.3 billion) in 2013, surpassing other brand legends such as Coca-Cola, McDonald’s, and Microsoft. Apple’s sales jumped from $19 billion in 2006 to $156 billion in 2012, while its market value skyrocketed from $56 billion to $494 billion during that same time period (see Exhibit 4). Much of that increase in market value was attributed to the introduction of the iPhone and iPad.

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Conclusion AT&T enjoyed a number of noteworthy benefits as a result of the Apple alliance. AT&T’s share in the emerging smartphone market increased significantly from 28 percent just prior to the release of the iPhone in 2007 to 32 percent by the end of 2011. Its partnership with Apple also helped bolster AT&T’s image among increasingly technology-hungry consumers. Finally, although painful, high demands from Apple pertaining to the consumer experience and increased user network requirements ultimately forced AT&T to strengthen its network capabilities and customer service. Indeed, for AT&T, the alliance appears to have paid healthy dividends in terms of increased subscribers, a stronger brand, and improved operations. But the costs were substantial as well. Along with the upfront development costs, AT&T paid a $5 billion to $6 billion in service revenue to Apple. Nevertheless, by the end of the alliance, AT&T saw its wireless segment’s operating margin improve by nearly 10 percent, in large part because of its operating profit per subscriber increasing by roughly $75 (and see Exhibits 5 and 7; also see Exhibits 6 and 8 for a comparison of revenue per user and earnings per share over time). At the time of its release, the iPhone was the first to use a multitouch interface with a large touchscreen that did not require use of a stylus, keyboard, or keypad. The user interface was also known for its intuitiveness and visual aesthetics, a hallmark of Apple products. Apple helped transform the smartphone from a primarily business-centric device, at the time dominated by BlackBerry, to a product attractive to the general consumer.47 Despite Apple having revolutionized the consumer smartphone experience, competitors such as Samsung, LG, Operating Margin 40.00% 35.00% 30.00% AT&T

25.00%

Verizon

20.00%

Sprint

15.00%

T-Mobile

10.00%

Apple

5.00% 0.00% 2006

EXHIBIT 5

2007

2008

2009

2010

2011

2012

Operating Margin

Revenue per Subscriber $800.00 $750.00 $700.00 $650.00

AT&T

$600.00

Verizon

$550.00

Sprint T-Mobile

$500.00 $450.00 $400.00 2006

EXHIBIT 6

2007

2008

2009

2010

2011

Revenue per Subscriber

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006–2012.

2012

Conclusion C-97 Operating Income per Subscriber $250.00

$200.00

AT&T

$150.00

Verizon Sprint

$100.00

T-Mobile $50.00

$0.00

EXHIBIT 7

2006

2007

2008

2009

2010

2011

2012

Operating Income per Subscriber

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006–2012.

Earnings per Share $50.00 $40.00 $30.00

AT&T Verizon

$20.00

Sprint $10.00

T-Mobile Apple

$– 2006

2007

2008

2009

2010

2011

2012

$(10.00) $(20.00)

EXHIBIT 8

Earnings per Share

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006–2012.

HTC, and Microsoft, using Android and Windows-based operating systems, caught up to and, in some cases, surpassed some of the iPhone’s technological features. In 2008, the Android operating  system, which was backed by Google, was launched on the HTC Dream. The Android system, with a user interface similar to that of iPhone’s iOS, was touchscreen-focused for use on smartphones and tablets. It incorporated hardware such as gyroscopes, accelerometers, and proximity sensors to provide an enhanced user experience similar to that of Apple’s iPhone.48 Releases of smartphones by Apple’s competitors, such as Samsung (notably the Galaxy S series), HTC, LG, Microsoft, Sony, Nokia, and BlackBerry, in the latter years of the Apple–AT&T alliance showed how quickly Apple’s technological and user interface advantages were neutralized. Competitors were even surpassing the iPhone on features such as screen size, built-in cameras, and speakers. As a result, some wondered whether it had been wise for Apple to limit the introduction of the iPhone through the AT&T alliance. Were the millions of dollars in development fees and the share of monthly revenue worth the price of exclusivity with AT&T? Had exclusivity created a greater frenzy for the iPhone than would have happened had it been released through multiple carriers? Or did exclusivity with AT&T hurt Apple’s ability to gain broader market penetration before competitors (notably Samsung) were able to develop phones with similar functionality and technology? Although it is impossible to know exactly what would

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have happened without the strategic alliance, there is no doubt that its effects helped to shape both companies’ footholds and futures in the smartphone market. As Stephenson and the AT&T leadership team looked to the future, it was apparent that they would continue to use alliances, and acquisitions, as vehicles for accessing key resources in other firms. Between 2011 and 2014, AT&T announced a series of strategic alliances to help improve the company’s position providing telecommunication and Internet services to business customers. In particular, AT&T announced alliances with Akamai and CSC to develop nextgeneration technology solutions for enterprise businesses. For example, CSC, a recognized leader in enterprise cloud computing, will deliver its BizCloudTM and other cloud services through AT&T’s global cloud infrastructure platform and networks. AT&T also announced alliances with McAfee, to provide enhanced security benefits to business customers, and Microsoft, to combine the Microsoft Azure platform (one of the most popular PaaS services) and AT&T’s network services.49 But AT&T’s biggest strategic move was done through acquisition rather than alliance. To expand its broadband U-Verse television service, AT&T proposed an acquisition of DirecTV, the largest satellite TV operator in the United States and Latin America. “What it does is it gives us the pieces to fulfill a vision we’ve had for a couple of years,” said AT&T CEO Randall Stephenson, “the ability to take premium content and deliver it across multiple points: your smartphone, tablet, television or laptop.”50 Even as the acquisition was announced, there was considerable debate as to whether it was wise to acquire DirecTV, with some suggesting that AT&T could have used an alliance instead of an acquisition to achieve its strategic objectives. Undoubtedly, like the Apple alliance, the success of the DirecTV acquisition was likely to be debated in years to come.

References 1 AT&T, “A Brief History: The Bell System,” http://www.corp.att.com /history/history3.html, accessed December 24, 2013.

ICC stands for Interstate Commerce Commission.

J.H. Bear, “When Was Desktop Publishing Invented?” http://desktoppub .about.com/cs/beginners/f/when_dtp.htm, accessed December 24, 2013. 10

Hormby.

2

11

3

AT&T, “A Brief History: Post Divestiture,” http://www.corp.att.com /history/history4.html, accessed December 24, 2013.

12

A. Kupfer, “AT&T’s $12 Billion Cellular Dream .  .  . ,” CNN Money (December 12, 1994), http://money.cnn.com/magazines/fortune/fortune _archive/1994/12/12/80051/, accessed December 24, 2013.

13

4

5 Unknown, “AT&T Wireless Services,” Wikipedia.com, http://en.wikipedia .org/wiki/AT%26T_Wireless_Services, accessed December 24, 2013.

C. Guglielmo, “AT&T’s Big Call: Randall Stephenson on the iPhone, His Wireless Ambitions, and The Next Big Thing,” Forbes (January 2, 2013), http://www.forbes.com/sites/connieguglielmo/2013/01/02/atts-big -call-randall-stephenson-on-the-iphone-his-wireless-ambitions-and -the-next-big-thing/, accessed December 24, 2013. 6

Stephen Colbert takes a stab at explaining the various mergers, acquisitions, and name changes in this amusing clip: http://videosift. com/video/Colbert-regarding-the-new-ATT. 7

8 C. Guglielmo, “Life After the iPhone: How AT&T’s Bet on Apple Mobilized the Company,” Forbes (January 21, 2013), http://www .forbes.com/sites/connieguglielmo/2013/01/02/life-after-the-iPhone -how-atts-bet-on-apple-mobilized-the-company/2/, accessed December 24, 2013. 9 T. Hormby, “Good-bye Woz and Jobs: How the First Apple Era Ended in 1985,” LowEndMac.com (August 16, 2013), http://lowendmac.com/2013 /good-bye-woz-jobs-apple-1985/, accessed December 24, 2013.

T. Hormby, “Michael Spindler: The Peter Principle at Apple,” LowEndMac.com (August 17, 2013), http://lowendmac.com/2013 /michael-spindler-peter-principle-apple/, accessed December 24, 2013. D. Eran, “1990–1995: Hitting the Wall” (September 7, 2006), http:// www.roughlydrafted.com/RD/Home/B8DA34A3-333B-4204-BDF3 -E74608998702.html, accessed August 14, 2008. See “Table: Apple (APPL) Yearly Adjusted Close Average Stock Price.”

14

A. Sharma, N. Wingfield, and L. Yuan, “How Steve Jobs Played Hardball in iPhone Birth,” The Wall Street Journal (February 17, 2007), http://online.wsj.com/news/articles/SB117168001288511981, accessed December 24, 2013. 15

Ibid.

16

AT&T, “iPhone and AT&T’s Wireless Data Network,” http://www.att .com/Common/merger/files/pdf/iphone_att_network_fs.pdf, accessed December 24, 2013.

17

Guglielmo, January 2, 2013.

18

Sharma, Wingfield, and Li.

19

F. Vogelstein, “The Untold Story: How the iPhone Blew Up the Wireless Industry,” Wired (January 9, 2008), http://www.wired.com /gadgets/wireless/magazine/16-02/ff_iphone?currentPage=all, accessed December 24, 2013.

20

References C-99 Guglielmo, January 2, 2013.

21

Vogelstein.

22

N. Patel, “Confirmed: AT&T and Apple Signed 5 Year i-Phone Exclusivity Deal—but Is It Still Valid?” Engadget (May 10, 2010), http://www .engadget.com/2010/05/10/confirmed-apple-and-atandt-signed-five -year-iphone-exclusivity-de/.

23

Vogelstein, 2008.

24

W. D. Gardner, “The New AT&T Is on a Roll, but Challenges Await,” InformationWeek.com (January 18, 2007), http://www.informationweek .com/the-new-atandt-is-on-a-roll-but-challenges-await/d/d-id /1050827?, accessed December 24, 2013.

25

M. Reardon, “Apple, AT&T Stores Prepare for iPhone Frenzy,” cnet .com (June 6, 2007), http://news.cnet.com/2100-1039_3-6189186.html, accessed December 24, 2013.

26

27 A. Chansanchal, “iPhone, iPad Maxed Out AT&T Network,” msnbc.com (April 22, 2011), http://www.nbcnews.com/technology/iphone-ipad -maxed-out-t-network-123538, accessed December 24, 2013.

P. Burrows, “Can AT&T Meet iPhone Network Demands?,” BloombergBusinessweek.com (August 23, 2009), http://www.businessweek .com/technology/content/aug2009/tc20090823_412749.htm, accessed December 24, 2013. 28

F. Vogelstein, “Bad Connection: Inside the iPhone Network Meltdown,” Wired (July 19, 2010), http://www.wired.com/magazine/2010/07/ff _att_fail/all/, accessed December 24, 2013. 29

Knowledge@Wharton, “For AT&T, Is There Life After the iPhone?” (January 19, 2011), http://knowledge.wharton.upenn.edu/article/for-att -is-there-life-after-the-verizon-iphone/, accessed December 24, 2013.

30

Burrows.

31

Statista.com, “Global Apple iPhone Sales in the Fiscal Years 2007 to 2013 (in million units),” http://www.statista.com/statistics/276306 /global-apple-iphone-sales-since-fiscal-year-2007/, accessed December 24, 2013.

32

33 H. Tsukayama, “How Many iPhones Has Apple Sold?,” The Washington Post (August 10, 2012), http://www.washingtonpost.com/business /technology/how-many-iphones-has-apple-sold/2012/08/10 /97c360e4-e2e4-11e1-a25e-15067bb31849_story.html, accessed December 24, 2013.

L. John and Y. Yufei, “Lesson 9: Article (6) What Factors Contributed to the Success of Apple’s iPhone?” (June 19, 2013), http://cyberu. uplus-solution.com/msitm/media/Cin/compre/1_What%20Factors%20 Contributed%20to%20the%20Success%20of%20Apple_s%20iPhone. pdf, accessed December 24, 2013. 34

M. Reardon, “AT&T’s iPhone 3G Subsidy Will Cost ‘Em,” CNET (Jun 9, 2008), http://news.cnet.com/8301-10784_3-9963999-7.html, accessed December 24, 2013. 35

Average revenue per user, defined as the total revenue divided by the number of subscribers.

36

37 P. Cohan, “How Steve Jobs Got ATT To Share Revenue,” Forbes (August 16, 2013), http://www.forbes.com/sites/petercohan/2013/08/16/how-steve -jobs-got-att-to-share-revenue/, accessed December 24, 2013.

S. Weintraub, “AT&T Activated 3.7M iPhones Last Quarter Representing 73 Percent of All Smartphones and 56% of Total,” 9To5Mac.com (July 24, 2012), http://9to5mac.com/2012/07/24/att-sold-3-7-million -iphones-last-quarter-representing-73-of-all-smartphones-sold/, accessed December 24, 2013. 38

C. Welch, “AT&T Adds 296k New Subscribers, Sells 6 Million Smartphones in Q1 2013,” TheVerge.com (April 23, 2013), http://www .theverge.com/2013/4/23/4253874/att-new-1-2-million-smartphone -q1-2013-financials, accessed December 24, 2013.

39

Vogelstein, 2008.

40

D. Rowinski, “4 Real Secrets We’ve Learned So Far About Apple,” readwrite.com (August 7, 2012), http://readwrite.com/2012/08/07/4-real -secrets-weve-learned-so-far-about-apple#awesm=~orQrOK47Wu0Fzq, accessed December 24, 2013. 41

Tsukayama.

42

D. Etherington, “Apple’s Average Selling Price on iPhones in Q3” (July 23, 2013), http://techcrunch.com/2013/07/23/apple-asp-iphone -trending-down/.

43

J. Sherman, “Spendy but Indispensable: Breaking Full $650 Cost of the iPhone 5,” Digital Trends (July 26, 2013), http://www .digitaltrends.com/mobile/iphone-cost-what-apple-is-paying/, accessed December 24, 2013.

44

A. Spektor, “Strategy Analytics: Apple Becomes World’s Largest Handset Vendor by Revenue in Q1 2011,” Enhanced Online News (April 21, 2011), http://www.enhancedonlinenews.com/portal/site/eon /permalink/?ndmViewId=news_view&newsId=20110421005965&new sLang=en&permalinkExtra=Apple/Nokia/revenues, accessed December 24, 2013.

45

J. Paczkowski, “Breaking Down Apple’s Retail Distribution Strategy,” AllThingsD.com (October 3, 2012), http://allthingsd.com/20121003 /apple-stores-get-the-glory-but-retail-partners-shoulder-load/, accessed December 24, 2013.

46

B. McCarty, “The History of the Smartphone,” (December 6, 2011), http://thenextweb.com/mobile/2011/12/06/the-history-of-the -smartphone/#!tiRDT.

47

http://en.wikipedia.org/wiki/Android_(operating_system)#cite_note -AndroidOverview-12. 48

49 M. Sapien, “AT&T’s Enterprise Theme Is Mobile First,” ovum.com, http://ovum.com/2013/10/04/atts-major-enterprise-theme-is-mobile -first/

J. Craft, “Is AT&T’s Acquisition of DirectTV a Wise Move for Both Parties?” http://www.forbes.com/sites/quora/2014/05/22/is-atts-acquisition-of -directv-a-wise-business-move-for-both-parties/ 50

CASE 9 Samsung Overtaking Philips, Panasonic, and Sony as the Leader in the Consumer Electronics Industry During the past century, industry leadership in the global consumer electronics industry (e.g., radios, TVs, movie and music players) has changed, with Philips (Netherlands), Panasonic, Sony (Japan), and Samsung (Korea) emerging as leaders at different times. Indeed, each company achieved leadership with a different international strategy, a different organization design, and a different set of organizational capabilities. Philips built a worldwide federation of independent national organizations able to gain access to the company’s renowned technological prowess and then to apply and adapt it to meet local market needs. Philips was the worldwide leader in consumer electronics from the early 1900s until the late 1970s. During the 1980s, Panasonic used overseas expansion to leverage its centralized, highly efficient operations in Japan, exploiting global-scale economies in R&D and production to offer lower-cost products and overtake Philips as the world leader in consumer electronics. In similar fashion, Sony leveraged its centralized operations in Japan to produce standardized products around the globe. Sony invested far more in R&D than Panasonic did, though, and it was typically the technological and innovation leader in the industry, if not the sales leader, from 1980 to 2005. By 2009, Samsung had seemingly come out of nowhere to become the world leader in consumer electronics, however. Like Sony, Samsung made large investments in R&D so that it emerged as a technological leader in TVs, DVD players, and smartphones. But rather than just making standardized products that were sold around the globe, Samsung took a more decentralized approach than Panasonic and Sony, which allowed it to do some customizing of products for specific markets. By 2014, Samsung’s lead continued to grow. Observers wondered whether the pattern of leader replacement would continue or if Samsung was on top to stay.

Philips Leadership Era: 1900–1980

C-100

Philips was founded in 1891 in Eindhoven, Netherlands, by Dutch engineer Gerard Philips and his brother, Anton. The two brothers initially focused on the light bulb business, with Gerard in charge of product development and Anton in charge of sales. Gerard and Anton began a friendly competition in which Gerard would try to produce more than Anton could sell and vice versa.1 The two agreed that strong basic R&D and product development efforts where vital to the success of Philips, so the company made R&D and product development high priorities. The Philips emphasis on research and product development helped it to become a leader in its field, rivaling General Electric in the early 1900s in the electric lamp industry. In 1914, Philips established its first research laboratory dedicated to developing breakthrough technologies in lighting. This investment helped the company create some of the world’s leading innovations in lighting, such as the tungsten metal filament bulb—a superior advancement over the common carbon-filament lamps. Moreover, the Philips emphasis on research led the company to experiment and develop new technologies that allowed it to expand its product portfolio. For example, in 1918, Philips started to produce electronic vacuum

Philips Leadership Era: 1900–1980

tubes, and soon after that, it was producing X-ray tubes, electric shavers, and small generators. Philips’ most successful new products were arguably its radios, which, by 1936, a mere ten years after the device’s introduction, had captured a nearly 20 percent world market share.2 Due to the small size of the Netherlands, Philips was forced to expand internationally in order to leverage its investment in R&D and develop economies of scale in production. By the early 1900s, Philips had begun selling in a wide range of countries, including the United States, France, Russia, Brazil, Canada, Australia, and Japan.3 With such a diverse group of international operations, Philips decided to adopt English as the company language, requiring its use across all of its management ranks. In anticipation of what would become World War II, Philips shifted assets away from the Netherlands and further decentralized management control to the national organizations (NOs) in each country. Anton Philips and much of the top management team fled to the United States, and its main research lab was moved to England. The decentralization of Philips during the war enabled the NOs in each country to become more independent, thus allowing them to respond to their local market conditions. Each of the larger country NO presidents controlled multiple functions for their countries, including R&D, product design, manufacturing, and sales and distribution (see Exhibit 1). In order to succeed in each local market, the NOs tailored the Philips products to meet consumer preferences in each different country market. For example, some countries, such as the United States, preferred large furniture-encased television sets, but other countries, such as India, demanded inexpensive, small TVs—often placed inside closable shutters to keep the dust away. Additionally, different countries had different ways to penetrate the market, such as through establishing a TV rental business or selling through department stores or discount retailers.4 The NOs had the flexibility to address the local market as they saw fit while drawing upon Philips’s technology and financial resources. For example, Philips of Australia made the first stereo TV, and Philips of the United Kingdom created the first TV with teletext.5 Other countries could then access those technologies and adapt them to their local markets. As time went on, Philips matured into its postwar organization. Fourteen product divisions (PDs) with responsibility for each product’s development, production, and global distribution were established in Eindhoven. The product divisions were created to better coordinate across country markets. But the real power remained with the NOs.6 The NOs were highly

CEO and Management Board

International Concern Council

Administration -Finance, Legal HR

R&D

National Organizations (U.S., U.K., Germany, Japan, etc.)

Product Development

Manufacturing

Product Divisions

Marketing

Development

Production

Distribution EXHIBIT 1

Philips Organization Structure in the 1950s

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C-102

Samsung

autonomous and reported directly to the management board (often sending proxies to represent their interests). But after the European Common Market broke down trade barriers during the 1960s and 1970s, Philips’ competitors—especially Panasonic (then named Matsushita) and Sony—started to gain the upper hand. Products started to become more standardized across markets. Whereas Panasonic and Sony were producing large volumes of standardized products in low-wage countries in Asia, Philips was producing smaller volumes of more tailored products in many different countries. Over time, Philips’ products could not compete with the products of its Japanese competitors on price or reliability. As a result, Philips’s market share in various consumer electronics products started to fall. The company made numerous attempts to centralize the company in order to compete against its large-scale competition. Such attempts included consolidating production to a smaller number of high-volume plants called international production centers, closing inefficient operations, shifting production to low-wage countries, and reorganizing the company into core and noncore businesses. But Philips’s market share and profitability continued to decline. Other problems outside of production also arose for Philips as a result of its decentralized organization structure. In the 1970s, Philips lost the battle as the provider of the preferred videocassette technology when its V2000 format had to be abandoned due to its North American NO deciding to license and sell Panasonic’s VHS format (originally developed by JVC, a subsidiary of Panasonic).7 Despite being a technologically superior format, V2000 was unable to capitalize on world market demand because it sold only in Europe on the PAL standard, whereas its Japanese competitors sold globally. VHS would eventually become the market’s preferred format, surpassing both Philips’s V2000 and Sony’s Beta formats, and it would lead Panasonic to the top of the consumer electronics industry in the 1980s.8 By 1987, Philips was one of only two non-Japanese consumer electronics companies in the world’s top ten (the other was General Electric). Its profit margins of 1 to 2 percent lagged behind its Japanese competitors’ 4 to 6 percent (see Exhibit 2). Between 1990 and 2005, Philips continued to reorganize to centralize operations in an attempt to gain greater efficiencies. In the early 1990s, CEO Jan Timmer reduced headcount by EXHIB IT 2

Philips Group Summary Financial Data, 1970–2016

In millions of dollars:

1970

1980

1990

2000

2005

2010

2013

2014

2015

2016

Net Sales

$4,163

$16,993

$32,996

$35,253

$25,628

$19,228

$31,209

$33,423

$29,335

$29,664

SG&A

N/A

N/A

N/A

N/A

N/A

$556

$1,270

$9,173

$8,499

$8,147

Cost of Sales

N/A

N/A

N/A

N/A

$4,006

$3,968

$6,789

$20,602

$17,409

$16,824

N/A

N/A

N/A

N/A

16%

21%

22%

61.6%

59.3%

56.7%

N/A

N/A

N/A

N/A

$2,152

$1,192

$2,318

$2,555

$1,463

$1,022

8.4%

6.2%

$0

7.6%

5.0%

3.4%

As % of net sales R&D Expenses As % of net sales Advertising Expenses

N/A

N/A

N/A

N/A

N/A

$1,235

$1,355

$1,427

$1,210

Income Before Taxes

N/A

N/A

−1414

2814

1500.0%

1562.0%

$2,664

$759

$754

$1,681

Net Income

123

247

−2631

N/A

1097.0%

1085.0%

$1,568

$642

$797

$1,804

3%

2%

−8%

N/A

4.3%

5.6%

5%

1.9%

2.7%

6.1%

$5,273

$18,440

$30,530

$35,885

$28,551

$24,409

$35,530

$44,300

$37,481

$39,087

359

373

273

219

159

119

116

1,627

7,134

10,404

7,895

5,760

N/A

N/A

39%

42%

32%

22%

23%

24%

N/A

As % of net sales Total Assets Employees (in thousands) Labor Costs As % of total employees

1,12,959 1,13,678

Net Income per Employee Exchange Rate (fiscal period end; guilder or euro/dollar) Source: Annual reports.

$13,761 3.62

2.15

1.69

1.074

1.186

1.322

1.25

1.25

1.1

1.1

Panasonic and Sony Leadership Era: 1980–2000

68,000, or 22 percent, earning him the nickname “The Butcher of Eindhoven.”9 Due to European laws that require substantial compensation for layoffs (typically 15 months of pay), the first round of 10,000 layoffs cost Philips $700 million. However, after three years of cost cutting, a McKinsey study estimated that the value added per hour in Japanese consumer electronic factories was still 68 percent above that of European plants. In 1996, Cor Boonstra replaced Timmer and announced that “There are no taboos, no sacred cows” and “The bleeders must be turned around, sold, or closed.”10 Within three years, he sold off 40 of Philips’ 120 major businesses, including well-known units such as Polygram and Grundig. While closing 100 of the company’s 356 factories worldwide, he argued, “How can we compete with the Koreans [new competitors Samsung and LG]? They don’t have 350 companies all over the world. Their factory in Ireland covers Europe and their manufacturing facility in Mexico services North America.” He also increased advertising by 40 percent to raise awareness of the Philips brand and de-emphasize most of the other 150 brands it supported worldwide—from Magnavox TVs to Norelco shavers to Marantz stereos (many of these local brands had been acquired to strengthen Philips’s position in specific local markets). These and other actions helped Philips become more efficient and improved profitability from losses in the early 1990s to profit margins typically in the 4-6 percent range from 2000 to 2010 (see Exhibit 2). During the first decade of the new century Philips continued the trend of closing factories in high wage countries, outsourcing most of the production of its consumer electronics lines and moving in house production to China, Poland, or Mexico. Still, by 2012, Philips had 118 production plants in 24 countries In addition to looking for savings in manufacturing, Philips also cut back on its advertising budget and focused its channel management on 200 large chains (as opposed to 600 prior to 2001). These moves bore fruit as Philips’ net margins increased to 4.3 percent in 2005 and 5.6 percent in 2010, but the increasingly intense competition cut their margins to 1.9 percent in 2014. In response, Philips increased its advertising but cut its R&D budget by 60 percent by 2016. That revived the bottom line, bringing it up to 6.1 percent in 2016, but at what cost for a firm that was known for its innovation? The cost turned out to be very steep indeed. Philips decided to restructure its company in fundamental ways. In 2011 net profit had dropped 85 percent, and in response Philips laid off 4,500 workers and vowed to cut costs by $1.1 billion dollars.11 To meet that goal, they sold their television manufacturing operations,12 their audio and video businesses,13 consumer electronic operations,14 and even divested themselves of their lighting business15—the business that launched Philips in 1891. This move was highlighted by a change in the name from Philips Electronics to just Philips.16 Their new focus was on medical equipment, consumer lifestyle products,17 and products for emerging markets (e.g., they acquired Preethi, a leading India-based kitchen appliance firm in 2011). Philips had gone from being the undisputed market leader in consumer electronics and lighting to exiting both businesses. With such fundamental change it was anyone’s guess as to whether Philips could turn things around.

Panasonic and Sony Leadership Era: 1980–2000 In 1918, a 23-year-old Osaka Electric Company inspector named Konosuke Matsushita (affectionately known as “KM”) invested a mere 100 yen to start Matsushita Electric Industrial (MEI). KM started MEI in a two-room house with his wife, brother-in-law, and two employees. The company’s first product was a light bulb attachment plug, and KM aimed to produce products 30 percent cheaper than its competition. MEI was effective at efficient production, and, by 1931, it had grown to employ 1,200 people in 10 plants, producing more than 200 products. KM argued that “what manufacturers should aim for is to produce as abundantly and as cheaply as tap water; when this is achieved poverty will be conquered from the face of the earth.” A public offering in 1935 allowed Panasonic to diversify further into domestic fans, light bulbs, small motors, and a variety of domestic appliances. Soon the wave of new products became a flood: black-and-white TV sets in 1958; transistor radios in 1959; color TVs, dishwashers, and electric ovens in 1960. By 1968, Panasonic produced 5,000 products compared to

C-103

C-104

Samsung

80 for Japanese rival Sony. Capitalizing on this broad product line, the company opened 25,000 domestic retail distribution outlets. With more than six times the number of outlets than Sony, the ubiquitous “National Shops” represented about 40 percent of all appliance stores in Japan in the late 1960s.

Panasonic’s Organization Structure KM organized MEI into product divisions and forced each division to become self-sufficient in various activities including product development, production, and marketing (see Exhibit 3). This structure allowed KM to easily measure each division’s profit performance because each was a semiautonomous business unit. If a division needed additional funding, it needed to make a loan request to headquarters; a loan request was then received and reviewed, and, if granted, it was accompanied by an interest rate comparable to market rates. Headquarters received 60 percent of each division’s earnings and expected high performance from its division managers (a drop in operating profits to below 4 percent of sales for two consecutive years led to the replacement of the product division general manager). As a result, internal rivalry among the 36 divisions was intense—a characteristic that was believed to fuel the company’s focus on efficiency and rapid growth. Even the central R&D laboratory was underfunded, which forced it to go directly to the product divisions to ask for R&D projects that would be funded by the product divisions. These management practices helped MEI efficiently produce low-cost products, and by the 1960s, MEI was a dominant player in Japan. As the company looked for growth options, it decided to expand internationally and leverage economies of scale from its large-volume factories in Japan. It wasn’t long before MEI was exporting a diverse set of products, including transistor radios, color TVs, dishwashers, and electric ovens under the Panasonic brand. As MEI expanded internationally, the strategic direction and product development for the company remained closely regulated by its headquarters in Japan. For the most part, products were researched, designed, and manufactured in Japan, and then foreign managers came and tried to negotiate for changes to accommodate the products for their region’s preferences. Headquarters, however, ultimately had the final say as to whether these proposed changes were approved. In order to ensure efficient control of international operations, the

Matsushita Electric Industrial Co., Ltd (MEI) Matsushita Electric Trading Co. (METC)

Tape Recorder Division

Radio Division

Europe Department

Asia I Department

North America Department

Overseas Sales Companies

Television Division

Overseas Sources Companies

Corporate Overseas Management (COM)

Middle East and Africa Department

Asia II Department

Overseas Sales and Manufacturing Companies

Personnel Division

Planning Department

Latin America Department

Financial and Accounting Division

Foreign Relations Department

Overseas Advertising Department

North America Sales Companies

(ex. N. America) EXHIBIT 3

Panasonic’s (Matsushita) Headquarters Organization for International Companies in 1987

Source: Adapted from Sumantra Ghoshal and Christopher A. Bartlett, “Matsushita Electric Industrial (MEI) in 1987,” Harvard Business School Case 9-388, 1990.

Panasonic and Sony Leadership Era: 1980–2000

company sent hundreds of expatriate Japanese managers and technicians abroad to oversee international operations and to report back candidly on the state of the company in their assigned areas. As one senior executive noted, “Even if a local manager speaks Japanese, he would not have the long experience that is needed to build relationships and understand our management processes.”18 As such, Panasonic maintained centralized control of local operations around the globe.

Panasonic Overtakes Philips The birth of the videocassette recorder (VCR) propelled Panasonic into first place in the consumer electronics industry during the 1980s. In 1975, Sony introduced the technically superior “Betamax” format VCR, and the next year JVC (a subsidiary of Panasonic) launched a competing “VHS” format. Whereas Sony decided to maintain full control over its Betamax format, Panasonic aggressively licensed the VHS format to a host of other manufacturers, including Hitachi, Sharp, Mitsubishi, GE, RCA, Zenith, and, eventually, Philips. The company quickly built production facilities to meet its own needs as well as those of OEM customers, such as GE, RCA, and Zenith, who decided to outsource production to Panasonic or other Japanese manufacturers. Between 1977 and 1985, capacity increased 33-fold to 6.8 million units. Leveraging the distribution channels and brand names the company had established with earlier products (e.g., Panasonic, National, JVC), the new VCRs met with huge success abroad. Panasonic’s overseas sales growth increased a remarkable 52 percent in 1980 and then by a further 35 percent in 1981. In 1985, VCR sales comprised an estimated 43 percent of overseas revenue. Increased volume enabled Panasonic to slash prices 50 percent within five years of product launch, while simultaneously improving quality. By the late 1980s, VCRs accounted for 30 percent of Panasonic’s sales and 45 percent of profits. It wasn’t until the late 1980s and a change in CEO that Panasonic looked to move toward a more decentralized strategy. CEO Toshihiko Yamashita launched “Operation Localization” in hopes of dispersing innovation development and increasing local customization of products; however, for a company so entrenched in a centralized mentality, the change was met with resistance. By 1995, only 250 of the company’s 3,000 R&D scientists and engineers were located outside of Japan, and this was viewed as a problem given the emergence of lower-cost sources of high-quality engineers and scientists outside of Japan. Panasonic did establish numerous factories in countries such as Malaysia where wage rates were significantly lower than they were in Japan. Due to low-cost competition and Panasonic’s difficulty in decentralizing operations, Panasonic spent nearly 20 years in decline. Overall profit margins were 3.9 percent in 1990 but steadily declined until they hit rock bottom at −9.8 percent in 2013 (see Exhibit 4). The decline in profits were accompanied by exiting the analog TV business (30% of Panasonic’s TV business) in 2006,19 exiting the HDTV segment in 2008,20 and much of the rest of its television manufacturing businesses in 2011.21 CEO Kazuhiro Tsuga stated in its annual report, “Our status is one of deep crisis. If we fail to act now, we will lose our standing in the eyes of the world.” In 2009 Panasonic merged with Sanyo in a bid to increase market share.22 It did increase sales temporarily but resulted in overlapping businesses. Panasonic laid off 40,000 workers in 201123 and another 10,00024 in 2012 after their stock dropped to its lowest point since 1975.25 Clearly something was not working. Finally, Panasonic made the decision to build more plants in low wage countries, starting with a factory in Vietnam in 2013.26 Following that move, Panasonic began a series of projects and joint ventures including a stake in a Slovenian household appliance business,27 the acquisition of a video surveillance service,28 a joint venture to make personalized digital store signs,29 entry into Africa,30 an indoor vegetable growing factory in Singapore31 and the acquisition of a satellite communication service provider.32 The jewel of the scattered approach to recovery was the 2014 announcement of a joint venture with Tesla to build a “GigaFactory” in the United States to manufacture batteries for Tesla’s electric cars.33 This joint venture went so well that in June 2016 Tesla named Panasonic its sole supplier of batteries.34 In response Panasonic raised $3.86 billion in bonds to complete the Gigafactory.35

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C-106

Samsung

EXHIB IT 4

Panasonic Summary Financial Data, 1970–2016

In millions of dollars:

1980

1990

2000

2005

2010

$2,589

$13,690

$37,755

$70,864

$73,847

SG&A

N/A

N/A

N/A

N/A

R&D Expenses

N/A

$479

$2,176

$5,107

Net Sales

1970

2012

2013

2014

2015

2016

$89,373

$80,889

$73,497

$64,035

$69,494

$18,890

$22,723

$11,945

$17,029

$14,989

$16,459

$5,220

$5,747

$5,363

$4,549

$3,795

$4,138

6.2%

5.9%

6.0%

$53,569

$45,876

$49,128

72.9%

71.6%

70.7%

As a % of net sales Advertising Expenses

N/A

N/A

N/A

N/A

$207

N/A

$21,000*

Cost of Sales As a % of net sales Income Before Taxes Net Income

$408

$1,521

$3,597

$2,126

$2,093

−$349

$451

$1,959

$1,514

$1,997

$194

$587

$1,484

$971

$492

−$2,060

−$7,961

$1,144

$1,490

$1,769

7.6%

4.3%

3.9%

1.4%

0.7%

−2.3%

−9.8%

1.6%

2.3%

2.5%

Total Assets

$2,042

$11,638

$49,377

$77,233

$68,280

$100,699

$68,052

$49,523

$49,443

$51,492

Employees (units)

78,924

107,057

198,299

290,448

334,752

384,586

293742

271789

254084

N/A

N/A

59,216

143,773

184,110

231,733

175000

150000

147387

N/A

N/A

30%

50%

55%

60%

59.6%

55.2%

58.0%

360

213

159

103

118

83

0.0103

0.0095

0.0083

As % of net sales

Overseas Employees As % of total employees Exchange Rate (fiscal period end; yen/dollar)

0.0125

0.0092

*Advertising expenses are for 2012. Note: Data prior to 1987 are for the fiscal year ending November 20; data from 1988 and after are for the fiscal year ending March 31. Source: Morningstar.com & Panasonic Annual Reports. Source for advertising expenses: http://www.wikinvest.com/stock/Panasonic_Corporation_(PC)/Data/ Advertising_Expenses/2010.

Despite the scattered approach, all of these moves, particularly the alliance with Tesla, revived Panasonic’s fortunes. Profit margins slowly rose. By the end of 2016 they were at 2.5 percent (see Exhibit  4). And perhaps the cherry on top of the cake was that in 2016 Panasonic was able to re-enter the television market with a transparent TV.36 Both Philips and Panasonic had been leaders in consumer electronics. Both suffered deep losses and, in order to survive, ended up divesting themselves of consumer electronics and re-creating themselves in other businesses. While Philips focused on a few businesses where it was a market leader, Panasonic struck out in dozens of directions from vegetables to satellites. Which approach will pay off? Or will both companies decline again?

Sony Enters the Fray In 1946, Masaru Ibuka and Akio Morita launched Sony (originally Totsuko) as a radio repair business and short-wave converter manufacturer.37 Although the company had humble beginnings, during the inauguration of the company, Ibuka prophetically declared that the company would create technologies that large corporations could not match. Ibuka said, “The reconstruction of Japan depends on the development of dynamic technologies.”38 The founders then set out to use the surplus of electricity left by the wartime factories to create consumer electronics. The founders hired engineers with a desire to create new products and focused the company on innovation. Some products, such as the vacuum-tube voltmeter and the electrically heated cushion, “sold like hotcakes,” but others, including the primitive electric rice cooker, were memorable failures.39 The company learned from its successes and failures, however, as the founders guided their employees with the slogan “Research Makes the Difference.” Sony’s focus on innovation motivated its leaders to invest a much higher percentage of their revenues on R&D, an amount typically estimated to be two to three times higher than that invested by Panasonic. The innovations that followed included Japan’s first transistor radio,

Panasonic and Sony Leadership Era: 1980–2000

C-107

the first all-transistor TV, the first VCR (Betamax), the first personal stereo (Walkman), the first CD player, the PlayStation game system, Blu Ray, and many other products.40 Panasonic was usually content to reverse engineer Sony’s products and to be a fast follower with a “me-too” product that was lower priced. Consequently, Panasonic would wait and see how the market responded to Sony’s new products before imitating them.41 Sony, on the other hand, was an industry pioneer. Sony’s innovative new products allowed it to successfully expand on a global scale, particularly to major industrialized nations looking for innovations, such as the United States. In 1960, Sony established Sony Corporation of America (SONAM) in the United States and Sony Overseas, S.A., near Zurich, Switzerland.42 Sony followed that with overseas product development and production facilities in San Diego, California, and Bridgend, Wales. However, these represented a small percentage of Sony’s product development and production activities because Sony’s operations, like Panasonic’s, were largely centralized and conducted in Japan. The main difference between the two companies was that Sony’s R&D focused more on breakthrough technologies that would lead to new products, whereas Panasonic’s focused more on process technologies that allowed for low-cost and reliable production of products. Although Sony and Panasonic were leaders in the industry in 1990, the following ten years brought new challenges. Most significantly, Japan’s domestic market for consumer electronics collapsed due to a recession—from $42 billion in 1989 to $21 billion in 1999. Excess capacity drove down prices, and profits evaporated (see Exhibits  4 and  5 for Panasonic and Sony financial information). Although offshore markets were growing, the rise of new competition— first from Korea, then China—created worldwide overcapacity. Samsung had become a particularly effective new competitor by focusing on design and innovation as a way to differentiate its products. By 2005, Samsung was rivaling Sony as a leader in innovation and design and its brand had surpassed Panasonic’s in terms of general desirability by consumers.

EX HIB I T 5

Sony Summary Financial Data, 1970–2016

In millions of dollars:

1970

1980

1990

2000

2005

2010

2013

2014

2015

2016

Net Sales

$414.37

$4,191.38 $22,745.39 $66,301.00 $56,718.00

$75,957.00

$70,111.87

$73,789

$68,192

$74,573

SG&A

$89.31

$1,010.69

$5,583.48

$15,660.86

$3,675.00

$18,094.00

$15,027.07

$16,421

$15,035

$15,566

N/A

$220.54

$1,294.26

$4,045.71

$4,545.00

N/A

N/A

$3,740

$3,332

$3,771

N/A

0.2%

1.7%

5.3%

N/A

N/A

5.1%

4.9%

5.1%

Advertising Expenses

$4,507

$3,689

$3,600

Cost of Sales

$56,584

$43,784

$55,887

76.7%

64.2%

75.0%

R&D Expenses As % of net sales

As a % of net sales Income Before Tax

$56.58

$573.55

$1,900.51

$2,187.83

$(532.00)

$2,407.00

$2,372.16

$245

$413

$2,801

Net Income

$28.51

$322.27

$735.38

$16,754.00

$(569.00)

$(3,128.00)

$443.65

−$1,220

−$1,037

$1,360

7.6%

4.3%

3.9%

1.4%

−1.0%

−4.1%

0.6%

−1.7%

−1.5%

1.8%

Total Assets

$445

$4,119

$28,946

$75,999

$90,665

$85,089

$146,300

Employees (units)

N/A

N/A

N/A

36,700

158,500

N/A

91,500

Overseas employees

N/A

N/A

N/A

22,387

N/A

N/A

62.50%

As % of total employees

N/A

N/A

N/A

61%

N/A

N/A

Exchange Rate (fiscal period end; yen/dollar)

0.0360

0.0213

0.0159

0.0103

0.0118

0.0083

As % of net sales

Note: Data prior to 1987 are for the fiscal year ending November 20; data from 1988 and after are for the fiscal year ending March 31. Source: Sony Investor Relations Historical Data; Morningstar; Sony Form 20-4 SEC Filing.

0.0097

$145,670 $131,425 $153,395 140,900

131,700

125,300

0.0095

0.0083

0.0092

C-108

Samsung

Samsung Leadership Era: 2000–Present Samsung group was founded in 1938 by Lee Byung-chul as a simple trading company in Taegu, Korea that exported basic goods such as dried fish, vegetables, and fruit before expanding into several business lines, including insurance, securities, and retail.43 In 1969, Lee decided to enter the electronics industry and established Samsung-Sanyo. The new unit would undergo several name changes due to joint ventures with foreign companies and mergers with other units, but it would eventually settle with the name Samsung Electronics Company (SEC).44 At first, SEC was primarily a low-cost manufacturer of black-and-white televisions, which it sold to other companies that would then resell them under their own better-known brand names. The company followed a neo-Confucian culture that led engineers and designers to imitate the masters of their industry, Japanese firms such as Panasonic and Sony.45 However, Samsung was exceptional in at least one area—manufacturing. By 1976, the company had produced their millionth black-and-white TV, and two years later, SEC produced its 4 millionth black-and-white TV, which made it the market share leader in units produced.46 Shortly thereafter, SEC started mass production of several products, including the successfully reverse-engineered designs of the Panasonic microwave oven and VCR. A couple of years later, SEC entered the telecommunications and semiconductor businesses, and by 1985, it had started mass production of its own DRAMs and integrated circuits.47

Samsung New Management Initiative In 1987, Lee passed away of lung cancer and was succeeded as chairman by his youngest son, Kun-Hee Lee. The younger Lee had been involved in Samsung’s leadership since he started at the company in 1968.48 When he took his father’s place, Samsung had already established itself as Korea’s undisputed leader in most of its markets, which were largely components such as semiconductors (DRAMS), TV screens, hard drives, and batteries. In some product areas, such as DRAMs from the semiconductor business, Samsung emerged as the worldwide market-share leader.49 But the Japanese, notably Panasonic and Sony, were still the clear leaders in most consumer electronics products, including TVs, VCRs, DVDs, and cameras. Lee saw an opportunity when Samsung’s Japanese competitors faced recession in their home market, however. The Japanese, leaders in analog technology, which was used in most products, were reluctant to adopt digital technology due to the large investments that would be required to displace analog. The market, however, seemed to be moving in the digital direction in the form of cameras, audio equipment, and other electronic goods.50 Lee knew that this was a chance to overtake the competition. But, in order to take advantage of its rivals’ hesitancy, Samsung needed to not only act quickly but also to prepare itself for the digital transformation. As the leader of a Korea-centric company, Lee felt that a change was needed.51 That change came in 1993 when Lee introduced the new management initiative, which emphasized four issues: decentralization, innovativeness, globalization, and outward-looking management.52 The aim was to retain core competencies in manufacturing and production processes while improving R&D, design, and marketing. The company decentralized by establishing more production and R&D centers around the globe. Although most of Samsung’s manufacturing had been done in Korea, the company established a number of new factories in China, India, Hungary, Slovakia, Mexico, and Brazil. Samsung also established new R&D centers in Japan, Frankfurt, and the United States—each working on the development of products for their respective regions of the world.53 Additionally, SEC hired IDEO, a US-based innovation design firm, to help in the design process for their consumer products.54 Designers and design thinking were introduced to the company. Before this time, the engineers controlled the design process.55 This resulted in products that were imitations with no distinct design. The new management initiative, however, empowered designers by requiring them to take a yearlong course in mechanical engineering so that they could properly defend their ideas.56 Engineers were also taught basic ideas in design in order to better work with designers. At first, progress was slow. For example, Gordon Bruce, a veteran design consultant who helped Samsung set up the $10 million state-of-the-art

Samsung Leadership Era: 2000–Present

Innovative Design Lab of Samsung (IDS), was teaching a class to designers and engineers and asked what they considered to be a perfectly designed object. He suggested a banana and said, “Nature is the best designer. The banana fits in your pocket. It comes in its own sanitary package. It’s biodegradable. And the color indicates when the fruit is ripe.” After he explained there was a confused silence in the class. Then one a student asked, “You mean you want us to design a cell phone in the shape of a banana?”57 Gradually, SEC started to see improvement in their product designs. Through the new management initiative, Lee created a “hybrid management system” that imported Western best practices and combined them with their existing Korean management practices.58 This implementation was done sensitively. Only practices that needed change were implemented in a process that employees could understand and embrace. Some of those changes were adopted faster than others depending on the level of resistance from employees. For example, Samsung slowly added into its seniority-based pay structure a merit-based compensation system like those of General Electric and Hewlett-Packard. Some changes such as stock options were abandoned completely when resistance was too strong.59 The new system challenged key fundamentals and established a long-term commitment to investment in premium products and brand value—an area that had troubled Samsung in the past. The company had suffered from an image of “cheap Korean goods” due to its low-cost mass production methods that made it successful during the 1980s.60 To the chagrin of Lee, that image was sometimes validated. For example, as a New Year’s gift in 1995, Lee sent out some of Samsung’s newest phones, only to be informed shortly afterward that the phones didn’t work in the way they were meant to.61 However, the new management initiative aimed to correct such problems with the adoption of General Electric’s Six Sigma, which was customized to involve not just management but every Samsung employee.62 The new management initiative started to internationalize Samsung so that it was no longer a completely Koreacentric organization.

Effects of the Asian Financial Crises In 1997, the Asian financial crises took a large toll on South Korea’s economy. For example, after the Asian market downturn, Moody’s lowered South Korea’s credit rating from A1 to A3. The Seoul stock exchange experienced historic one-day drops (7.2 percent). The South Korean won weakened from 800 per US dollar to 1,700 per dollar, and many large businesses crashed or were bought up by foreigners.63 The effect of the crisis was both bad and good for Samsung. SEC had to cut its domestic and foreign workforces by 26 percent and 33 percent, respectively (a total of about 29,000 workers), and it had to sell nearly $2 billion in corporate assets that were not directly related to its core electronics businesses.64 The crisis forced Samsung to focus on core businesses and to think carefully about how it would offer unique value to customers. Eric Kim, who acted as executive vice president for global marketing operations at SEC, explained, “The economic crisis in my view, impressed upon people the need for a system that could create a resilient and enduring value proposition unique to Samsung—products that would distinguish us from our competitors.”65 In other words, the crisis proved to those involved with SEC that the firm needed to differentiate itself from the competition with premium products. In the wake of the crises, SEC dropped its debt from $15 billion in 1997 to $4.6 billion by 2002. In the same time frame, net margins went from –3 percent to 13 percent.66

Samsung’s Continued “Global Localization” The post-crisis initiative was again about increasing R&D, design, and brand value. In 1999, SEC began its “Samsung DigitAll: Everyone’s Invited” campaign in order to solidify its position against rivals as the premier consumer electronics company.67 Furthermore, from 1999 to 2007, SEC spent an average of 3 percent of net sales on changing its image as a producer of cheap products.68 Additional investment was put into R&D and design, with the construction of seven additional regional design centers located in Seoul, London, Los Angeles, Milan,

C-109

C-110

Samsung

New Delhi, Shanghai, and Tokyo (IDS being the corporate design center).69 This “Global Localization” strategy, as some called it, enabled designers to develop “product design blueprints according to global design standards and themes, while remaining flexible enough to allow local design centers to accommodate specific market needs and cultural contexts.”70 For example, in India, where inexpensive but clunky cathode-ray-tube televisions were more popular due to their affordability, Samsung didn’t try and push its more expensive LCD flat screen televisions. It relied on its design centers in emerging economies, such as New Delhi and Shanghai, to design a broad range of products, including some for price-sensitive customers. As a result, Samsung captured a quarter of the market for TVs in India while its Japanese competitors fought for a collective 13 percent of market share.71 The same was true for mobile phones. Although typically known for its higher end smartphones like the Galaxy series, Samsung developed different low-end smartphone models for Africa, Eastern Europe, Central America, Russia, India, and the Middle East. Between 1992 and 2005, Samsung also established high-volume manufacturing operations in different parts of the world, with North and South America primarily serviced by plants in Mexico and Brazil (with one large semiconductor plant in Austin, Texas) and Europe largely serviced by plants in Hungary, Slovakia, and the Czech Republic. Asia and much of the world was serviced by more than a dozen plants in China (which by 2007 made up 20 percent of Samsung’s worldwide workforce), as well as plants in India, Malaysia, Indonesia, the Philippines, Thailand, and Vietnam (See Samsung’s organization structure in Exhibit 6). Samsung Leadership Samsung Institute of Advanced Technology

9 Regional Headquarters Consumer Electronics

IT & Mobile Communication

Device Solutions

Middle East

Global R&D Center

New Delhi RDC*

Visual Display

Mobile Communication

Memory

Digital Appliance

Network

System LSI

Printing Solutions

Digital Imaging

LED

Health and Medical Equipment

Media Solution Center

Product & Development Team

Product & Development Team

Product & Development Team

Europe Europe RDC Latin America LA RDC North America

Southeast Asia Tokyo RDC China Shanghai RDC CIS* and Baltics Milian RDC Africa

*RDC: Regional Design Center *CIS: Commonwealth of Independent States EXHIBIT 6

Samsung’s Organization Structure in 2013

Source: Samsung, S.D.I. Sustainability Report, 2013.

Southwest Asia Seoul RDC

Samsung Leadership Era: 2000–Present

C-111

Samsung Becomes the World Leader in Consumer Electronics Samsung’s international strategy began to really bear fruit after 2000. For four consecutive years, from 2000 to 2003, Samsung posted net earnings higher than five percent (see Exhibit 7 for Samsung financial information). This was at a time when 16 out of the 30 top South Korean companies ceased operating in the wake of the unprecedented crisis. In 2005, Samsung Electronics surpassed Japanese rival Sony for the first time to become the world’s twentieth most valuable consumer brand, as measured by Interbrand. By 2013, Samsung’s brand was valued at $39.6 billion, making it the eighth most valuable global brand.72 Samsung became the world’s largest maker of LCD panels in 2002, the world’s largest television manufacturer in 2006, and the world’s largest manufacturer of mobile phones in 2012. Samsung has also become a leading producer in a broad array of other products, including tablets, laptops, printers, cameras, and refrigerators. In 2009, Samsung achieved total revenues of US $117.4 billion, overtaking Hewlett-Packard to become the world’s largest technology company measured by sales. And that was just the beginning. By 2013 they reached over US $207.9 billion in sales, almost doubling their record setting sales in just four years and then maintaining that pace year after year. Additionally, in 2013, 26 percent of SEC’s employees (approximately 235,868) were made up of R&D personnel.73 By 2015 SEC had been granted more US patents than any other company—that includes Google, Apple, Microsoft, and IBM. By December of 2015 SEC had 7,679 US patents.74 Moreover, SEC set the goal to triple its foreign R&D personnel (reaching 30,000) within the headquarters in Seoul, South Korea by 2022.75 Despite Samsung’s success in research, design, and innovation, it continued to stay true to its initial core strength in manufacturing and components. Samsung had long been a major manufacturer of electronic components and continued to be a leader manufacturing lithium-ion batteries, semiconductors, chips, flash memory and hard drive devices for clients such as Apple, Sony, HTC and Nokia. As of 2014, it operated 37 production facilities throughout the world, including Asia, Eastern Europe, the United States, and other regions.76 It continued to look for low-cost production sites, and in 2013, SEC announced that it would invest $2–4 billion to build 40 percent of its smartphones EX HIB I T 7

Samsung Electronics Corp. Summary Financial Data, 1970–2016

In millions of dollars:

1995

2000

2005

2010

2013

2014

2015

Net Sales

$20,917

$27,230

$56,720

$135,771

$207,902

$195,883

$203,302

Cost of Sales

$12,122

$17,469

$39,642

$90,145

$125,178

SG&A

$3,262

$3,856

$9,121

$23,042

$19,372

$22,404

$23,128

R&D Expenses

$3,137*

$1,596

$5,434

$7,990

$13,018

$13,561

$13,887

$3,398

$4,080

$3,557

$3,903

$121,857

$125,112

62.2%

61.5%

Advertising Expenses Cost of Sales As a % of Net Sales Income before tax

$3,884

$6,434

$8,756

$16,971

$33,441

$26,480

$26,304

Net Income

$3,237

$4,777

$7,542

$14,177

$27,110

$22,223

$18,942

15.5%

17.5%

13.3%

10.4%

13.0%

11.2%

9.3%

$51,595

$21,362

$49,890

$117,911

$194,614

$203,680

$214,072

$3,491

$16,907

$16,682

$18,609

As a % of net sales Total assets Labor Costs Employees

96,898

Employees overseas Exchange Rate *Reported as 15% of total sales for 1995 Source: Morningstar.com; Samsung Annual Reports.

1.035

0.9795

0.9427

1.0132

C-112

Samsung

in Vietnam, where wages were one-third of those in China. Of course, as with any business, not everything went as planned. In 2012 a US court ruled that Samsung had violated six of Apple’s patents. Samsung had to pay Apple $1.05 billion in damages.77 Even worse, in August 2016 SEC unveiled their newest, high-end smartphone, the Galaxy Note7, only to discover that there was a defect in the battery that caused some phones to catch fire or even explode. Ultimately SEC had to recall every Galaxy Note7 worldwide and permanently end production of that model.78 Despite those difficulties, Samsung’s future still looked very bright because it retained its position as the world leader in consumer electronics. The real question, though, is what did Samsung do right and what did the other three do wrong? Each of the other three companies had been the worldwide leader in consumer electronics—each with a different model and different responses to crises. Why Samsung? And if the others lost their footing and fell from the number 1 position is Samsung destined to follow in their footsteps?

References 1 C. A. Bartlett, Philips Versus Matsushita: The Competitive Battle Continues (Boston, MA: Harvard Business School Publishing, 2009). 2

Ibid.

3

Ibid.

4

Ibid.

5

Ibid.

6

Ibid.

7

Ibid.

8

Ibid.

9

Ibid. Ibid.

10

Anonymous, “Philips to Cut 4,500 Jobs,” The Guardian, October 17, 2011. 11

S. Lezhnev and A. Hellmuth, “Taking Conflict Out of Consumer Gadgets: Company Rankings on Conflict Minerals 2012,” Enough Project, August 2012.

12

“Panasonic Prepares for ‘Garage Saley,’ to Axe 10,000 Jobs,” Reuters, November 14, 2012.

24

“Panasonic Falls to 37-Year Low on Wider Loss Target,” Bloomberg, November 5, 2012.

25

A. Maierbrugger, “Big Names Ready to Enter Vietnam,” Inside Investor (May 18, 2013).

26

M. Novak, “Panasonic to Buy Stake in Slovenia’s Gorenje,” Reuters (July 5, 2013).

27

“Panasonic Europe Announce New Operating Company to Expand New Cloud Video Surveillance Service at IFA 2013,” Panasonic Business. Panasonic UK & Ireland.

28

A. Ha, “Panasonic Partners with Photon to Build Smarter Signs in Stores,” TechCrunch, November 16, 2014.

29

“Panasonic .  .  . Big Plans for Africa and SA,” BizCommunity.com, April 21, 2015.

30

“Panasonic Indoor Vegetable Farm Offers More Opportunities for Farm-to-Table Experience,” Panasonic, November 18, 2015.

31

T. Mochizuki, “Panasonic to Buy Houston-Based ITC Global,” The Wall Street Journal, March 16, 2015.

13 “Philips Exits Shrinking Home Entertainment Business,” Reuters, January 29, 2013.

32

“Koninklijke Philips Electronics N.V.: Name Change,” eurex, May 15, 2013.

33

14

“Dutch Electronics Giant Philips Plans to Split Business,” BBC News, September 23, 2014.

15

Ibid.

16

“Philips to Merge Preethi Biz in Future,” www.moneycontrol.com, September 5, 2012.

17

Ibid.

18

“Panasonic, Tesla Agree to Partnership for US Car Battery Plant,” Nikkei Inc., July 29, 2014.

34 “Gigafactory Battery Plant Planned by Tesla in Tie-up with Panasonic,” San Diego News.Net, August 1, 2014.

“Panasonic to Raise $3.9 Billion, Partly to Finance Tesla Plant Investment,” Yahoo Finance, July 29, 2016.

35

“This Is an Invisible TV . . . Really!” Yahoo Tech, October 7, 2016.

36

Sony, “Corporate Info: Sony History,” Chapter 1, “Rebuilding from the Ashes.”

M. Perton, “Panasonic Exiting Analog TV business—Engadget,” Engadget (January 19, 2006).

37

20

“Reports: Panasonic to Cut 40,000 Jobs,” The Jakarta Post, April 28, 2011.

38

“Panasonic to Trim TV Business, Cut 1,000 Jobs,” Japan Today, Japan News and Discussion,” October 20, 2011.

39

19

21

“Panasonic Officially Owns Sanyo and Boasts the World’s Largest Plasma Panel Plant Now,” Tech Crunch, December 22, 2009.

22

“Reports: Panasonic to Cut 40,000 Jobs,” The Jakarta Post, April 28, 2011.

23

Ibid. Ibid.

Sony, “Corporate Info: Corporate History,” http://www.sony.net /SonyInfo/CorporateInfo/History/history.html, accessed July 31, 2017.

40

K. Kashani and J. B. M Kassarjian, “Sony Europa (A),” IMD International (December 27, 2002), p. 2.

41

Ibid.

42

References C-113 43 J.-B. Rolland and Robert A. Burgelman, “Samsung Electronics in 2004: Conquering the Wireless Digital World,” Stanford Graduate School of Business (2004), p. 2.

63

K. J. Freeze and K. Chung, “Design Strategy at Samsung Electronics: Becoming a Top-Tier Company,” Design Management Institute 441 (2008): 441, p. 6.

64

44

“The Crash: Timeline of the Panic,” PBS Frontline, http://www.pbs .org/wgbh/pages/frontline/shows/crash/etc/cron.html, accessed July 31, 2017. C. Velazco, “How Samsung Got Big,” TechCrunch (June 1, 2013).

J. Quelch and A. Harrington, “Samsung Electronics Company: Global Marketing Operations,” Harvard Business School (2008), p. 2.

65

Bill Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

66

Anonymous, “Samsung Group: Our History,” Samsung.com (2012).

67

45 46

Ibid.

47

C. Velazco, “How Samsung Got Big,” TechCrunch (June 1, 2013).

48

Ibid.

49

T. Khanna, J. Song, and K. Lee, “The Paradox of Samsung’s Rise,’” Harvard Business Review 89 (7–8) (2011): 2301–2306, p. 3.

50

Ibid.

Ibid.

K. J. Freeze and K. Chung, “Design Strategy at Samsung Electronics: Becoming a Top-Tier Company,” Design Management Institute (2008): 441, p. 13. A. Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University of Hong Kong (2009), p. 6.

68

B. Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

69

51

A. Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University of Hong Kong (2009), p. 2.

52

A. Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University of Hong Kong (2009), p. 6.

70

Ibid, p. 3.

S. Ichii, S. Hattori, and D. C. Michael, How to Win in Emerging Markets: Lessons from Japan (Boston, MA: Harvard Business School Publishing, 2012).

B. Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

72

Ibid, p. 3.

53 54 55

Ibid.

56

71

“Best Global Brands 2013,” Interbrand.com, http://www.interbrand .com/en/best-global-brands/2013/Samsung, accessed July 31, 2017. Samsung, S.D.I. Sustainability Report, 2013.

57

73

T. Khanna, J. Song, and K. Lee, “The Paradox of Samsung’s Rise,’” Harvard Business Review 89 (7–8) (2011): 2301–2306, p. 3.

74

Ibid.

58

Ibid.

59

A. Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University of Hong Kong (2009), p. 1.

60

C. Velazco, “How Samsung Got Big,” TechCrunch (June 1, 2013).

61

T. Khanna, J. Song, and K. Lee, “The Paradox of Samsung’s Rise,’” Harvard Business Review 89 (7–8) (2011): 2301–2306, p. 4.

62

T. Bishop, “New Stats: Samsung Surges Past IBM to Lead U.S. Patent Race for 2015,” December 15, 2015.

S. Choudhury, “Inside View: Samsung,” Business Because (January 5, 2012). 75

Samsung, S.D.I. Sustainability Report, 2013.

76

J. E. Vascellaro, “Apple Wins Big in Patent Case,” The Wall Street Journal, Online.wsj.com, accessed July 31, 2017.

77

“Samsung Expands Recall to All Galaxy Note7,” Samsung, January 22, 2017. 78

CASE 10 Tesla Motors Disrupting the Auto Industry? Introduction Driving down the Silicon Valley corridor from San Francisco to the brown hills of Palo Alto near Stanford University, a casual observer might catch multiple sightings of the Model S, an allelectric vehicle made by Tesla Motors with a range of almost 300 miles. Although the company has many fans in the tech-friendly valley, it also has its critics, who argue that Tesla loses money on each car sold. Indeed, with losses of $290 million in 2014 and $888 million in 2015, it’s unclear if, or when, the company will eventually hit profitability. On the positive side, Tesla was ranked by Forbes as the World’s Most Innovative Company in 2015, with a flashy feature on the front cover.1 This was largely because of the success of its second model, the Model S, named Car of the Year by the magazine Motor Trend in 2013, the only unanimous choice anyone could remember. Consumer Reports had given it the highest rating ever (99 out of 100) for overall performance. The car could do 0 to 60 miles per hour in just over 3 seconds (shaved to 2.7 seconds in “ludicrous mode,” a feature launched that summer), was possibly the safest sedan ever built (protected in part by the battery packs that lined the chassis), required less maintenance than a combustion engine (no oil changes, spark plugs, filters, or hoses), and was beautifully designed with curved lines reminiscent of a Maserati or Jaguar. These characteristics combined to garner rave reviews from the media and owners alike. However, for the car company trying to change the automotive industry, many roadblocks remained. For one, with a price tag of at least $67,500, topping out at $135,000 fully loaded, the Model S was affordable to only a small niche of wealthy owners. Although Tesla executives were pleased with the sales of the Model S, the roughly 20,000 units sold in 2014 represented less than 0.06 percent of the 16.5 million cars sold in the United States that year. Moreover, sales had been boosted by a government subsidy of at least $7,500 per vehicle that could be taken away at any moment and was already scheduled to go away after the company sold 200,000 units. Furthermore, Tesla was trying to succeed in one of the world’s most difficult-to-enter industries, controlled by a few global players who struggled to squeeze out profitability. Perhaps most telling, the majority of drivers were skeptical about electric vehicles, afraid of getting stranded by a lack of recharging or repair stations. Just a few years earlier, Better Place, a start-up with almost $1 billion in funding, had attempted to introduce electric vehicles in Israel, a smaller and well-defined market, with the backing of Renault and the Israeli government, but had been defeated by the immense costs of building an electric vehicle and the infrastructure to support it. Tesla seemed to be heading down the same path of trying to do it all: creating its own vehicles, charging stations, and a network of company-owned dealerships. Experienced executives who had toured the Tesla factory whispered behind closed doors that the manufacturing line had major inefficiencies that signaled deeper problems in the production process. Could Tesla really manufacture high volumes efficiently enough to make the company profitable? New York Times columnist Joe Nocera voiced concerns about Tesla’s C-114

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profitability, stating that the company “eats through cash, loses money on every sedan it sells, routinely overpromises what it will deliver to Wall Street and is regularly in need of new funding.”2 Indeed, according to analysis by The Wall Street Journal, in the past five years, Tesla had fallen short on more than 20 projections made by company CEO Elon Musk, ranging from carproduction output to financial targets.3 Against this backdrop of enthusiasm and skepticism, the company launched the Model X in fall 2015 with mixed results. The Model X was a $100,000-plus SUV that could take seven passengers, with falcon-winged doors that opened vertically above the top (like the gull-wing doors of the iconic DeLorean sports car), designed to appeal to the same high-end niche of wealthy customers as the Model S. While the car itself received great reviews, Musk admitted that the Model X’s advanced technology (notably the falcon-winged doors) caused major delays and was “the most difficult car in the world to build.” On a grander scale, it planned to launch Model 3 in 2017, a four-door sedan with a starting price of $35,000. The goal was to build an electric vehicle for the masses and to sell significant volumes—upwards of 500,000 per year—launching electric vehicles into the mainstream of cars in the United States. When Tesla unveiled the Model 3 in March 2016, the company had more than 300,000 customers plop down $1,000 to “reserve” their Model 3 in the first week. The enthusiasm over the Model 3 suggested that that selling upwards of 500,000 per year was not just a pipe dream. But as of 2015 Tesla had not been able to produce more than 50,000 cars per year; so building 500,000 was far more than a “stretch” goal. Tesla executives like to say they are on a mission to transform the automotive industry from one dominated by combustion engines that pollute the air with carbon emissions to one driven by electric vehicles using battery technology charged at Tesla’s solar-powered super charging stations. In short, they are out to disrupt and make combustion engine vehicles obsolete. The question is, can they do it?

History of Tesla In 2003, Martin Eberhard, a serial entrepreneur with concerns about global warming and US dependence on the Middle East for oil, decided to build a sports car that was environmentally friendly. He had noticed that many of the driveways of northern California had two cars that didn’t seem to go together—a Toyota Prius (which he called a “dork mobile”) and an expensive sports car. As he later explained, “It was clear that people weren’t buying a Prius to save money on gas—gas was selling close to inflation-adjusted all-time lows. They were buying them to make a statement about the environment.”4 After investigating a variety of alternative fuel options, Eberhard concluded that an electric-powered vehicle was the answer to provide the greatest efficiency and performance. During his investigation, he came into contact with Al Cocconi, founder of AC Propulsion (an electric vehicle firm) and one of the original engineers of GM’s ill-fated electric vehicle, the EV-1. AC Propulsion had produced an electric car, called the tzero, that could go from 0 to 60 miles per hour in 4.1 seconds. Eberhard was impressed, but because the tzero used heavy lead-acid batteries, he felt that he could improve performance using lighter lithium-ion batteries, which were mass produced for electronics such as laptops. Said Marc Tarpenning, a Tesla co-founder and co-founder of an earlier venture with Eberhard: One of the things we kept running across was these articles that would say the reason why electric cars will never succeed is that battery technology has not improved in a hundred years. Literally, articles would say that, and it’s true of lead acid batteries. Yet it is not true of lithium-ion batteries . . . They get better, on average, at around 7% a year . . . It goes in fits and starts as they roll out new chemistries . . . They get cheaper and better.5 After several failed attempts to talk AC Propulsion into producing the vehicles, Eberhard licensed the electric drive train technology from the company and teamed up with Tarpenning to

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found Tesla Motors. The company was named after Nicolai Tesla, the inventor who developed the key ideas behind AC electrical systems used in the United States today. About this time, Elon Musk, a co-founder of X.com (the online banking company that later became PayPal) and the space exploration company SpaceX, also became interested in developing electric vehicles based on the tzero. Like Eberhard, Musk had concerns about fossil fuels. He also recognized the speed and performance that was possible with electric vehicles, particularly if technologies such as ultracapacitors (energy storage devices that can store 10–100 times more energy per unit of volume and recharge more quickly and for more cycles than standard batteries) were able to compete commercially against traditional battery technologies. When Musk approached Cocconi to discuss the possibility of buying the tzero and the embedded technology, Tom Gage, then CEO of AC Propulsion, suggested he collaborate with Eberhard because they were trying to achieve the same objective. Musk was impressed with Eberhard’s plan and agreed to put in $6.3 million to fund Tesla’s development of a long-range electric vehicle. Musk would become the chairman of the company, while Eberhard would serve as CEO. J. B. Straubel, a young engineer who was fascinated with the idea of building electric-powered vehicles, joined the Tesla team as another co-founder. According to technology writer Ashlee Vance, “Had anyone from Detroit stopped by Tesla Motors at this point, they would have ended up in hysterics. The sum total of the company’s automotive expertise was that a couple of the guys at Tesla really liked cars .  .  . What’s more, the founding team had no intention of turning to Detroit for advice on how to build a car company.”6

The Tesla Roadster The first Tesla model, the Roadster, was based on the Lotus Elise, a fast and light sports car that seemed to fit perfectly with the all-electric car vision of Eberhard and Musk. However, the Roadster suffered numerous production delays during development. Its early transmissions could not handle the high-torque gear changes from the electric motor, resulting in transmission failure within a few thousand miles.I Although Tesla worked with multiple suppliers, none were able to resolve the issue. Other delays came from small details such as installing electronic rather than conventional latches on the door. The delays became so long that Musk allegedly forced Eberhard out of the company, a move that prompted legal retaliation from Eberhard, who claimed Musk was at fault. Soon after the first vehicles were produced, they had to be recalled for loose hub flange bolts that could cause the car to crash. There were scary stories that if a Roadster was allowed to run its battery to empty, it would become an unusable “brick,” requiring a $40,000 replacement of the battery pack at the owner’s expense to become operational again. But despite these rumors, as Tesla started to mass produce the first Roadsters in March 2008 (dubbed the “Founder’s Series”), enthusiasm was high among celebrities and wealthy individuals for the new car. It was fast, “green,” and well designed.

The Model S Just as the first Roadsters were seen on the highways around California, Tesla announced the Model S—a high-performance sedan, priced at $65,000 to $85,000 to compete with the BMW 5 Series and similar cars. The Model S would have an all-aluminum lightweight body and could run for up to 300 miles on a charge. The cost to develop the Model S was expected to reach $500 million, but Tesla was fortunate to receive a $465 million loan from the US government to build the car as part of an initiative to promote technologies that would help the country achieve energy independence. A transmission allows a vehicle to change “gears,” or the torque an engine provides, and is typically a complex module in the vehicle consisting of more than one hundred parts.

I

The Electric Vehicle Market

To build the Model S, Tesla purchased a recently shut-down automobile plant in Fremont, California. Before it closed, the plant and land had reportedly been appraised at $1 billion, but its fate had compromised future operation (it was labeled by the United Auto Workers Union as the “worst workforce in the automobile industry”). In a bold move, Tesla purchased the factory (which had far more space than needed to manufacture the Model S), at the bargain price of $42 million, and rehired the former workforce. By May 2012, Tesla was said to have 10,000 reservations from customers hoping to buy the Model S. Although it encountered several challenges in designing the Model S, production went more smoothly than the Roadster, and by June 2012 the first cars were rolling off the factory floor. Critical reception of the Model S exceeded all expectations: The car won virtually every major automobile award in the book. Critics, however, cited reliability issues in the car’s electric components (failure of the 17-inch touchscreen, stalling) and design flaws in its uncomfortable rear seats.

The Model X As the Model S gained prominence, Tesla unveiled the Model X, a full-size crossover utility vehicle that went into production in fall of 2015. The Model X would seat seven and sport falconwing doors, making it easy to enter and exit. The initial cost of a Signature Series model was a pricey $130,000. Like the Model S, the Model X would go from 0 to 60 in less than 3 seconds in “ludicrous mode” and would travel roughly 250 miles on a charge. The production date for the Model X had been pushed back numerous times to accommodate increased production of the Model S. As Musk conceded, “The Model X is a particularly challenging car to build. Maybe the hardest car to build in the world.” With the announcement that the first Model X vehicles would come off the production line in September 2015, Tesla also revealed pre-orders of roughly 23,000 vehicles. Since its 2015 production had already sold out, anyone ordering a Model X would have to wait six months for delivery. At the same time, Tesla also announced that production of the Model 3, its more modestly priced four-door sedan for the masses, would start in late 2017.

The Electric Vehicle Market Tesla introduced battery electric vehicles (BEVs) (sometimes called plug-in electric vehicles or PEVs) into an electric vehicle market that was virtually nonexistent. Although hybrid electric vehicles (HEVs) had gained some traction, notably with the Toyota Prius, as had plug-in hybrid vehicles (PHEVs) with the Chevy Volt and the Prius, Musk claimed that they were “bad electric cars” since they carried around an additional gas engine and drive train, adding weight, cost, and parts to maintain and repair. Despite his criticisms, for many customers these vehicles alleviated the concern of being stranded without a charge or service. Unit volumes grew steadily (see Exhibit 1) and in 2012 Toyota estimated that sales of hybrid models would top 1 million per year going forward, and planned to roll out 21 new or redesigned hybrid vehicles by 2015.7 If HEVs could get fuel economy up to 75 or 100 miles per gallon, some observers thought it would prevent BEVs from gaining traction. Tesla faced battery electric vehicle competition from the Nissan Leaf (launched in 2010) and Ford Focus (launched in 2011) and PHEV competition from GM’s Chevy Volt (launched in 2007). The Leaf was priced from $22,000 to $29,000 (not including tax credits of roughly $7,500 for which all US buyers of electric vehicles qualified), had a range of 75 miles, and was the largest seller worldwide, selling 80,000 total units in the United States (30,200 units sold in 2014). The Ford Focus, a vehicle with similar price and specifications, was launched in 2011 but had sold fewer than 5,000 units by 2015. The Chevy Volt, priced at $40,000, could do

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Tesla Motors Cumulative US Hybrid-Electric Vehicle Sales by Year (Total Sales and the Leading Models 1999–2014) 3500

3000

2500 Thousand HEVs

Total HEVs

2000

Toyota Prius family

1500

Prius Family Camry Hybrid Civic Hybrid

1000

500 Honda Civic Hybrid Toyota Camry Hybrid

99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14

0

19

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EXHIBIT 1

Cumulative US Hybrid Electric Vehicles Sales by Year

Source: https://en.wikipedia.org/wiki/Hybrid_electric_vehicles_in_the_United_States.

50 miles on a charge and had a back-up gasoline engine. It sold 23,000 units in 2013, but that figure had dropped 20 percent by 2015, the year that GM launched the Cadillac ELR, another PHEV, priced at $65,000.8 Other car manufacturers were getting into the game. In 2014 BMW launched its allelectric i3, a small sedan priced at $43,000 with a range of 80 miles. It also launched the plug-in hybrid i8, a high-performance sports car starting at $136,000 that directly targeted Tesla. In 2015, Porsche announced the Mission E sports sedan concept car, another direct challenger to the Model S.9 A potential threat at the low end of the electric vehicle market was BYD, a Chinese manufacturer poised to break into Western markets. BYD attracted the attention of Warren Buffett, who had invested some $230 million for a 10 percent equity stake. The price of BYD cars was anticipated to be close to $20,000 for a BEV that would go up to 250 miles on a single charge. Despite the fanfare for BEV and PHEV vehicles, total unit sales were quite small, and some players went out of business (Fisker had launched a beautifully designed high-end electric vehicle in 2011, but declared bankruptcy in 2013 having only sold 3,000). In 2014, there were 119,710 plug-in electric vehicles (BEV plus PHEV) sold in the United States, representing only 0.07 percent of the entire market of 16.5 million vehicles, up 23 percent from the 97,235 sold in 2013.10

Tesla’s Approach and Strategies Product Development and Design On the surface, the Tesla looked much like other cars, but it hid a significant difference that drew praise from some and criticism from others. If you peeled the skin off a Tesla and compared it to a combustion engine vehicle or electric vehicle such as the Nissan Leaf, you would

Tesla’s Approach and Strategies

see that the car’s architecture is completely different. All major auto manufacturers to date had operated off the traditional combustion engine platform, inserting the battery as a module into the standard platform, which included space in the frame for gear transmission and often for the drivetrain, which created a tunnel through the frame. By contrast, in designing the Model S, Tesla abandoned the standard car architecture because the systems and drive train were engineered from the ground up around the battery packs. Chief Designer, Franz von Holhausen, described the design process: We weren’t taking the recipe of what we have known as a car with a big block somewhere in the car in the front, the middle, or the rear and having to work around that. With the new architecture that we created, electric propulsion allowed us to innovate what a car experience could be beyond a normal ICE motor. I think that is something where we were able to give back space and create an experience that you just can’t get in another premium sports sedan.11 Moreover, some of the car’s subsystems, such as traction control, were based on different technologies from those of a standard car. Perhaps most shocking, the Tesla Model S eliminated the transmission. Although its designers hailed the benefits of the new architecture, critics pointed out the challenges, including the unforeseen errors that could crop up in designing a new platform and how to get repairs to an architecture that many mechanics would not understand.

Manufacturing Tesla manufactured its cars somewhat differently from major automakers. The factory was vertically integrated and automated, with extensive use of eight 10-foot-tall red robots, reminiscent of Transformers. While typical auto factory robots performed one function, Tesla’s performed up to four tasks on multiple models: welding, riveting, bonding, and installing a component. “From the manufacturing standpoint, the way we assemble this car is essentially different from any other car,” said Gilbert Passin, vice president of manufacturing at Tesla and a 23-year industry veteran.12 Other manufacturing executives pointed out serious flaws. For example, employing only one robot per task typically resulted in more efficient manufacturing, which in the hyper cost-competitive auto industry could be a significant disadvantage. In addition to the body, Tesla had to manufacture or purchase the battery. Batteries had been a concern for EVs for some time. In addition to being heavy, volatile, and expensive, chemical batteries had limited storage capacity, and dealers reported that their greatest challenge with customers was the fear of running out of power. Tesla invested heavily in developing the battery, starting construction of a Gigafactory, intended to produce more batteries in 2020 (when at full production) than in the entire world in 2013. Like most Tesla moves, it drew praise as well as criticism. Hitherto, lithium-ion batteries were produced in a complex supply chain, with raw materials mined in South America, shipped to North America for processing, then shipped to Japan for further processing and back to North America. Tesla hoped to save on costs by bringing all these operations under one roof—saving an estimated 30 percent—in a net zero-energy factory. It also had plans to sell batteries for other applications, including a “Powerwall” for home use—marketed as a money-saving device because it recharged when utility rates were low.II To achieve its ambitious goal, Tesla committed to build a $5 billion factory, operational by 2017—a massive investment for a new company, even with Panasonic putting up 30–40 percent of the capital (see section on Tesla’s Strategic Partnerships). Overshadowing Tesla’s massive investment, a Japanese company announced it would commercialize an aluminium-air battery 40 times more efficient than Tesla’s within the next

II The Powerwall is also marketed as a battery for solar systems and has been employed in pilot projects with SolarCity and Sun Edison.

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couple of years. If true, this could make the Gigafactory obsolete before it even starts production.13 An analysis published in Forbes magazine estimated that consumers would pay 30 cents/kWh for energy with a Powerwall, whereas grid power was often much cheaper (an average of 12.5 cents/kWh in the United States), arriving at the conclusion that the Powerwall was “just another toy for rich green people.”14 Despite the challenge, Tesla invested significantly to improve the performance of lithiumion batteries, developing its own techniques for linking the battery cells together and cooling them. The battery cells were designed to vent heat in a proprietary way and employ coolant running through the entire pack to maintain optimal temperature. It also invested heavily in protecting its innovations, refusing to let outsiders tour battery production and heavily patenting its innovations. Musk insisted that, “We felt compelled to create patents out of concern that the big car companies would copy our technology and then use their massive manufacturing, sales, and marketing power to overwhelm Tesla.” However, in a surprise move in 2014, he renounced patent control in a blog post titled, “All Our Patents Belong to You,” making them “open” for use.III Following this invitation, Nissan and BMW reportedly contacted Tesla to potentially cooperate on charging networks. As the Huffington Post commented, “That pretty much validates why the Silicon Valley company freed up its patents in the first place: Tesla wants its superchargers to become the industry standard.”15

Marketing Tesla was unusual in that it spent no money on advertising, nor planned to use TV or print advertising in the future. As spokesperson Alexis Georgeson explained: “Right now, the stores are our advertising. We’re very confident we can sell 20,000-plus cars a year without paid advertising. . . . It may be something we will do years down the road.” Early on, when Eberhard hired PR professionals to build publicity for the Tesla Roadster, Musk reportedly fired them because he felt his involvement would generate enough publicity.16 As of 2015, marketing at Tesla was done by a relatively small team of fewer than ten individuals. Its marketing and advertising budget was miniscule compared to major automotive companies (General Motors spent more than $3 billion on advertising and marketing in 2013; Nissan spent $25 million advertising just the Leaf).17 But whether Tesla could realistically sell more than 20,000–30,000 vehicles per year without significant advertising was unclear. It might work as long as Tesla was focused on the niche market at the high end, but not for the Model 3, which targeted the mass market.

Distribution and Service Rather than follow the typical franchise-dealership arrangements used by traditional automakers to sell cars, Tesla chose instead to own and operate all of its own dealerships, located in high-end malls or affluent suburbs, not far from the Apple stores on which they were modeled. In fact, now you can also shop for your Tesla while you browse for suits at Nordstrom. In 2016, a Tesla Gallery store opened inside the high-end retailer, located in the men’s department at The Grove in Los Angeles. Walk-in customers to a Tesla store would see one or two Model S cars plus an exposed version of the car’s chassis near the back of the store to show off the battery pack. They could order a car from the store or online, and it would be delivered to their home. Without a large inventory of cars or salespeople, Tesla stores were far less expensive than typical dealership. Moreover, because electric vehicles had so few moving parts compared to a combustion engine, they didn’t require a service bay at the store; servicing typically would be done by technicians at the customer’s home. But the question was, how this could possibly work if a III The “open” nature of Tesla’s patents remains a subject of significant debate since patents are “open,” meaning searchable, already but cannot be used unless they are licensed or assigned. Tesla, however, has not assigned or licensed its patents to anyone and has vaguely stated it would not initiate legal proceedings against anyone who uses them “in good faith” (see J. J. Roberts, “What Elon Musk Did—and Did Not—Do When He ‘Opened’ Tesla’s Patents,” 2014).

Tesla’s Strategy

large number of customers bought Tesla vehicles? Because electric vehicles were so different from combustion engines, customers could neither service their own vehicles nor tap into the ubiquitous auto service shops.

Charging Stations At the core of transforming the auto industry from gas to electric engines was ensuring that customers could conveniently charge the battery when traveling. To address that issue, Tesla started building solar-powered “supercharging” stations where customers could charge their battery when on the go. Tesla claimed that it took 30 minutes to charge a battery up to 175 miles or 45 minutes to get a full charge. Self-service charging stations were located on major freeways and at locations near restaurants or malls so that customers could do other things while the car charged. By late 2015, Tesla had built more than 500 supercharging stations—most with six to eight chargers—with many more planned. These worked only with Tesla cars and were provided for free—for life. This was promoted as a major advantage over gas vehicles, with an estimated $6,000–$8,000 of gas savings over four to five years. Some questioned whether Tesla could—or should—afford to provide free charging for the life of their vehicles. If, as one estimate reckoned, Tesla allocated roughly 5 percent of its capital budget of $1 billion to $1.5 billion to expand its charging stations by 50 percent in 2015,18 each charging station must cost $200,000 to $300,000. What would happen if the Tesla Model 3 became so popular that there were long queues at supercharging stations—further increasing the time needed to charge up? Tesla had not announced what Tesla Model 3 owners would pay for a charge, but it was not expected to be free as it was for Model S and X owners.

Partnerships Like many start-ups, Tesla formed important partnerships to help it access key resources. The battery technology partnership with electronics giant Panasonic was perhaps the most important because battery technology was critical to Tesla’s ultimate success. Not only did Panasonic bring years of experience with lithium-ion battery technology, it also brought significant financial resources to the table. Tesla also developed a partnership with Dana Holdings, the first company to introduce battery-cooling technology for electric vehicles.19 In addition to R&D alliances, Tesla struck deals with two major automakers: Daimler and Toyota. In 2009, Daimler purchased roughly 10 percent of Tesla for $50 million.20 Musk and the Tesla team reportedly amazed skeptical Daimler executives by modifying a stock Daimler Smart car into an all-electric vehicle in less than two months. This was followed by a Tesla announcement in 2012 indicating a deeper relationship with Daimler: “We are pleased to announce the start of a development program with Daimler for a new Mercedes-Benz vehicle with a full Tesla powertrain.”21 Toyota reportedly purchased 3 percent of Tesla’s stock for $50 million in 2010. This sparked negotiations for Tesla to purchase the NUMMI manufacturing plant in Fremont, California, which ultimately became Tesla’s car factory. Tesla agreed to provide parts to power the electric version of Toyota’s crossover SUV, the RAV4.22

Tesla’s Strategy According to Elon Musk, Tesla’s strategy was to start selling vehicles in the high-end niche and gradually move downmarket. If all went according to plan, the Model S and X would be followed in 2017 by a far less expensive Model 3, starting around $35,000 (though many observers questioned whether the Model 3 could really hit this price point given that the Model X came in higher than expected, at around $130,000). And even if it did, they wondered whether it would succeed given that gas prices looked set to remain low for some time and overall sales for electrics and hybrids were basically flat.

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Even Musk had been unsure whether Tesla would work at the beginning: “I didn’t ask for outside money for Tesla—and SpaceX—because I thought they would fail.” While it now seemed unlikely to fail, whether Tesla could be sold to the masses—and truly disrupt industry incumbents by making the internal combustion engine obsolete—was unknown. As Tesla prepared to launch the Model 3, onlookers tended to polarize into the idealists who believed it would change the industry and the skeptics who doubted its ability to change one of the oldest technology paradigms in recent history. Displacing the internal combustion engine (ICE) would require significant technology advancements, changes in customer preferences, infrastructure enhancements, and changes to government policy—well beyond the reach of a start-up with limited capital. Tesla seemed to be too thinly spread—developing multiple lines of vehicles, then adding home energy storage, Gigafactory1, charging stations, and dealerships. Moreover, in early 2017 the company decided to acquire Solar City, a company dedicated to putting solar panels and shingles on commercial and residential homes. Some questioned this expansion of activities when the company was trying to ramp up production. Indeed, Tesla’s manufacturing appeared inefficient compared to incumbent auto manufacturers who had been working for years to shave cents off the production. Indeed, many hybrids had become comparatively less attractive as ICE engine efficiencies increased globally, a fate that might befall electric cars. In this context, could Tesla ever make money? Idealists pointed to the incredible strides made from the Roadster to the Model S, which seemed to be selling well, and now the Model X, with plans for the Model 3 in the pipeline. Clearly investors believed in Tesla’s innovations, judging by the premium paid by investors betting on its future growth. But would Tesla ever make a profit? And if so, when? Tesla’s income statement showed large losses and growing liabilities and Tesla’s production costs, not including costs for R&D, sales and distribution, general and administrative, and the Gigafactory were just shy of revenue in 2015 (See Exhibits 2 and 3). Was its business model sustainable, or would it eventually become yet another electric vehicle failure like Better Place or Fisker? Fiscal Year

2015

2014

2013

2012

2011

2010

$4,046,025

$3,198,356

$2,013,496

$ 413,256

$ 204,242

$ 116,744

Automotive sales

3,740,973

3,007,012

1,921,877

385,699

148,568

97,078

Cost of revenues

3,122,522

2,316,685

1,557,234

383,189

142,647

86,013

922,232

603,660

285,569

150,372

104,102

84,573

1,640,132

1,068,360

517,545

424,350

313,083

177,569

$(716,629)

$(186,689)

$(61,283)

$(394,283)

$(251,488)

$(416,838)

(118,851)

(100,886)

(32,934)

(254)

(43)

(992)

13,039

9,404

2,588

136

489

173

$(888,663)

$(294,040)

$(74,014)

$(396,213)

$(254,411)

$(154,328)

$1,196,908

$1,905,713

$ 845,889

$201,890

$255,266

$ 99,558

Total current assets

2,791,568

3,180,073

1,265,939

524,768

372,838

238,886

Property, plant and equipment, net

3,403,334

1,829,267

738,494

552,229

298,414

114,636

$8,092,460

$5,830,667

$2,416,930

$1,114,190

$ 713,448

$ 386,082

2,816,274

2,107,166

675,160

539,108

191,339

85,565

$7,003,516

$4,918,957

$1,749,810

$ 989,490

$ 489,403

$ 179,034

$1,088,84

$911,710

$667,120

$124,700

$224,045

$207,048

Income Statement Items Revenues

Selling, general and administrative Total operating expenses Operation Income Interest expense Income tax Net loss Balance Sheet Items Cash and cash equivalents

Total assets Current liabilities Total liabilities Total equity EXHIBIT 2

Tesla Financials (in thousands)

Sources: https://www.sec.gov/Archives/edgar/data/1318605/000156459016013195/tsla-10k_20151231.htm; http://ir.teslamotors.com/secfiling.cfm?filingid=1564590-15-1031&cik=1318605; http://ir.teslamotors.com/ secfiling.cfm?filingID=1193125-13-96241&CIK=1318605.

References C-123

Quarter

Revenue*

Production Costs**

Units Produced***

3Q 2012

$50,023

$58,865

250

4Q 2012

294,377

268,333

2,400

1Q 2013

555,203

461,818

4,900

2Q 2013

401,535

303,599

5,150

3Q 2013

430,196

324,883

5,500

4Q 2013

610,852

453,578

6,892

1Q 2014

588,871

462,471

6,457

2Q 2014

727,829

554,104

7,579

3Q 2014

849,009

598,472

7,785

4Q 2014

814,303

694,964

9,834

1Q 2015

893,320

631,745

10,045

2Q 2015

878,090

666,386

11,532

3Q 2015

852,555

628,729

11,597

4Q 2015

1,117,008

896,442

17,400

EXHIBIT 3

Unit Volume and Cost of Revenue

Notes: *These sales figures are derived from “Automotive sales” per the statement of operations in the respective Tesla Motors 10-Q financial statements. **These cost figures derive from cost of sales under “Automotive sales” per the statement of operations in the respective Tesla Motors 10-Q financial statements. ***These production figures represent total quarterly Tesla vehicle production per the respective Tesla Motors 10-Q financial statements as well as press releases.

References 1 J. Dyer, H. Gregersen, and N. Furr, “Decoding Tesla’s Secret Formula,” Forbes (September 7, 2015), http://www.forbes.com/sites/innovatorsdna /2015/08/19/teslas-secret-formula/, accessed July 31, 2017.

http://www.nytimes.com/2015/08/29/opinion/joe-nocera-the-tesla -cheerleader.html?_r=0, accessed July 31, 2017. 2

S. Pulliam, M. Ramsey, and I. J. Dugan, “Tesla Talks Big: Falls Short,” Wall Street Journal, August 6, 2016. 3

M. V. Copeland, “Tesla’s Wild Ride,” Fortune, 158 (2) (2008): 82–94.

4

http://www.businessinsider.com/tesla-the-origin-story-2014-10, accessed July 31, 2017.

5

A. Vance, Elon Musk (New York: Harper Collins, 2015): p. 155.

6

C. Dawson, “Toyota Details Broader Hybrid Lineup,” The Wall Street Journal, September 24. 7

http://insideevs.com/chevrolet-volt-sales-plunge-in-january-2015-to -just-542-units/, accessed July 31, 2017. 8

http://www.dezeen.com/2015/09/17/porsche-mission-e-concept -electric-sports-car-frankfurt-motor-show/, accessed July 31, 2017. 9

http://fortune.com/2015/01/08/electric-vehicle-sales-2014/, accessed July 31, 2017. 10

Casewriter interview with Franz von Holhausen, May 10, 2015.

11

http://seekingalpha.com/article/2604485-teslas-highly-scalable -model, accessed July 31, 2017. 12

13 http://fortune.com/2015/04/27/gigafactory-obsolete/, accessed July 31, 2017.

C. Helman, “Why Tesla’s Powerwall Is Just Another Toy for Rich Green People,” Forbes (May 1, 2015), accessed June 28, 2015.

14

15 http://www.huffingtonpost.com/2014/06/16/tesla-patent-super charger-station_n_5500724.html, accessed July 31, 2017.

M. Shilling, Tesla Motors, case study, pp. 3–202.

16

http://www.statista.com/statistics/192043/ad-spending-of-general -motors-in-the-us/, accessed July 31, 2017. 17

http://www.fool.com/investing/general/2015/08/26/what-does -providing-free-charging-cost-tesla-motor.aspx, accessed July 31, 2017. 18

http://www.prnewswire.com/news-releases/dana-develops -industry-first-battery-cooling-technology-for-electric-vehicles -69767127.html, accessed July 31, 2017. 19

A. Vance, Elon Musk (New York: Harper Collins, 2015): p. 155.

20

D. Howell, “Tesla Motors Rises on Q4 Revenue, Wider Daimler Deal,” Investors Business Daily (February 15, 2012), http://bit.ly/1esW44f, accessed July 31, 2017.

21

“Tesla Notifies SEC of Agreement with Toyota to Develop Electric Version of RAV4,” Tesla Motors (October 13, 2013), http://bit .ly/1eaaB3U; J. Mueller, “What Do Toyota and Mercedes See in Tesla? A Bit of Themselves,” Forbes (June 1, 2013).

22

CASE 11 Smartphone Wars in 2013 Following six years of innovation and upheaval in the smartphone industry, 2013 was shaping up to be no different. Industry players continued to differentiate and capitalize on the rapidly evolving landscape. Early market leaders struggled to recapture market share lost years earlier to newer entrants, and new players vied to remain disruptive. Apple, whose iPhone had sparked the smartphone frenzy in 2007, sought to broaden its appeal by introducing a less expensive iPhone that had a casing made of plastic, instead of glass. Search engine giant Google’s Android OS was the most widely adopted smartphone platform, with almost half of all Android devices being made by Samsung, the Korean electronics company. Having started its smartphone endeavor by building phones and supplying parts for other equipment manufacturers, Samsung had burst on the scene in 2010, rapidly gobbling up market until it had become the world’s highest-volume phone maker in 2012.1 Meanwhile, Research in Motion (RIM), Nokia, and Microsoft, which were all market leaders in the pre-iPhone smartphone industry, continued to sputter (see Exhibit 1). After an exclusive partnership with Nokia failed to produce strong enough results, Microsoft announced an agreement to acquire the Finnish phone maker in hopes that the combination might yield cost savings and innovations that neither company had been able to obtain on its own. Microsoft Windows 8 Phone sales had not met expectations, but analysts remained hopeful that new developments would produce the next wave of creativity and value. By 2013, RIM, which had changed its name to BlackBerry after its iconic banner product, had struggled with ventures in tablets and new operating systems. Finally, in late 2013, BlackBerry announced plans to cut 40 percent of its workforce and stop selling to consumers.2 Every player in the smartphone wars had delivered innovative products at some point and had dealt with strategic moves by competitors, but market leadership had been fleeting. These companies dealt with challenges on every front. Each move brought with it competitive responses and countermoves. New products, such as tablet computers and smart watches, threatened to make the entire industry obsolete. Could any of the companies involved in the smartphone wars find a path to sustained industry leadership? And if not, could they at least avoid the path of demise followed by RIM?

EXHIB IT 1

Global Smartphone Sales to End Users from 1st Quarter 2009 to 2nd Quarter 2013, by Operating System (millions of units)

Android

iOS

Microsoft

RIM

Symbian

Others

2009

2.76

16.22

10.83

23.83

57.02

7.92

2010

67.22

46.59

12.38

49.65

111.58

12.47

2011

220.67

89.27

51.53

88.41

14.25

2012

449.54

129.07

17.01

34.21

28.51

19.27

2013

334.09

70.23

13.4

12.4

1.98

3.28

8.76

Source: Gartner Company, “Gartner Says Worldwide Mobile Device Sales to End Users Reached 1.6 Billion Units in 2010; Smartphone Sales Grew 72 Percent in 2010” [Press Release] (February 9, 2011).

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History of the Industry

History of the Industry The first mobile phones emerged shortly after World War II.3 Briefcase-sized and very limited in range and functionality, commercialized mobile phones took another three decades to gain critical mass. These first mobile phones were typically so large that most were only found in cars. However, in the 1970s, the first handheld mobile phones hit the market. The United States, Japan, Denmark, Sweden, Finland, and Norway all rolled out mobile phone networks between 1979 and 1981. These first handhelds ran on an analog system, called 1G. Beginning in the 1990s, the new all-digital 2G network continued to expand as more cellular towers were built. Better technology allowed for smaller components, new features such as SMS text messaging, and smaller phones. As phones became more convenient to carry around, demand exploded. With the 2G network, the first downloadable ringtones introduced a concept that would later be crucial as smartphones gained popularity a decade later: downloading information from the Internet via a wireless connection. Smartphones emerged as “a category of mobile device that provides advanced capabilities beyond a typical mobile phone. Smartphones run complete operating system software that provides a standardized interface and platform for application developers.”4 These new smartphones were more advanced and offered greater flexibility than feature or “dumb”5 phones. Early smartphones would hardly be recognized as such today, however. In 1993, IBM launched the first smartphone, the Simon,6 which offered a full touchscreen. The Simon had a few applications, or apps (software used for functions other than running the device’s operating system7), such as fax, personal digital assistant (PDA), pager, calculator, and address book. Unlike users of later smartphones, which stored applications on the device itself, Simon users had to switch out memory cards that held individual applications in order to enjoy many of the features offered. In addition to being bulky and expensive (the Simon retailed for $899), The Simon lacked access to a wide variety of apps. Within two years of hitting the markets, IBM had retired the Simon. Although a business failure for IBM, the Simon was the first spark that ignited a new sub-industry of smartphones. Throughout the next 10 years, additional smartphones hit the market.8 Nokia and Ericsson launched their own versions in the late 1990s. Ericsson’s second generation phone featured a full touchscreen at a time when button-centric devices dominated the landscape. In addition, this device offered the first “open” operating system (OS), the Symbian OS. An open OS allowed third-party developers to create applications to be downloaded and run on a device. Thirdparty developers gave users access to a much broader array of technologies on their devices. These early smartphones developed slowly until the birth of what modern smartphone users would recognize as the earliest “pure” smartphones. By 2007, Nokia, Palm, Microsoft, and RIM had all risen to power, but new companies such as Apple, Google, and Samsung would usher in a new wave of innovation.

Nokia Nokia was a Finnish company that rose to prominence in the late 1990s, enjoying market leadership in the mobile phone industry for more than 15 years. Mass adoption of feature phones helped Nokia establish itself as the leading producer of handsets. Following success among mass consumers with feature phones, Nokia launched many different smartphones. The first Nokia smartphones were expensive and primarily targeted to business customers.9 Nokia smartphones, like Ericsson’s, ran on the Symbian OS, making it the largest OS for more than five years. Nokia strove to differentiate its phones early on by investing heavily in mobile gaming and music technologies. However, Nokia struggled later in the decade as the BlackBerry (see below) gained momentum. Although easily the top overall cell phone supplier, Nokia felt the sting of losses in its smartphone business and took measures to protect its market share among smartphone users. For example, in response to the growing threat of Palm smartphones, Nokia began launching phones with a full keyboard.

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Palm An early player in the PDA realm, Palm decided to merge its PDA functionality with a cell phone in 2002,10 calling it the Treo. The resulting technology was a great solution for business people who didn’t want to carry around a PDA and a phone. Although the Treo enjoyed mass adoption and market domination, its reign on top of the smartphone world was threatened by two other players that launched smartphones in the same year—software giant Microsoft and a startup called Research In Motion, or RIM. By 2007, Palm controlled less than 10 percent of the smartphone market and watched the rest of its share erode over the next couple years.11

Microsoft Envious of the growth of other technology companies in the mobile industry, the maker of the seemingly ubiquitous Windows OS for PCs, Microsoft, decided to stake its own claim in the mobile game. In 2002, the company introduced what it touted as a “Microsoft Windows-powered smartphone.”12 Microsoft hoped the first handset to run its new OS, the Orange SPV, and subsequent devices would leverage its reputation in desktop computing to create a “pocket PC” that would appeal to customers already using Windows for their PCs at home or in the office. Rich in software-building capabilities, Microsoft entered the smartphone market in a revolutionary manner. Previously, the phone and the operating system that powered the phone were made by the same company. However, in the spirit of its desktop history, Microsoft decided to sell its open Pocket PC operating system to equipment manufacturers such as Samsung and HTC. By licensing its OS, Microsoft earned new revenues without needing to branch outside of its core software competency into hardware manufacturing. For the next five years, the Microsoft OS increased in proliferation and market share.13

RIM/Blackberry In 2002, the Canadian startup, RIM, launched the first version of a blockbuster line of products. Although Palm’s Treo represented a significant technological advancement by combining a PDA and cellular phone, many corporate technology departments were not keen on the idea of providing employees with phones that offered access to corporate email accounts, unless the email could be made more secure. Sensing a market opportunity, RIM launched the first email-optimized smartphone, the BlackBerry. The BlackBerry ensured a secure and protected connection to corporate email accounts. First road warriors, then the rest of the business world, and finally average consumers, bought BlackBerrys. Its plastic keyboard and large screen added to its appeal. People everywhere seemingly could not get enough of their “CrackBerries.” RIM, recognized by many as a leader of innovation and creativity, invested millions into think tanks and technological institutes.14 A second market-smashing product, the BlackBerry Pearl, came out in 2006, propelling RIM to market leadership through 2009.15 By 2007, BlackBerry was on top of the world, and Microsoft and Nokia were not far behind. Consumers loved their phones, which allowed them to email, talk, or text anyone cheaply and quickly. As the year started, none of the phone makers could have imagined their worlds would be turned upside down by a maker of computers and MP3 players. However, Apple’s new iPhone served as the catalyst that completely redefined the battle for smartphone supremacy and paved the way for the rise to dominance of Apple, Google, and Samsung.

Apple Apple Computer, a Silicon Valley–based computer hardware and software maker, had been making headlines for years because of an adjacency move—leveraging strengths built in one industry or business to help the company in another area—that not only reshaped an industry but saved the floundering Microsoft competitor. By the turn of the century, Apple cofounder

History of the Industry

Steve Jobs had returned to the company and was again CEO. Faced with slipping sales and market share in the PC industry, Jobs introduced a new product in 2001 that would revive Apple’s creativity and design prowess that had all but had disappeared in the recent past. The new iPod16 was an MP3 player capable of holding more than 1,000 songs, which users could download from Apple’s iTunes music platform onto its 5 GB hard drive. Although it was hardly the first MP3 player, the iPod’s unique design and gargantuan capacity turned the music player device industry on its head. For the next six years, Apple continued to launch different iterations of the iPod. Incumbents were caught off guard by Apple’s jump into, and dominance of, the MP3 market. Similarly, six years later, few people expected what was to come next when Apple made another leap into the smartphones market. On January 9, 2007, Steve Jobs unveiled what Apple touted as a combination of an iPod, a cell phone, and an Internet communications device17 all merged into one pocket-sized machine, the iPhone. The initial iPhone featured EDGE (a predecessor to 3G technology that provided Internet access over cellphone networks) and Wi-Fi capabilities, which allowed users to connect with the Internet anywhere there was service. It came with built-in applications, or apps, including Google Maps, Google Search, a calendar, iTunes, and an email client that could connect to most commonly used email accounts. Initially, Apple partnered with the largest cellular company, Cingular (later acquired by AT&T), as the exclusive provider for the iPhone. Although the iPhone attracted media attention, most competitors believed it was not a serious threat. Unlike previous smartphones, the iPhone did not have a physical keyboard; all operations were carried out on its large touchscreen. The 8 GB iPhone was set to retail at $599, a price point similar to other high-end smartphones at the time, although Windows phones were frequently discounted substantially from list prices.18 Some critics scoffed at the new product, saying it would never become a substantial player in the highly competitive smartphone industry, especially among BlackBerry-addicted business people. Windows CEO, Steve Ballmer, whose Windows Mobile OS was enjoying a 17 percent market share at the time, boldly stated, “That is the most expensive phone in the world, and it doesn’t appeal to business customers because it doesn’t have a keyboard, which makes it not a very good email machine.” Ballmer continued, “I kinda look at that and I say, well, I like our strategy. I like it a lot.”19 Instead of directing its initial focus on business customers, Apple sought to grab market share by appealing to general consumers. Apple included applications on the iPhone such as its iTunes music player, a full Web browser, and a photo management application for its 2-megapixel camera. The combination of iPhone-only apps and impressive design made June 29, 2007, one of the most anticipated release dates and product launches ever.

Google At the time of the iPhone’s launch, Google and Apple had an unusually good relationship for two of the nation’s largest tech companies. Apple featured Google’s search and mapping technologies prominently in its marketing campaigns, increasing the iPhone’s appeal and driving search results to Google. In addition, Google’s CEO, Eric Schmidt, sat on Apple’s board of directors. However, Google, always eager to spot the next big technology trend, began to recognize the tremendous potential smartphones and mobile computing had in shaping the future of technology. Google realized that the company owning the operating system most phones ran on would be well positioned to reap the benefits of this growth. In November 2007, Google announced that it had partnered with multiple tech companies, including Samsung, HTC, Motorola, and ARM, in acquiring a startup that had been developing a mobile OS called Android. These companies joined together to form the Open Handset Alliance (OHS) with the goal of creating the first truly open and comprehensive platform for mobile devices.20 With this announcement, Google threw its hat into the smartphone ring. Unlike Apple, however, Google was not interested in building phones; rather, it wanted to provide an open OS that could be run on phones made by different manufacturers. The first Android-powered device, a cellphone made by HTC and carried by T-Mobile, launched later the next year. Although not as flashy or heavily promoted as the iPhone, the cheaper Android phones began rapidly grabbing market share.

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Samsung The Korean conglomerate, Samsung, first got involved with the smartphone industry by building smartphones for Sprint in 2001. Unlike many stylus-centric phones of the time, Samsung phones were touch-friendly. As the RIM BlackBerry gobbled up market share, Samsung released a copycat version in 2006, which ran on the Windows OS, the Blackjack.21 In 2005, Samsung contracted a deal with Apple to provide flash memories for iPods at a locked-in price.22 Samsung increased its business with Apple over time, providing inexpensive, quality components for its electronics. Supplying parts to other hardware manufacturers, although a viable cash stream in and of itself, also allowed Samsung to develop its own handsets more cheaply through the economies of scale these activities produced. The first iPhone ran on many Samsung parts. “Samsung supplied the majority of Apple’s NAND flash memory and a large portion of another chip type, the ‘DRAM (both important components of a cellphone’s computing capabilities)’ in mobile devices,”23 estimated Mark Newman, an analyst at Sanford Bernstein in Hong Kong. Samsung would continue to become a more important player in the smartphone industry.

Industry Dynamics After Google’s announcement of the Android OS, competition intensified as rapid moves by each player accelerated the rate of change in the industry. The Android platform followed an open model, meaning any third-party software programmer could develop apps for the Android market, from which Android owners could download the apps onto their phones. Apple, on the other hand, maintained a closed software model, tightly controlling which apps were available for download. After the announcement of Android, however, Apple adjusted its strategy to allow third-party developers to launch apps in the App Store after Apple had approved them.24 By making this move, Apple sought to mitigate fears that Google’s totally open platform might entice developers to create more apps for Android than Apple, thereby increasing the market appeal of Android-powered smartphones and creating a network effect. Apple made this change to allow third-party apps in its App Store months before Android devices were available, stemming any damage that might have been inflicted had the company made the move later. The App Store topped 10 million app downloads in its first weekend.25 At the same time, Apple launched a new version of its phone, the iPhone 3G,26 which allowed users to surf the Web at twice the speed of the EDGE technology built into the first phone.27 The iPhone 3G also introduced GPS navigation in a phone. Like the App Store, the iPhone 3G met a warm welcome, selling one million phones in the first weekend.28 The new phones sold for less than one-third the price of the first iPhones. Former market leaders were baffled as they ceded market share to two companies with no prior experience in the mobile industry. Microsoft’s Windows Mobile platform sputtered as the software giant struggled to develop a response to Apple’s iPhone. RIM continued to grow for two more years after the launch of the first iPhone, but it too fell from grace as the Android OS gained traction.29 Samsung released the Instinct, an iPhone lookalike, which ran on a patchwork Java-based OS. A few months later, Samsung launched another smartphone, the Omnia, running on Windows. Although neither of these products achieved the hoped-for success, early vestiges of future user-interfaces (UI) were first seen with these launches.30 There were many changes in the rapidly evolving smartphone industry during 2009. Google launched its newest version of the Android OS, called “Cupcake,”31 which offered a touchscreen (or soft) keyboard and video recording capability. For this Android update (each update is named alphabetically after a popular confection), Google and Motorola teamed up to produce a keyboard-less phone, the Droid. Later that year, Eric Schmidt was asked by Apple’s director, Steve Jobs, to resign from Apple’s board. Jobs stated, “As Google enters more of Apple’s core businesses with Android and now Chrome OS, Eric’s effectiveness as an Apple Board member

Industry Dynamics C-129

will be significantly diminished.”32 The two former allies had officially become competitors. However, Google’s and Apple’s approaches to the market still differed substantially. Said one industry expert: Google’s answer is that most computing tasks should happen in the cloud, via software that runs in massive Internet data centers housing users’ data, files, and contacts so they’re accessible from anywhere. Apple’s vision for the future is very different. Its business is about selling elegant, powerful, high-margin machines that put much of the computing power in your pocket [iPhone], in your briefcase [MacBook], or on your desk [iMac]. For that it relies more than any other tech company on so-called ‘native code’ written for a specific machine. Apple, more than any company in tech history, has been able to create its own proprietary environment.33 Apple faced another major challenge in addition to Google, though. Since 2005, Apple had sourced many parts for its devices from Samsung. But, as the Korean electronics company increasingly moved into head-to-head competition with Apple for smartphone sales, Apple executives began searching for alternative suppliers. Apple leaders believed that, although Samsung claimed to keep its parts and phones businesses separate, sending design plans for its new products was giving a dangerous advantage to a growing competitor. In 2009, Apple started sourcing most of its NAND flash memory from Toshiba in an effort to diversify its supply chain strategy.34

Evolving Markets As 2010 began, Android really took off. By then, Google had released multiple versions of Android, which handset manufacturers tweaked in order to differentiate their products, often adding their own look and feel to the native Android version. In an effort to present Android as Google had meant it to be, the search-engine-giant-turned-mobile-OS provider commissioned HTC to build the Nexus One, a phone without any of the tweaks that other Android phone makers added to their phones. The Nexus One ran a “pure” version of the Android OS. Although the project to bring an unaltered Android representation to market might have seemed minor in light of the hundreds of other Android devices, it represented an important milestone in the battle between Google and Apple. The Nexus One demonstrated a shift in Google’s strategy as it started moving closer to actual hardware manufacturing, instead of just providing a free operating system.35 By the end of the first quarter in 2010, Android had started to reach critical mass, gaining a 10 percent market share.36 In the first half of 2010, Apple made its own shock waves by debuting a new product, the iPad.37 With the iPad, Apple merged its phone and computer products to create a new product segment of computing devices, called tablets. The iPad drew heavily on the processing and power of Apple computers, while incorporating the Apple’s mobile operating system, iOS. Uncertain about whether tablets belonged to the phone or computer world, phone and computer makers responded with tablets of their own.38 Additionally, in June 2010, the next version of the iPhone, the iPhone 4, was released. The iPhone 4 was the thinnest smartphone ever and featured a front-facing camera for its FaceTime application, a function that allowed users to make video calls from their phones. The phone also ran the newest version of the Apple mobile operating system, iOS 4. By the launch of the iPhone 4, more than 225,000 apps were available on the App Store, and more than 5 billion apps had been downloaded (see Exhibit 2).39

EX HIB I T 2

Total App Downloads

Q3’10

Q4’10

Q1’11

Q2’11

Q3’11

Q4’11

Q1’12

Q2’12

Q3’12

Q4’12

Q1’13

Q2’13

iOS App Store

6

7

11

13

15

18

25

30

34

37

40

50

Google Play

1

2

3

4

6

10

13

20

23

29

40

48

Source: “The App Store’s 50B Downloads vs. Google Play’s 48B: Android Closes the Gap,” TechCrunch (May 15, 2013).

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Smartphone Wars in 2013

As the Google versus Apple battle continued through the summer of 2010, Samsung released the first phone in its Galaxy product line, the Galaxy S Vibrant.40 The Vibrant ran on Android with a slightly customized UI. The Galaxy S was somewhat successful, but more importantly, it paved the way for the Galaxy S II and S III—two phones that would have tremendous impact in solidifying Samsung’s market share and popularizing its brand among smartphone users. Former competitors, Nokia and Windows, were both losing market share rapidly and looking for ways to stop the bleeding (see Exhibit 3). Nokia’s CEO, Olli-Pekka Kallasvuo, was replaced by Stephen Elop of Microsoft’s Office Division.41 The new Windows Phone 7 went on sale in November and was available on the Samsung Focus and two models from HTC.42 This release was Microsoft’s response to the iPhone launched over two years earlier. The Windows Phone did not have the hoped-for effect of increased sales, however. Both former smartphone heavyweights, Nokia and Microsoft, partnered in early 2011 to combat the undeniable market shifts brought on first by Apple and intensified by Google. In a presentation alongside Microsoft CEO Steve Ballmer, Elop announced Nokia’s commitment to use Windows Phone software in future smartphones.43 At the same time, Apple was having struggles of its own with one of its largest suppliers, Samsung. Worried that Samsung was encroaching too much into Apple’s phone business, Apple executives tried to move the screen production of its new iPad to electronics company Sharp. However, Sharp was unable to meet the time demands and product requirements, and Apple was eventually forced to return to using Samsung as its screen provider. Samsung then unexpectedly moved to acquire a 3 percent stake in Sharp. The move, said one analyst, “would make Samsung not only Sharp’s fifth-largest shareholder but its key client, potentially preventing Apple from gaining more bargaining power with Sharp.”44 Smartphones continued to dominate the market (see Exhibit 4), but phone makers were increasingly exploring the tablet computer space. In February of 2011, Google released a version of its OS exclusively for Android tablets, which represented a strategic offshoot from the search company’s main phone business.45 Apple responded a month later with the launch of its second tablet iteration, the iPad 2.46 In that same month, Google beefed up its game across phone and tablet platforms by introducing in-app billing functionality. In-app billing allowed app developers to collect money directly from end users, instead of hassling with phone carriers who had allowed users to charge app purchases directly to their phone bill and had traditionally taken a large chunk of all app revenues.47 Google’s strategy in introducing this flexibility in billing was to entice more developers to build Android apps, creating a more appealing OS (see Exhibit 5). In April 2011, Apple, Google, and Samsung all made headlines. Apple became the largest smartphone vendor by revenue and units sold, selling 18.6 million iPhones in the first quarter of 2011. Samsung was close behind, with 17.5 million phones shipped. Google hit a milestone by becoming the most universally used smartphone platform. Its Android OS had a 36.6 percent market share, as opposed to former market leader Symbian’s 27.0 percent.48

E XH IB IT 3

Top Five Smartphone Vendor Shipments (millions of units)

Unit Shipments Vendor

2010

2011

2012

Nokia

100.3

77.3

35.1

Apple

47.5

93.1

136.8

BlackBerry

48.8

51.1

32.5

Samsung

23

94.2

215.8

HTC

21.5

43.6

32.6

Others

61.5

136

Source: IDC Worldwide Mobile Phone Tracker (January 24, 2013; January 27, 2011).

92.4

Industry Dynamics C-131

EXH I B I T 4

Smart Versus Feature Phones

Type Month

Smartphone

Feature Phone

Sep-10

29%

71%

Oct-10

30%

70%

Nov-10

30%

70%

Dec-10

35%

66%

Jan-11

36%

64%

Feb-11

38%

62%

Mar-11

37%

63%

Apr-11

37%

59%

May-11

40%

58%

Jun-11

41%

57%

Jul-11

42%

56%

Aug-11

43%

Sep-11

44%

56%

Oct-11

44%

54%

Nov-11

46%

Dec-11

48%

52%

Jan-12

48%

52%

Feb-12

50%

50%

Source: Nielsen Mobile Insights (February 2012).

EXH I B I T 5

App Revenue per Platform Index

Month

iOS App Store

Google Play

Jan-12

100

7

Feb-12

95

8

Mar-12

105

10

Apr-12

115

13

May-12

103

14

Jun-12

98

13

Jul-12

114

17

Aug-12

115

18

Sep-12

11

24

Oct-12

117

27

Nov-12

124

30

Dec-12

170

46

Source: Data approximated from the App Annie Intelligence Index (App Store January 2012 Revenue Index set to 100).

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Smartphone Wars in 2013

Worried about the momentum of its suppliers in its own smartphone business, Apple sued Samsung for “copying hardware and design features from Apple.”49 In response, Samsung launched its second Galaxy phone, the Galaxy S II, in May, causing Apple to double-down its efforts to push through litigation.50 The Galaxy S II exploded on the smartphone scene. In the past, many phones were released on only one wireless provider (like iPhone and AT&T’s initial partnership); however, Samsung arranged deals with three of the four major US carriers for the Galaxy S II launch. Its wide availability and iPhone-esque design (one of the reasons Apple was suing Samsung) played important roles in Samsung’s strategy for driving mass adoption at a rate faster than Apple’s. After losing most of its market share, Microsoft won an important legal battle requiring LG, Samsung, and HTC to pay per-handset royalties for patent infringements.51 Although the adoption of the Windows Phone 7 had not met optimistic predictions, Microsoft secured a revenue stream on handsets made by these three companies. In a move that baffled analysts, in August 2012, Google announced its decision to acquire the cellphone division of Motorola, one of the early pioneers in the commercialization of mobile phones during the 1980s. Industry experts were shocked to see Google, a software company, purchase a hardware company. The search giant agreed to pay $12.5 billion for Motorola Mobility.52 With the acquisition, Google took another step closer to competing in the hardware side of the smartphone war just as much as it did on the software side (see Exhibit 6). Searching for an option to stunt the growth of its Silicon Valley neighbor, Google, Apple launched the iPhone 4S in October 2011.53 Apple hoped to slow down Google by reducing the search traffic Apple sent its way. So, the new iPhone integrated Siri, a virtual personal assistant app that helped users access information without sending them to Google’s search engine. Apple’s extensive marketing campaigns for the 4S launch were directed at creating hype around the Siri feature, in hopes that such enthusiasm would lead fewer people to turn to Google when they needed help.54 First weekend sales of the 4S topped 4 million devices.55 (See Exhibit 7.)

E XH I B I T 6

Google Simplified Financials 2009–2012

Google (USD Millions) 2009

2010

2011

2012

23,651

29,321

37,905

50,175

8,844

10,417

13,188

20,634

14,807

18,904

24,717

29,541

Operating costs

6,495

8,523

12,975

16,781

Operating profit

8,312

10,381

11,742

12,760

Revenue Cost of revenues Gross margin

Source: Google Annual Reports.

E XH I B I T 7

Apple Simplified Financials, 2009–2012

Apple (USD Millions) 2009

2010

2011

2012

Net revenue

42,905

65,225

108,249

156,508

Cost of sales

25,683

39,541

64,431

87,846

Gross margin

17,222

25,684

43,818

68,662

Operating costs

5,482

7,299

10,028

13,421

Operating profit

11,740

18,385

33,790

55,241

Source: Apple Inc. Annual Reports.

Industry Dynamics C-133

Samsung stole the show for the last quarter of 2011 and the first quarter of 2012, however. In November 2011, it became the global leader in smartphone shipments, surpassing Nokia and Apple.56 Samsung also won the contract to produce the newest version of the Google Nexus. Early in 2012, Samsung unveiled a new category-busting product. The Galaxy Note was too large to be considered an ordinary smartphone, but it was not large enough to really act as a full-fledged tablet; therefore, the “phablet” was created.57 At first, analysts worried this oversized phone would not gain a foothold in the market, but sales for the Note boomed. Android-based phones now accounted for more than 50 percent of the smartphone market58 and continued to grow as Google continued to improve its OS and release new features. One such feature, Google Music (now Google Play Music, after the Android Marketplace became Google Play), allowed Google to compete with yet another feature of Apple’s offering, a music store.59 After five years of struggling, first against the iOS and then against Android, RIM’s coCEOs and co-chairmen, Jim Balsillie and Mike Lazaridis, resigned in January 2012.60 The former market leader had seen the company’s market share erode over the course of a few short years. At its peak in May 2008, RIM stock prices had reached $138.87 per share. Now, a little more than three years later, stocks were scraping along at a measly $16.63 per share. In an attempt to rejuvenate sales, RIM had developed and launched a new operating system. The OS was first released on the company’s first tablet product, the PlayBook.61 However, before the beginning of 2012, RIM had already been forced to write off nearly half a billion dollars for the unsold and discounted tablets still sitting in inventory.62 The company hoped to slow the bleeding by launching a new phone, the BlackBerry 10, but the product’s outlook remained bleak. In the summer of 2012, Samsung tightened its foothold again with another version of the Galaxy (see Exhibit 8). The Galaxy S III was released on all four major US carriers and was even featured in the opening ceremonies of the 2012 London Olympic Games.63 The Galaxy S III combined hardware, availability, and intense marketing to drive its success.64 As Apple announced the new iPhone 5, a group of Samsung marketers teamed up with an advertising agency to craft a response. The result was a marketing spree poking fun at Apple fan boys (die-hard Apple product fans), portraying smart customers to be those who chose the Galaxy S III.65 In its first 100 days on the market, more than 20 million Galaxy S IIIs were sold.66 Samsung passed Nokia for total cellphones (smart plus feature phones) shipped worldwide, selling 93 million units to Nokia’s 83 million and Apple’s 35 million.67 A marketing attack by Samsung was not the only concern Apple had to face with the iPhone 5’s launch in September.68 After its attempt to choke the search stream being sent to Google by introducing Siri, Apple took its plan one step further. Google Maps, a highly featured app on the first iPhones, Apple announced, would be replaced by an Apple map app.69 However, Apple’s alternative left many owners of the new iPhone 5 disgruntled and lost. The company’s mapping capabilities, said customers, were not good enough. After two months of bad press, Apple finally surrendered and, with a quiet announcement, returned Google Maps to the App Store.70

EX HIB I T 8

Samsung Simplified Financials 2009–2012

Samsung (USD Millions) 2009

2010

2011

2012

Net revenue

25,355

30,631

154,049

187,754

Cost of sales

19,280

20,347

104,701

118,245

Gross margin

6,075

10,284

49,348

69,509

Operating costs

5,927

7,429

34,742

42,389

Operating profit

148

2,855

14,606

27,120

Source: Samsung Electronics Co LTD Annual Reports.

C-134

Smartphone Wars in 2013

In November 2012, Microsoft released its next smartphone, the Windows 8 Phone.71 The phone’s launch was accompanied by Microsoft’s release of the new Windows 8 OS for PC and its first tablet, the Surface. All products, including the Xbox 360, were compatible with each other. Following the Windows 8 Phone debut, a report from comScore revealed that Microsoft-powered smartphones had actually decreased in overall market share.72 However, a report by Frost and Sullivan predicted, “Nokia/Microsoft will continue to gain share based on brand recognition of both companies and device designs. The Nokia Lumia 710 has consistently been one of the top-five selling smartphones on T-Mobile USA since it launched in January 2012.”73 Whether Windows could capitalize on synergies with Nokia remained unclear. In January 2013, Samsung continued to make gains in the market. Forty-five percent of all Android phones were made by Samsung. However, the Korean phone maker also released a Windows 8 Phone and announced plans to continue working on the development of a new OS, Intel-backed Tizen.74 Long the global leader in smartphone sales, Samsung passed Apple as the leader in domestic smartphone sales75 for May 2013, after releasing the Galaxy S IV.76 In July, Apple finalized a deal with Taiwanese TSMC to begin making some of its chips starting in 2014—another effort to reduce its dependence on Samsung.77

Looking Forward Nearly two years after announcing the deal to acquire Motorola, Google and Motorola released the Moto X in August 2013.78 It was the closest pure “Google Phone” to ever hit the markets. On August 23, 2013, Steve Ballmer, the only CEO besides co-founder Bill Gates to lead the software giant, announced plans to retire within the following year. Within two weeks of the announcement, Microsoft also revealed a deal to acquire virtually all of Nokia’s business. In a joint press release, the move was explained as follows: “Microsoft aims to accelerate the growth of its share and profit in mobile devices through faster innovation, increased synergies, and unified branding and marketing.”79 In addition, the deal would give Nokia more financial stability. Later that month, Apple announced two new iPhone models, the 5S (a standard improvement on the 5) and the 5C (the first iPhone with a plastic case).80 Many industry experts expected the 5C to represent a strategic jump by Apple into less expensive smartphones. However, after the announcement, some analysts were disappointed by a $99 price tag, which they felt was still too steep for mass adoption in developing nations, where the world was seeing the fastest growth in smartphone sales.81

Conclusion The relentless pace of technology ensured ever better handsets would continue to emerge and that companies would be locked in a feature race for the foreseeable future. Windows and Nokia had committed to working together in hopes of regaining a market that Nokia had once dominated. RIM desperately sought to find some way out of its downward spiral. In an effort to more fully control the whole mobile offering, Google continued to push forward with its partnership with Motorola. Apple strove to retain its reputation for high-quality products and beautiful design, while somehow reaching a broader base of developingmarket consumers who demanded a cheaper iPhone. In the United States, Apple was also faced with the challenge of stemming Samsung’s meteoric growth. Samsung had a bright future but still faced challenges in navigating its relationships with Apple for component parts and Google for the Android OS. As smartphone companies look toward the future, each wonders how it might position itself to remain a viable successful player in the decades to come.

References C-135

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29

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34

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16

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18

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19

P. Burrows, “Apple vs. Google: Tech’s Newest Rivalry?,” BusinessWeek (August 4, 2009). Lessin, Luk, and Osawa. Verge Staff.

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36

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C-136

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Segan.

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C. Smith, “Windows Phone 7 Devices Go on Sale in the U.S.: HTC HD7, HTC Surround, Samsung Focus,” Huffington Post (November 8, 2010), http://www.huffingtonpost.com/2010/11/08/windows-phone -7-devices-on-sale_n_780318.html, accessed July 31, 2017.

42

43 C. Arthur, “The History of Smartphones: Timeline,” Guardian  (January 24, 2012), http://www.theguardian.com/technology/2012 /jan/24/smartphones-timeline, accessed July 31, 2017.

Lessin, Luk, and Osawa.

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Verge Staff.

45

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48

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55

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58

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59

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60

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61

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81

CASE 12 Lincoln Electric Aligning for Global Growth We are a global manufacturer and the market leader of the highest quality welding, cutting, and joining products. Our enduring passion for the development and application of our technologies allows us to create complete solutions that make our customers more productive and successful. We distinguish ourselves through an unwavering commitment to our employees and a relentless drive to maximize shareholder value.1 John Stropki looked over at the Vision 2020 document that sat on his desk. The Cleveland, Ohio, based manufacturer of arc welding equipment, Lincoln Electric, had adopted the Vision 2020 strategy two years earlier, in 2011. The document set an aggressive goal for a compound annual revenue growth of 10 percent between 2011 and 2020. Shareholders would see a marked increase in their wealth if the company met its target of 15 percent compound annual growth in return on invested capital. Stropki was proud of his contribution to the company’s vision. During the first two years that the Vision 2020 strategy was implemented, Lincoln’s revenues had grown 38 percent, from $2.07 billion to $2.853 billion, and the return on invested capital had grown a whopping 75 percent, from 10.7 to 18.7 percent.2 Exhibit 1 provides financial information for the company. Stropki had spent 41 years at Lincoln, starting with the company while still in college. His career path began in the sales side of the organization, and he became a company executive in 1996 with his appointment as executive vice president and president of Lincoln’s North American operation. He was named CEO in 2004. In spite of the Great Recession of 2007–2009, Stropki oversaw a company that doubled sales, from $1.3 billion to $2.85 billion, between 2004 and 2012. Shareholder dividends also doubled over the same period, from $0.34 to $0.71 per share, and the stock had been split 2 for 1 in 2011. Stropki produced total shareholder returns of 365 percent during his time as CEO.3 Although these numbers sounded impressive, Stropki considered them to be a typical achievement from one of America’s most unique and surprising companies.

Lincoln Electric: The Cleveland Years John C. Lincoln founded the Lincoln Electric Company in 1895 after being laid off from his job at a Cleveland producer of electric motors. Lincoln was a natural inventor and, by 1895, already possessed more than a decade of experience in the high-technology sector of electricity generation and electrical products.4 Rather than find work for another company, John began producing motors of his own design in his basement. Cleveland proved to be a great place to start a business. At the end of the nineteenth century, Cleveland was the Silicon Valley of its day, and the city was a hotbed for technological innovation and new business start-ups. The Lincoln Electric Company was in good company and began to grow. C-137

C-138

Lincoln Electric

EXHIB IT 1

Selected Financial Results

Year

2004

2005

2006

2007

2008

2009

2010

2011

2012

Net Revenue ($ Billions)

1.334

1.602

1.971

2.28

2.479

1.729

2.07

2.695

2.853

20.09%

23.03%

15.68%

8.73%

−30.25%

19.72%

30.19%

5.86%

2.67

3.98

4.67

2.68

0.85

1.52

2.51

3.16

29.61%

49.06%

17.34%

−42.61%

−68.28%

78.82%

65.13%

25.90%

18.00%

20.50%

18.60%

21.30%

4.50%

10.46%

11.50%

19.20%

28.57%

13.89%

−9.27%

14.52%

−78.87%

132.44%

9.94%

66.96%

0.652

0.853

1.087

1.01

1.086

1.15

1.193

1.358

13.00%

30.83%

27.43%

−7.08%

7.52%

5.89%

3.74%

13.83%

Growth Rate Earnings per Share ($)*

2.06

Growth Rate Return on Equity

14.00%

Growth Rate Total Equity ($ Billions)

0.577

Growth Rate Cash Flows ($ Millions)

51.3

Growth Rate Dividends** Growth Rate

117 128.07%

0.69

118.7 1.45%

0.73

0.79

5.80%

8.22%

249.8 110.45%

257.4 3.04%

0.91

1.02

15.19%

12.09%

250 −2.87%

157

194

327

−37.20%

23.57%

68.56%

1.1

1.15

0.79

0.71

7.84%

4.55%

37.39%

−10.13%

* Numbers for 2004–2007 do not reflect adjustment of a 2 for 1 stock split in 2011. Figures for 2008–2012 reflect the stock split. ** Dividends for 2011 and 2012 are per share, after 2 for 1 stock split, growth rate assumes holders enjoyed split. Sources: Annual Reports 2012, 2008. Dividend data from http://www.nasdaq.com/symbol/leco/dividendhistory ROE Data from GuruFocus; http://www.gurufocus.com/term/ROE/LECO/Return%2Bon%2BEquity/ Lincoln%2BElectric%2BHoldings%252C%2BInc.

John’s younger brother, James F. Lincoln, joined the new company as a salesman. Their father, William, had immigrated to the United States from London just before the Civil War and became a preacher. The elder Lincoln had strong views, which were often at odds with the views of the congregations he led, and the family moved throughout the Midwest as a result of those convictions. William instilled in both of his boys a deep faith in Christianity and its principles of respect for humanity. He also taught his boys how to work and to love the work they did. James Lincoln became General Manager of the company in 1914 and would drive that work ethic throughout the company until his death 51 years later in 1965. James managed the business operations, while John Lincoln focused his energies on developing welding technology. When James took control, Lincoln was beginning to expand its product line into other areas of electrical equipment, including a new, portable arc welding machine they brought to market in 1911. Arc welding uses the heat of an electric current to melt two metal pieces and join them together. Welding was a critical process in the manufacture of many consumer products, such as automobiles, home appliances, bridges, and high-rise office buildings, and factories also relied on welding technology and products in their construction. The Lincoln brothers worked throughout the 1920s to advance welding technology. John created several innovations that improved welding in general and Lincoln’s line of products in particular. James focused the company on a single goal: making better welding products to sell to more customers. By the time the stock market crashed in 1929, Lincoln Electric held 30 percent of the growing market for arc welding.5

The Lincoln System James Lincoln considered Lincoln Electric to be a “manufacturing company” above all else. The competitive logic of the Lincoln Electric Company rested on using manufacturing excellence to create increasingly higher-quality welding equipment at ever lower costs. Lincoln focused on customer service, learning as much as it could about how its welders were used in the

Lincoln Electric: The Cleveland Years

field. Lincoln hired engineers to staff its sales force, and after an intensive, eight-month training course in welding technology and technique at the Cleveland headquarters, the company’s technical sales people used their engineering skills and knowledge to create welding solutions for customers.6 This deep customer knowledge flowed back to product engineers at Lincoln for use in continuous product enhancements. The company lowered costs through several means. Lincoln operated with a flat management structure that removed a layer of supervisory costs and pushed decision making down to workers on the assembly line.7 While most companies hired one manager per 20 employees and sometimes went as high as 1:5, Lincoln maintained a ratio of about 1:100.8 Assembly workers focused on a single task that allowed them to improve their own output and to identify and implement techniques that raised quality or lowered production costs. The Cleveland plant itself was designed to minimize the costs of moving materials through the facility, and very little time was wasted looking for supplies.9 Shortly after James Lincoln assumed control of the company, he established the Employee Advisory Board. That board has met every two weeks since its inception in 1915. The board allows managers and workers to work together as equals to solve problems. The board grew out of James’s deep respect for people, his belief that a company had to earn the efforts of its employees, and the view that productive employees would prove to be Lincoln’s most valuable asset. By 1915, the company provided employees with group life insurance, an innovative business practice at the time.10 And, Lincoln founded a welding school in 1917 in order to deepen the knowledge base about welding among employees, customers, and the community at large. The Great Depression affected all companies, but it affected Lincoln in a unique way. Companies laid off thousands of workers, and the unemployment rate climbed from 3.2 percent in 1930 to a high of 24.9 percent in 1933, an eight-fold increase. In manufacturing cities such as Detroit and Chicago, the rate exceeded 40 percent.11 In the midst of this meltdown, Lincoln avoided layoffs by reducing hours and wages. At the close of 1933, with unemployment in Cleveland standing at 50 percent, a Lincoln employee approached James Lincoln with a proposition: “If we did more, tried harder, and worked together as a real team, could the company pay us more?” James Lincoln agreed to a one-year experiment, stating that any increases in the company profits in 1934 would be shared with every employee.12 At the end of 1934, Lincoln paid out $131,800 in bonuses to its workers.13 The Lincoln compensation system had been born, and the bonus has been paid every year since then. In 2012, Lincoln paid out $99.3 million to almost 3,000 American employees, averaging almost $34,000 apiece with those same workers, averaging total pay of a little more than $82,000. The bonus never represented a gift from the company to its workers; it was a payoff for their hard work and effort. Shortly after World War II, the company developed a performance evaluation system to determine the size of employee bonuses. Every year, each Lincoln worker receives an assessment on five items: Productivity, Quality, Adaptability and Flexibility, Dependability and Teamwork, and Compliance with health, safety, and environmental policies. The bonus represented one pillar of Lincoln’s unique compensation system. The second prong was a piece rate system that paid workers for what they actually produced. Lincoln adopted the piece rate system very early in its history, just as this system was falling out of favor in the United States. Managers lost confidence in piece rates because they saw workers game the system and focus on quantity rather than quality of output. For their part, workers came to despise piece rates because they often saw companies adjust rates down in response to high productivity by workers.14 At Lincoln, all jobs were subject to a time-and-motion study to determine the base rate for the job, and the base rate roughly equaled the prevailing hourly wage for average productivity. The rate could be changed only if the nature of the production process changed and not if the worker became more efficient at their task. Each piece that a Lincoln worker produced carried the stamp with his initials. When a piece failed in the field, it was sent back to the bench of the employee. Employees reworked low-quality pieces but would not be paid again because they had already been paid for that piece. The third prong of Lincoln’s compensation system was its guaranteed employment promise. If a worker could not perform well under the demanding conditions of the Lincoln system, they normally left the company and found other, less taxing (yet less lucrative) work. Even at the height of the Great Depression, Lincoln chose to reduce hours rather than lay

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E XH I B I T 2

Lincoln’s Guaranteed Employment Program37

• It is seen as a competitive advantage for the company. • It provides workers with security against layoffs because of lack of work when the economy slows down. • The plan covers permanent employees in Cleveland (about 95 percent of the US workforce) who have completed three years of service. • Employees are guaranteed at least 30 hours of work per week. • Employees are required to work overtime whenever scheduled. • Workers are not guaranteed a particular job or rate of pay. • Every employee must be willing to accept transfer from one job to another. • The plan only covers workers who uphold Lincoln Electric’s well-defined performance standards. • Finally, if the company’s survival is threatened by conditions beyond its control, from recession to natural disasters, the guarantee does not hold.

off workers. The company formalized the guaranteed employment policy in 1958, after 20 years of study. James Lincoln had no desire to implement a policy that his company could not keep. The policy guaranteed workers up to 30 hours per week, regardless of the economic condition. The workers agreed to work overtime whenever needed and, in the case of a downturn, to work whatever job, at whatever rate of pay, the worker was assigned by the company. Because of the policy, Lincoln was leery to hire additional workers and preferred to fill most internal positions from within the company’s ranks.15 Exhibit 2 details the guaranteed employment policy. The Lincoln system worked well for the company throughout its history. The company became, largely, a collection of entrepreneurs. Whether a line worker or manager, each employee at Lincoln directed their own work and reaped the benefits of hard work and smart effort. The Lincoln compensation system kept turnover rates at about 6 percent per year, well below the 25–30 percent common in manufacturing.16 Lincoln had many employees who worked 30, 35, 40, or more years for the company. Managers considered the wealth of human capital and organizational knowledge among its workforce to be a key to its competitive advantage. Lincoln established early market leadership in arc welding and created a lead over some well-heeled competition, including General Electric and Westinghouse.17 During World War II, Lincoln shared its technological expertise with these companies to help the war effort. James Lincoln estimated that his advanced manufacturing and incentive system saved the government $35 million (more than $500 million in 2013 dollars) per year in defense procurement costs.18 Even with Lincoln’s technology, both Westinghouse and GE exited the welding market after the war, finding it too difficult to compete with Lincoln.19 Lincoln’s success during the last 95 years is legendary: the company never lost money, never experienced a layoff, and became the world’s leader in arc welding.

Lincoln Goes Global, Round 1 The recession in the United States from 1981 to 1983 was the deepest since the Great Depression. For Lincoln, the recession caused two problems. First, with most of its sales in the domestic market, Lincoln was hit hard by the drop in demand. Second, the recession led to a strong dollar that made imported foreign goods inexpensive for US consumers. It also made the assets of US companies cheaper for non-US companies to purchase. Foreign producers of welding equipment, primarily Japanese and European firms, entered the market and began to challenge Lincoln’s dominance. Lincoln executives saw globalization as the answer to both problems. With increased access to growing markets in the developing world, Lincoln would be less vulnerable to cyclical swings in the United States. Foreign entry also allowed Lincoln to practice the strategy of parry and thrust; by entering the home markets of foreign competition, Lincoln hoped to slow their advances in the US market.20

Lincoln Goes Global, Round 1

Lincoln’s historical approach to international sales was to establish partnerships with companies working globally and have those companies serve as its sales agents. A Lincoln executive explained: We dealt with Armco International, which was a division of Armco Steel. Lincoln licensed Armco to manufacture and market our products in Mexico, Uruguay, Brazil, Argentina, and in France. It was electrodes, but included assembly of machines in Mexico. Armco also marketed Lincoln products along the Pacific Rim and in a few other areas of the world. At one point, we also had a joint venture with Big Three Corporation in Scotland.21 Lincoln changed tactics in 1986 when Ted Willis, their new CEO—only the fourth in the company’s history—purchased the Italian and British operations of Harris Calorific, a maker of cutting torches. During the next five years, Lincoln poured $325 million into a mix of Greenfield expansion and acquisitions. The company opened its own operations in Japan, Venezuela, and Brazil. In Brazil, where Swedish welding manufacturer ESAB held an estimated 70 percent market share, Lincoln built a new plant and began with a huge competitive disadvantage.22 Willis oversaw the acquisition of facilities in Germany, Norway, the United Kingdom, the Netherlands, Spain, and Mexico, and Lincoln’s international portfolio eventually included operations in 16 countries. To finance this rapid expansion, Lincoln borrowed money for the first time in the company’s history, a total of $250 million by 1992.23 When Don Hastings succeeded Ted Willis as chairman and CEO of Lincoln Electric in July of 1992, he realized the company’s scattered, shotgun approach to globalization had not worked. He recounts: At 5:01 on the last Friday of July, 1992, I took over as chairman and CEO . . . at 5:25 p.m., while I was engaged in small talk in the hallway, Ellis Smolik, our chief financial officer, walked up and said, “I’ve got some grim news. The numbers just came in from the European operations, and they’re bad. Very bad. They lost almost $7.5 million in June, and that means we’ll have to report a second quarter loss. We’ll violate our covenants with the banks and default on our loans.24 What had gone wrong? Hastings had previously headed the North American operations and had not been privy to the details of expansion. As he began to dig into the expansion binge, he learned several things. First, Willis directed the process alone. He made the purchase decisions, negotiated the sales agreements, and had all new operations report directly to him. Second, neither Willis nor anyone on the Board had substantial experience beyond the United States. Twelve of the 15 board members were insiders, and none of the other three could provide expertise. In fact, Hastings discovered that CFO Smolik did not even have a passport; due diligence for the acquisitions had been done without the lead finance officer ever visiting the new sites.25 Lincoln bought some operations at the peak of the business cycle. For example, the company purchased the German firm Messer Griesheim for more than $70 million, only to see the company retrench and shrink during the recession of 1991. Hastings realized that the company operated on several faulty assumptions. First, Lincoln listened to competitors and distributors in foreign markets who assured it that customers, especially Europeans, would never buy machines imported from the United States. Hastings and his successors would discover that assumption was false. Lincoln executives also believed that their 90 years of success would naturally translate into global success, and they systematically failed to understand the complexities of competing in different countries. Finally, executives assumed that the Lincoln system would transfer around the globe and that their focus on manufacturing efficiency, cost reduction, and productivity through the incentive program would overcome any country-specific difficulties. They learned, sadly, that parts of the incentive system were blocked by law in some countries and by standard practice in others. Brazilian law, for example, prohibited piece rates, and the manufacturing culture in Germany emphasized quality and attention to detail over speed.26

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With the company facing a loss for 1992, Hastings confronted the grim prospect of Lincoln not being able to pay the annual bonus to Cleveland employees. The American operations continued to be profitable, but the bonus was based on the overall corporate profit. Missing the bonus could have disastrous consequences for the company because it would violate its agreements and implicit contracts with employees. The resulting loss of trust would alter the most fundamental relationships in the company. After tough negotiations, Lincoln was able to borrow more money to meet its bonus commitments to its Cleveland workers. The bonus for 1992 totaled $52.1 million.27 Hastings went to the Cleveland workforce and explained the problem to them. He admitted that the international expansion had been a mistake and emphasized that it had been a management error. He then asked them to help bail the company out of its difficulty by boosting productivity, output, and sales in the United States. Hastings hoped that increased profitability in the home market would offset the losses abroad and give him time to fix the foreign mess. US employees responded. With a mix of productivity gains, increased sales efforts, and new products, including a welder sold through Home Depot, US sales went from $1.8 million per day up to $3.1 million. Hastings moved to Europe in order to deal with the situation there. What he found shocked him. The European companies allocated money to individual operations based on their budget targets, not actual sales. This led managers to inflate their projections with little punishment if they missed numbers. Hastings saw first-hand the company’s failure to transfer the Lincoln system abroad. During a visit to a German plant, for example, Hastings saw three employees sleeping on the job. This was after the plant had been told the CEO would be visiting!28 Like most competitors in the industry, Lincoln had relied on trade shows as a way to market its products. These trade shows had typically been events where customers were showered with gifts and did not buy products. Hastings changed all that and instructed the sales force to sell, not just schmooze. Lincoln sold more than 1,700 machines at Germany’s largest trade show in September 1993. The products had been manufactured in Cleveland and shipped to Germany. Because they sold well, Lincoln realized that in-country manufacturing was not necessary to sell high-quality welding equipment. With that knowledge, Lincoln began to divest itself of many of its money-losing foreign operations in 1994. At the end of 1994, Lincoln recorded a profit of $48 million after paying out $55 million in bonuses to the US workforce. Hastings and the board realized that international expansion was more time consuming and difficult than they imagined, and that the lack of knowledge and talent about doing business globally had jeopardized the company’s existence. In response, Lincoln brought in several outside executives with substantial global experience. Although these new hires brought new perspectives to Lincoln, they also stood to shake up the familial, egalitarian culture at Lincoln.29 Shortly before his retirement in 1996, Hastings summed up the experience for Lincoln: “We made major additions and thought things could be done the American way. We thought workers and management would respond to problems the way we do, but they didn’t . . . We did too much too fast without understanding various cultures.”30 It was decided that, moving forward, Lincoln would send its own sales people to a new market in order to determine which of Lincoln’s products would meet market needs and the best way to expand. When possible, Lincoln would rely on exports from its Cleveland factory before setting up operations overseas. The new strategy would move internationally by finding experienced local partners and setting up joint ventures or alliances.

Lincoln Goes Global, Round 2 In 1996, Lincoln appointed Anthony Massaro, the first outsider to lead the company as president and CEO, and in 1997, he was named the chairman. Massaro had spent 26 years at Westinghouse before joining Lincoln during the recovery from its earlier globalization push. Lincoln wanted to create a substantial presence in every major market in the world, and over

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the next several years, the company bought, built, or found partners in the top 20 markets for welding products. Massaro led investments in China, Indonesia, Turkey, South Africa, the Philippines, Italy, Brazil, Venezuela, and Poland.31 Rather than rush to enter these markets, Lincoln chose to join the markets in a measured fashion. In China, for example, the company opened its own electrode facility in Shanghai in 1998, but it chose to form several joint ventures with partners along the welding value chain. As these ventures grew and the Lincoln presence became more substantial, Lincoln bought out the venture partner and assumed full control. The Massaro era also witnessed substantial innovation and new product development. The company introduced a number of new products and services that incorporated increasingly sophisticated computer-guided technology and improved materials. Although the basic technology of welding remained unchanged, Lincoln continued to lead in making welding both more effective and more efficient, bringing to market advanced robotic welding systems, plasma welders, and oxy-fuel cutting equipment. Product development aimed at the retail market, which had begun as a measure to increase sales during the crisis of the early 1990s, continued to progress, and in 2002, the company brought together these businesses in Lincoln Electric Welding, Cutting, Tools, and Accessories, Inc. In March 2001, Massaro dedicated the state-of-the-art, $20 million David C. Lincoln Technology Center, named after the son of founder John Lincoln. At that time, 50 percent of Lincoln’s domestic sales came from products introduced in the past five years.32 John Stropki led the US operations during the 1990s expansion crisis. His leadership and sales acumen helped the company exceed its domestic sales target by $1 million per day.33 Stropki became the company’s seventh chairman and CEO in 2004. In 2005, Lincoln celebrated 10 years as a public company, and Stropki managed a company that rewarded investors with a long-term orientation. Sixty-three percent of the company’s shareholders were institutional investors locked in to Lincoln for its long-term returns and stable investment strategy.34 Stropki continued to expand globally with the intent of deepening Lincoln’s presence and market share in key markets such as China, the Middle East, and Eastern Europe. In 2009, the company entered the Indian market when it opened a 100,000 square foot consumables (flux rods) facility in Chennai. In 2010 and 2011, the company bought Russian welding manufacturers MGM and Severstal, giving Lincoln a strong presence in this market. When Stropki retired in 2013, Lincoln competed in more than 40 global markets. Product development efforts also increased during Stropki’s tenure. In 2009 alone, the company brought over 100 new products to market. Lincoln expanded through its own internal development programs as the Lincoln Technology Center continued to produce improvements to existing technologies and create new, advanced welding systems. Acquisitions played a role as well. In 2005, Lincoln purchased J. W. Harris, a world leader in brazing and soldering materials. In 2011, Lincoln acquired Torchmate, a company producing advanced plasma and oxy-fuel cutting tables and systems; Techalloy, which made nickel alloy and stainless steel welding consumables; and Arc Products, a producer of orbital welding systems and automation components.35

Conclusion When John Stropki concluded his tenure, Lincoln had developed into a bigger, grown-up version of the company John C. Lincoln founded almost 125 years before. The unique compensation system created a competitive advantage in human capital, and Lincoln’s research and development efforts continued to produce high-quality products and to continually lower prices. Lincoln’s success had not gone unnoticed. President George Bush visited the Cleveland facility in 2008, as had many others over the years, to praise Lincoln for its innovative business practices. In 2013, John Stropki introduced his successor, Christopher Maples, as “the right person to lead Lincoln Electric into its exciting future and continue our long track record of uninterrupted success.”36

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References 1 Lincoln Electric, “The Lincoln Electric Vision,” http://www .lincolnelectric.com/en-us/company/Pages/vision-statement.aspx, accessed February 5, 2014.

Data compiled from Lincoln Electric, Annual Report, 2012, http:// ir.lincolnelectric.com/phoenix.zhtml?c=100845&p=irol-reports annual, accessed February 5, 2014. 2

Lincoln Electric, “Lincoln Electric Executive Chairman John M. Stropki to Retire,” press release (August 20, 2013), http://www.lincolnelectric .com/en-us/Company/NewsRoom/Pages/john-stropki-retire.aspx, accessed September 26, 2013. 3

Information drawn from Chapter 1. Material also drawn from Lincoln’s official history, http://www.lincolnelectric.com/en-us/company/Pages /company-history.aspx, accessed September 26, 2013. 4

5

Koller, p. 23.

Information drawn from a Lincoln recruiting circular. Available at http://sme.tamu.edu/sme.tamu.edu/node/Lincoln, accessed September 26, 2013. 6

Koller, p. 31.

17

Conversion performed at http://data.bls.gov/cgi-bin/cpicalc.pl?cost1 =35000&year1=1942&year2=2013, accessed September 26, 2013.

18

J. Roberts, The Modern Firm Organizational Design for Performance and Growth (London, UK: Oxford University Press, 2004), p. 41. Available at http://site.ebrary.com/id/10266508.

19

Material in this section taken from D. F. Hastings, “Lincoln Electric’s Harsh Lessons from International Expansion,” Harvard Business Review (May-June 1999).

20

A. Sharpin and J. A. Seeger, “Lincoln Electric in 1996,” Case Research Journal 17 (1) (Winter 1997). The version quoted here found at http:// www.jmbruton.com/images/Lincoln_Electric.pdf, accessed September 27, 2013.

21

Sharpin and Seeger.

22

Hastings, p. 6.

23

Hastings, p. 3.

24

Ibid.

D. W. Huffmire, Handbook of Effective Management: How to Manage or Supervise Strategically (Westport, CT: Praeger Publishers, 2006), p. 142.

25

D. F. Hastings, “Lincoln Electric’s Harsh Lessons from International Expansion,” Harvard Business Review (May–June 1999).

27

7

8

Plant visit by Dr. Burke Jackson, BYU professor of operations in the mid-1990s, indicated this layout. 9

See official Lincoln company history, referenced above.

10

Data for the 1930s taken from http://www.huppi.com/kangaroo /Timeline.htm, accessed September 26, 2013. Data on the manufacturing belt can be found in D. M. Kennedy, Freedom from Fear: The American People in Depression and War, 1929–1945 (London, UK: Oxford University Press, 2001).

11

Koller, p. 29.

12

Data on the bonus found at Lincoln Electric Company, “Encyclopedia of Cleveland History,” http://ech.case.edu/cgi/article.pl?id=LEC, accessed September 26, 2013. 13

See F. W. Taylor, “A Piece Rate System” (1896), http://wps.ablongman.com/wps/media/objects/27/27956/primary sources1_22_1.html, accessed September 26, 2013.

14

Koller provides a vivid history and extensive discussion of the Lincoln compensation system.

15

Brian Richards, “The Remarkable True Story of the Company that Doesn’t Lay Off Its Employees,” The Motley Fool (June 23, 2011), http:// www.fool.com/investing/general/2011/06/23/the-remarkable-true -story-of-the-company-that-does.aspx, accessed September 28, 2013.

16

Sharpin and Seeger.

26

Hastings, p. 3. Hastings, p. 3.

28

Personal conversation with Dr. Burke Jackson, who visited the Lincoln Cleveland facility after the new hires (November 2013).

29

M. Gleisser, “Lincoln Electric Has Learned Its Lessons and Is Seeking Help Overseas,” Cleveland Plain Dealer (June 1, 1996).

30

List of countries drawn from official Lincoln Electric Company history.

31

Lincoln Electric, “Lincoln Electric Dedicates New Technology Center,” press release (March 21, 2001), http://phx.corporate-ir.net/phoenix .zhtml?c=100845&p=irol-newsArticle&ID=541231&highlight=, accessed September 27, 2013. 32

Hastings.

33

Data taken from letter to shareholders in Lincoln’s 2005 Annual Report, http://www.lincolnelectric.com/en-us/company/Documents /annualreport2005.pdf, accessed September 27, 2013.

34

Company list adapted from official Lincoln Electric company history, cited above.

35

Cleveland Engineering Society leadership breakfast, October 17, 2013. Quotation available at http://www.cesnet.org/evtView.asp?evtID=410, accessed September 27, 2013.

36

F. Koller, Spark: How Old-fashioned Values Drive a Twenty-First Century Corporation (New York, NY: Public Affairs/Perseus Books, 2010), p. 60.

37

CASE 13 ICARUS Revisited The Rise and Fall of Valeant Pharmaceuticals Robert Ingram glanced away from his computer screen after checking the stock price of Valeant Pharmaceuticals. As board chairman, Ingram was pleased to see that the stock price had climbed after the announcement of the hiring of new CEO Joseph Papa. Papa replaced Michael Pearson, who had led Valeant through a period of phenomenal growth and a phenomenal collapse. Valeant had, at one point, lost almost 90 percent of its market value as its stock fell from $262 per share to a little more than $26. (Exhibit 1 displays Valeant’s stock price during the Michael Pearson era.) The recent release of the company’s long-delayed 2015 financial statements restated its 2014 revenue downward by $57.5 million; its net income dropped by $26.8 million. The release of the financial statements eased creditor concerns that Valeant would violate key debt covenants, and Ingram hoped that Valeant could leave its troubled past behind. As he thought about the future direction of the company, Ingram wondered how the board had missed so many signals that Valeant’s business model was unsustainable, and many of its business practices were ethically problematic. What changes should be made

EX HIB I T 1

Valeant (VRX) Share Price Valeant’s Share Price, 2008–2016

$300.00

$250.00

$200.00

$150.00

$100.00

$50.00

$– 2/1/2008 2/1/2009 2/1/2010 2/1/2011 2/1/2012 2/1/2013 2/1/2014 2/1/2015 2/1/2016

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Valeant Stock Highlights Date

Closing Price

Date

Closing Price

31-Mar-16

$ 26.30

31-Dec-13

$ 117.40

31-Dec-15

$ 101.65

29-Jun-12

$ 44.79

30-Sep-15

$ 178.38

30-Dec-11

$ 46.69

31-Jul-15

$ 257.53

30-Jun-11

$ 51.96

31-Mar-15

$ 198.62

31-Dec-10

$ 28.29

31-Dec-14

$ 143.11

31-Dec-09

$ 13.96

30-Jun-14

$ 126.12

31-Dec-08

$ 9.45

Source: NASDAQ Data, http://charting.nasdaq.com/ext/charts.dll?2-1-14-0-0-5120-03NA000000VRX-&SF:7|5-BG=FFFFFFBT=0-WD=635-HT=395--XTBL- April 23, 2016.

to Valeant’s governance structure and business strategy to help the company compete both profitably and ethically?

Valeant Pharmaceuticals ICN Pharmaceuticals, the company that would become Valeant, enjoyed a storybook birth. ICN started in 1960, its first office the Los Angeles garage of founder Milan Panic.1 Panic was a former member of the Yugoslavian Olympic cycling team who defected to the United States during the team’s 1956 tour. Panic had just $200 to begin his new life, but from that humble start he was able to attend the University of Southern California and found ICN. The company initially grew by acquiring a niche product to treat dermatological conditions, while it worked on its first home-grown drug. Ribavirin (marketed as Virazole), was an antiviral that treated adults suffering from hepatitis-C and children with respiratory syncytial virus (RSV). Panic later marketed Ribavirin as a cure for the deadly virus that causes AIDS, a claim that drew formal charges of misleading information from the Securities and Exchange Commission in 1991.2 In the early 1990s, Panic moved the company back to his native Yugoslavia. The move allowed ICN to expand into Eastern Europe following the fall of the Iron Curtain. Sales of Virazole provided a foundation for growth, and ICN supplemented its product line through selective acquisitions of both individual drugs and medical devices. ICN grew moderately, and sales exceeded $500 million by 1996.3 Panic, always in the limelight, served for a time as prime minister of his native country alongside then–President Slobodan Milosevic; however, Panic’s flamboyant behavior led to repeated sexual harassment complaints by female employees. Most of these claims were settled out of court, and there appeared to be little appetite inside the company to curb Panic’s behavior. When he finally was forced out of the company, Panic drew the ire of shareholders concerned with what many considered to be an overly generous compensation package for a company of ICN’s size and profitability. For its first four decades of life, ICN’s board seemed completely happy to follow a strong-willed CEO with a clear vision about where to lead the company, whether that vision led to sustained growth, truthful actions in the marketplace, or violated norms and laws of employee treatment. Panic created his company as a larger-than-life CEO, and a culture of quiescence and deference to the CEO. In 2002, however, a group of activist shareholders forced Panic out of the company, claiming “We believe [Panic’s] presence at the helm [of ICN], his dismissive attitude toward shareholders, and his controversial reputation are among the chief reasons ICN’s market valuation lags those of its peers and fails to adequately reflect [ICN’s] fundamentals.”4 The board hired Robert W. O’Leary to take the helm; O’Leary brought a strong history in health care and medical devices, but also experience in business spin-offs and corporate reorganizations.5 The board appointed three new directors, and the new leadership team began a comprehensive review of the company’s product and business strategies with an eye toward improving shareholder returns.

Valeant: The Michael Pearson Strategy

When ICN changed its name to Valeant Pharmaceuticals in 2003, the company issued a statement: “Our new name represents our focus on value and supports our vision to be a leading, fully integrated specialty pharmaceutical company with a robust research and development capability and a worldwide capacity to commercialize products.”6 Valeant intended to pursue a strategy of developing its own drug pipeline of neurological drugs. The company also produced its own branded generic drugs to supplement its existing product line of skin care medications. The new strategy attempted to make Valeant look and act like other, major pharmaceutical companies that all relied on internal research and development to create a strong pipeline of ethical (prescription) drugs. Once again, the board and company seemed willing to follow a CEO with a clear vision; strangely, the board failed to ask about the viability and long-term sustainability of this strategy before tasking O’Leary to implement it. Valeant’s first problem was size. With $823 million in 2003 revenue and $87 million in R&D spending, Valeant had little hope of developing the depth or breadth of a new drug pipeline that could compete with major pharmaceutical houses.7 By comparison, Merck’s 2003 sales exceeded $22 billion and its R&D expenditures were more than $3 billion.8 Valeant pursued a “Big Pharma” strategy, but its lack of size and scale made it difficult (at best) to create an internal pipeline of innovative new drugs. The second problem was Valeant’s lack of product and regional focus. With a small R&D budget to begin with, the company placed its investments in increased product breadth and geographic reach. By 2007, the company sold 2,200 different versions of its 370 core products around the globe, using 85 different third-party suppliers.9 The company’s lack of adequate staff, resources, and skills in global marketing and distribution left it a competitor in too many markets, and leader in too few. As the years passed, it became clear to the board that Valeant’s attempts to act like a traditional pharmaceutical company had produced few results, and it had little likelihood of profitable long-term growth. Revenue for 2007 was $842 million, barely ahead of sales five years before. Importantly, the 2007 revenue number represented a 20 percent decline from the previous year, primarily because of a core drug, Wellbutrin, facing intense competition from generic producers.

Valeant: The Michael Pearson Strategy In late 2007, the board hired Michael Pearson, a McKinsey consultant with deep experience in the global pharmaceutical industry, to evaluate Valeant’s business. Pearson had risen from humble beginnings (his father was a phone installer) to earn his undergraduate degree at Duke and an MBA from the Darden School at the University of Virginia. He joined McKinsey after graduate school and rose to become a partner, board member, and head of McKinsey’s pharmaceutical consulting practice. While acting as a consultant to the board, Pearson surveyed Valeant’s current condition. He reported: “Your current strategy is not only not working, it doesn’t have much of a chance to be successful.”10 Pearson then laid out a bold strategy for the company: Valeant should streamline its operations and compete only in global regions and therapeutic categories where it had a reasonable chance of success. The product portfolio needed to shift away from highly competitive categories such as cardiovascular and infectious disease drugs in which Valeant competed head to head with Big Pharma. The company would always be outgunned in these categories, both in terms of R&D and marketing and sales budgets. The company should instead focus on niche categories such as dermatology (skin care). Dermatology offered adequate demand and a stable base of customers who often needed lengthy, ongoing treatments to treat chronic conditions. The dermatology market also featured a broad range of specialty, niche ailments that required unique treatments, and a payer base of primarily private individuals rather than government agencies. Pearson also suggested cutting R&D and focusing on mergers and acquisitions (M&A) to drive growth. Valeant could acquire smaller companies or individual products that produced enough revenue to create growth but were too small to interest Big Pharma buyers. Pearson, and the Valeant board, believed that there were enough of these undervalued, orphan products to drive substantial future growth. The board liked Pearson’s bold vision, and they

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appreciated his direct management style. “[His]leadership style wasn’t a cult of personality or a force of will—though he’s extremely willful—but one where the decision making was going to be based on facts, which was a breath of fresh air,” said one director. “He felt like a much better fit for what we needed to do.”11 In short, Pearson displayed the clarity and boldness of vision that typified the founder, Milan Panic; however, Pearson did not appear as iconic or eccentric as Panic. Pearson joined Valeant as CEO in February 2008. During that month Valeant’s stock price averaged $13.88, ranging from $13.24 to a high of $14.17.

Icarus Flies High: Implementing the New Strategy As Pearson and the board began to execute the strategy, they enjoyed three advantages. First, the company had a well-established pipeline that would generate current revenue. Second, the company’s balance sheet provided ample room for leverage. In 2008, cash or equivalents represented 60 percent of total assets; importantly, the company had no long-term debt (Exhibit 2 provides selected financial data for Valeant from 2008 to 2015.). Third, it appeared that there

EXHIB IT 2

Valeant Pharmaceuticals, Selected Financial Data

2015

2014 (restated)

$ 10,292.20

$ 8,046.10

$ 154.30

2013

2012

2011

2010

2009

2008

$ 5,640.30

$ 3,288.59

$ 2,255.05

$ 1,133.37

$ 789.03

$ 714.55

$ 159.90

$ 129.30

$ 191.80

$ 208.04

$ 47.87

$ 31.40

$ 42.63

$ 2,531.60

$ 2,177.70

$ 1,846.30

$ 905.10

$ 683.75

$ 395.60

$ 204.31

$ 197.67

$ 53.10

$ 58.40

$ 58.80

$ 64.60

$ 43.08

$ 10.15

$ 13.85

$ 23.03

$ 2,699.80

$ 2,026.30

$ 1,305.20

$ 756.10

$ 572.47

$ 276.55

$ 167.63

$ 188.92

Research and development

$ 334.40

$ 246.00

$ 156.80

$ 79.10

$ 65.69

$ 68.31

$ 47.58

$ 69.81

Restructuring, integration and other costs

$ 361.90

$ 381.70

$ 462.00

$ 267.10

$ 97.67

$ 140.84

$ 30.03

$ 70.20

$ 1,527.40

$ 2,000.70

($ 409.50)

$ 79.70

($ 110.08)

$ 181.15

$ 181.15

$ 124.11

$ 3.30

$ 5.00

$ 8.00

$ 6.00

$ 4.08

$ 1.29

$ 1.12

$ 9.40

($ 1,563.20)

($ 971.00)

($ 844.30)

($ 481.60)

($ 333.04)

($ 84.31)

($ 24.88)

($ 1.02)

($ 291.70)

$ 880.70

($ 866.10)

($ 116.00)

$ 159.56

($ 208.19)

$ 176.45

$ 199.90

Basic

($ 0.85)

$ 2.63

($ 2.70)

($ 0.38)

$ 0.52

($ 1.06)

$ 1.11

$ 1.25

Diluted

($ 0.85)

$ 2.58

($ 2.70)

($ 0.38)

$ 0.49

($ 1.06)

$ 1.11

$ 1.25

Basic

342.70

335.40

321.00

305.40

304.65

195.81

158.23

159.73

Diluted

342.70

341.50

321.00

305.40

326.12

195.81

158.23

159.73

Revenues Product sales Other revenues Expenses Cost of goods sold Cost of other revenues Selling, general and administrative

Operating income (loss) Interest income Interest expense Net income (loss) attributable to Valeant

Earnings (loss) per share for Valeant

Weighted-average common shares (in millions)

Valeant: The Michael Pearson Strategy

2015

2014 (restated)

C-149

2013

2012

2011

2010

2009

2008

Assets Current assets: Cash and cash equivalents

$ 597.30

$ 322.60

$ 600.34

$ 916.09

$ 164.11

$ 394.27

$ 114.46

$ 317.55

Accounts receivable

$ 2,686.90

$ 2,075.80

$ 1,184.76

$ 913.83

$ 569.27

$ 274.82

$ 112.16

$ 90.05

Inventories, net

$ 1,256.60

$ 889.20

$ 882.96

$ 531.25

$ 355.21

$ 229.58

$ 82.77

$ 59.56

Total current assets

$ 5,507.20

$ 4,131.70

$ 3,885.89

$ 2,777.45

$ 1,357.51

$ 1,020.16

$ 342.87

$ 490.36

Goodwill

$ 18,552.80

$ 9,361.40

$ 9,752.10

$ 5,141.36

$ 3,581.51

$ 3,001.38

$ 100.29

$ 100.29

Total assets

$ 48,964.50

$ 26,304.70

$ 27,970.79

$ 17,950.38

$ 13,108.12

$ 10,795.12

$ 2,059.29

$ 1,623.56

$ 433.70

$ 398.00

$ 326.97

$ 277.38

$ 157.62

$ 101.32

$ 72.02

$ 41.07

$ 5,312.60

$ 2,708.40

$ 2,512.39

$ 1,822.75

$ 924.27

$ 692.46

$ 249.15

$ 267.17

Long-term debt

$ 30,265.40

$ 15,228.00

$ 17,162.95

$ 10,535.44

$ 6,539.76

$ 3,478.37

$ 313.97

$–

Total liabilities

$ 42,934.70

$ 20,903.00

$ 22,737.47

$ 14,232.98

$ 9,178.29

$ 5,884.02

$ 704.92

$ 421.97

$ 5,911.00

$ 5,279.40

$ 5,233.32

$ 3,717.40

$ 3,929.83

$ 4,911.10

$ 1,354.37

$ 1,201.60

$ 48,964.50

$ 26,304.70

$ 27,970.79

$ 17,950.38

$ 13,108.12

$ 10,795.12

$ 2,059.29

$ 1,623.56

Liabilities Current liabilities: Accounts payable Total current liabilities

Total equity Total liabilities and equity

Source: Company 10K filings, various years.

were, in fact, a number of just the right types of drugs, and companies, that Pearson identified as attractive targets. The company was poised to create value by implementing what, to all accounts, was a sound strategy for growing a small, specialty pharmaceutical company. In 2008 and 2009, Valeant acquired four companies selling dermatology or aesthetics compounds around the world. The moves added more than $300 million in long-term debt, but the immediate effect of the new strategy had yet to be realized in significant stock price appreciation. As 2010 began, Valeant pressed ahead with its strategy, spending more than $400 million for Aton Pharmaceuticals (ophthalmology care) and a private label Brazilian producer of generic drugs. Pearson’s boldest move to date came on June 21, when he announced that California-based Valeant would sell itself to Canada’s largest publicly owned pharmaceutical maker, Biovail, for $3.3 billion.12 Biovail brought its own checkered business history to the new combination. The company’s original patent was a timed-release drug delivery technology that allowed many drugs to be taken once a day rather than multiple times. Biovail’s founder, Eugene Melnyk, built a high-flying company, but some accused Melnyk of using questionable accounting methods to inflate the company’s performance. In 2003, a Biovail truck was involved in a fatal accident; Melnyk claimed that between $10 and $20 million worth of Wellbutrin XL was destroyed in the crash, an amount significant enough to have an impact on earnings.13 The next year the company admitted that only $5 million of Wellbutrin had been lost, and the ensuing accounting scandal consumed Biovail over the next few years. The company settled by paying a $10 million fine to the SEC in 2008.14 Although Biovail bought Valeant, the deal represented a form of a reverse merger that would later be known as an inversion. Biovail bought Valeant, which made Valeant a Canadian company. The new firm, in which Valeant held a 49.5 percent ownership stake, would keep the Valeant name, CEO, and business strategy. The deal benefited shareholders of both companies in the short term as Biovail’s shareholders enjoyed a 15 percent premium on their shares and Valeant shareholders received a cash dividend of almost $17 per share.15 The big winner, however, was Valeant. Valeant’s US tax credits were about to expire, and the company lowered its effective tax rate from 35 percent (as a California company) to 10–15 percent as a company headquartered in Ontario. Pearson said, “We had to do this sooner rather than later from a standpoint of gaining this tax rate.”16

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ICARUS Revisited

With the Biovail deal, Valeant’s long-term debt jumped more than tenfold, to just under $3.5 billion. Valeant’s shares rose 12 percent, moving from $16.67 to $18.87. They would rise to $28.29 by year’s end, and the Biovail purchase represents an inflection point in Valeant’s share price. Between 2011 and the end of 2015, Valeant would spend more than $32 billion on more than 24 acquisitions. Purchases ranged from paying $22 million in 2012 for Eyetech, an ophthalmology biotech, to $14.5 billion in 2015 for gastrointestinal medication maker Salix Pharmaceuticals. Exhibit 3 lists Valeant’s major acquisitions.

EXHIB IT 3

Valeant Pharmaceuticals, Selected Acquisitions, 2008–2015

Year

Target

2008

Coria Laboratories

$ 95

Dermatology products

Derma Tech (Australia)

$ 13

Dermatology products

Dow Pharmaceutical Services

$ 285

Dermatology products

Tecnofarma (Mexico)

$ 33

Branded/private label generics

Laboratoire Dr. Renaud

$ 18

Dermatology/aesthetic products

Aton Pharmaceuticals

$ 318

Ophthalmology

Brazilian Generics Maker

$ 56

Dermatology products

Biovail

Reverse Merger

Moves to Canada for tax breaks

PharmaSwiss (Switzerland)

$ 481

Generic drug maker with markets in Eastern Europe

Ortho Dermatologics

$ 345

Dermatology products, Retin-A Micro, Ertaczo, Renova

AB Sanitas (Lithuania)

$ 500

Generics, plus dermatology and ophthalmology

Inova (Australia)

$ 698

OTC and prescriptions in Australia, South Pacific, and Africa

Afexa Life Science

$ 76

Cold and flu remedies

Dermik

$ 425

Dermatology products, including BenzaClin and Sculptra

Medicis Pharmaceutical

$ 2,600

Dermatology products

Probiotica (Brazil)

$ 44

Sports nutrition

Eyetech, Inc

$ 22

Ophthalmology biotech company

Pedinol

$ 27

Podiatry specialty pharma

AcneFree

$ 64

Dermatology products

Orapharma

$ 312

Oral health including Arestin (antibiotic)

Atlantis Pharma (Mexico)

$ 71

Generics, gastrointestinal, analgesics, and anti inflammatory

Natur Produkt (Russia)

$ 180

Cough and cold medications

Obagi Medical Products

$ 344

Dermatology products

Bausch & Lomb

$ 8,600

Contact lenses

Solta Medical

$ 250

Medical aesthetics

PreCision Dermatology

$ 475

Dermatology products, including acne

Salix Pharmaceuticals

$ 14,500

Gastrointestinal Medications

Mercury Holdings (Cayman)

$ 800

Holding co for Amoun Pharma (Egypt)

Sprout Pharmaceuticals

$ 1,000

Women’s libido drug Addyi

Brodalumab (from AstraZeneca)

$ 445

Psoriasis treatment

Synergetics USA

$ 192.00

Eye surgery products

Paragon vision services

undisclosed

Gas permeable contact lens products

2009

2010

2011

2012

2013

2014

2015

Source: Casewriter research.

Purchase Price (millions)

Key Products

Valeant: The Michael Pearson Strategy

C-151

The majority of deals complemented Valeant’s core of dermatology; however, the company diversified into ophthalmology and eye care with its $8.6 billion purchase of contact lens maker Bausch and Lomb, and the global consumer market with cough and cold company Natur Produkt (Russia) and Priobiotica, the Brazilian sports nutrition concern. The common thread that ran through all acquisitions, according to Pearson, was a focus on “mispriced products.”17 Investors loved the Valeant strategy, rocketing Valeant’s shares into the stratosphere. The stock went from $18.87 the day after the Biovail merger to a high of $262.52 in August 2015, for total shareholder return of 1,391 percent. The Big Pharma model grounded long-term company profitability in the creation of new patented drugs, and then pricing those drugs so as to recover the development costs of between $1 and $2.6 billion, generate cash to fuel the next round of innovation, and provide shareholders with a return.18 Valeant eschewed that model by cutting its own R&D, replacing that driver with debt-fueled acquisitions. To recover the cost of that debt and provide attractive returns to shareholders, Valeant chose to raise prices on key drugs in its expanding portfolio. For some of its purchases—Valeant’s drugs had not yet come “off-patent” (subject to competition from generic formulations)—the company used its monopoly position to raise prices between 60 and 2,850 percent (Exhibit 4 provides a list of some of Valeant’s price increases.). A report from Deutsche Bank indicated that the average Valeant price increase was 66 percent, more than five times the rates of competing pharmaceutical companies.19 An investigation by the United States noted that “from 2014 to 2015, Valeant increased the prices of more than 20 additional ‘US Prescription Products’ by more than 200 percent. Valeant raised the prices of several of these products multiple times from 2014 to 2015, in some cases by as much as 800 percent.”20 CFO Howard Shiller admitted in May of 2015 that about 80 percent of Valeant’s revenue growth for the quarter was driven by price increases.21 Valeant chose the drugs to add to its portfolio based on the level to which a drug had been “mispriced” in the market, but the company also focused on drugs that were used to treat the chronic nature of dermatological and other conditions. Valeant’s price increases would result in long-term substantial increases in cash flow and profitability. The impact on drug consumers would be similar, although it would mean a long-term increase in their out-of-pocket drug costs. One consumer saw their cost for Cuprimine, a drug that treats Wilson’s disease (an inherited malady that can affect the liver and nervous system), rise from $366 per month to more than $1,800. For retirees and other middle-income patients, Valeant’s gain was their loss.22 EX HIB I T 4

Product

Valeant Pharmaceuticals, Selected Drug Price Increases

Initial Price

New Price

Percentage

$ 1,500

$ 3,000

100%

Assisted suicide pill

Benzaclin

$ 150

$ 500

202%

Acne treatment

Nitopress

$ 258

$ 806

212%

Cardiac drugs from Salix Pharmaceuticals

Wellbutrin

$ 480

$ 1,400

290%

Antidepressant

Oxsoralen-Ultra

$ 1,227

$ 5,204

324%

Psoriasis treatment

DHE 45

$ 3,090

$ 14,000

356%

Migraine treatment

$ 175

$ 900

414%

Acne treatment

Isuprel

$ 4,489

$ 36,811

720%

Treats abnormal heart rhythm

Glumetza

$ 1,000

$ 10,000

900%

Diabetes treatment

Syprine

$ 1,395

$ 21,267

1425%

Wilson’s disease

Targetin

$ 1,687

$ 30,320

1800%

Cutaneous T-cell lymphoma treatment

Carac

$ 159

$ 2,865

1800%

Treats precancerous skin lesions actinic keratoses

Curprimine

$ 888

$ 26,189

2849%

Used in treatment of Wilson’s disease

Seconal

Retin-A micro

Source: Casewriter research, various primary sources.

Usage

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ICARUS Revisited

Valeant defended its price increases on three grounds. Internally, the company noted that increases (often major) in price did not affect demand. A consultant’s report on heart medication Nitropress noted that, “With roughly one year of data showing essentially static volume performance after a substantial price increase (350%), [the consulting firm] believes pricing flexibility may still exist for the product up to the perceptual price point of $1,000 per vial. . . . With current WAC [Wholesale Acquisition Cost] pricing at $214 per vial, Nitropress is likely to still have flexibility by multiple orders of magnitude.”23 Nitropress had apparently not reached its economic price ceiling, where demand would begin to decrease. Externally, Valeant claimed that its price increases were justified by the money saved from drug therapies versus hospitalization or other intensive treatments. Northern California’s KQED reported on Valeant’s price increase of Seconal, an assisted suicide drug: “‘Valeant sets prices for drugs based on a number of factors,’ the company said in a statement, including the cost of developing or acquiring the drug, the availability of generics, and the benefits of the drug compared with costly alternative treatments. ‘When possible, we offer patient assistance programs to mitigate the effects of price adjustments and keep out-of-pocket costs affordable for patients.’”24 Those patient assistance programs represented the third element of Valeant’s justification for its strategy. The company argued that few consumers bore the brunt of their price increases—most of the higher bills would be paid by third-party payers, either private health insurers or government agencies such as Medicare or Medicaid. Valeant’s anti-depressant Wellbutrin provides an example. Patients who visited the Wellbutrin website learned that, depending on their insurance plan, they may pay between zero and $50 for “unlimited use.” Doctors were told that if they prescribed Wellbutrin XL, and specified “no generic substitution” would find “no hassles and no need for call-backs—guaranteed. Your prescription decision is never questioned by the pharmacy.”25 Wellbutrin had been on the market for three decades and was available in generic form for about $30 per month. Valeant had increased the price 11 times to more than $1,400 a month. The drug’s 2015 revenue was projected to top $300 million, double its 2013 level.26

Icarus Returns to Earth: The Fallout of Valeant’s Acquisition Strategy Valeant’s drug pricing strategy came under criticism as the US presidential election heated up in the fall of 2015. Democratic candidate Bernie Sanders called for an investigation in August 2015, and Hillary Clinton followed in September. Her tweet pledged action around “outrageous price gouging” by pharmaceuticals put investors in the sell mode. Valeant’s shares, trading at more than $250 per share in August, began to fall. On September 28 alone, Valeant’s shares dropped 16 percent.27 Valeant had no response to these attacks. Just over two weeks later, on October 15, Australian hedge fund manager—and short seller of Valeant stock—John Hempton reported a questionable connection between Valeant and Philidor, a specialty pharmacy that distributed a number of Valeant products. Hempton claimed that Philidor was a “captive pharmacy” rather than an independent agent.28 Information emerged during the next couple of weeks showing the Valeant staff, posing as Philidor employees, fraudulently wrote “dispense as written” on prescriptions to avoid generic substitution. They also deceived insurers by listing the drugs as being filled by smaller pharmacies in order to avoid attracting suspicion of too many high-priced prescriptions filled by Philidor.29 Valeant’s response showed that the executive team and the board failed to understand the threat. The company initially (and emphatically) denied the charges of any improper affiliation with Philidor; however, the company later disclosed that it was, in fact, quite entwined with Philidor. Valeant blended Philidor’s financials with its own, and the company had invested $100 million in the pharmacy. Valeant pledged to cut ties with Philidor and launched an internal investigation. Valeant held a conference call on October 30 to quell investor fears; instead, Valeant’s poor handling of the call and the overall situation stoked investor concern. The stock dropped another 16 percent.30 Problems with Philidor would affect the company’s financial results and

Valeant: The Michael Pearson Strategy

were responsible for the delay in Valeant releasing its 2015 annual report—a move that threatened to throw the company into default with its creditors. In late December of 2015, Valeant announced that Pearson would take a leave of absence because of a severe case of pneumonia; CFO Howard Shiller would assume Pearson’s role and serve as temporary CEO. Robert Ingram would become board chairman and Valeant would finally split the roles of chairman and CEO. Pearson returned to work at the end of February 2016, but Ingram remained board chairman.31 Throughout the winter of 2016, Valeant continued to exhibit a surprisingly nonchalant public attitude about its drug pricing troubles. In February 2016, Clinton continued her assault: “[Valeant] is one of these companies that is absolutely gouging American consumers and patients,” she said. “I’m going after them. We are going to stop this. This is predatory pricing. It is unjustified, it is wrong, and we’re going to make sure it is stopped.”32 Between August 2015 and February 2016, Valeant’s shares lost more than 60 percent of their value. As Valeant’s troubles became front-page news, the US Congress and the US Department of Justice jumped on the bandwagon, the former calling for hearings and the latter opening an investigation into Valeant’s pricing behavior.33 Other Valeant problems came to light. Its 2013 acquisition of Bausch & Lomb resulted in a commanding market position in the contact lens market. When Valeant purchased Paragon Vision Services in 2015, the company held an estimated 80 percent market share in orthokeratology “buttons,” a key input to gas permeable hard contact lenses. The US Federal Trade Commission opened another investigation, and a contact lens manufacturer filed a class action suit to stop Valeant. Jan Svochak, president of the Contact Lens Manufacturers Association described the threat: “The issue is the orthokeratology market  .  .  . We believe they have a monopoly situation in that market,” Svochak said. “They significantly raised prices in the orthokeratology market, and they’ve also taken control of distribution channels.” Valeant used the Paragon acquisition to raise prices for the buttons by more than 100 percent. In a final blow to the now-beleaguered company, investors began to raise concerns about CEO Michael Pearson’s compensation package. In 2014, activist investor William Ackman noted that Pearson held stock options in Valeant worth more than $1.3 billion, on top of $10.275 million in salary and bonus compensation for the year. Ackman noted that the pay plan would richly reward the Valeant team and Pearson for raising share price over the long term. The company’s proxy statement included this description of the pay plan: “Our compensation philosophy is to align management’s pay with long-term TSR [Total Shareholder Return] . . . We richly reward for outstanding TSR performance, but pay significantly less for below-average TSR performance.” Executives would receive their shares only if the stock price hit an annual return of 15 percent; however, if the stock returned 45 percent, shares tripled. They quadrupled if the stock went up 60 percent. Valeant claimed its “executives could be among the best-paid in the industry.” Because of Valeant’s collapse, neither Pearson nor other Valeant executives would receive stock compensation for the period of 2013–2016, as their options would not vest until 2017. The late-filed 2015 10K report included the board’s investigation of the Philidor scandal. The board admitted “the company has determined that the tone at the top of the organization, with its performance-based environment, in which challenging targets were set and achieving those targets was a key performance expectation, was not effective in supporting the control environment . . . [and] may have been contributing factors resulting in the company’s improper revenue recognition.” The company also noted the burgeoning number of federal and state investigations underway; the SEC, the United States Senate, and state-level inquiries in Massachusetts, New York, New Jersey, and North Carolina. Doctors, hospitals, and other activist groups began targeting the company. With its future revenue growth increasingly uncertain, investors jumped off the Valeant bandwagon and continued to sell their shares. With the prospect of increased scrutiny from stakeholders in the public and private sectors, Valeant’s ability to find, acquire, and re-price “mispriced” drugs appeared in jeopardy. On March 21, Valeant announced that Pearson would be leaving the company and a search for a new CEO would begin immediately.34 Valeant’s stock finally hit bottom on March 31, tumbling to $26.30, down almost exactly 90 percent from its peak seven months earlier.

C-153

C-154

ICARUS Revisited

Conclusion The shares had come back to Earth, leaving long-term holders of Valeant stock with a company valued at its 2010 price. Consumers who saw their prescription bills were clearly worse off. Who were the real winners in Valeant’s rise and fall? These and other questions gave Ingram pause as he considered how to work with the new CEO and directors Valeant named to its board. The investing community was waiting to see how new CEO Joe Papa would alter Valeant’s strategy and lead the company toward a new future. As the board chairman, Ingram wanted to see Valeant return to profitability, but he also wanted to ensure that Valeant, and the board, proved more responsive to the charged stakeholder environment in the health care industry. Had Valeant simply transferred wealth from consumers to shareholders through its price increases? How should it set prices in the future to reflect the real value of the drugs but avoid excessive, “gouging” price increases? How should the board govern the company in order to avoid further fraud or accounting scandals? Finally, Ingram wondered about how to address Papa’s compensation and other board-level policies: How could they incentivize long-term sustainable growth and build an ethical culture?

References Material in this paragraph from “ICN Pharmaceuticals, Inc. History,” Funding Universe, http://www.fundinguniverse.com/company -histories/icn-pharmaceuticals-inc-history/, accessed April 22, 2016. 1

“Biovail to Merge with Valeant,” New York Times (June 21, 2010), http://dealbook.nytimes.com/2010/06/21/biovail-to-merge-with -valeant/?_r=0, accessed April 28, 2016.

14

Ibid.

15

Ibid.

16

Ibid.

L. Lorenzetti, “Valeant Eases Up on Strategy to Buy Up ‘Mispriced Drugs’,” Fortune (October 19, 2015), http://fortune.com/2015/10/19 /valeant-backs-down-drug-prices/, accessed April 28, 2016.

2 3 4

“ICN Pharmaceuticals Appoints Robert W. O’Leary as Chairman and CEO,” PR Newswire, June 20, 2002, http://www.prnewswire.com/news -releases/icn-pharmaceuticals-appoints-robert-w-oleary-as-chairman -and-ceo-77943717.html, accessed April 22, 2016. 5

“ICN Pharmaceuticals, Inc. Changes Its Name to Valeant Pharmaceuticals International,” Newswire, November 12, 2003, available at http://www.prnewswire.com/news-releases/icn-pharmaceuticals-inc -changes-its-name-to-valeant-pharmaceuticals-international-72992612 .html, accessed April 22, 2016. 6

Financial data for 2003 from Valeant’s 20-F filing with the SEC, http:// hsprod.investis.com/ir/valeant_pharmaceuticals/jsp/sec_index .jsp?ipage=2796961&ir_epic_id=valeant_pharmaceuticals, accessed April 23, 2016. 7

Data from Merck’s 2003 Annual Report, http://www.merck.com/finance /annualreport/ar2003/pdf/merck2003ar.pdf, accessed April 23, 2016. 8

9 S. Silcoff, “How Valeant Became Canada’s Hottest Stock,” The Globe and Mail, February 21, 2013, http://www.theglobeandmail.com/report -on-business/rob-magazine/how-valeant-became-canadas-hottest -stock/article8889241/?page=all, accessed April 23, 2016.

Ibid.

10

Ibid.

11

P. Jorda and E. Dey, “Drugmaker Biovail to Buy Valeant in $3.3 Billion Deal,” Reuters, June 21, 2010, http://www.reuters.com/article /us-biovail-valeant-idUSTRE65K1LA20100621, accessed April 28, 2016.

12

Silcoff.

13

Jorda and Dey. Ibid.

17

A. E. Caroll, “$2.6 Billion to Develop a Drug? New Estimate Makes Questionable Assumptions,” New York Times (November 18, 2014), http://www.nytimes.com/2014/11/19/upshot/calculating-the-real -costs-of-developing-a-new-drug.html?_r=0, accessed April 29, 2016.

18

Ibid.

19

“Emails Reveal Turing, Valeant (VRX) Price Increases Were Basis for Revenue Growth,” Biospace, February 3, 2016, http://www .biospace.com/News/emails-reveal-turing-valeant-price-increases -were/407561, accessed April 26, 2016.

20

S. Armour and J. Rockoff, “Valeant, Turing Boosted Drug Prices to Fuel Preset Profits,” Wall Street Journal (February 2, 2016), http://www.wsj .com/articles/valeant-turing-boosted-drug-prices-to-fuel-preset-profits -1454445342, accessed April 26, 2016.

21

A. Pollack and S. Tavernise, “Valeant’s Drug Price Strategy Enriches It, but Infuriates Patients and Lawmakers,” New York Times (October 4, 2015), http://www.nytimes.com/2015/10/05/business/valeants-drug -price-strategy-enriches-it-but-infuriates- patients-and-lawmakers .html, accessed April 29, 2016.

22

Ibid.

23

L. Lopez, “Valeant Bought a Drug that Helps Terminally Ill People Die and Doubled the Price,” Business Insider (March 23, 2016), http:// www.businessinsider.com/valeant-seconal-price-increase-2016-3, accessed April 26, 2016.

24

Ibid.

25

References C-155 26

N. Weinberg and R. Langreth, “How Valeant Tripled Prices, Doubled Sales of Flatlining Drug,” Bloomberg (January 8, 2016), http://www .bloomberg.com/news/articles/2016-01-08/how-valeant-tripled-prices -doubled-sales-of-flatlining-old-drug, accessed April 26, 2016.

32 D. Crow, “Price of Valeant Drug Singled Out by Clinton Rose 356% in a Year,” Financial Times, http://www.ft.com/cms/s/0/fff89b8e -c922-11e5-be0b-b7ece4e953a0.html#axzz46y EaggbM, accessed April 26, 2016.

S. Gandel, “What Caused Valeant’s Epic 90% Plunge,” Fortune (March 20, 2016), http://fortune.com/2016/03/20/valeant-timeline -scandal/, accessed April 26, 2016.

33

27

28 S. Gandel, “Valeant: A Timeline of the Big Pharma Scandal,” Fortune (October 31, 2015), http://fortune.com/2015/10/31/valeant-scandal/, accessed April 29, 2016.

J. Hempton, “Philidor 2.0: Valeant and Stephen King Play Chess with a Lot of Pharmacies,” November 26, 2016, http://brontecapital .blogspot.com/2015/11/philidor-20-valeant-and-stephen-king.html, accessed April 29, 2016.

29

Gandel, Valeant.

30

A. Pollack, “Valeant Pharmaceuticals Chief Returns from Medical Leave,” New York Times (February 28, 2016), http://www.nytimes.com /2016/02/29/business/valeant-pharmaceuticals-j-michael-pearson-ceo .html?_r=0, accessed May 6, 2016.

31

A. Pollack, “2 Valeant Dermatology Drugs Lead Steep Price Increases, Study Finds,” New York Times (November 25, 2015), http:// www.nytimes.com/2015/11/26/business/2-valeant-dermatology -drugs-lead-steep-price-increases-study-finds.html?_r=0, accessed April 26, 2016. N. Vardi, “Mike Pearson Is on His Way Out of Valeant, Former CFO Refuses to Leave Board,” Forbes (March 21, 2016), http://www.forbes .com/sites/nathanvardi/2016/03/21/mike-pearson-is-on-his-way -out-of-valeant-amid-more-drama-former-cfo-refuses-to-leave -board/#2c7f12525c1a, accessed May 6, 2016.

34

CASE 14 Safe Water Network Mastering the Model at Dzemeni With mixed emotions, Charles Nimako put down the 2011 summary report on Safe Water Network’s projects in Ghana. His team, along with Safe Water Network leaders in New York, had worked for almost two years to make the Dzemeni (pronounced JEM-uh-nee) site profitable and provide safe drinking water to local Ghanaians. They had brought innovative ideas and actions to address enormous problems that had plagued water providers for decades; however, difficult challenges and choices remained just ahead. He considered the two questions he and Hew Crooks, the organization’s SVP of Operations, discussed during their last phone call. How can we optimally expand the system to increase profitability at the Dzemeni site? And, should we move ahead with plans to expand the Dzemeni site into a regional “micro-utility” to provide safe water to the people living in nearby Tongor? A native Ghanaian, Nimako had earned his MBA from Stanford University, worked as a consultant with McKinsey & Company in South Africa, and had most recently served as the CEO of the PepsiCo Bottler in Ghana and franchise director for East Africa.1 His work in the corporate world had proved invaluable in solving the many project problems encountered at the Dzemeni site, but the remaining challenges looked daunting. Founded by American actor and philanthropist Paul Newman and a group of business and civic leaders, Safe Water Network sought to “develop innovative solutions that provide safe, affordable water to those in need.”2 Safe Water Network’s core values, as determined by the founders, are outlined in Exhibit  1. The organization brought together a group of dedicated professionals who had made their mark in private industry and civic work. For example, the founding CEO of Safe Water Network, Kurt Soderlund, also cofounded North Star Partners, a marketing and strategy consulting firm, and he had served as a special assistant to the president at New York City’s New School, assisting the president in his role as chairman of Human Rights Watch.3 Safe Water Network’s partner list features titans of industry from a variety of industries. The organization counts the Conrad N. Hilton Foundation, Kosmos Energy, the Merck Company Foundation, Newman’s Own Foundation, PepsiCo Foundation, Navajbai Ratan Tata Trust, and Starr International Foundation among its funders, and it has partnered with the International Finance Corporation (IFC), IBM, and the Johns Hopkins Bloomberg School of Public Health (JHBSPH). The Safe Water Network team on the ground in Ghana has contributed unique and valuable experience as well. In addition to Charles Nimako, the organization also hired Charles Yeboah to be its monitoring and evaluation, health, and hygiene coordinator, as Yeboah brought a public sector perspective from his work with the Ghana Health Service’s National Buruli Ulcer Control Program.4 Safe Water Network saw its role as a “Johnny Appleseed” of clean water, helping communities to jump start the journey toward clean water, relinquishing ownership and control, and then moving on to other communities to provide benefits. Safe Water Network currently operates in two countries: India and Ghana. The organization began in 2008 with the launch of a rainwater harvesting program in Rajasthan, India. The Indian operations expanded in 2010 with a 20-village safe water station initiative and the opening of an office in New Delhi. In 2011, C-156

The Dzemeni Project

EX HIB I T 1

Safe Water Network Core Values20

Access Making water available and affordable for all Empowerment Providing communities the confidence and competency for self-sufficiency Impact Realizing lasting health, social, and economic benefits Measurement Documenting success and failure Lessons Learned Adopting best practice Environment Safeguarding water resources Risk Taking Investing in new approaches Open Source Sharing our findings with the water sector at large

Safe Water Network provided technical assistance to the NGO Shining Hope for Communities in Nairobi, Kenya, in establishing a water tower in the Kibera slum to serve a girls’ school and the surrounding community. In 2012, they completed a market and feasibility assessment in collaboration with IFC to identify opportunities for commercial approaches to provide safe water to the poor in Kenya.5 The Ghana project started in 2009 when Safe Water Network funded the installation of five safe water stations in the country. WaterHealth Ghana (WHG), a local affiliate of WaterHealth International, approached Safe Water Network about an alliance: Safe Water would fund the sites and WaterHealth Ghana would manage and operate them. The physical and chemical process of water purification occurs at these safe water stations, as does the purchase of clean water by local consumers. Safe Water Network’s role in the project expanded after the initiative’s performance fell short of the business objectives of delivering safe water to thousands of rural and suburban Ghanaians, creating a sustainable and replicable model for commercial clean affordable water, and facilitating local ownership of the safe water stations. Safe Water Network partnered that same year with Johns Hopkins University, which conducted an independent study to evaluate the impact of the safe water stations on health outcomes.

The Dzemeni Project Located on the Gulf of Guinea just north of the equator, Ghana gained its independence from Britain in 1957. Almost half of the country’s 24.3 million residents live in the coastal urban centers of Accra, Takoradi, the Gold Coast, and inland Kumasi; the other half reside in the country’s rural areas. After years of military dictatorships and coups, Ghanaians now enjoy a stable democratic government and a solidly growing economy. GDP growth has averaged a little more than 8 percent for the five-year period of 2007–2011.6 In spite of these impressive gains, Ghana remains a fairly poor country. Although the per capita income averages $1,230 annually for the country as a whole, 39 percent of rural Ghanaians earn less than $456 per year, or $1.25 per day, the global standard for extreme poverty.7

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World Bank data indicate that 80 percent of rural Ghanaians have access to “improved” water; however, water systems fail at an alarming rate. For example, the Ghanaian Ministry of Water Resources, Works, and Housing found that 30 percent of hand pumps did not function at all and another 50 percent operated incompletely. Between 40 and 45 percent of rural Ghanaians, roughly 4.6 million people, lack consistent access to clean water. Money allocated by the government toward clean water projects often gets diverted to other uses; in 2010, more than 90 percent of funds budgeted failed to be spent. Water-borne diseases such as diarrhea, Buruli ulcer, and intestinal worms run rampant among the population, with 70 percent of diseases in the country traceable to the lack of safe water.8 Four of the five safe water stations served residents of the greater Accra peri-urban region (i.e., the area between the suburbs and the countryside), which include Amasaman, Pokuase, Obeyeyie, and Oduman. Exhibit 2 provides country-level data for Ghana, the two regions with safe water stations, and the five site locations. Dzemeni, located on the southeast shores of Lake Volta, represented the first attempt to reach rural and semirural Ghanaians. Lake Volta, formed in 1964 when the government dammed the Volta River at Akosombo Gorge, is one of the largest manmade lakes in the world.9 Dzemeni residents can draw water directly from the lake; however, decades of human and animal use have resulted in levels of microbial pollution that leave the water unsuitable for human use. With about 7,000 residents, Dzemeni exists primarily as a market town and urban center, and it serves as a trading center for about 15,000 Ghanaians in the outlying hamlets. The Dzemeni safe water site made sense to Safe Water Network for several reasons. First, Dzemeni had no municipal water source and no other commercial water vendors existed; the convenience of Lake Volta effectively eliminated competition. Since it first appeared, residents have drawn water out of the lake, in spite of its contaminated state. Second, Safe Water Network

E XH I B I T 2

Country-level Data for Ghana

District

Ga West

South Dayi

Region

Greater Accra

Volta

Population

262,742

46,661

Population density (per sq. km)

370

46

Water coverage

19%

69%

% of communities paying tariffs

90%

60%

Water tariffs

10p/20L

10p/20L

Average size of population in LMS-ready communities

1,269

Nil

Average size of population in MSSF-ready communities

1,759

487

% of selected communities with electricity (LMS)

95%

Nil

Potential population to be served

60,000

1,000

District

Community

Population

Ga West

Amasaman

6,000

Pokuase

16,000

Obeyeyie

2,500

Oduman

2,500

Dzemeni

7,700

Total

34,700

South Dayi

Source: SWN internal planning documents.

The Water Users—Customers

research indicated that more than 50 percent of residents, while poor, could reasonably afford to purchase clean water. Third, Safe Water Network was able to identify community leaders who would create excitement about safe water stations and encourage educational efforts that stressed the importance of clean water. Finally, nearby Tongor, which was also a combination of a number of villages, provided another potential market if the safe water station could profitably scale its operation.10 Delays and problems, however, cropped up almost immediately. Locating, screening, and selecting sites took longer than expected. Negotiations with community leaders at selected sites took time, and the sites required different water purification systems to address specific challenges. The Dzemeni center opened 18 months behind schedule, and capital costs for construction of the site exceeded its budget by 80 percent. Operating performance fell short of expectations; sales volumes indicated penetration rates (the percent of the population using the safe water station) around 20 percent instead of the 75 percent target, and the facilities failed to even cover operating costs. In late 2010, Safe Water Network replaced WHG as the controlling partner. Safe Water managed health and hygiene education, marketing and demand development, and overall management at the Dzemeni site (as well as the other four sites). WHG continued its role as the Dzemeni site technical operator.11 Nimako and his local team began the hard work required to solve the many problems that stymied success. Safe Water Network began to learn that even the first goal, providing affordable potable water to rural Ghanaians, proved elusive and difficult, even more difficult than they expected.

The Water Users—Customers Although the need for water is universal to humans, the demand for safe water is dependent on a variety of factors, including price sensitivity, convenience, seasonal variation in demand, and consumer knowledge about the benefits of clean water.

Price Sensitivity Before the management transition to Safe Water Network began, in order to stem operating losses, WHG had doubled the price of water from 0.05 Ghana cedis (GHS) or 5 pesewas (p)— about $0.035—to 0.10 GHS or $0.07 for 20 liters (20 L). An average person needs 7 L of safe water for drinking and cooking each day, according to the WHO, and a family of five would use about 40 L per day. Overall demand dropped 30 percent immediately after the price increase, and the reduction in demand from the poorest Ghanaians, those Safe Water Network most wanted to reach, likely exceeded that figure. Incomes for the 40 percent living below the $1.25 per day poverty line averaged $1.08 per day, or $5.40 for a family of five.12 These families would have to spend about 2 percent of their income on commercial water, and studies from the Johns Hopkins group indicated that “cost did not seem to be a barrier to use.”13 In spite of increased operating costs, Safe Water Network ruled out any further price increases that would put the stations’ water out of reach of the poorest consumers, committing instead to achieving sustainability through increasing consumption and reducing costs.

The Convenience Factor Water is heavy! A 20 L container weighs nearly 45 pounds, and not only did the spending of hard-earned cash for the water dampen demand but so did the physical energy required to transport water from the station to the home. Safe Water Network mapped water purchasers and found usage to be highly dependent on distance. For example, in Pokuase, they found that 85 percent of those living within 100 m (just short of the length of a football field) purchased

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water, but purchasing fell to 55 percent for those living between 100 and 200 m from the site, and only 10 percent of those living beyond 200 m made the effort to buy clean water. Dzemeni exhibited a similar pattern, with use dropping substantially for customers who lived further than 300 m from the site. Exhibit 3 details the effect of convenience on water consumption. Safe Water Network decided to pipe water to remote kiosks (sales stations) some 400 m away from the main station to increase demand and consumption. The remote kiosks almost doubled sales at Dzemeni. The increased water sales, combined with the low incremental operating costs of the remote kiosks, significantly improved the economics of the safe water stations in these sites. Exhibit 4 illustrates the economics at the Dzemeni site. Total system cost per liter declined by 33 percent in Dzemeni after the remote kiosks were installed. Safe Water Network leveraged its positive experience and installed remote kiosks in two additional communities and early results are promising.14

E XH I B I T 3

The Effect of Convenience on Water Purchases

A. Household Mapping in Pokuase Well

Scale 100m

Well Well Well Legend Household that have used SWS water within the last 6 months Road

Well

Nsaki River

Well

Well Well

Well

Sale Water Well

Well

Station Well

Accra-Kumasi Highway

Well

N © Safe Water Network - 2011

100% Household Penetration

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85%

75% 55% 50%

25%

0%

10%

200

Source: Safe Water Network, “Decentralized Safe Water Kiosks,” [Internal Document] (August 2012). Available at http://www.issuelab.org/resource/decentralized_safe_water_kiosks_working_toward_a_sustainable_model_in_ghana. Reproduced with permission of Safe Water Network.

The Water Users—Customers B. Remote Kiosk Impact on Sales Volumes in Dzemeni and Pokuase 1,000,000

Volume Sold (L)

800,000 600,000 400,000 200,000

Ja n-

11 Fe b11 M ar -1 1 Ap r-1 1 M ay -1 1 Ju n11 Ju l-1 1 Au g11

–

Main Site/Bulk

Remote Kiosks

1,000,000

Volume Sold (L)

800,000 600,000 400,000 200,000

12

Ja

n-

11

1 -1

De

c-

1

ov N

ct

-1

11

Main Site/Delivery

O

1

11

p-

Se

g-

l-1

Au

Ju

Ju

n-

11

–

Remote Kiosks

Source: Safe Water Network, “Decentralized Safe Water Kiosks,” [Internal Document] (August 2012), http://www .issuelab.org/resource/decentralized_safe_water_kiosks_working_toward_a_sustainable_model_in_ghana.

EX HIB I T 4

Comparison of Actual and Pro Forma Monthly Results at the Dzemeni Site

Monthly Results Monthly Volume

Base Site

2 Remote Kiosks (Current)

2 Remote Kiosks (Projected)

4 Remote Kiosks (Projected)

400,000

600,000

7,500,000

1,000,000

Utilization

57%

50%

63%

83%

Realized Price

0.08

0.08

0.08

0.08

Revenue

1,600

2,400

3,000

4,000

Total Direct Operating Cost

1,196

1,591

1,736

2,131

404

809

1,264

1,869

WHG Fee

1,150

1,150

1,150

1,150

Profit/(Loss) After WHG Fee

(746)

(341)

114

719

Profit/(Loss) Before WHG Fee

Source: Safe Water Network, internal company documents.

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A water delivery service was initiated by Safe Water Network to cater to convenience at the Accra sites. The price charged for truck-delivered water is 0.20 GHS for 20 L, twice the price charged at the main site. Costs increased as the service required a truck, driver, fuel, insurance, and maintenance. Even at the higher price, delivery sales were sufficient for the service to cover its operating costs. The service would need to grow its volume by an additional 25 percent, however, if it hoped to cover its capital costs—the trucks and containers.15 Nimako and his team identified and explored several potential avenues for expanding the reach and purchase penetration at Dzemeni, including truck and donkey delivery, additional remote kiosks, and contracting with local shop owners to sell water. Delivery services did not exist in Dzemeni, and Nimako wondered about how such a new distribution method would affect demand.

Seasonality As with rural populations around the world, Ghanaians have relied on rainwater harvesting to provide fresh, potable water during the rainy seasons, which in southern Ghana extend from April to July and from September to November. The annual rainfall average in Ghana is more than 80 inches per year, a foot more rain than in Mobile, Alabama, the rainiest location in the continental United States.16 The demand for commercial water could potentially vary 50 to 65 percent between the dry and rainy seasons, depending on the intensity of the rainy season. Demand for clean water would be strong and require sufficient capacity during the dry season, but Ghanaians would naturally economize during the rainy season and collect free water. Safe Water Network chose to install enough capacity to cover the dry seasons, and believed it could stimulate enough demand for commercial water during the rainy season.

Education and Recontamination Many people in developing countries do not understand the need for consistent clean water to combat water-borne diseases, and this lack of understanding leads to mishandling and recontamination of clean water by consumers. A list of common myths, and the truths that refute them, can be found in Exhibit 5. Since the beginning of the initiative, Safe Water Network used local health and hygiene teams to engage in community education and outreach. Dzemeni’s cultural tradition of strong local leaders (chiefs) meant that, after Safe Water Network taught them, others in the community would likely become informed. Safe Water Network did not rely solely on the chiefs, and the organization recruited other influential volunteers, including local women, teachers, and even primary school children (peer educators) to teach residents about the need for, and benefits of, clean water. The downside of this intervention came at a cost—$200 (285 GHS) per month added to the Dzemeni operating costs. The upside could be sustained with increases in demand for commercial water. However, an internal report noted “the full effects of health and hygiene education and resulting changes in behavior may not be realized for some years.”17 The open or multiple-use water containers that people used, and lack of hygienic practices, often resulted in recontamination of the treated water. Consumers dipped their hands into their clean water and introduced contaminants to the water in the container, and those contaminants remained in the container to pollute the next batch of clean water purchased. To solve this problem, Safe Water Network introduced narrow-mouthed containers because the smaller opening kept hands out. Solving this problem created another, however: the cost of the containers. Two thousand narrow-mouthed containers were sold to Dzemeni residents along with a coupon that provided users with vouchers good for 30 containers of free water if they purchased a container for GHS 3 ($2.10). Although most consumers would willingly accept a subsidized container, it was not clear what the demand would be if they had to purchase them at the full cost. Charles Nimako recognized that Safe Water Network had learned much about how people use—and whether they will buy—water. The result of their efforts was a 151 percent increase in overall demand from late 2010 to late 2011. That impressive figure encouraged both Nimako and

The Safe Water Network Business Model

EX HIB I T 5

Consumer Education Materials

Overturning Myths, Selecting Messages, and Identifying Influence Leaders to Promote the Safe Water Station Section 1: Myths That Need to Be Addressed in Promoting the Safe Water Station MYTH #1: Groundwater is pure. TRUTH: Groundwater can contain many kinds of chemical and microbiological contaminants that are natural or generated by humans. These can cause diarrhea, cholera, and arsenic or other chemical poisoning. MYTH #2: Water cannot cause illness since illnesses are sporadic and not constant, whereas water is drunk daily. TRUTH: Illnesses can be present all the time but only be apparent when the body is overpowered by the contaminant causing the illness. Dirty water may not always cause illness, but safe water and hygienic practices will always prevent it. MYTH #3: Groundwater and water front natural streams are pure. TRUTH: Both water sources can be contaminated by people, animals, or naturally occurring pollutants. Our water quality tests can show this. MYTH #4: Boiling treats the water of its contaminants. TRUTH: Boiling water can eliminate microbiological contaminants and help reduce diarrhea. It is, however, useless against chemical contaminants including arsenic, fluoride, and “chalk” or hardness. MYTH #5: Consuming safe water sporadically can prevent health issues. TRUTH: Safe water needs to be consumed by all family members at all times to prevent health problems. Drinking unsafe water occasionally can contaminate both individuals within the household and the places where it is stored. Occasional use of unsafe water can make safe water unsafe! MYTH #6: Schemes are not to be trusted. TRUTH: We know this is often the case. But the Safe Water Station is owned and managed by friends and neighbors in your own community. You can contact them or the other Safe Water Station Partners at any time if you require any information that will encourage your trust. Also, the water that is sold must pass strict testing requirements that ensure the quality of the Safe Water Station water is as good as any sold anywhere in the country—and they are required to make the results of these tests available to customers. Source: Safe Water Network, “Tools for Safe Water Stations,” p. 125.

Hew Crooks, the SVP of Operations, but it did not solve their fundamental problem. Even with the impressive increases in demand for Safe Water products, the revenues generated covered only the operating expenses. Nimako wondered whether demand would ever cover the full costs of the Safe Water Stations and whether the fundamental business model and cost structure of Safe Water Network would need to change in order for the company to stay in business.

The Safe Water Network Business Model Safe Water Network envisioned solving the challenge of potable water by creating financially sustainable and community-welcoming safe water facilities. The organization believed that if it could accomplish these goals, a third goal could be reached: finding local owners to buy and run the safe water stations. Taken together, these three overarching goals constituted the Safe Water Network objective. Nimako had an emerging understanding of the consumer side of the safe water initiative, and he mentally reviewed each pillar of Safe Water Network’s business model. Exhibit 6 shows the Safe Water Network process for implementing the safe water initiative in a rural community.

Financial Sustainability Rain water is pure; the evaporation process removes inorganic pollutants—chemicals, sediments, residues—as well as bacteria or other organic contaminants. Unfortunately, many “fresh water” sources in Ghana, such as Lake Volta, streams, wells, or springs, provide contaminated or impure water because of the presence of inorganic chemicals and minerals or

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EXHIBIT 6

SCREENING

The Safe Water Network Implementation Process

COMMUNITY

SOURCE

PURIFY

SELL

DISTRIBUTE

DRINK

Source: Safe Water Network, Tools for Safe Water. Stations, p. 125. Reproduced with permission of Safe Water Network.

microbial contaminants associated with human or livestock fecal matter in the water. The essence of Safe Water Network’s mission involves purifying impure water by moving it through a treatment system. The physical and biological characteristics of the water source drive the choice of treatment technology, which in turn underlies the financial sustainability of the Safe Water Network business model. The technology then determines the capital cost of the system. The cost of equipment identified as suitable for community-sized systems in Ghana ranges from $23,000 (32,600 GHS) to $100,000 (142,000 GHS), not including land, building, and permitting costs (see technology descriptions below). Consumables such as sand, gravel, chemicals, membranes, operator and staff salaries, and maintenance expenses constitute operating costs. Safe Water Network has no allegiance to any particular technology, and leaders seek to install the most appropriate and cost-effective technology for a given site. Exhibit 7 describes the advantages and disadvantages of each treatment technology. Carbon filter with ultraviolet light treatment (CUV). All five initial sites in Ghana used CUVbased systems. These systems employ sand, carbon, and 10- and 1-micron polypropylene wound cartridge filters in addition to ultraviolet (UV) treatment systems. Water passes through a carbon filter and a series of other filters to remove chlorine, sediment, and other inorganic compounds. Exposure to UV light alters organic DNA and kills bacteria, viruses, yeast, mold spores, fungi, algae, and fecal coliform.18 CUV systems cost $50,000–$90,000 to purchase and install. This system may prove to be the most costly technology to operate because it requires well-trained technicians to operate the systems. Limited mechanization systems (LMS). LMS involves installing a submersible pump in a newly drilled or existing borehole (well), pumping water to an elevated water storage tank, and distributing the water via gravity to standpipes. This system does not provide water filtration; it only provides more water from existing boreholes. The water produced must be chlorinated before distribution to guarantee purity. The cost of LMS varies according to number of boreholes and pumps and the size of the storage tank. Safe Water Network’s budgeted LMS costs are $23,000 for 1,000 people, $32,500 for 2,000 people, or $48,000 for 5,000 people. The use of solar power would reduce operating costs but increase capital outlay by $5,000–$6,000. Safe Water Network is evaluating the use of LMS technology for a possible expansion in the Eastern Region. Modular slow sand filtration (MSSF). Slow sand filtration (SSF) has been in use since the early nineteenth century; however, in the last few years, the design and construction of modular systems has made MSSF an attractive method for smaller communities in the developing world. The system is appropriate and suitable for perennial surface water sources with low turbidity (mud and sediment). The system consists of twin modular plastic tanks for use as the main filter, supported with plastic raw and treated water storage tanks. The treated water is distributed by gravity, pumping, or a combination of the two, depending on the size of the system and the location and distribution of a remote kiosk. MSSF systems run $43,000 for 1,000 people, $47,000 for 2,000 people, and $69,500 for 5,000 people. Safe Water Network is employing MSSF at two new sites launched in the spring of 2013, in preparation for a larger-scale MSSF-based expansion planned around Lake Volta. Ultra-filtration (UF). UF utilizes a range of polymeric-based semipermeable membranes to filter particulates of different sizes. UF provides a filtering solution for communities with surface water sources but variable levels of turbidity or contamination. Primarily used in industrial

The Safe Water Network Business Model

EX HIB I T 7

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Treatment Technology Advantages and Disadvantages

Technology

How It Works

Pros

Cons

LMS (Limited Mechanization Systems)

Mechanizes existing boreholes; can use solar power

• Can leverage existing 24,000 boreholes in Ghana; low initial outlay cost

• Requires a high-yield borehole or well

• Low operating costs; costs of purchasing solar energy materials are dropping and are expected to continue to drop • 77 promising sites in Ghana for LMS technology • Builds on the investments of existing boreholes at a very low incremental unit cost to significantly improve convenience

MSSF (Modular Slow Sand Filtration)

Addresses microbial contamination in surface water; can use solar power

Appropriate for communities whose water needs aren’t served by LMS and MSSF (have highly variable turbidity/contamination)

• Requires perennial surface water source with low turbidity

• Minimal maintenance costs

• Effective for microbial contaminants for the most part but more aggressive parasites like viruses may not be filtered

• Able to treat surface water with high or variable turbidity, certain metals (including iron and manganese, which require pretreatment), color bodies, and a broader range of microbes (including viruses) may not be reduced as efficiently in SSF systems • Treated water will be of adequate quality regardless of operational challenges • UF units are modular and can be scaled as demand changes

Carbon Filter w/Ultraviolet Light Treatment

• Requires soil and water tables that allow for bore holes—not useful near large bodies of surface water with a shallow water table or where soil is contaminated

• Flexibility to expand with demand, avoiding overspending on unneeded capacity; relatively easy to operate • Costs of purchasing solar energy materials are dropping and are expected to continue to drop

Membrane Ultra-Filtration (UF)

• Requires pure water source supplemented by chlorine

• New approach in Ghana (untested)

• Higher outlay costs; need a population of at least 3,000 to achieve lower cost per capita water production • Because of high costs, considered an option only when conditions require this technology (this technology is superior and has fewer cons other than the fact that it is very expensive and difficult to fit a viable business model)

• Known and tested technology

• Requires skilled technicians to operate.

• The only viable turnkey solution for treating microbial contaminated surface water when the Dzemeni project was initiated

• If filters or UV bulbs are not maintained/ replaced, system still operates but produces contaminated water

• Multiple technologies can be combined depending on source water

• High initial capital expense • Not easily scalable

Source: Adapted from Safe Water Network internal planning materials.

settings, the technology has recently shown potential for adaption in developing world settings. Its wide range of operational modes (pressure, gravity, chemical addition) allows for broad applications in a variety of settings and input water qualities. UF systems range between $50,000 and $100,000; capacity is not an issue (a UF station could filter 2,000 L per hour), but costs vary based on the filtration method used. Safe Water Network is using UF for two new sites in the Western Region. The availability of electrical power also plays a significant role in technology and cost. Access to the electrical grid represents one challenge of working in rural Ghana, because the provision of safe water must depend on the reliability of another system. Solar power provides a possible alternative, but the Safe Water Network will incur greater capital costs in exchange for lower operating costs. A major benefit of solar power is the possibility of creating remote charging stations for appliances, cellphones, and batteries. If the solar recharging sites generate 100 to 200 GHS ($70–$140) per month, it would contribute to the overall profitability of the safe water station. Safe Water Network launched its first sites using solar power in 2013.

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Safe Water Network

Welcoming Communities Several criteria factor into the decision to build a safe water station in a community. Safe Water Network hoped to locate in communities with greater than 4,000 people or 800 families within reasonable proximity to the station to provide adequate demand for clean water. The type, nature, and prevalence of water-borne diseases in the community affect the type of treatment system and the overall value added from clean water. Finally, Safe Water Network had learned through its India initiatives that communities without a commercial water market increase the level of difficulty—and time required—to get people to adopt clean water. Again, Exhibit 5 displays common myths that often stymie adoption within a community. Asking residents to pay for treated water when they were accustomed to collecting untreated water for free added a new layer of resistance to Safe Water Network initiatives.

Local Ownership The exit strategy for a safe water intervention in a community calls for local, community-based groups or individuals to take control of the station after capital costs have been recouped by Safe Water Network. Local ownership could dramatically improve adoption rates, assist in consumer education, and provide employment and income for a community. Safe Water Network saw its role as helping communities to jump start the journey toward clean water, relinquishing ownership and control and then moving on to other communities to provide benefits. Safe Water Network’s strategic planning materials identified several characteristics of ideal local owner/partners. These included credibility with local stakeholders, competence in running a business and fulfilling the duties of a good partner, and high ethical and moral character. The costs for the Dzemeni site illustrate the revenue model for all Safe Water Network safe water stations. Capital costs to install the UV filtration unit to service the almost 8,000 residents in the area totaled $91,000, almost twice the budgeted amount. Operating costs include staff and technician labor, consumables such as cartridge filters, UV light sources, electricity costs, maintenance, and repair. The pro forma costs displayed in Exhibit 4 detail the basic economics of running the Dzemeni site, including a management fee payable to WHG. Nimako saw his team’s hard work reflected in the operating profits at Dzemeni. After nearly two years, the Dzemeni site generated a positive cash flow from direct operations; unfortunately, the management fee, negotiated at the beginning of the project, paid to WHG turned profitability negative. Reducing the fee represented one hurdle to financial sustainability. The Safe Water Network team believed that, if a cluster of safe water stations and accompanying kiosks could be installed close to the Dzemeni site, they would be able to amortize the flat management fee over a number of independent profit centers. Exhibit 8 presents the expected capital budget for a new safe water station in the neighboring community of Tongor. The Tongor site would service another six surrounding communities and about 11,000 people, and the site would allocate the management fee among a number of communities that the team calls micro-utilities.19 These utilities might create other economies of scale in consumer education, demand generation, and other operating activities such as repair and maintenance. Safe Water Network’s initial business model sought not only operating profitability and the creation of a small reserve, but also the recovery of the station’s capital costs. The organization viewed its capital investments as loans to the facility with a payback period of eight years. With an imputed interest rate of 2 percent, the Dzemeni site would fail to pay back its $90,000 (135,000 GHS) capital loan even if the two remote kiosks could generate almost ($500,000) 750,000 GHS in total sales. If the organization could create a micro-utility to service a number of communities, capital costs could be recovered in the appropriate time horizon. The underlying appeal of local ownership came from the potential of the safe water stations to provide income for a local partner/owner. The Safe Water Network financial models predicted a monthly profit for owners or communities of $90–$100 per month, just about the per capita income for Ghana. To date, the Dzemeni project team had invested little time and energy in identifying and selecting potential long-term partners. The team’s time had been

Conclusion C-167

EX HIB I T 8

Projected Capital Costs at Tongor (CUV Treatment Technology)

Uses

US$

GHS

20,000

30,000

31,000

465,000

Tank cover

6,000

9,000

Shipping and clearing

8,000

12,000

10,000

15,000

5,000

75,000

Raw water storage (3 Polytanks of 25k litres each)

12,500

18,750

Treated water storage (3 tanks of 25k litres each)

12,500

18,750

Overhead tank

45,000

67,500

Local design and consultancy

20,000

30,000

Chlorination system

2,000

3,000

Electrical connection to source (including transformer)

6,500

9,750

Service points (6 & 3k)

18,000

27,000

3hp submersible pump

8,500

12,750

4 inch HOPE pipes (from source to plant)

15,000

22,500

2 inch HOPE pipes (for supply of treated water)

25,000

37,500

Sand media

5,000

7,500

Source pump sump

5,000

7,500

Working capital (post-opening)

15,000

22,500

Contingency

10,000

15,000

280,000

420,000

Local civil works (small office block, base of tanks, trenching, etc.)

$

Steel tank (Blue Filter quote) 150m3/day capacity

Tank welding supervisor (per Blue Filter quote) Blue Filter supervisor

Total Uses

Source: Safe Water Network, “Tongor-Dzemeni Case Study” [Internal Document] (June 2011).

filled with learning the business in the communities and achieving operational profitability. No one knew how easy it would be to find a partner with the passion, skill, and vision to run a safe water station even if the financial rewards were in place.

Conclusion Nimako and his team had made significant progress at Dzemeni. The team had created demand for safe water, the site was now operationally viable, and the Ghana and New York staffs both saw in Dzemeni the seeds of a financially sustainable solution to the clean water problem. Now that the Dzemeni system had established a track record of successful operations over the course of three years, Nimako wondered how the organization could optimally expand the system to serve the surrounding communities. What knowledge gained from their experiences should guide the development of a fully functional micro-utility system through both (1) expansion of safe water services into other nearby communities and (2) additional points of sale or distribution methods within Dzemeni. Nimako knew more sales points would improve access, convenience, and usage, but the existing pay-as-you-fetch model worked only for relatively centralized, high-volume remote kiosks. (Basically, the first 50 users paid the operator’s salary.)

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Safe Water Network

Likewise, if the company pursued a multitown micro-utility, what elements of the process should it replicate in order to deal with the inevitable cultural differences, even among local villages? How would the company solve the management challenges? Private system operators in Ghana have said that they would not be interested in managing a system as small as Dzemeni, so how would Safe Water Network select and train entrepreneurs to run a system that spanned several communities? Nimako began to think of some larger, more strategic questions as well. For example, should Safe Water Network partner and engage with the local or Ghanaian government? Government leaders often made promises to build municipal systems, usually during the election season. Municipal systems would represent a formidable competitor to the Safe Water Network’s model. Should Safe Water Network partner with the government to forestall entry and protect their investments? What opportunities existed to employ lower-cost treatment technologies than the system currently installed? The Dzemeni model worked for aggregated communities of 7,000 or more people, but could the organization create safe water stations to service smaller communities? Finally, should Safe Water Network rethink its financing approaches to support capital investment? Should it shift the business model to targeted philanthropic investment (with no repayment) rather than the current loan-based model? Would the financial rewards of ownership produce the outcomes Safe Water Network predicted and create dedicated and skilled local partners capable of running the community water business?

References http://www.safewaternetwork.org/team.asp, accessed March 8, 2013.

1

Internal Safe Water Network, FAQ, https://www.safewaternetwork .org/faqs, accessed February 19, 2013. 2

K. Soderland, http://www.safewaternetwork.org/Team.asp, accessed February 20, 2013. 3

Information on the leadership team of Safe Water Network taken from http://www.safewaternetwork.org/team.asp, accessed February 4, 2014.

rural poverty gap is 13.5 percent, meaning that the average household income of those living below the poverty line is 13.5 percent below $1.25 per day. Poverty gap data found at http://www.tradingeconomics .com/ghana/poverty-gap-at-rural-poverty-line-percent-wb-data.html, accessed February 19, 2013. Safe Water Network, internal documents.

13

4

Information drawn from internal Safe Water Network documents.

5

Calculated from data available through the World Bank, http://databank .worldbank.org/ddp/home.do?Step=3&id=4, accessed February 20, 2013.

Safe Water Network, “Remote Kiosks: A Path to Improved Economics and Coverage” [Internal Report] (2013).

14

Decentralized Safe Water Kiosks, pp. 8–9.

15

6

Ibid.

7

Safe Water Network, “Decentralized Safe Water Kiosks” [Internal Document] (August 2012), p. 3. 8

Safe Water Network, “Tongor-Dzemeni Case Study,” [Internal Document] (June 2011), p. 5. 9

Ibid.

10

Ibid.

11

This figure was calculated from the Poverty Gap Index, a measure designed to assess the intensity of poverty for those living in extreme poverty. The gap measures the average measured gap between the actual measured household income and the poverty line. For Ghana, the 12

Data on Ghana taken from http://www.ghanaweb.com/GhanaHome Page/geography/climate.php, and data for the United States taken from http://www.livescience.com/1558-study-reveals-top-10-wettest-cities .html, accessed February 20, 2013. 16

Decentralized Safe Water Kiosks, p. 10.

17

A description of different treatment technologies can be found at Engineers Without Borders, http://www.stevens.edu/ewb/docs /ME423_Fall_07_Phase_III_Group_10_EWB_-_Water_Purification.pdf, accessed February 21, 2013.

18

Personal communication between the case writer and Safe Water Network leaders.

19

http://www.safewaternetwork.org/Values.asp, accessed February 4, 2013. 20

CASE 15 Facebook at a Crossroads: Russian Interference in the 2016 Election “Trump says Facebook is against him. Liberals say we helped Trump. Both sides are upset about ideas and content they don’t like. That’s what running a platform for all ideas looks like.” —Facebook CEO Mark Zuckerberg,1 September 2017 “We are in a new world. It is a new challenge for internet communities to deal with nation states attempting to subvert elections. But if that’s what we must do, we are committed to rising to the occasion.” —Facebook CEO Mark Zuckerberg,2 September 2017 Elliot Schrage sighed. He had just finished streaming the testimony of the heads of the major United States intelligence agencies to the Senate Intelligence Committee. During those hearings, the Director of National Intelligence offered a sanguine assessment of the upcoming US congressional election cycle: “We expect Russia to continue using propaganda, social media, false-flag personas, sympathetic spokespeople, and other means of influence to try to exacerbate social and political fissures in the United States.”3 As vice president of communications and public policy at Facebook, Eliot had played an influential role in the company’s ongoing response to charges that its massive platform and user base had been co-opted and had become a tool for undermining the integrity of democratic elections around the world. Schrage was, frankly, less concerned about the 2018 election cycle—which would start in less than three months in some states—than he was about the long-term strategic position and identity of the social media giant. The company had taken a set of coordinated steps to combat known sources of untoward influence by Russian intelligence services, but only time would tell how the Russians had morphed their infiltration operation. The longer-term issue surrounded how Facebook perceived and marketed itself. Was the company in fact just a platform that brought people together for social interaction, or was it—as critics argued—a media and news organization? The difference had more importance than public perception; the designation as a social media platform, or Internet intermediary, protected Facebook from liability for the content its users posted. As a media company, Facebook would have a legal responsibility to monitor content on its site. The cost of monitoring billions of daily posts from Facebook’s 2 billion users would be astronomical.4 Whether a media or platform company, Facebook also faced the threat of regulation. Schrage glanced at a quote he’d found important enough to print out and place on his desk, a threat from Senator Diane Fienstein (D-CA) in November 2017 to Colin Stretch, Facebook’s General Counsel: “You created these platforms .  .  . and now they’re being misused. .  .  . And you have to be the ones who do something about it—or we will.”5 Doing something about Russian interference seemed to push Facebook in the direction of a media company: filtering (censoring) content beyond legal minimums, vetting truth claims in stories and posts, and

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ensuring that it provided consumers with balanced representation of perspectives on important issues. Schrage and others in the company realized that Facebook sat at the top of—if they not had already travelled significantly down—a slippery slope that could change the nature and strategy of the company. Like others in the company, he wondered about the company’s ethical and social responsibilities, not just its legal obligations, regarding the information on its site. Schrage clicked open his file on the company’s response as he thought about how the upcoming election might define Facebook’s identity.

The Rise of Social Media Facebook competed in and dominated the social media industry, defined as “websites and applications that enable users to create and share content or to participate in social networking.”6 The idea that technology and tools could improve networking, social interaction, and relationships did not begin with the Internet. Each improvement in communications technology, from the advent of postal services through the telegraph and to the telephone, enhanced people’s ability to communicate, share news and ideas, and deepen relationships. The technology of social media had always been a platform, and little else, that allowed people to connect with others. The first real digitally based, online, and scalable social media application appeared in 1979 in the form of UseNet, a platform that allowed users to communicate via a newsletter, articles, or posts to newsgroups. ListServ (1986) offered a functional improvement as users could now connect with many other users in a single email. In 1994, “The Palace” offered the first online, graphical chatroom. 1997 marked a new era in social media with the advent of SixDegrees.com, a site on the World Wide Web where users could upload pictures and connect with others. The site also allowed users to befriend each other and create expandable social networks. LiveJournal provided one of the first weblogging (blogging) sites in 1999. LunarStorm, launched in 2000, changed the business model as it became the first site underwritten by commercial advertisers. The site was a hit with young Americans, and 70 percent of its eventual 1.2 million members were aged 12–17.7 Myspace and LinkedIn were founded in 2003. LinkedIn was, and still is, the most popular social media platform for business professionals. Myspace represented the first large-scale site where users could create a unique profile and share information about themselves with others. The forerunner of Facebook, thefacebook.com, launched to a limited audience of Harvard students in 2004. In 2005, YouTube came online and allowed users to create and upload extensive video content. Reddit, “the front page of the internet,” a user-curated news site with thousands of threads, or sub-Reddits, also began in 2005. Twitter followed in 2006, the same year Facebook launched its service under a new name and URL.8 The rise of social media, along with the advent of the smartphone in 2007, changed how Americans interacted with each other, how they shared information, and how they received Facebook

1,871

WhatsApp

1,000

Facebook Messenger

1,000

QQ

877

WeChat

846 632

Qzone

600

Instagram Tumblr

350

Twitter

317

Baidu Tieba

300

Snapchat

300

Skype

300

EXHIBIT 1

Popular Global Social Media Sites, Ranked by Active Users, January 2017, in Millions

Source: Smartinsights.com51.

The Rise of Social Media

news of events and happenings in the larger world. As of the end of 2014, Pew Research estimated that two-thirds of the American population used social media, with rates among young users (18–29) approaching 90 percent. By 2016, the formal beginning of the US presidential election cycle, 62 percent of Americans received their news from social media, with 18 percent reporting that they used social media “often” and another 26 percent using it “sometimes.”9 Sixty-six percent of Facebook users reported that Facebook was where they turned for news. See Exhibit 1 for a ranking of the most popular social media sites and Exhibit 2 for the news sources consulted for users of each social media platform. Researchers from the Pew Foundation found that most people get news from only one site: 64 percent of survey respondents get news on only one site, 26 percent go to two sites, and only 1 in 10 social media users go to three or more sites.10 As the 2016 election cycle began, Facebook dominated the industry in both the number of users and the provision of news and information to those users. Exhibit 3 presents data about where social media users get their news. 70%

Reddit

66%

Facebook 59%

Twitter 31%

Tumblr 23%

Instagram

21%

YouTube

19%

LinkedIn

17%

Snapchat

14%

Vine EXHIBIT 2

Percentage of Users Who Use the Site as a News Source

Source: Pew Research52.

Local TV

Cable TV

Facebook

39%

Facebook

Network nightly TV

25%

Facebook

23%

YouTube

30

YouTube

24

YouTube

21

Twitter

30

Twitter

20

Twitter

21

Instagram

33

Instagram

Instagram

20

LinkedIn

33

LinkedIn

LinkedIn

23

46

All adults

YouTube

33 53 42

Instagram LinkedIn All adults EXHIBIT 3

23%

Facebook

YouTube

26

YouTube

Twitter

27

Twitter

LinkedIn All adults

30

Print newspapers

Facebook

Instagram 50

28

All adults

31

Radio

33%

Twitter

26

All adults

News websites/apps Facebook

25

21

Instagram 30

25

Where Social Media Users Go for News

% of news users of each site who often get news from… Source: Survey conducted Jan. 12–Feb. 8, 2016. “News Use Across Social Media Platforms 2016,” 53.

LinkedIn All adults

15% 13 8 12 15 20

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Facebook Mark Zuckerberg, a psychology student at Harvard with a penchant for computer programming, created thefacebook.com in 2004. The site represented his third effort; he had developed Coursematch, which allowed users to see who else at Harvard had the same major, and Facemash, a site where users could rate the physical attractiveness of others. The original site allowed users to create a personal profile and to share with others. Within 24 hours of launching thefacebook.com, over 1,200 Harvard students had signed up for the site, which soon spread to the rest of the Ivy League schools. In August 2005, the site became Facebook. com after Zuckerberg purchased the Facebook name for $200,000, and in September of that year Facebook extended its reach to US high school students.11 In September 2006, Facebook became a site open to anyone over age 13 who had a valid e-mail address.12 By May 2007, Facebook was already the sixth most visited website in the US,13 and by mid-2008 the site had signed up its first 100 million subscribers. As of January 2017, Facebook had over 1.8 billion registered users. Facebook, named after the student directory at Harvard that contained student pictures and profiles, entered the market two years behind Myspace, a site with a similar premise that had sold to Rupert Murdoch’s NewsCorp for $580 million in July 2005. Myspace would attract almost 76 million unique visitors a month at its peak in 2008, and in 2006 it surpassed Google as the most visited website in the United States.14 In contrast, Facebook had, in 2006, just closed a round of funding that added just under $13 million to its coffers.15 How did the young company hope to succeed? First, Facebook operated on a strong vision: “I’m here to build something for the long term,” Zuckerberg said. The core Facebook idea was that by providing an open platform where users could share information, human relationships would improve and the world would become a better place.16 Second, Facebook offered users things that Myspace didn’t, couldn’t, or wouldn’t. Shortly after its sale to NewsCorp, Myspace became a professionally managed company that worked to establish and scale its current offering and not evolve the site; Facebook, on the other hand, allowed its users—and the market in general—to set its direction and inform how the site would evolve in terms of features and functionality. The company worked to create technology that would enable its users to do what they wanted, from finding new friends on the site to playing games (think Farmville), and to easily upload content.17 Facebook was a platform for interaction and would respond to customer requests to improve the platform’s functionality. Third, Facebook differed from Myspace in what turned out to be critical design features. Myspace allowed users to design the look and feel of their own pages, which led to a “wild west” collection of radically different profiles. Facebook provided users with a predesigned template that gave the site a homogenous, pleasing look and feel. Myspace filled pages with various banner ads that added clutter to an already busy site, while Facebook limited advertising to the right-hand column of any page.18 Myspace also forced members to use pseudonyms, a barrier to “real” interaction on the site and an invitation for potential abuse by predators; Facebook encouraged people to use their real names, a practice that soon became commonplace throughout the social media sphere.19 No feature set Facebook apart more effectively than its News Feed, added in September 2006. Before the News Feed came online, Facebook users had to visit the individual profiles of friends to see new posts or information; they had to search the platform to find what they wanted. News Feed now brought the power of the platform to users; it became the new landing page that would constantly update to feature the latest posts and activities of the user’s friends as well as provide news content that appealed to particular users. News Feed made Facebook a dynamic website that offered users a constant set of new ways to interact on the site.20 The company’s post announcing the launch of News Feed touted this dynamic capability: “[News Feed] updates a personalized list of news stories throughout the day, so you’ll know when Mark adds Britney Spears to his Favorites. Now,

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whenever you log in, you’ll get the latest headlines generated by the activity of your friends and social groups.”21 In 2009, the company allowed users to “like” posts, pictures, or other content. The company added an algorithm to predict the news stories that would be most relevant to users based on their Facebook visit history, calling the concept “your own personal newspaper.”22 Users also gained the ability to self-filter their News Feed to only receive updates from people and groups they selected.23 In 2011, News Feed began to display a user’s News Feed by interest rather than chronology.24 These developments on the News Feed mirrored other algorithms at Facebook that allowed the company to microtarget advertising to a user’s known—and anticipated—preferences. This microtargeting capability contributed to strong revenue and profit growth at the company. Exhibit 4 provides data on Facebook’s user growth and revenues. Facebook dealt with the problem of users facing overwhelming information in their feed by narrowing the funnel. Critics noted that the News Feed led to an “echo chamber,” or a platform where users only get exposed to content they are likely to agree with. Academic studies confirmed the existence of this echo chamber; one study found that “the algorithm suppresses the diversity of the content you see in your feed by occasionally hiding items that you may disagree with and letting through the ones you are likely to agree with. The effect wasn’t all or nothing: for self-identified liberals, one in 13 diverse news stories were removed, for example. Overall, this confirms what many of us had suspected: that the Facebook algorithm is biased towards producing agreement, not dissent.”25 Facebook’s News Feed allowed users “to promote their favorite narratives, form polarized groups and resist information that doesn’t conform to their beliefs.”26 Ironically, the News Feed turned Facebook into a site that, instead of bringing people together, drove them apart. Facebook had developed a set of capabilities that allowed it to effectively filter information that users saw, to make sure they saw the types of information they wanted to see and were likely to act upon, and that they didn’t see things that challenged their opinion or world view. These capabilities would become central to the 2016 US presidential election.

EXH I B I T 4

Facebook, Registered Users and Revenues

Users (in millions)

Total Revenue (in millions)

2004

1

$

.4

2005

6

$

9

2006

12

$

48

2007

58

$

153

2008

100

$

272

2009

360

$

775

2010

608

$

2,000

2011

845

$

3,711

2012

1,056

$

5,089

2013

1,228

$

7,872

2014

1,393

$

12,466

2015

1,591

$

17,928

2016

1,860

$

27,638

2017

2,072

$

40,653

Sources: Registered user data from Statista, revenue data from various news articles.

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The 2016 US Presidential Election Facebook’s entry into the 2016 election fray came in winter of 2016 with the publication of an awkward post by the news site Gizmodo of an internal question for an all-hands meeting: “What responsibility does Facebook have to help prevent President Trump in 2017?” Gizmodo would follow that post with a headline in May: “Former Facebook workers: we routinely suppressed conservative news.”27 Facebook was seen by many, on the left and the right, as anything but a neutral platform for the sharing of ideas. Conservatives, liberals, and company executives began to worry that the platform was, or could be, much more than a mere facilitator of information; Facebook, with its dominant position in news dissemination, might be a powerful tool for influencing public opinion and individual electoral attitudes and behaviors. Gizmodo’s posts sparked a letter from Senator John Thune (R-SD) asking for answers from Facebook about potential bias. Facebook responded by hosting a day-long event for prominent conservatives at its Menlo Park headquarters. The company’s main message, as recounted by conservative icon Glenn Beck: “I asked [Zuckerberg] if Facebook, now or in the future, would be an open platform for the sharing of ideas or a curator of content. Without hesitation, with clarity and boldness, Mark said there is only one Facebook and one path forward: ‘we are an open platform.’”28 Late in the election cycle itself, and in the immediate aftermath of Trump’s unexpected victory, allegations surfaced that Russian intelligence agencies, often working through intermediaries, had used these same tools and capabilities to illegally and surreptitiously influence the outcome of the election through the dissemination of false news stories and posts aimed at making political issues more divisive. An army of Russian “trolls,” government agents and actors who posed as American citizens and created false profiles on Facebook, disseminated stories, opinion posts, videos, and memes that focused on such divisive issues as gun control, immigration, LGBT rights, and movements such as Black Lives Matter. Posts by Russian trolls were written to amplify and exacerbate divisions and tensions around these issues among readers.29 Exhibit 5 displays a sample of ads traced to Russian sources. Trolls initiated posts that were “scathing or defamatory towards Hillary Clinton. Widely circulated fake stories include accounts of Pope Francis endorsing the Republican candidate, Hillary Clinton murdering an FBI agent and President Obama ‘admitting’ he was born in Kenya.” These hoax stories appeared in the News Feed alongside fact-based posts, and many of these stories were picked up and shared by people sympathetic to the political ideology in the posts.30 The Internet Research Agency, posing as an independent organization, but allegedly sponsored by the Russian government, bought political advertisements on Facebook, an open violation of US election laws. Alex Stamos, Facebook’s chief security adviser, reporting on the company’s own internal investigation, noted that, “In reviewing the ads buys, we have found approximately $100,000 in ad spending from June of 2015 to May of 2017—associated with roughly 3,000 ads—that was connected to about 470 inauthentic accounts and Pages in violation of our policies. Our analysis suggests these accounts and Pages were affiliated with one another and likely operated out of Russia.”31 Estimates of the impact of these ads vary, with estimates ranging from 10 million to 135 million Americans viewing these false ads.32, 33 Five hundred posts from six known Russian-backed groups had been shared a total of 340 million times between Facebook groups and users.34 In an analysis of the use of Facebook by Russian entities, researchers concluded: Following the 2016 U.S. presidential election, many have expressed concern about the effects of false stories (“fake news”), circulated largely through social media. . . . Drawing on web browsing data, archives of fact-checking websites, and results from a new online survey, we find: (i) social media was an important but not dominant source of election news, with 14 percent of Americans calling social media their “most important” source; (ii) of the known false news stories that appeared in the three months before the election, those favoring Trump were shared a total of 30 million times on Facebook, while those favoring Clinton were shared 8 million times; (iii) the average American adult saw on the order of one or perhaps several fake news stories in the months around the election, with just over half of those who recalled seeing them believing them; and (iv) people are much more likely to believe stories that favor their preferred candidate, especially if they have ideologically segregated social media networks.35

The 2016 US Presidential Election

EXHIBIT 5

Russian-Backed Ads and Posts on Facebook

Source: Facebook.

The Director of US National Intelligence concluded: “Moscow’s influence campaign followed a Russian messaging strategy that blends covert intelligence operations—such as cyber activity—with overt efforts by Russian Government agencies, state-funded media, third-party intermediaries, and paid social media users or ‘trolls.’”36

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The Aftermath and Facebook’s Response On November 7, 2016, Donald J. Trump won the US presidential election; he earned 306 votes in the electoral college (270 votes needed to win), even though he lost the popular vote by just under 3 million votes. Trump’s election took pundits by surprise as most polls showed Secretary Clinton winning the election.37 Within days, accusations of Russian manipulation of the election emerged as a cause of the unexpected election outcome, and attention soon focused on the role of false news on Facebook. On November 11, 2016, Mr. Zuckerberg publicly questioned how much influence Facebook might actually have, saying, “I think the idea that fake news on Facebook—of which it’s a very small amount of the content—influenced the election in any way is a pretty crazy idea. . . . Part of what I think is going on here is people are trying to understand the results of the election. . . . I think there is a certain profound lack of empathy in asserting that the only reason why someone could have voted the way they did is because they saw some fake news.” 38 Zuckerberg’s comment reflected his deeply held belief that Facebook was, at its core, a platform and not a media company, but the comments appeared naïve to critics, both inside and outside the company; after all, Facebook’s entire pitch to advertisers was that running ads on the platform would influence user behavior. While a causal link between disinformation and false news and the election outcome would be almost impossible to prove, the potential for such influence—and the presence of false information—seemed beyond doubt to many. Investigations were initiated by independent researchers and US national security agencies, and Facebook ran its own internal investigation as well. These investigations identified and tracked the purchase of advertising by Russian-backed companies, the activity of false personae (Internet trolls), and a coordinated effort by Russian operatives to create momentum for the Trump campaign. In January, 2017, Facebook hired Campbell Brown, a former CNN anchor and respected journalist, to head up the company’s Journalism Project, an effort to come to grips with Facebook’s relationships with news and news media organizations, and to think hard about what kinds of moral and social responsibilities the platform had or should assume. As findings from the investigations came forward, Facebook executives realized that the Russian influence was anything but a “crazy idea.” In September 2017, Facebook officials responded to the reality of the Russian activity during the 2016 election. The company admitted that its site and systems had been abused but highlighted the difficulties it faced in monitoring and mitigating such abuse. Schrage himself stated: Even when we have taken all steps to control abuse, there will be political and social content that will appear on our platform that people will find objectionable, and that we will find objectionable. . . . We permit these messages because we share the values of free speech—that when the right to speech is censored or restricted for any of us, it diminishes the rights to speech for all of us, and that when people have the right and opportunity to engage in free and full political expression, over time, they will move forward, not backwards, in promoting democracy and the rights of all.39 Facebook moved away from the “crazy idea” that nation-states might use its platform and embraced the idea that the events surrounding the 2016 election—if replicated—could pose a threat to the integrity of democratic elections around the globe. Facebook began to move away from being a platform and toward being curator of content, the opposite of what Zuckerberg had told Glenn Beck months earlier. Company executives shifted the frame of the debate, and the rationale for Facebook’s response, away from business issues of advertising effectiveness, customer satisfaction, and profits to a moral quandary. COO Sheryl Sandberg noted that her company owed the American public an apology and described the mood at the company: “It’s not just that we apologize. We’re angry, we’re upset. But what we really owe the American people is determination.”40 On September 27, 2017, CEO Mark Zuckerberg posted a text and video message that outlined several concrete steps Facebook would implement to prevent further abuse. The company

The Aftermath and Facebook’s Response

would follow the adage articulated by Supreme Court Justice Louis Brandies a century earlier: “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”41 Exhibit 6 presents a screen shot of Zuckerberg’s Facebook post. He stated: Going forward—and perhaps the most important step we’re taking—we’re going to make political advertising more transparent. When someone buys political ads on TV or other media, they’re required by law to disclose who paid for them. But you still don’t know if you’re seeing the same messages as everyone else. So we’re going to bring Facebook to an even higher standard of transparency. Not only will you have to disclose which page paid for an ad, but we will also make it so you can visit an advertiser’s page and see the ads they’re currently running to any audience on Facebook. We will roll this out over the coming months, and we will work with others to create a new standard for transparency in online political ads.42 In December 2017, Facebook announced that it would hire 1,000 more screeners and begin to develop machine learning algorithms to help the company police its site for potential abuse by trolls and other purveyors of false information. Eric Gilbert, a University of Michigan

EXHIBIT 6

Zuckerberg Responds

Source: Facebook54.

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Facebook at a Crossroads: Russian Interference in the 2016 Election

computer scientist, noted that “much of that technology is years away from replacing people.”43 Screeners determined what constituted objectionable content and could be removed while protecting the right to free expression. For example, Facebook already banned content and advertising that promoted overt violence or “shocking content,” but the company announced an expanded goal: to shut down advertising that contained “subtle expressions of violence.”44 Facebook hoped to have 20,000 employees and contractors working on safety and security by the end of 2018. Facebook announced sweeping changes in its News Feed in January 2018. These changes, according the company, would provide a further layer of protection against false information and news, making it harder, but not impossible, for malicious content to appear and spread. The driving objective of the News Feed would change from providing “relevant content” that may interest a user and toward content that would encourage “meaningful interaction” between users on the site. For example, users would see fewer posts from third parties, such as news organizations, and more posts from friends and family, the logic being that posts from the latter would be more likely to encourage a meaningful response or even human interaction.45 Third-party News Feed items would be prioritized to feature posts from more trustworthy and reputable outlets, based on criteria such as public polling about the publisher, and whether people are willing to pay subscription fees to the publisher.46 Facebook committed to test the impact of having third-party logos appear more prominently with posts, and Facebook might condone paywalls, or access to subscription-only content on the News Feed. News Feed would deemphasize video, which Facebook deemed as a passive form of engagement, and also “likes” and “shares.” Comments, on the other hand, would improve the odds of a post appearing in the News Feed. The changes seemed to do little to overcome the “echo chamber” problem, as the News Feed might not include news stories that provided alternative viewpoints. The company felt that it had a legitimate interest in and responsibility to regulate and monitor content without becoming an “arbiter of truth.”47 According to Mark Zuckerberg, the changes to the News Feed were designed to encourage users to spend less overall time on Facebook. While this change responded to long-time critiques of the company that saw Facebook as addictive, the threat to revenue could be very real. If users failed to spend enough time on the site, or continue patterns of use and “likes,” Facebook’s advertising algorithms may not serve up the types of targeted ads that sponsors loved. In spite of the business risks, Zuckerberg saw the changes to the News Feed as a part of an ongoing evolution at Facebook, an iterative and interactive evolution that included the billions of Facebook users: “The world feels anxious and divided and Facebook has a lot of work to do—whether it’s protecting our community from abuse and hate, defending against interference by nation states, or making sure that time spent on Facebook is well spent.”48

The Next Steps As Schrage reached the last document in his file, he felt a sense of pride that Facebook had grown and matured in the aftermath of the election; the company accepted that its platform had been commandeered in ways that threatened the foundations of democratic elections and had taken substantive action to make such abuse harder in the future. As he thought about Facebook’s future, however, he saw the company at a crossroads, facing three choices: platform company, media company, or hybrid. First, Facebook could continue to view itself as a platform company and enjoy the legal protections of the 1996 Communications Decency Act that absolved platform companies (“Internet intermediaries” was the technical term) from legal liability for the content on their sites.49 That legal immunity also implied a moral immunity for platform companies that allowed them, in the name of free speech, to exercise very little control over how users behaved on the platform. That notion of immunity didn’t sit well with Schrage, Zuckerberg, and many inside Facebook who say that such a hands-off attitude had facilitated the Russian abuse. In response, Facebook had moved in the direction of a media and news company in that they more actively

References C-179

edited content on their site. Media companies had legal and moral requirements around their content; they needed to ensure that content presented as fact was truthful, and they had an obligation to provide consumers with a balanced view that incorporated differing perspectives. The second option for Facebook entailed becoming more like a media company, and perhaps expanding Campbell Brown’s Journalism Project into an internal news division. The company had taken a number of steps in this direction already, and there seemed to be a natural momentum moving Facebook along this path. Schrage saw a third option as well, one he called “platform +,” where Facebook would continue to operate primarily as a platform company but accept some level of moral and legal responsibility for content on its site. The recent changes, he felt, had moved the company into a “platform +” identity and strategy. The devil with “platform +” was in the details; finding a sustainable space between platform and media had not been easy so far, and the evolving nature of Facebook, and the emergence of new threats and little legal precedent, implied that “platform +” would require constant adjustment. Schrage noticed an article in his file by Harvard law professor Jonathan Zittrain that had helped his thinking over the past year. He agreed with how Zittrain framed the issue for Facebook: As we use these services, they learn more and more about us. They see who we are, but we are unable to see into their operations or understand how they use our data. As a result, we have to trust online services, but we have no real guarantees that they will not abuse our trust. Companies share information about us in any number of unexpected and regrettable ways, and the information and advice they provide can be inconspicuously warped by the companies’ own ideologies or by their relationships with those who wish to influence us, whether people with money or governments with agendas.50 Zittrain’s solution was for companies to accept their role as an “information fiduciary” and act accordingly. A fiduciary acts in behalf of another, and fiduciaries are bound by a long legal tradition to act with prudence as they work in behalf of the interests of those others. Zittrain argued for new legislation that would give the notion of an information fiduciary the weight of law; as long as companies acted as fiduciaries, they would be immune from legal liability around privacy or content issues. Schrage liked Zittrain’s idea as it would allow Facebook to migrate more fully into a media company without losing the protections it enjoyed as a mere content provider. He realized, however, that such legislation lay far in the future, but also that how Facebook performed its de facto duty as an information fiduciary would shape any eventual law. Was Facebook already a moral, if not legal, information fiduciary? What did those responsibilities entail if Facebook held fast to its identity as a platform company? What would they entail if Facebook continued down the slippery slope to becoming a media company? Could the company find a position as a “platform +” where it adopted some fiduciary duties but not others? Where did Facebook’s future lie?

References Cited in J. Shinal, “Mark Zuckerberg Responds to Trump, Regrets He Dismissed Election Concerns,” CNBC (September 27, 2017), https:// www.cnbc.com/2017/09/27/mark-zuckerberg-says-facebook -impact-on-2016-election-went-beyond-ads.html, accessed January 15, 2018. 1

M. Zuckerberg, Facebook post, September 21, 2017, https://www .facebook.com/zuck/posts/10104052907253171, accessed January 17, 2018. 2

M. Rosenberg, C. Savage, and M. Wines, “Russia at Work on US Midterms, Spy Chiefs Warn,” New York Times (February 14, 2018), p. A1. 3

4 N. Thompson and F. Vogelstein, “Inside the Two Years that Shook Facebook—and the World,” Wired (February 12, 2018), https://www .wired.com/story/inside-facebook-mark-zuckerberg-2-years-of-hell/, accessed February 14, 2018. 5 C. Newton, “Senators Blast Tech Companies over Russian Meddling: ‘Do Something About It—or We Will’,” The Verge (November 1, 2017),

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Facebook at a Crossroads: Russian Interference in the 2016 Election

https://www.theverge.com/2017/11/1/16591646/facebook-senate -hearing-feinstein-russia-google-twitter, accessed February 15, 2018.

www.huffingtonpost.com/zeynep-tufekci/facebook-algorithm-echo -chambers_b_7259916.html, accessed January 18, 2018.

“Social Media,” Oxford English Dictionary, https://en.oxforddictio naries.com/definition/social_media, accessed January 17, 2018.

26

6

7 M. Beck, “Pew Survey: Nearly Two-Thirds of All Americans Use Social Media,” Marketing Land (October 9, 2015), https://marketingland .com/pew-survey-nearly-two-thirds-of-all-americans-use-social -media-146026, accessed January 17, 2018; C. A. McFadden “A Chronological History of Social Media,” Interesting Engineering (June 29, 2017), https://interestingengineering.com/chronological-history-of-social -media, accessed January 17, 2018. Material also drawn from M. Riese, “The Definitive History of Social Media,” The Daily Dot (September 11, 2016), https://www.dailydot.com/debug/history-of-social-media/, accessed January 17, 2018. 8

McFadden and Riese.

J. Gottfried and E. Shearer, “News Use Across Social Media Platforms 2016,” Pew Research Center, Journalism and Media report, May 26, 2016, http://www.journalism.org/2016/05/26/news-use-across-social -media-platforms-2016/, accessed January 15, 2018. 9

Gottfried et al.

10

Information in this paragraph, to this point, taken from S. Phillips, “A Brief History of Facebook,” The Guardian (July 25, 2007), https://www .theguardian.com/technology/2007/jul/25/media.newmedia, accessed January 18, 2018.

11

“History of Facebook,” Wikipedia, https://en.wikipedia.org/wiki /History_of_Facebook, accessed January 18, 2018.

12

E. McGirt, “Facebook’s Mark Zuckerberg: Hacker. Dropout. CEO,” Fast Company (May 1, 2007), https://www.fastcompany.com/59441/facebooks -mark-zuckerberg-hacker-dropout-ceo, accessed January 18, 2018.

13

W. Mitchell, “Myspace—The Rise, Fall, and Rise Again?,” Startup Bros .com, https://startupbros.com/myspace-the-rise-fall-and-rise-again -infographic/, accessed January 18, 2018.

14

McGirt.

15

McGirt.

16

17 A. Hartung, “How Facebook Beat Myspace,” Forbes (January 14, 2011), https://www.forbes.com/sites/adamhartung/2011/01/14/why-facebook -beat-myspace/#2399b722147e, accessed January 18, 2018.

K. Kelleher, “How Facebook Learned from MySpace’s Mistakes,” Fortune (November 19, 2010), http://fortune.com/2010/11/19/how -facebook-learned-from-myspaces-mistakes/, accessed January 18, 2018.

18

M. Schenker, “Former MySpace CEO Explains Why MySpace Lost Out to Facebook So Badly,” Digital Trends (May 12, 2015), https://www .digitaltrends.com/social-media/former-myspace-ceo-reveals -what-facebook-did-right-to-dominate-social-media/, accessed January 18, 2018.

19

News Feed, see below.

20

S. Murphy, “The Evolution of Facebook News Feed,” Mashable (March 12, 2013), http://mashable.com/2013/03/12/facebook-news-feed-evolution /#Q3pKQwZUQPqj, accessed January 18, 2018.

21

Murphy.

22

Murphy.

23

“News Feed,” Wikipedia, https://en.wikipedia.org/wiki/News_Feed, accessed January 18, 2018.

24

Zeynep Tufekci, “Facebook Said Its Algorithms Do Help Form Echo Chambers. And the Tech Press Missed It,” Huffington Post, https://

25

C. Emba, “Confirmed: Echo Chambers Exist on Social Media. So What Do We Do About Them?,” Washington Post (July 14, 2016), https://www .washingtonpost.com/news/in-theory/wp/2016/07/14/confirmed -echo-chambers-exist-on-social-media-but-what-can-we-do-about -them/?utm_term=.b32eee072391, accessed January 18, 2018. Thompson and Vogelstein.

27

Quoted in Thompson and Vogelstein.

28

C. Leonnig, T. Hamburger, and R. Helderman, “Russian Firm Tied to Pro-Kremlin Propaganda Advertised on Facebook During Election,” Washington Post (September 6, 2017), https://www.washingtonpost .com/politics/facebook-says-it-sold-political-ads-to-russian -company-during-2016-election/2017/09/06/32f01fd2-931e-11e7-89 fa-bb822a46da5b_story.html?utm_term=.72c155c33d88, accessed January 17, 2018.

29

“US Election 2016: Trump’s ‘Hidden’ Facebook Army.” BBC trending, November 15, 2016, http://www.bbc.com/news/blogs-trending-37945486, accessed January 15, 2018.

30

A. Abramson, “Facebook Says Russian Accounts Bought $100,000 in Ads During the 2016 Election,” Time (September 6, 2017), http://time .com/4930532/facebook-russian-accounts-2016-election/, accessed January 17, 2018.

31

Romm, “10 Million People,” below.

32

B. Thornton, “Social Media, Fake News, and Free Speech,” Frontpage Magazine (December 4, 2017), https://www.frontpagemag .com/fpm/268572/social-media-fake-news-and-free-speech-bruce -thornton, accessed January 18, 2018. 33

Thompson and Vogelstein.

34

H. Allcott and M. Gentzkow, “Social Media and Fake News in the 2016 Election,” NBER Working Paper #23089, https://www.nber.org/papers /w23089, accessed January 17, 2018.

35

“Intelligence Community Assessment, Assessing Russian Activities and Intentions in Recent US Elections, 06 January, 2017,” Office of the Director of National Intelligence, https://www.dni.gov/files/documents /ICA_2017_01.pdf, accessed January 17, 2018.

36

For example, Nate Silver of the website 538.com had the odds of a Clinton victory at 71 percent based on a number of polls. See N. Silver, “Final Election Update: There’s a Wide Range of Outcomes, and Most of Them Come Up Clinton,” 538.com, November 8, 2016, http:// fivethirtyeight.com/features/final-election-update-theres-a-wide -range-of-outcomes-and-most-of-them-come-up-clinton/, accessed January 22, 2018.

37

K. Kokalitcheva, “Mark Zuckerberg Says Fake News on Facebook Affecting the Election Is a ‘Crazy Idea’,” Fortune (November 11, 2016), http://fortune.com/2016/11/11/facebook-election-fake-news-mark -zuckerberg/, accessed January 17, 2018.

38

T. Romm, “10 Million People Saw Russian Ads on Facebook Around the 2016 Presidential Election,” Recode (October 2, 2017), https:// www.recode.net/2017/10/2/16405900/russian-advertisements -facebook-2016-us-presidential-election-trump-clinton, accessed January 17, 2018.

39

40 “Sheryl Sandberg: Facebook Owes US an Apology over Russian Meddling,” The Guardian (October 12, 2017), https://www.theguardian .com/technology/2017/oct/12/sheryl-sandberg-facebook-owes-us -an-apology-over-russian-meddling, accessed January 22, 2018.

References C-181 Quotation and a description of Justice Brandies’ career can be found at https://www.brandeis.edu/legacyfund/bio.html, accessed January 22, 2018.

41

M. Zuckerberg, Facebook post, September 21, 2017.

https://www.wsj.com/articles/facebook-considers-prioritizing -trustworthy-news-sources-in-feed-1515714244, accessed January 19, 2018. Seetharaman, Alpert, and Mullin.

42

47

L. Weber and D. Seetharaman, “The Worst Job in Technology: Staring at Human Depravity to Keep It Off Facebook,” Wall Street Journal (December 27, 2017), https://www.wsj.com/articles/the-worst-job-in -technology-staring-at-human-depravity-to-keep-it-off-facebook -1514398398, accessed January 19, 2018.

48

43

K. Wagner, “Facebook Is Hiring Another 1,000 People to Review and Remove Ads,” Recode (October 2, 2017), https://www.recode.net/2017 /10/2/16395342/facebook-mark-zuckerberg-advertising-policies -russia-investigation-election-moderators, accessed January 17, 2018.

44

S. Maheshwari and S. Ember, “The End of the Social News Era? Journalists Brace for Facebook’s Big Change,” New York Times (January 13, 2018), https://www.nytimes.com/2018/01/11/business /media/facebook-news-feed-media.html, accessed January 19, 2018. 45

46 D. Seetharaman, L. Alpert, and B. Mullin, “Facebook to Overhaul How It Presents News in Feed,” Wall Street Journal (January 11, 2018),

Maheshwari. Thompson and Vogelstein.

49

J. Balkin and J. Zittrain, “A Grand Bargain to Make Tech Companies Trustworthy,” The Atlantic (October 3, 2016), https://www.theatlantic .com/technology/archive/2016/10/information-fiduciary/502346/, accessed February 15, 2018.

50

https://www.smartinsights.com/social-media-marketing/social-media -strategy/new-global-social-media-research/attachment/top-social -network-sites-by-number-of-active-users-2017/, accessed January 17, 2018. 51

52 Available at http://www.journalism.org/2016/05/26/news-use-across -social-media-platforms-2016/, accessed January 15, 2018.

Pew.

53

See Zuckerberg, note 41.

54

CASE 16 CVS in 2015 From Neighborhood Pharmacy Provider to Healthcare Company “It’s my job as the CEO to ensure that we’re positioning the company for not just short term success, but long term success . . . We’re evolving into more of a health care company and we’re doing many things. We have 26,000 pharmacists and nurse practitioners, who are helping millions of patients across the country every day, manage conditions like high blood pressure, high cholesterol, [and] diabetes.” Larry J. Merlo, CEO of CVS Health in 20141 As Larry J. Merlo, CEO of CVS Health, looked up from the morning news reports, his eye drifted to a picture of his dynamic predecessor, Stanley Goldstein. Goldstein, his brother Sidney, and Ralph Hoagland, a Proctor and Gamble salesman, had founded Consumer Value Stores with a single health and beauty products store in 1963. From that single store in Lowell, Massachusetts, CVS had grown into a dominant player in the pharmacy and pharmacy services business, filling more than one in five prescriptions for Americans.2 With the just-announced acquisitions of Omnicare and Target’s in-store pharmacies, Merlo saw CVS as a dynamic and innovative player migrating from a pharmacy chain to a diversified healthcare provider. As he glanced back at the announcement, he wondered which assets he still needed in order to accomplish that vision.3

The Pharmacy Industry The pharmacy industry consists of firms engaged in the distribution of prescription and nonprescription drugs to consumers, divided into four major segments. Institutional pharmacies dispense drugs for inpatient use in healthcare facilities such as hospitals or long-term care facilities. Retail pharmacies fill prescriptions for individual customers in physical stores. Mail Order and Specialty pharmacies allow patients to access larger doses (90-day supplies) of regularly used prescriptions or provide drugs and related services for specialized medication regimes, such as infusion therapies, that can be used outside of hospitals. Finally, the Pharmacy Services segment provides prescription drug benefit management programs for various government entities (the federal Medicare program and state-run Medicaid programs), health insurers, and large employers who self-insure their employees.

Industry Drivers The industry originated at the turn of the twentieth century as the medical profession saw benefits to separating the prescribing of medications from the sale and dispensing of those drugs; the split avoided conflicts of interest in which physicians would prescribe medications C-182

The Pharmacy Industry

financially best for them at the expense of patient health.4 From the end of World War II through about 1990, the number of retail pharmacies in the United States remained constant at about 55,000 (See Exhibit 1).5 In 1950, more than 90 percent of all prescriptions were filled by neighborhood pharmacists, small stores with no more than a few geographically-limited operations. By 1990 that number would decline to 64 percent. By 2007, concentration in the industry had completely reversed, with 64 percent of revenue owned by the top four firms, and 68 percent garnered by the top 20 firms. The largest players by sales in 2014 were CVS (24 percent), Walgreens (16 percent), Express Scripts (12 percent), Walmart (6 percent), and Rite Aid (6 percent).6 Three interrelated factors drove this radical change in the industry. First, healthcare in the United States increasingly relied on pharmacology (drugs) as the solution to health problems. Much of this reliance came from innovation within the pharmaceutical industry, the major supplier to the pharmacy industry. Major pharmaceutical companies continued to bring new drugs to market, drugs often aimed at very specialized diseases. It now cost almost $2.6 billion to bring a new drug to market, more than double the cost a decade earlier.7 Many of these drugs targeted special maladies with small markets and long treatment regimens. For example, in 2013 Gilead Sciences gained FDA approval for Solvadi, designed to combat hepatitis C, at a cost of $84,000 for a 12-week treatment.8 Medicare expenses for the treatment of hepatitis C increased 15-fold, to $4.5 billion, in 2014. In spite of these specialty drugs, the increasing cost of inpatient treatment or professional services also drove the use of medication as a lower cost alternative. Second, and related to the first, the increasing sophistication of drugs, coupled with increased demand, resulted in ever-increasing drug prices. Exhibit 2 details average drug price

EXH I B I T 1

Growth in Retail Pharmacies, 1950–2105

CVS

CVS

Stores

Share

Year

Number

1950

55000

1970

55000

100

0.18%

1990

55000

1250

2.27%

1997

43000

3900

9.07%

2002

40234

4122

10.25%

2007

42045

6301

14.99%

2012

43338

7508

17.32%

2015

44638

9466

21.21%

N/A

Data sources: Schondelmeyer and Thomas (see note 5), Hoovers online CVS, Forbes (http://www.forbes .com/2003/09/29/cx_lw_0929mondaymatch.html), Statista (http://www.statista.com/statistics/241544/ cvs-caremark--number-of-stores-since-2005/). 2015 estimate contains 1,600 Target pharmacies.

EXH I B I T 2

Changes in Prescription Drug Prices, 1970–2013

Average Annual Increase

Average Annual Inflation

1970–1979

3.60%

8.70%

1980–1989

9.60%

5.00%

1990–1999

10–15%

2.75%

2000–2004

5–6%

2.43%

2006–2013

9.20%

1.95%

Data sources: 1970–1990, Schondelmeyer and Thomas (see note 5), 1990–1999, http://content .healthaffairs.org/content/20/5/43.full, 2000-2004: http://www.gao.gov/new.items/d05779.pdf, 2006–2013: http://www.aarp.org/content/dam/aarp/ppi/2014-11/rx-price-watch-report-AARPppi-health.pdf, U.S. Average annual inflation: http://www.usinflationcalculator.com/.

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CVS in 2015

increases in the United States during the last 45 years. The hyperinflation decade of the 1970s represents the only decade where consumer prices outpaced prescription drug price increases; since 2006 drug prices had outpaced core inflation by a factor of 4. Drug pricing increased from 5.5 percent of total healthcare spending in 1990 to 15 percent of private health insurance spending in 2014.9 The market for prescription drugs featured two buyers, often with differing objectives. Patients who took the drugs wanted whatever medication would solve their particular problem. Insurers, private insurance companies, large employer self-insurance plans, and Medicare and Medicaid providers looked to find the lowest cost drug with the highest probability of solving a patient’s medical issues. These third-party payers worked to align their incentives with patients, usually through the practice of co-pays and deductibles that shared costs with patients. In 2015, 25 percent of third-party payers offered only “high deductible” plans where patients incurred greater out-of-pocket expenses, nearly double the 13 percent only three years previously.10 Both buyer groups were becoming more price sensitive. Finally, the rise of prescription drug and healthcare costs in general, and the importance of healthcare to a full life, led to high levels of federal and state government regulation of the pharmacy industry. On the supply side, the FDA regulated pharmaceutical companies, and states all had their own licensing requirements for professional pharmacists. Since the introduction of Medicare and Medicaid in the 1960s, the federal government set reimbursement rates for most medical services for those covered by its plans. Private insurers often used these “shadow prices” to benchmark their own reimbursement rates. In 2003 George W. Bush signed the Medicare Prescription Drug, Improvement, and Modernization Act (MMA) into law and created Medicare Part D. Part D allowed retirees to purchase a private insurance supplement to their Medicare coverage that offset the cost of prescription drugs. Understanding and managing Part D expenses became an important part of succeeding as a pharmacy.

Industry Evolution The pharmacy industry sits in the middle of a value chain that connects patients, third-party payers, and the larger pharmaceutical companies. By the late 1960s, the pharmacy services segment began to emerge. With close to 90 percent of prescriptions still filled by local “mom and pop” pharmacies in small dollar amounts, an increasing number of prescriptions created an immense paperwork burden on insurers and employers who covered the costs of prescriptions. Pharmacy benefit management (PBM) companies offloaded this burden from third-party payers by using sophisticated computing resources and standardizing key elements of the process. Small pharmacies joined a PBM network, and the network handled the tasks of transaction processing.11 Two decades later, PBMs had grown in size and sophistication. PBMs were an early developer and user of “big data,” gathering data about what drugs were prescribed, drug interactions, and drug efficacy. As drug prices continued to rise in the late 1980s and 1990s, PBMs shifted their focus from being efficient providers of transaction and financial services into organizations focused on controlling drug cost increases. Using their massive databases about drug safety, interactions, and efficacy, PBMs developed drug formularies or lists that identified the most effective medications for different ailments. Formularies often recommended a generic drug instead of a higher priced, name brand drug. PBMs entered the arena of drug plan design and administration as third-party payers used formularies to control which drugs their plans would cover. PBMs earned money in one of, or a combination of, three ways. PBMs could arbitrage the negotiated price spread between suppliers and buyers. For example, CVS might negotiate a 20 percent discount for a medication, but pass only 19 percent on to network members. A PBM might choose to pass on all the discount, but charge a fee, either on each claim or a fee per member (capitation). PBMs also earned money by keeping volume-based rebates from pharmaceutical companies as a source of profit. By the end of the 1990s, PBMs had continued to expand their offerings into efforts to change patient behaviors, such as encouraging the use of generics or lower cost alternatives, using their massive data volume to help control prescription drug fraud and abuse, and continuing to refine formularies to create effective disease management protocols.

CVS Health C-185

The rise of the Internet in the late 1990s allowed PBMs to vastly enlarge a new distribution channel: mail-order pharmacies. They had been around since the US Veterans Administration offered mail-order prescriptions in the 1950s. With the Internet, patients using drugs to treat chronic, ongoing conditions could receive a 90-day supply of their medication instead of the traditional 30-day supply through a brick-and-mortar store. Consumers and insurers saved money through these volume discounts, and PBMs earned money as well. CVS, for example, operated four mail-order pharmacies to service the entire country. Without the expenses of retail locations and the need for customer interactions, mail-order pharmacies could fill prescriptions at high volumes and low costs. A high-volume local pharmacy might fill a thousand prescriptions each day, but a mail-order pharmacy would fill almost 500,000.12 The PBM industry had become large and fairly concentrated by the mid-2010s. PBMs provided prescription drug management services for more than 210 million Americans as of 2012.13 Express Scripts held the largest share at a little more than 28 percent, CVS had almost 27 percent, United Health captured 10 percent of the market, and Catamaran took a little more than 7 percent.14 At this scale, PBMs could effectively negotiate with the large pharmaceutical companies for the best prices for insurers, patients, and pharmacies in their networks.

Current Challenges With the rise in cost and complexity of specialty drugs, such as Solvadi and many drugs to treat cancer, multiple sclerosis, and HIV/AIDS, PBMs have turned to creating more specialty pharmacies. These pharmacies focus on products with high cost (minimum monthly cost of $600, but often approaching $10,000), and high touch (unique dispensing conditions and storage requirements, 24-hour access to specialists, high levels of patient interaction and education). Specialty pharmacies allow PBMs to leverage their volume advantages and dispense medications in a setting that ensures patient compliance and drug efficacy without the high costs of inpatient treatment. Specialty drugs represent a small fraction of total prescriptions filled, between 1 and 4 percent, but a large portion of total drug spending, between 25 and 30 percent.15 For example, a specialty pharmacy might provide patients with chemotherapy services and help avoid the costs of inpatient chemo treatments. Data about drug usage, efficacy, and safety continue to grow; in fact, most pharmacists know more about the different drugs patients take, and the interactions among them, than the prescribing doctors. A growing business for pharmacies involves creating collaborative agreements with physicians or other healthcare providers that allow pharmacists to perform, and be compensated for, services such as modification of current prescriptions, ordering lab services, or physical assessments of patients.16 PBMs and member pharmacies also use patient data to improve medication compliance, or getting people to take their medication as prescribed and in the recommended dosage. Estimates suggest that one-half of all patients fail to take medications as prescribed, almost 20 percent of new prescriptions are never filled, and the total healthcare cost of noncompliance reaches almost $300 billion, 13 percent of all health spending.17 As the Affordable Care Act (also known as Obamacare) rolled out and more people participated in the US healthcare system, the pharmacy industry was likely to continue to change in some expected, and unexpected, ways.

CVS Health Stanley Goldstein graduated from the Wharton School in 1955 and went to work with his brother Sidney as distributors of health and beauty products. In 1963 the brothers teamed up with a Proctor & Gamble salesman named Ralph Hoagland to open their own store: Consumer Value Stores. CVS sold health and beauty products at discounted prices, taking advantage of easing government restrictions on drug product pricing. The team founded their store on three principles: being constantly aware of what customers wanted, realizing that consumers valued

C-186

CVS in 2015

convenience as much as price, and providing employees with a great work environment. CVS paid workers more than competitors, offered health insurance benefits, and provided legendary holiday parties.18 Those three principles built a business. Within a year, the chain had expanded to 17 stores, and by 1967 had expanded from a provider of health and beauty products into the retail pharmacy space. Pharmacy sales effectively doubled in-store revenue.19

The Melville Era: Growth in the 1970s and 1980s In 1969 the chain was purchased by Melville Corporation, a retail conglomerate with a stable of brands that included mall stores such as shoe retailers Thom McAn and Footaction, and specialty retailers such as Kay-Bee Toys and Linens 'n Things.20 The company migrated into standalone general retail with the CVS acquisition, and eventually added the Marshalls brand. Melville, originally a shoe manufacturing company, had diversified into the larger specialty retail segment in order to accelerate growth. Melville acted as a holding company and provided its brands with rigid reporting discipline of key metrics for specialty retail success, active monitoring and oversight, and the use of corporate capital to invest in promising new brands.21 With a lean staff, Melville had made a series of smart acquisitions that contributed to 15 percent compounded earnings growth throughout the 1970s and 1980s.22 CVS contributed to Melville’s growth through a smart acquisition strategy that consistently grew the number of locations. The company bought 84 Clinton Drug and Discount stores in 1972, which deepened its presence in the Northeast but also provided a presence in the Midwest.23 In 1977 CVS purchased the Mack Drug chain’s 36 New Jersey stores; with these acquisitions and organic store growth, CVS ended the 1970s with more than 400 stores and $400 million in annual revenue. By 1990, CVS had tripled in size to more than 1,250 stores, fueled in large measure by its acquisition of 500 Peoples Drug Stores that year. During the 1980s, Melville’s sales and earnings had increased 300 percent.24

Focused and Strategic Expansion: The 1990s and 2000s The 1990s brought hard times for the Melville Corporation. While CVS accounted for 28 percent of the corporation’s revenue and operated in markets across the nation, other specialty retail brands suffered flagging sales growth amid the deep recession of 1991–1992. Big-box retailers such as Walmart began to offer branded merchandise at lower prices, and new specialty formats such as The Gap plied customers with in-house brands. Stanley Goldstein, now CEO and chairman of Melville, shuttered stores and ultimately broke up the business by selling Marshalls to rival TJX for $600 million and Kay-Bee Toys for $315 million. Wilsons Leather and This End Up generated additional cash through management-led buyouts. The Melville transformation was completed in 1996 as the company became CVS Corporation and completed the divestiture of its last other brand, Linens 'n Things, by 1997. CVS’ 1996 sales grew 10 percent to $4.3 billion, and profits shot up 16 percent.25 In the midst of the 1990s restructuring, CVS quietly created its own PBM, PharmaCare, providing drug management services for about one million Americans.26 By 1997, flush with cash from its divestitures and strategically focused on the pharmacy segment, a streamlined CVS moved quickly to expand its position with the purchase of Revco, an Ohio-based drug store chain active in 17 Midwestern, Southern, and Eastern states. With 2,500 new stores, CVS had again tripled its size. With the acquisition of 200 Arbor Drug stores in Michigan in 1998, CVS had 4,100 stores in 24 states, a dominant presence in the Detroit market, and revenues a little more than $15 billion.27 CVS closed out the decade with one final acquisition, designed to give CVS a leg up in the new millennium: for $30 million in stock, the company purchased Soma.com, an online pharmacy. CEO Tom Ryan noted, “It’s all about making life easier for the customer and giving them what they want.” Tom Pigott, CEO and founder of Soma.com, realized the potential for CVS to grow: “They’re going to start putting a dot-com on the bottom of three-quarters of a billion bags. How are you going to compete against that?”28 Exhibit 3 provides a summary of key events in CVS history.

CVS Health C-187

EX HIB I T 3

Timeline of Key Events in CVS History

Year

Key Event

1963

First Store

1967

First Pharmacies

1969

CVS Sold to Melville

1970

Chain Reaches 100 Stores

1972

Buys Clinton Drug and Discount

1974

$100 Million in Annual Sales

1977

Acquires Mack Drug Chain (NJ)

1980

408 Locations, $414 M in Sales

1988

CVS has 750 Stores, $1.6BB in Sales

1990

Buys 500 Stores from People’s Drug

1994

CVS Launches PharmaCare PBM

1996

CVS Spins Out of Melville

1997

Buys 2,500 Stores from Revco

1998

Buys 200 Stores from Arbor Drug (MI)

1999

Buys Soma.com for Online Refills

2000

CVS Buys Stadtlander Pharmacy

2004

CVS Acquires 1,268 Eckerd Stores & Eckerd Health Services

2005

CVS Partners with Minute Clinic (3 stores)

2006

CVS Acquires 700 Sav-on and Osco Drugs from Albertsons

2007

CVS and Caremark Merge

2008

Acquires 541 Longs Drug Stores

2011

CVS Caremark Exceeds $100 Billion in Sales

2014

CVS Purchases Coram, Specialty Infusion

2015

CVS Purchases OmniCare, Nursing Home Pharmacy

2015

CVS Buys 1,600 Target Pharmacies

Data: Case writer compilation from sources noted in case, CVS website.

Extending Dominance in the Pharmacy Industry: The 2000s CVS began the new millennium where it ended the old, in acquisition mode. CVS added a specialty pharmacy to the mix when it bought Pittsburgh’s Stadtlander Pharmacy in July for $125 million in cash. Stadtlander, with an annual revenue of $100 million, operated as a specialty pharmacy.29 Stadtlander generated its earnings through a different business model; where a CVS pharmacy sold high-volume drugs at thin margins, specialty pharmacies dispensed highmargin drugs to patients with chronic, difficulty-to-treat, or exotic conditions. CVS continued to expand its network of traditional pharmacies as well, with its purchase of 1,260 Eckerd stores in 2004 for $2.5 billion. Eckerd expanded CVS’s footprint into the Sunbelt states of Florida and Texas. CVS also acquired Eckerd’s mail-order pharmacy operations. With this acquisition, CVS became the largest pharmacy in number of stores, with more than 5,000 compared to Walgreen’s 4,300. CVS executives continued to position the company for growth in a new and expanding economy. In 2005 the company partnered with MinuteClinic to begin offering a new service to customers. Steve Pontius, Rick Krieger, and Doug Smith started QuickMedx (later changed

C-188

CVS in 2015

to MinuteClinic) as a kiosk in a Minneapolis Cub Foods grocery store in 2000. QuickMedx used nurse practitioners and physicians’ assistants to diagnose and treat common ailments such as strep throat, pink eye, and ear or sinus infections, and to do early pregnancy testing. The company marketed itself with the slogan “You’re sick, we’re quick,” and offered consumers convenient and fast care for a flat fee of $35.30 CVS hoped to establish MinuteClinics in a number of its traditional pharmacies. MinuteClinic would move CVS from a pharmacy provider to an overall healthcare provider, with the possibility of third-party reimbursement for clinical, as well as pharmacy, services. CVS purchased MinuteClinic in mid-2006 for $170 million.31 CVS ended the year just shy of $44 billion in total revenue. As 2006 drew to a close, CVS launched its most aggressive move yet, bidding $21 billion (all stock) for outstanding shares of Caremark. Caremark provided PBM services to a network of 60,000 retail pharmacies and managed drug benefits for a number of large employers such as the 4.5 million federal government employees, retirees, and their families. By contrast, PharmaCare, the in-house CVS PBM, counted the Chrysler Corporation as a large client with 183,000 enrollees.32 With the acquisition, CVS would extend its reach and power in the “back of the house” part of the pharmacy business. Coupled with CVS’s 6,300 retail pharmacies, the CVS/Caremark combination could combine customer-based services in ways that pure PBM companies could not. CVS made its bid in November 2006, shortly after Walmart announced plans to sell generic prescriptions for $4 through its in-store pharmacies. The Walmart announcement had driven shares of Caremark down by 17 percent.33 The country’s other PBMs took notice of the potential disruption, and one, Express Scripts, launched its own $26 billion (cash and stock) bid for Caremark, a premium of 15 percent over the CVS bid. Express Scripts wooed shareholders with the promise that an Express Scripts/ Caremark combination would provide at least $100 million in additional costs savings (and profit) for Caremark over what it would get through the CVS offer. Express Scripts would also combine its strengths in prescription management with Caremark’s mail order and specialty pharmacy strengths. With a market cap roughly one-third of Caremark’s ($9 billion to $23.45 billion for Caremark), Express Scripts would fund the deal by increasing the debt load on its balance sheet. Express Scripts leaders hoped to negotiate a cooperative agreement but indicated a willingness to engage in a shareholder vote if needed. Negating the merger agreement with CVS would cost Caremark a $675 million termination fee. After four months of contesting the merger, which eventually went to a shareholder vote, Caremark chose to accept the now $26.5 billion bid from CVS.34 A deal with Express Scripts faced uncertain prospects in an anti-trust review, but the merger with CVS would create a complementary vertical merger rather than a horizontal one. Express Scripts would eventually buy Medco for $29 billion in 2011, becoming the largest PBM company with revenues of $116 billion.35 CVS and Caremark would both benefit through larger size and greater negotiating leverage. CVS gained access to Caremark’s excellent mail order and specialty operations, while Caremark could now offer its customers promotions and discounts at CVS retail outlets. During the next three years, CVS would invest $110 million in new information systems to help integrate the two companies.36 CVS changed its name to CVS/Caremark and was a market leading competitor in both the retail and PBM segments of the industry. Exhibit  4 provides selected financial data on CVS from 2009 to 2014.

Charting New Territory: The 2010s and Beyond CVS/Caremark continued to grow through acquisition. In 2008 the company extended its reach into the western United States and Hawaii with a $2.9 billion (cash tender offer) acquisition of 541 Long’s Drugs.37 With a new focus as a healthcare provider, CVS took the name CVS Health as it continued to move into new markets. Its 2014 purchase of Coram for $2.1 billion represented an extension of its specialty pharmacy business into the specialty infusion niche. CVS hoped to win in this new segment by reducing patient therapy costs (its own data indicated that homebased infusion treatments cost less than hospital or clinic-based ones), bringing order and scale to this fragmented, emerging segment, and capitalizing on the expected growth in infusion therapy. Several infusion-based drugs looked to become top-10 selling drugs by 2020.38

CVS Health C-189

EX HIB I T 4

CVS Selected Financial Data

In Millions

Pharmacy Services Segment

Retail Pharmacy Segment

Consolidated Totals

$88,440

$67,798

$139,367

Gross profit

4,771

21,277

25,367

Operating profit

3,514

6,762

8,799

2014 Net revenues

630

1,205

1,931

Total assets

Depreciation and amortization

42,302

30,979

74,252

Goodwill

21,234

6,908

28,142

308

1,745

2,136

$76,208

$65,618

$126,761

Gross profit

4,237

20,112

23,783

Operating profit

3,086

6,268

8,037

560

1,217

1,870

Total assets

38,343

30,191

71,526

Goodwill

19,658

6,884

26,542

313

1,610

1,984

Additions to property and equipment 2013 Net revenues

Depreciation and amortization

Additions to property and equipment 2012

$73,444

$63,641

$123,120

Gross profit

Net revenues

3,808

19,091

22,488

Operating profit

2,679

5,636

7,210

517

1,153

1,753

Total assets

36,057

29,492

66,221

Goodwill

19,646

6,749

26,395

422

1,555

2,030

$58,874

$59,599

$107,100

Gross profit

3,279

17,468

20,561

Operating profit

2,220

4,912

6,330

433

1,060

1,568

Total assets

35,704

28,323

64,543

Goodwill

19,657

6,801

26,458

461

1,353

1,872

$47,145

$57,345

$95,778

Gross profit

3,315

17,039

20,219

Operating profit

2,361

4,537

6,137

Depreciation and amortization

Additions to property and equipment 2011 Net revenues

Depreciation and amortization

Additions to property and equipment 2010 Net revenues

390

1,016

1,469

Total assets

Depreciation and amortization

32,254

28,927

62,169

Goodwill

18,868

6,801

25,669

234

1,708

2,005

Additions to property and equipment Source: CVS 10 K Filings, 2014, 2011.

C-190

CVS in 2015

2015 brought further activity with the $12.7 billion dollar purchase of Omnicare, the largest provider of pharmacy services to nursing homes. Omnicare took CVS into the institutional pharmacy segment, the only area of the business where CVS had no presence. Larry Merlo commented on the Omnicare deal: “With this acquisition, we will significantly expand our ability to dispense prescriptions in assisted living and long-term care facilities serving the senior patient population. And again, with the population aging, more people are projected to use assisted living facilities and independent living communities in the coming decades, creating a substantial growth opportunity for us.”39 The June purchase of 1,600 Target pharmacies for $1.9 billion extended the company geographically in all 50 states, and it gave the chain a brand presence inside locations that might be viewed as competition. Target gained immediate scale on its pharmacy operations and access to the CVS Health PBM network; likewise, CVS would now boast the largest retail pharmacy chain with 9,500 locations.40 One out of every five retail pharmacies would now be owned and operated by CVS. With the Target acquisition, CVS would gain another venue to place MinuteClinics and other diagnostic services. On the flip side, however, CVS would need to figure out how to create a complementary relationship with the Target brand, merchandise, and retailing philosophy. Larry Merlo glanced briefly at what he had said just a few months previously about Omnicare. He felt confident that CVS had made good moves and was well positioned for the future. Nevertheless, two questions haunted him. First, how would CVS respond to a world of declining reimbursement rates for prescription drugs? Would CVS see margin erosion in a lower priced world, or would massive scale continue to provide CVS with adequate profits? How would entering the institutional pharmacy affect scale and CVS’ ability to contain costs? Second, what were the short- and long-term implications of CVS becoming more of a healthcare provider? Could the company continue to provide value as an alternative to institutional (hospital and clinic) based medical care? How would third-party insurers respond? What were the risks in this new business model?

References http://www.cbsnews.com/news/cvs-ceo-larry-merlo-on-plan-to -stop-selling-tobacco-products/, accessed November 27, 2015. 1

CVS, 2014 10-K Filing, p. 6

2

“CVS to Buy All of Target’s Pharmacy Stores—A Win-Win for Both,” Forbes, June 30, 2015, http://www.forbes.com/sites/greats peculations/2015/06/30/cvs-to-buy-all-of-targets-pharmacy-stores-a -win-win-for-both/, accessed November 27, 2015. 3

See AMA code of ethics for more information: http://www.ama-assn .org/ama/pub/physician-resources/medical-ethics/code-medical -ethics/opinion806.page?, accessed November 27, 2015. 4

S. W. Schondelmeyer and J. Thomas, “Trends in Retail Prescription Expenditures,” Health Affairs, 9 (3) (1990): 131–145, http://content .healthaffairs.org/content/9/3/131.full.pdf, accessed December 7, 2015. 5

C. Ornstein, “New Hepatitis C Drugs Are Costing Medicare Billions.” The Washington Post, June 29, 2015, https://www.washingtonpost.com/ national/health-science/medicare-spent-45-billion-on-new-hepatitis -c-drugs-last-year-data-shows/2015/03/29/66952dde-d32a-11e4-a62f -ee745911a4ff_story.html, accessed November 27, 2015. 8

Data for 1990 from J. D. Kleinke, “The Price of Progress: Prescription Drugs in the Health Care Market,” Health Affairs 20 (5) (2001): 43–60. Data from 2014 from “Medical Cost Trend: Behind the Numbers 2015,” PWC Health Research Institute, http://www2.census.gov/econ2007/ EC/sector44/EC0744SSSZ6.zip, accessed November 27, 2015. 9

Data from PWC Health Research Institute, Behind the Numbers, 2016 ed., http://www.pwc.com/us/en/health-industries/behind-the -numbers/assets/pwc-hri-medical-cost-trend-chart-pack-2016.pdf, accessed November 27, 2015.

10

6 “2014’s Top Pharmacies: Specialty Shifts Industry Leadership, http://www.drugchannels.net/2015/01/2014s-top-pharmacies -specialty-shifts.html,” accessed November 28, 2015.

11

R. Mullin, “Cost to Develop New Pharmaceutical Drug Now Exceeds $2.5B,” Scientific American, November 24, 2014, http://www .scientificamerican.com/article/cost-to-develop-new-pharmaceutical -drug-now-exceeds-2-5b/, accessed November 27, 2015.

12

7

“The ABCs of PBMs,” National Health Policy Forum, October 27, 1999, http://www.nhpf.org /library/issue-briefs/IB749_ABCsofPBMs_ 10-27-99.pdf, accessed November 27, 2015. “An Industry Leader, VA Mail Order Pharmacy Service Delivers,” http://www.blogs.va.gov/VAntage/18632/an-industry-leader -va-mail-order-pharmacy-service-delivers-quality-quantity/, accessed November 27, 2015.

References C-191 “Pharmacy Benefit Management Industry Report,” IBIS World, 2015, accessed November 28, 2015.

13

Ibid.

14

The PWC HRI report cited above provides the 4%/25% number. The 1%/30% number comes from Delliotte Consulting, “The PBM Industry: A Sea of Change,” February 16, 2015, http://blogs.deloitte .com/centerforhealthsolutions/the-pbm-industry-a-sea-of-constant -change/, accessed November 27, 2015.

15

“Policy 101: Collaborative Practice Empowers Pharmacists to Practice as Providers,” http://www.pharmacist.com/policy-101 -collaborative-practice-empowers-pharmacists-practice-providers, accessed November 27, 2015. 16

“Medication Adherence: A $300 Billion Problem,” http://adhereforhealth .org/who-we-are/medication-adherence/, accessed November 27, 2015. 17

P. Grimaldi, “Drugstore Pioneer Stanley Goldstein Looks Back,” The Providence Journal, May 11, 2006, http://www.bigpicture .org/2006/05/drugstore-pioneer-stanley-goldstein-looks-back/, accessed November 30, 2015.

18

I. Barmash, “Retailing: The Specialty Case of Melville Corp,” New York Times, Business Day, April 4, 1982, http://www.nytimes .com/1982/04/04/business/retailing-the-special-case-of-melville-corp .html?pagewanted=all, accessed November 30, 2015. 19

Ibid.

20

“Will BBBY Take You for a Bath?,” http://seekingalpha.com/article/ 1113311-will-bbby-take-you-for-a-bath, accessed November 30, 2015.

21

Grimaldi, cited above.

22

“CVS Corporation—Company Profile, Information, Business Description, History, Background Information,” http://www.referencefor business.com/history2/23/CVS-Corporation.html, accessed November 30, 2015. 23

Ibid.

24

J. Steinhauer, “Melville Plans to Split into 3 Companies,” New York Times (Business Day), October 25, 1995, http://www.nytimes .com/1995/10/25/business/company-reports-melville-plans-to -split-into-3-companies.html, accessed November 30, 2015.

25

Melville Corporation, 10K Filing, March 31, 1995, http://edgar.sec .gov/Archives/edgar/data/64803/0000891092-95-000026.txt, accessed November 31, 2015.

26

CVS, 10K Filing, March 31, 1999, http://edgar.sec.gov/Archives/ edgar/data/64803/0001029869-99-000377.txt, accessed November 30, 2015.

27

L. Johannes, “CVS Agrees to Buy Soma.com for $30 Million in Stock Deal,” The Wall Street Journal, May 18, 1999, http://seekingalpha.com/ article/1113311-will-bbby-take-you-for-a-bath, accessed November 30, 2015.

28

S. Rubenstein, “CVS ProCare to Acquire Stadtlander Pharmacy,” The Street, July 5, 2000, http://www.thestreet.com/story/987898/1/ update-cvs-procare-to-acquire-stadtlander-pharmacy.html, accessed December 1, 2015. 29

P. Albro, B. Aull, R. Fitzgerald, J. Goldsmith, T. Harris, and J. Mohraz, “MinuteClinic: Bringing Change to Healthcare Delivery” The Tuck School, http://faculty.tuck.dartmouth.edu/images/uploads/faculty/ ron-adner/Minute_Clinic.pdf, accessed December 1, 2015.

30

“CVS to Buy MinuteClinic,” Minneapolis St. Paul Business Journal, July 13, 2006, http://www.bizjournals.com/twincities/stories/2006/07/10/ daily30.html, accessed December 1, 2015.

31

32 A. Sorkin, “CVS to Buy Caremark in All Stock Deal,” New York Times, November 1, 2006, http://www.nytimes.com/2006/11/01/business/ 01cnd-drug.html?_r=0, accessed December 1, 2015.

“Caremark RX, CVS Confirm Merger Talks,” CNN, November 1, 2006, http://money.cnn.com/news/newsfeeds/articles/djf500/200611010757 DOWJONESDJONLINE000532_FORTUNE5.htm, accessed December 4, 2015.

33

E. Rusli, “Caremark Approves CVS Merger,” Forbes, March 16, 2007, http://www.forbes.com/2007/03/16/caremark-approves-update -markets-equity-cx_er_0316markets29.html, accessed December 1, 2015.

34

R. Abelson and N. Singer, “FTC Approves Merger of the Biggest Pharmacy Benefit Manager,” New York Times, April 2, 2012, http://www .nytimes.com/2012/04/03/business/ftc-approves-merger-of-express -scripts-and-medco.html, accessed December 1, 2015. 35

36 G. Gruman, “CVS Creates Order, and Savings, by Integrating an Acquisition,” InfoWorld, June 1, 2009, http://www.infoworld.com/ article/2632516/it-management/cvs-creates-order--and-savings--by -integrating-a-big-acquisition.html, accessed December 1, 2015.

“CVS Caremark to Buy Longs for $2.9 Billion,” New York Times, August 12, 2008, http://dealbook.nytimes.com/2008/08/12/cvs -caremark-to-buy-longs-for-29-billion/, accessed December 1, 2015. 37

See M. Townsend, “CVS Agrees to Buy Apria’s Coram Unit for $2.1 Billion,” Bloomberg Business, November 27, 2013, http://www. bloomberg.com/news/articles/2013-11-27/cvs-agrees-to-buy-apria-s -coram-unit-for-2-1-billion, accessed December 1, 2015. See also A. Fein, “3 Reasons Why CVS Absorbed Coram,” http://www.drugchannels .net/2013/12/3-reasons-why-cvs-caremark-absorbed.html, accessed December 1, 2015.

38

W. McConnell, “CVS’ Omnicare Merger Creates a Muscular Stake in Medicare,” The Street, June 17, 2015, http://www.thestreet.com/ story/13186257/1/cvs-omnicare-merger-creates-a-muscular-stake-in -medicare.html, accessed December 1, 2015.

39

T, Team, “CVS to Buy All of Target’s Pharmacy Stores—A WinWin for Both,” Forbes, June 30, 2015, http://www.forbes.com/ sites/greatspeculations/2015/06/30/cvs-to-buy-all-of-targets -pharmacy-stores-a-win-win-for-both/, accessed December 1, 2015.

40

CASE 17 Uber Technologies Inc. Uber, a company providing peer-to-peer shared car rides through a smartphone app, was founded by Travis Kalanick and Garrett Camp in San Francisco, California, in March 2009. Within four years, by June 2014, Uber was operating in 130 cities, garnering $2 billion in net revenue, and was valued at $18.2 billion. With these impressive statistics came an aggressive international expansion plan. Traditional transportation methods such as taxis and other conventional pick-up services, including Express Shuttle, were quickly being overtaken by this innovative car hire transportation service.1 As Uber pursued multiple international markets, the ride-sharing company quickly encountered a multitude of lawsuits, competitors, and idiosyncrasies of local transportation markets. As of 2015, Uber was engaged in 173 lawsuits within the United States alone, as well as a litany of foreign government backlashes including raids in the Netherlands, a criminal trial of two top executives in France, proposed new regulations in London and Toronto, and an all-out ban of all services in Rio de Janeiro.2 Many of these lawsuits and outcries were attributed to illegal actions by Uber-employed drivers, such as sexual assault, theft, and even murder, casting a negative light on the overall image of the innovative company.3 Furthermore, Lyft, a new entrant in 2012, had successfully muscled its way into a position of 20 percent market share.4 By branding itself as a more community-oriented and friendly alternative to Uber, Lyft made a more trustworthy impression on the international community, even partnering with Chinese powerhouse corporations Alibaba and Tencent to produce the China-operated Didi Kuai to compete directly with Uber in China.5 In spite of the competition, in early 2016, the popular ride-sharing app had close to 8 million users in 58 countries and more than 300 cities worldwide. Speaking at a private event in Vancouver, British Columbia, in early 2016, Travis Kalanick, Uber CEO, made a solemn admission. Because of fierce competition in the Chinese market, he announced, Uber suffered losses of more than $1 billion in 2015.6 This severe loss underscored the daunting task the company faced in overcoming its tarnished image and responding to increased competition. While Kalanick remained hopeful, by 2017, the ride-sharing company faced new challenges to secure its position and its future (see Exhibits 1 and 2 for select financial information).

Uber Company Background

C-192

While attending the LeWeb conference in Paris, France, old-time friends Travis Kalanick and Garrett Camp stumbled upon the idea for Uber.7 Travis had recently sold his company Red Swoosh to Takamai Technologies for $19 million, and Garrett had sold his company StumbleUpon to eBay for $75 million and was doing “hard time” at a big company.8 During the conference, these two friends engaged in a pleasant conversation regarding the many inconveniences in life, the most poignant of which was waiting for a taxi in the rain in San Francisco, unable to waive down a vacant one. The entrepreneurs immediately began to brainstorm solutions to this problem. They quickly became convinced that the transportation industry was long overdue for an innovative makeover. Although the details remained clouded, it was clear that the solution needed to be fast and mobile.

Uber Company Background

EXH I B I T 1

Key Financials—Uber, 2014–2016 [$ million]66

1st Half of 2014

1st Half of 2015

1st Half of 2016

Net Revenue

247

663

2060

Total Cash

980

4150

~8000

1470

3630

8800

Gross Bookings

EXH I B I T 2

Selected Costs—Uber, 2014–2015 [$ million]67

1st Half of 2014 Sales & Marketing

123

1st Half of 2015 295

Research and Development (R&D)

32.95

94.7

General and Administrative

58.85

178.7

Operations and Support

79.95

159.1

Promotions and Price Cuts

28.65

72.0

Driver Incentives

43.3

130.1

Following the conference, Garrett spearheaded production of the idea, working earnestly to figure out what an iPhone app might look like and taking the name UberCab for the project. Despite sizeable progress, UberCab remained a side project for Garrett, who had again become CEO of StumbleUpon following its spinoff by eBay. This required Kalanick to ramp up his involvement. Taking the role of UberCab’s chief incubator, Travis was to run the company temporarily, get the product to prototype, and see Uber through its San Francisco launch. In January 2010, after $200,000 in seed funding and months of development, UberCab performed its first test run. With three cars cruising the Union Square, Chelsea, and Soho areas, UberCab had officially begun. With only the push of a few buttons, customers could download the Uber app to their phones, submit general personal and credit card information, and “order an Uber” from any location. Each ride required a pickup and drop-off address and in turn provided an estimate of the cost of a customer’s trip; all payments were handled through the app. No cash or even tips were exchanged between the driver and the customer during the ride. By the end of March, and with an expanded core team that included Oscar Salazar and Ryan Graves, Uber had successfully performed a beta launch in San Francisco, garnering enough interest to generate $1.25 million in additional funding. By the end of 2011, Uber had raised $44.5 million in funding. That same year, the company changed its name from UberCab to Uber. In May 2011, Uber commenced its aggressive expansion plans, opening in New York, Chicago, and Washington, D.C. (see Exhibit  3, Uber rides by city over time). The company continued to expand in smaller US cities, as well as overseas markets throughout 2012–2013, building a presence in European cities, including Paris and London, as well as Toronto, Canada, and Sydney, Australia, and later moving into the Asian cities of Seoul, South Korea, Beijing, China, and New Delhi, India. In India, Uber launched a new pricing option known as UberX, a lower-cost alternative in which the passenger was picked up by a driver in a typically modest sedan.9 Uber also expanded to less-developed countries, including Mexico, Pakistan, and Nigeria. In June 2014, Uber was valued at more than $18.4 billion. Less than a year later, in May 2015, the company announced that it planned to raise roughly $2 billion in funding, which would skyrocket the valuation to more than $50 billion.10 With its aggressive international expansion tactics cutting into domestic taxi markets, some regions pushed back on Uber. Spain, two cities in India, Berlin, Milan, Sao Paulo, and other cities banned the service.11 Taxicab drivers all over the world called for a ban against Uber in their cities as well, in some cases organizing large-scale protests and even bringing lawsuits against the company.12

C-193

Uber Technologies Inc. LOS ANGELES

20,000

Number of Active US Driver-Partners

C-194

SAN FRANCISCO NEW YORK

15,000

CHICAGO WASHINGTON DC BOSTON

10,000

MIAMI ATLANTA ORANGE COUNTY DALLAS SAN DIEGO DENVER PHOENIX SEATTLE BALTIMORE PHILADELPHIA MINNEAPOLIS

5,000 AUSTIN

HOUSTON

0 0

10

20

30

Months Since UberX Launched EXHIBIT 3

Uber Rides by City over Time68

Note: Figure reports the number of U.S. UberBLACK and UberX driver-partners making at least 1 trip in the specified month, indexed to the number of months since Uber began in the city or June 2012, whichever came later. Source: From Jonathan V. Hall, Alan B. Krueger, “An Analysis of the Labor Market for Uber’s Driver-Partners in the United States”, Copyright 2018. Reproduced with permission of Sage Publishers.

History of the Sharing Economy The success of Uber was part of the rise of what had been dubbed the “sharing economy,” the concept that each person possesses unemployed resources that can be rented to peers through a coordination mechanism, such as a smartphone app. With the technological boom came a massive drop in coordination costs, which made the possibility of sharing or renting personal assets an increasingly convenient reality. In addition to cars, the sharing economy promoted a wide variety of asset sharing, including homes, washing machines, office space, surfboards, loft storage, boats, lawn mowers, and even cocktail dresses.13 The sharing economy had grown at an astonishing rate. Airbnb, founded in 2008, totaled 155 million guest stays by 2014, whereas Hilton Worldwide, founded in 1919, reached only 127 million total guest stays by the same year.14 Projections by PricewaterhouseCoopers (PwC) showed that global revenues from the top sharing economy sectors could jump from $15 billion in 2016 to $335 billion by 2025.15 Beyond Airbnb, which offered more than 250,000 rooms in more than 30,000 cities in 192 countries, many other firms in the sharing economy had extensive offerings.16 Within retail sharing, Yerdle was an app designed to enable people to give away their “stuff” for credits on the app, which could then be used to buy other peoples’ “stuff.”17 Similarly, Poshmark promoted the exchange of unwanted clothing, essentially allowing users to shop other users’ closets.18

Competition C-195

While these companies were expected to achieve high growth rates in the next ten years, many complications arose for firms in the sharing economy. In a survey of end customers who had tried the sharing economy, 57 percent agreed that they were intrigued about the idea but held reservations and concerns about some of the companies; 72 percent believed that the sharing economy experience was not “consistent”; 69 percent refused to use sharing economy companies until they were given a positive recommendation by a trusted acquaintance.19 Richard Steinberg, CEO of DriveNow at BMW, summed up the largest problem facing sharing economy firms: “The biggest challenge all of us have in the shared economy is insurance. And insurance—whether it’s your house, your car, your driver—is really a fragmented market. [Insurance companies] don’t know how to deal with people occasionally using their asset. There are major issues around people who don’t understand the risks they’re taking on. So this is a real area for attention by the insurers—making sure that people know what they’re doing in terms of the risks they’re taking if they list their asset or use someone else’s asset in the sharing economy.”20 Within the sharing economy market, there had been cases of extreme damage to goods and crimes.

Competition Lyft While Uber opened the frontier for global organized car sharing, with relatively low barriers to entry, competitors such as San Francisco–based Lyft and Chinese company Didi Chuxing (formerly Didi Kuaidi), soon entered the market. Lyft was launched in June 2012 by Logan Green and John Zimmer as a service of Zimride, a ride-sharing company the two founded in 2007 that focused on longer, city-to-city trips. Lyft, targeted more toward shorter trips, is an app that connects passengers to drivers. Exactly like Uber, Lyft drivers and passengers both rate each other after a ride, which gives credence to both drivers and passengers for future “lyfts” (see Exhibit 4 for feature comparison).21 In July 2013, Lyft sold Zimride to Enterprise Holdings to focus exclusively on the growth of Lyft.22 Since 2012, Lyft had raised more than $1 billion from high-profile investors such as Alibaba, Rakuten Inc., Coatue, and Andreessen Horowitz, bringing the company valuation to about $2.5 billion.23 On January 4, 2016, Lyft announced a partnership with General Motors to achieve a common goal of accelerating their share in the ride-sharing market.24 In order to establish greater trust between passengers and drivers, Lyft implemented several screening processes to ensure the safety and positive experience of their users. All drivers were meticulously screened through a seven-year background check as well as personal interviews with Lyft personnel. Potential drivers were required to hold a driver’s license for at least a year and were expected to adhere to Lyft’s stringent zero drug or alcohol policies. After they were hired, drivers were eligible for a $1 million commercial liability insurance policy that could be maintained only by earning excellent ratings from passengers. These insurance benefits were meant to incentivize greater quality of service and discourage unprofessional and inappropriate behavior on the part of the driver (see Exhibit  5 for key differences between Uber and Lyft).25

EX HIB I T 4

Feature Comparison69

Uber

Lyft

Curb (App for Taxis)

Didi Chuxing

Mobile App Payment

Yes

Yes

Yes

Yes

Split Fares

Yes

Yes

Yes

Yes

No Tip Soliciting

Yes

Yes

No

No

Luxury Options

Yes

Yes

No

Yes

C-196

Uber Technologies Inc.

EXH IB IT 5

Key Differences—Uber & Lyft70

Avg. Wait Time % Using Competitor Avg. Cost per Mile Cities Serviced Service Types (#)

Uber

Lyft

4:16

4:10

11.09%

71.35%

$3.20

$4.20

184

224

5

3

Sidecar Founded in 2011, Sidecar not only provided ride-sharing services, but also B2B (business to business) delivery services.26 It had reached more than $10 million in funding and was backed by both Google Ventures and Lightspeed Venture Partners. But after facing legal challenges as well as intense competition from Lyft and Uber, Sidecar moved away from its ride-sharing services toward deliveries. By December 29, 2015, Sidecar had lost its battle in the industry and announced that it would be shutting down. The next month, General Motors acquired its assets and intellectual property following its $500 million investment in Lyft.

Didi Chuxing Home to one-sixth of the world’s population, China was an enormous country with enormous taxi service potential.27 While Uber wasted no time jumping into this market, local competitors, with their “home court advantage,” quickly surpassed Uber’s growth. The most formidable competitor in the Chinese market was Didi Chuxing (Chinese: 滴滴出行), which also launched in June 2012. Didi Chuxing was the most recent merger between Didi Dache and Kuaidi Dache.28 Translated directly into English as “drop-drop commuting,” Didi Chuxing was Alibaba and Tencent’s app-based taxi hiring firm. After just three years, in November 2015, Didi Chuxing was reported to own 83 percent of the market for car hire services in China, with its largest number of app-taxi-hire users.29 The service also claimed 90 percent market share within Beijing, with more than 1 million ride requests per day.30 Executives announced in January 2016 that the app had provided more than 1.43 billion rides during 2015.31 Didi Chuxing was valued at $20 billion in February of 2016, having raised more than $5 billion in funding.32 Compared to Uber, Didi Chuxing offered a wider variety of options, including traditional taxi-hailing, carpooling, two tiers of private car services, driver services, and even private bus services. Uber, however, offered more diverse payment options in China, including Alipay (only for Chinese residents), Baidu Wallet, and Visa or MasterCard, while Didi Chuxing accepted only cash, Alipay (for both locals and foreigners), and WeChat Payment. In September 2015, Didi Chuxing announced a partnership with Lyft, having invested $100 million to assist the two companies in taking on Uber. Concerning the investment, Lyft president John Zimmer called the deal “our first step toward global coverage.” It was expected that by May 2016, Lyft users would be able to summon rides through Didi Chuxing’s service network, delivering yet another painful blow to Uber’s presence in China. Though Zimmer declined to reveal the details of the partnership, it was apparent that Didi and Lyft investors were willing to place money wherever it hurt Uber the most. Tencent, one of Didi’s largest investors, had reportedly blocked Uber from its popular messaging app called “WeChat,” which held 697 million user accounts in support of both Lyft and Didi Chuxing. As a result, Uber had been losing roughly $1 billion per year in the market. In August 2016, Uber finally waved the white flag of defeat. In a stark signal of how difficult it is for American companies to thrive in China, Uber China sold itself to Didi Chuxing, its fiercest China competitor. Uber China, valued at $7 billion, and Didi Chuxing,33 valued at $28 billion, combined to form a new company with an approximate valuation of the two smaller firms together; Uber shareholders would receive a 20 percent stake in the new firm. With this deal, Uber joined the ranks of American peers such as eBay and Google, who also had been unsuccessful in establishing and capitalizing on early footholds in China (see Exhibit  6 for capital raised among ride–sharing companies).34

Competition C-197

EX HIB I T 6

Capital Raised (millions)

Ride Sharing Company

Total Capital Raised

Investor

Company Value

Didi

$7,400

Apple, Alibaba, Softbank, & Others

$28,00071

Uber

$8,710

Saudi Arabian Sovereign Fund, Goldman Sachs, Jeff Bezos

$68,00072

Lyft

$2,010

GM, Alibaba, Didi Chuxing

$5,50073

Ola

$1,230

Didi, Tiger Global Management

$5,00074

Grabtaxi

$1,430

Didi & CIC

$1,80075

The Taxicab Industry Since the early twentieth century, taxicabs had been escorting city-dwellers from one place to another. Despite dramatic and consistent technological developments during this time, the taxicab industry had remained a potent and prevalent force within the transportation industry, both on the domestic and international playing fields. The average city-dweller in New York and London spent an average of $238 on taxis annually, resulting in an $11 billion industry.35,36 With 239,900 drivers nationally, the industry maintained a consistent growth of 3.2 percent from 2009 to 2014.37 Despite constant growth up to 2014, Uber’s business model was expected to deal a heavy blow to the taxicab industry (see Exhibit 7 for proportion of business car expenses). Further debilitating the industry was the expensive medallion system to which taxicabs adhered. This medallion system was implemented in 1937 with the intent to control the quality and quantity of taxicabs, help ensure fair wages, and allow the drivers to legally transport passengers. While implemented with good intent, ride-sharing technology had brought the system under severe scrutiny, especially considering that the cost of procurement of a medallion ranged from $250,000 each in cities like San Francisco to $1,050,000 in New York. Given this kind of investment, owners had little flexibility in adapting to the new technology of app-based ridesharing. Uber and Lyft drivers did not require such a medallion to operate.38 Furthermore, annual net income for an Uber driver in New York averaged $63,128, compared to the paltry $31,553 of traditional taxicab drivers (see Exhibit 8 for rideshare growth forecast). In response to the disruption of the system, many taxi drivers complained via inc.com that “These new transportation systems lack the proper insurance, driver training, and passenger

60%

54.7% Uber + Lyft

50% 40%

48.7%

37.2% Car Rental

30%

Taxi

20%

37.3%

14.0%

8.1% 10%

Q2 2014 EXHIBIT 7

Proportion of Business Car Expenses76

Q2 2015

Q2 2016

C-198

Uber Technologies Inc.

E XH I B I T 8

Rideshare Growth Forecast, US, 201677

Year

Number of Ridesharers (millions)

% of US Adult Population

2014

8.2

3.4

2015

12.4

5.0

2016

15.0

6.0

2017

17.0

6.7

2018

18.2

7.1

2019

19.4

7.5

2020

20.4

7.8

E XH IB IT 9

Market Share Comparison in Number of Drivers, US, 2016

Rank

Company

Total Users

1

Taxis

239,90078

2

Uber

160,00079

3

Lyft

100,00080

liability measures” necessary to operate legally and ethically.39 In its efforts to influence regulations, the taxi industry spent $3,500 on state legislature lobbying for every $1 spent by Uber, Lyft, and Sidecar (see Exhibit 9 Market share comparison in number of drivers).40 Despite the disruption to the industry caused by Uber’s ride–sharing technology, there had been some positive results, the largest being emergent technologies and innovations improving the current taxi industry. Many privatized taxicab service providers have developed apps similar to Uber’s, enabling them to slow market share encroachment from Uber’s business model.41 One such app, Flywheel, is similar to Uber and Lyft and charges taxicab drivers a 10 percent commission for each ride referred by the app. Another app, Hailo, claims to have more than 60,000 qualified taxicab drivers using its service. However, despite the more standardized image maintained by taxicabs, Uber, Lyft, Didi Chuxing, and others were continually threatening to make taxicabs obsolete.

Uber’s Product Portfolio Uber continued to foster a culture of innovation by repeatedly developing and launching new products and services. While the original Uber app was still under development, the company created a think tank consisting of a nuclear physicist, a computational neuroscientist, and a machinery expert who worked on predicting demand for private hire car drivers.42 The think tank produced some of the most notable and most innovative creations from Uber to date, beginning with UberX in 2012, the original idea allowing local drivers to respond to notifications on the Uber app by driving customers in their own non-luxury vehicles (see Exhibit 10 for rideshare app usage in the United States).43 Uber offered its first non-car transportation option in UberChopper, an expensive helicopter service in the Hamptons of New York City, each ride raking up a tab of $3,000.44 In August 2014, Uber launched UberPool, a carpooling service with the intent to reduce fares below that of a typical subway ticket to further capture the price sensitive demographic.45 And later the same year, Uber released UberFresh in Santa Monica, a lunch delivery service that was later rebranded as

Uber’s Product Portfolio

E XH I B I T 10

C-199

Rideshare App Usage in US, 201681

Rank

Company

Percent Usage

1

Uber

37%

2

Lyft

10%

3

Side Car

2%

UberEats.46 The meal delivery service later operated in more than 50 cities across the globe and had been spun out as a stand-alone app (see Exhibit 11 for Uber service portfolio).47 Uber began delving further into the futuristic possibilities of its rapidly expanding business. In February 2015, it was announced that Uber would begin collaborating with Carnegie Mellon, the leading robotics and autonomous technology university, to establish a new business unit: Uber Advanced Technologies Center, a new research facility in Pittsburgh, Pennsylvania.48 Much to the chagrin of Carnegie Mellon, Uber hired 40 of Carnegie Mellon’s top researchers just two months later, including Chris Urmson, the former head of the Google self-driving car project.49 The goal? “To replace Uber’s more than 1 million human drivers with robot drivers—as quickly as possible.”50 A little more than a year later, on September 14, 2016, Uber launched its first fully autonomous self-driving car service to select customers in the Pittsburgh area, including Mayor Bill Beduto.51 Using landmarks, three-dimensional mapping, and other contextual information, these autonomous vehicles could keep track of their position. Uber maintained a fleet of Ford Fusion vehicles, each equipped with 20 cameras, seven lasers, a GPS, and associated radar equipment to accomplish the job.52 In July 2016, nearly coinciding with the launch of its self-driving fleet in Pittsburgh, Uber acquired Otto, a 91-employee driverless semi-truck startup founded earlier that year by a group of top engineers from Apple, Google, and Tesla.53 Included in this elite group of engineers were Anthony Levandowski, a lead engineer in Google’s self-driving division; Claire Delaunay, a lead engineer for Google robotics; and Lior Ron, the head of product at Google Maps.54 With these and the prior CMU hires, Uber now commanded the most capable self-driving research group in the world.

EX HIB I T 11

Uber Service Portfolio82

Service Name

Description

Year Launched

UberX

The original ride–sharing concept (4 passengers)

2012

UberXL

Larger vehicles, hosting up to 6 passengers

2012

UberSelect

Entry-level premium service (4 passengers)

2013

UberBlack [Black Car]

Large, premium service vehicle

2013

UberChopper

Commercial helicopter service

2013

UberRush

Small business and enterprise API delivery and logistics service

2014

UberPool

Carpooling service

2014

UberFresh

Meal delivery service

2014

UberBoat

Water-taxi service launched in Istanbul

2015

Uber Advanced Technologies Group

Fully autonomous self-driving vehicles for travel

2016

Street mapping

Uber began street mapping in order to determine the best pick-up and drop-off locations for its customers

2016

Otto

Autonomous semi-truck company with heavy engineering and Lidar talent

2016

(now UberEats)

C-200

Uber Technologies Inc.

But unlike many of its competitors, Uber never intended to build self-driving car hardware. Instead, leveraging the 100-plus million miles that Uber drivers log each day, the company intended to perfect the software brain of the car.55 “Nobody has set up software that can reliably drive a car safely without a human,” Kalanick said. “We are focusing on that.”56 Indeed, mapping, radar, and navigation capabilities are current bottlenecks in self-driving technology and could prove to be enormously valuable assets if Uber is able to license the technology out to the highest bidder among automakers desperate to adapt to the impending market shift toward autonomous vehicles. While the future of Uber was still uncertain, Merrill Lynch released a 2015 report predicting that by 2040, “robotaxis could make up as much as 43 percent of all [car] sales.”57 The Boston Consulting Group (BCG) went so far as to predict that robotaxis will make up “12 percent of global new car sales” as early as 2035.58

Changing Leadership and Going Public Coming under fire for various Uber driver-related crimes, including vehicular manslaughter, kidnapping, sexual assault, and physical assault, Uber had adopted several measures to combat their divisive image.59 These measures included background checks preventing any potential driver with histories of drunken driving, hit and runs, sexual violence or other illegal activity; biometrics and voice verification to screen drivers; GPS tracking of every ride; two-way feedback for every driver–rider experience; removing underperforming drivers; insurance policies up to $1,000,000; and new technologies allowing Uber riders to communicate instantly with Uber and loved ones in case of emergency.60 These procedures had already seen sizable effects, including a 10 percent reduction in DUIs.61 Although these measures had been extensive and thorough, Uber’s domestic and international image remained muddied. Exacerbating the product image damage was a series of leadership crises in 2017 as several high-profile sexual harassment allegations surfaced in company headquarters, and a private video was released showing Kalanick arguing with an Uber driver about low wages.62 In August 2017, the company announced that Kalanick would be stepping down as CEO and Dara Khosrowshahi, CEO of Expedia, would succeed Kalanick. Khosrowshahi forfeited his unvested stock options of Expedia, then worth $184 million, but Uber reportedly paid him over $200 million to take the CEO position. This move was designed to help the company move forward and improve its image as the company prepared for an IPO. Uber’s highly anticipated IPO occurred on May 10, 2019. The company priced its shares at $45 per share, leading to an initial market value of $75 billion. This was one of the highest valuations of any IPO from a tech company in history. However, the exuberance was mitigated by a gradual drop in the stock price over the ensuing months. By late August the stock was at $33, representing a 25 percent decrease in value since the IPO.

Looking Forward Uber had experienced remarkable growth since its inception in 2009. Revenues were projected to be roughly $12 billion by year end 2019 as the company continued to scale operations globally. However, while the company was growing rapidly, it was also losing significant amounts of money. In the company’s Q2 financial report in 2019 the company reported a loss of $1.3 billion on revenues of $3.1 billion.63 Despite Uber’s position as the global leader in ride-hailing services, Alyssa Altman of digital consultancy Publicis Sapient said Uber’s future was still in doubt. “Last year 5.2 billion people rode an Uber. In each of those trips, the company lost an average of 58 cents,” said Altman. “Uber continues to grow, and it’s fair to say it dominates the taxi-hailing market, but the company’s success is built on sand. The reality is that it still hasn’t made a profit. They need to have a reason for being and one that people value.”64

References C-201

Khosrowshahi’s response to criticisms of growth was to say that “Our story is simple. We’re the global player. Our job is to grow fast at scale and more efficiently for a long, long time.”65 As Khosrowshahi considered Uber’s future, myriad questions lay before him: How could Uber recover from massive losses in the Chinese market and propel itself to profitability internationally? Was Uber spending too much on global revenue growth and should it focus more on profitability? How could Uber improve its image in order to retain and grow its current customer base? Which new services should be launched, if any, to help the company achieve its goals? And ultimately would Uber’s business model be profitable?

References https://www.wsj.com/articles/uber-gets-uber-valuation-of-18-2-billion -1402073876 1

http://www.businessinsider.com/r-legal-troubles-market-realities -threaten-ubers-global-push-2015-10 2

http://www.cnn.com/2016/02/21/us/michigan-kalamazoo-county -shooting-spree/

3

http://www.businessinsider.com/lyft-ride-sharing-john-zimmer -2012-9 4

https://www.forbes.com/sites/liyanchen/2015/09/23/meet-ubers -mortal-enemy-how-didi-kuaidi-defends-chinas-home-turf/#4f80 f1396dce 5

6 http://betakit.com/travis-kalanick-speaks-out-ubers-ceo-on-risk -regulation-and-women-in-tech/

https://newsroom.uber.com/ubers-founding/

7

https://techcrunch.com/2007/05/30/ebays-stumbleupon-acquisition -confirmed-at-75-million/ 8

https://techcrunch.com/2013/07/12/lyft-zimride-enterprise/

22

http://www.businessinsider.com/r-lyft-raises-530-million-in -rakuten-led-funding-round-2015-3 23

http://media.gm.com/media/us/en/gm/home.detail.html/content /Pages/news/us/en/2016/Jan/0104-lyft.html

24

https://www.lyft.com/safety

25

https://en.wikipedia.org/wiki/Sidecar_(company)

26

https://en.wikipedia.org/wiki/China

27

https://www.crunchbase.com/organization/didi-dache#/entity

28

https://www.techinasia.com/didi-kuaidi-uber-china-market-share

29

https://phys.org/news/2016-10-chinese-ride-share-king-didi-chuxing .html 30

31 https://www.wired.com/2016/01/didi-kuaidi-announces-1-43-billion -rides-in-challenge-to-uber/

http://www.cnbc.com/2016/05/13/how-big-is-didi-chuxing.html

32

https://newsroom.uber.com/india/were-slashing-prices-by-25 -in-bangalore-2-2/

https://www.bloomberg.com/news/articles/2016-08-01/uber-said -to-merge-china-business-with-didi-in-35-billion-deal

https://www.wsj.com/articles/uber-valued-at-more-than-50-billion -1438367457

https://www.nytimes.com/2016/08/02/business/dealbook/china -uber-didi-chuxing.html

9

10

https://www.wsj.com/articles/sao-paulo-council-votes-to-ban-uber -1441841952 11

http://watchdog.org/173904/uber-effect-ridesharing/

12

13 http://www.economist.com/news/leaders/21573104-internet -everything-hire-rise-sharing-economy

https://en.wikipedia.org/wiki/Airbnb

33

34

35 https://dealbook.nytimes.com/2014/06/09/how-uber-pulls-in -billions-all-via-iphone/?_r=0

https://hbr.org/2014/12/making-sense-of-ubers-40-billion-valuation

36

https://en.wikipedia.org/wiki/Taxicab

37

https://en.wikipedia.org/wiki/Taxicabs_of_the_United_States

38

https://inc.com

14

39

15

https://www.pwc.com/us/en/technology/publications/assets/pwc -consumer-intelligence-series-the-sharing-economy.pdf

https://sunlightfoundation.com/2014/07/31/will-big-taxis-massive -political-spending-advantage-leave-ride-sharing-groups-stranded/

http://www.economist.com/news/leaders/21573104-internet -everything-hire-rise-sharing-economy

http://www.businessofapps.com/eight-uber-competitors -reinventing-taxi-apps/

16

https://www.yerdle.com/

17

http://www.businessinsider.com/how-to-use-poshmark-shopping -app-to-make-money-2016-2 18

40

41

42 http://marketinchoices.blogspot.com/2017/03/san-francisco-legal -market-marketing.html

https://en.wikipedia.org/wiki/Uber_(company)

43

19

file:///C:/Users/bryantjw/Downloads/2017-Sharing-Economy-Report -ALL-Chapters-Web-v1.pdf

https://newsroom.uber.com/us-california/soar-to-coachella-with -uberchopper/

https://bravenewcoin.com/news/lenderbot-by-deloitte-and -stratumn-to-bring-insurance-to-the-sharing-economy-using-bitcoins -blockchain/

45

20

https://en.wikipedia.org/wiki/Lyft

21

44

https://en.wikipedia.org/wiki/Uber_(company)

https://newsroom.uber.com/us-california/uberfresh-is-now -ubereats/ 46

https://newsroom.uber.com/ubereats-app/

47

C-202

Uber Technologies Inc.

http://fortune.com/2016/03/21/uber-carnegie-mellon-partnership/

48

https://www.wsj.com/articles/is-uber-a-friend-or-foe-of-carnegie -mellon-in-robotics-1433084582 49

http://www.bloomberg.com/news/features/2016-08-18/uber-s-first -self-driving-fleet-arrives-in-pittsburgh-this-month-is06r7on 50

https://qz.com/781151/why-is-uber-rushing-to-put-self-driving-cars -on-the-road-in-pittsburgh/ 51

https://www.revolvy.com/main/index.php?s=Strip_District,_Pittsburgh

52

http://www.bloomberg.com/news/features/2016-08-18/uber-s-first -self-driving-fleet-arrives-in-pittsburgh-this-month-is06r7on 53

https://www.independent.co.uk/news/business/news/uber -posts-1bn-loss-weeks-after-stock-market-float-a8938526.html

64

https://www.independent.co.uk/news/business/news/uber -posts-1bn-loss-weeks-after-stock-market-float-a8938526.html

65

https://www.forbes.com/sites/briansolomon/2016/01/12/leaked -ubers-financials-show-huge-growth-even-bigger-losses/#237e535236ba

66

https://www.forbes.com/sites/briansolomon/2016/01/12/leaked -ubers-financials-show-huge-growth-even-bigger-losses/#89f25e336bae

67

68 http://billypenn.com/2015/08/27/new-bill-seeks-to-legalize-rapidly -growing-uber-in-philadelphia/

https://en.wikipedia.org/wiki/Uber_(company)

http://www.bloomberg.com/news/features/2016-08-18/uber-s-first self-driving-fleet-arrives-in-pittsburgh-this-month-is06r7on

69

http://www.bloomberg.com/news/features/2016-08-18/uber-s-first -self-driving-fleet-arrives-in-pittsburgh-this-month-is06r7on

71

54

55

http://www.bloomberg.com/news/features/2016-08-18/uber-s-first -self-driving-fleet-arrives-in-pittsburgh-this-month-is06r7on 56

http://www.businessinsider.com/driverless-cars-may-lead-to-the -end-of-car-ownership-2015-11 57

http://www.businessinsider.com/driverless-cars-may-lead-to-the -end-of-car-ownership-2015-11 58

http://www.businessinsider.com/r-legal-troubles-market-realities -threaten-ubers-global-push-2015-10 59

https://www.uber.com/safety/

60

http://www.complex.com/life/2016/03/uber-decreasing-dui -numbers 61

https://www.nytimes.com/2017/03/07/technology/uber-travis -kalanick.html?_r=0 62

https://www.cnbc.com/2019/08/08/uber-earnings-q2-2019.html

63

https://quoted.thezebra.com/848/uber-vs-lyft/

70

https://www.crunchbase.com/organization/didi-dache#/entity https://www.crunchbase.com/organization/uber/funding-rounds

72

https://www.crunchbase.com/organization/lyft#/entity

73

https://www.crunchbase.com/organization/ani-technologies

74

https://www.crunchbase.com/organization/grabtaxi#/entity

75

https://venturebeat.com/2016/07/21/uber-dominates-q2-business -travel-as-taxis-sees-51-decline-in-past-2-years/ 76

https://www.emarketer.com/Article/How-Much-More-Ride-Sharing -Services-Grow-US/1013963 77

http://www.statisticbrain.com/taxi-cab-statistics/

78

https://www.usatoday.com/story/tech/2015/01/22/uber-drivers -pay-study/22159169/ 79

http://fortune.com/2016/03/20/lyft-drivers-owed-millions/

80

https://rideshareapps.com/2015-rideshare-infographic/

81

https://en.wikipedia.org/wiki/Uber_(company)

82

ONLINE CASE Amazon Verses Walmart: The Battle for Online Dominance Walmart.com’s CEO, Neill Ashe, announced in early 2013 that the online division of Walmart stores was on pace to reach its goal of $9 billion in revenue in its 2014 fiscal year (February 2013 through January 2014).1 In addition, Ashe noted that, after extensive website overhauls to improve search functionality and overall user experience, website traffic had increased 20 percent over the previous year, with over one-third of all visits coming from mobile devices. Ashe told reporters at Walmart.com’s media event that he felt that Walmart.com was demonstrating its ability to match any other e-commerce company. By combining its online capability with its massive retail operations, Ashe said Walmart was poised to “provide a commerce experience no one else can provide.”2 Ashe’s positive outlook obscured the long difficulties Walmart.com had experienced trying to compete with Amazon.com, the largest Internet retailer in the United States, and the uphill battle Walmart.com still faced. Even with revenue of $9 billion,3 Walmart.com was far behind Amazon’s $74 billion, suggesting that considerable growth would be needed if the company was to match Amazon’s online sales of products that fell into Walmart’s traditional sales categories. Company executives and the e-commerce branch had not always seen eye-to-eye regarding the importance of investing in online capabilities. The result was that Walmart.com did not receive the necessary funds to invest in state-of-the-art website design or online fulfillment systems during several years of its early history. With Walmart.com still behind Amazon, Mike Duke, CEO of Walmart Stores, had grown increasingly concerned that his company might have ramped up its efforts in online retail too late and would have to continually play catch-up with Amazon. In 2010, Walmart headquarters made new commitments to transforming its site in terms of navigability, search, and overall customer experience to take advantage of continuing ecommerce growth.4 Despite this, by 2013, Walmart.com accounted for just about 1.7 percent of total company sales.5 In the midst of these challenges and opportunities, Duke wondered what it would take for Walmart to finally participate in e-commerce revenues at a rate more consistent with its dominant retail store presence, and in particular, just how he could finally beat Amazon.

Walmart’s History Walmart grew from humble beginnings as a country discount store in Rogers, Arkansas, in 1962 to the world’s second largest public corporation.6 Sam Walton, the company’s founder, envisioned a retail store that offered low prices and great service. Focused on offering the “lowest prices anytime, anywhere,” the company grew rapidly. By 1972, Walmart was listed on the New York Stock Exchange, and its 51 stores recorded sales of $78 million.7 It reached $1 billion in sales in 1980, making it the fastest company to ever do so at the time.8 In 1983, the company opened its first Sam’s Club, a wholesale retail store, and installed a computer system 1

2 Amazon Verses Walmart: The Battle for Online Dominance E XH I B I T 1

Storewide Key Financials—Walmart, 2009–2013 ($ million)

2009

2010

2011

2012

2013

401,204

408,214

418,952

446,950

469,162

Net income

13,400

14,335

16,389

15,699

16,999

Total assets

163,429

170,706

180,663

193,406

203,105

98,144

99,957

109,416

117,241

121,367

2,095,000

2,100,000

2,100,000

2,200,000

2,200,000

Revenues

Total liabilities Employees Source: Marketline.

that brought additional cost savings by allowing stores to communicate product and inventory needs in real time via the company’s private satellite system, the largest in the United States.9 The first Walmart Supercenter, which combined general retail operations with a full-scale supermarket, opened its doors in 1988.10 Walmart became the largest retailer in the United States in 1990 and expanded internationally in 1991, with its first stores outside the United States located in Mexico. The 1990s were full of milestones as Walmart recorded its first $1 billion sales week (1992); expanded into Canada (1994), China (1996), and the United Kingdom (1999); and celebrated its first $100 billion sales year in 1997.11 In 2002, Walmart reached another milestone, topping the Fortune 500 list for the first time12 (see Exhibit 1 for Walmart financials). Initially, the company grew rapidly by increasing its number of retail locations worldwide. Walmart first introduced online shopping to customers via Walmart.com in 1996. Early versions of the website were slow and unattractive, and initial attempts at establishing market dominance online resulted in embarrassing failures. During the second half of the 1990s, companies such as online bookseller Amazon continued to expand into the Internet retailing market.

Amazon’s Backstory Amazon founder Jeff Bezos started his business by packing and shipping book orders out of his garage in 1995. The Internet, he believed, offered an ideal medium for delivering lower prices and better title selection to customers. Within two months of its launch, Amazon sales topped $20,000 a week.13 Amazon grew rapidly, went public in 1997, and began selling CDs and movies online. It was around 1999 that Amazon began morphing into the online retailer it is today. Bezos wanted Amazon to become the “Everything Store,”14 allowing customers to buy anything they wanted at the lowest prices and from the convenience of their own homes. After successfully transitioning from selling only books to general retailing, Amazon continued to grow its customer offerings and business. By 2013, Amazon had reached over $74 billion in revenue15 (see Exhibit 2 for Amazon financials).

E XH I B I T 2

Storewide Key Financials—Amazon, 2008–2012 ($ million)

2008

2009

2010

2011

2012

19,166

24,509

34,204

48,077

61,093

Net income

645

902

1,152

631

389

Total assets

8,314

13,813

18,797

25,278

32,555

Total liabilities

5,642

8,556

11,933

17,521

24,363

20,700

24,300

33,700

56,200

88,400

Revenues

Employees Source: Marketline.

The Battle for Online Dominance

Two Very Different Business Models Historically, Walmart and Amazon had very different business models. Walmart grew by employing a low-cost leadership strategy in brick-and-mortar stores. Amazon relied on an e-commerce-based model to drive its meteoric growth. A closer look at each business reveals important differences in each company’s respective strengths.

Walmart’s Principles of Retail Walmart had risen to world dominance by relying on the simple principles of retail: Buy and sell at low prices, enjoying thin profits margins but high sales volume. Although most retailers follow these basic rules of thumb, Walmart expanded volume further by passing much of the cost savings on to the end consumer through lower prices. By pricing low and driving volume, Walmart successfully pushed its competitors onto the sidelines by pricing everyday products lower than anyone else. In order to offer the lowest prices possible, Walmart worked hard to drive down its supply costs by negotiating lower prices from suppliers and reducing logistical expenses. As Walmart increased its stores, its bargaining power with suppliers increased. Eventually, Walmart became so large that the company was able to demand price concessions from suppliers who had come to rely heavily on Walmart’s business. Walmart also managed its logistics effectively. Shipping products from the manufacturers to the retail store can be a logistical challenge and, if managed poorly, could lead to higher costs. To address this, Walmart built regional distribution centers that stocked almost every item sold in its stores. Trucks then hauled products from the warehouses to the local stores. This distribution model resulted in inventory cost savings because products were pooled in regional superwarehouses and shipped more quickly to stores than if products were coming from a central distribution center. With its successful retail model, Walmart successfully and substantially increased demand for the products on the shelves and drove the company to record-breaking growth over a half century.

Amazon and E-commerce Unlike Walmart, which relied on brick-and-mortar stores, Amazon focused on an e-commerce business model in bookselling to launch its business. Without physical stores, online retailers eliminated the many costs typical retail operations incurred, including the construction and maintenance of stores or leases for store locations. Additionally, selling products over the Internet from central warehouse locations required a much smaller workforce to fulfill orders, giving Amazon and other online retailers an advantage over traditional retailers. Amazon’s initial business model wreaked havoc on the brick-and-mortar bookselling industry. Lower fixed costs allowed the company to pass cost savings on to its customers, which quickly led to increased market share. The Amazon model also allowed for a much greater selection of books than was available in typical stores. Instead of being limited to the titles stocked at a Barnes & Noble bookstore, Amazon customers had access to virtually any book published and carried by wholesale book distributors. After tackling books as a product category, Amazon extended its commerce into dozens of other categories.

The Battle for Online Dominance Walmart and Amazon had both risen to prominence in their respective spheres. As the companies continued to expand into overlapping areas, they began to see each other as relevant competitors. By the year 2000, Walmart had mastered the business of brick-and-mortar retail,

3

4

Amazon Verses Walmart: The Battle for Online Dominance

but its website was very basic, consisting of a list of categories and an electronic shopping cart. The company seemed to finally recognize the need to develop a stronger online business to combat Amazon’s encroachment in the retail product categories that Walmart had dominated. (See Exhibit 3–6 for size and growth of the online retail market.)

EXH IB IT 3

Online Retail Market Value, 2008–2012

Year

$ billion

2008

132.3

2009

133.4

2010

152.9

2011

172.5

2012

200.4

Source: Marketline.

E XH IB IT 4

Online Retail Market Value by Geography, 2012

Geography

$ billion

Europe

230.6

United States

200.4

Asia-Pacific

155.7

Rest of the World

45

Total

631.7

Source: Marketline.

EXH IB IT 5

Online Retail Segments, 2012

Category

$ billion

Electronics

43.8

Books, music, and videos

40.5

Apparel, accessories, and footwear

18.5

Other

97.6

Source: Marketline.

E XH IB IT 6

Projected Growth of Online Retail, 2012–2017

Year

$ billion

2012

200.4

2013

232.5

2014

259

2015

293.8

2016

331.1

2017

371.4

Source: Marketline.

The Battle for Online Dominance

The Early Years of Online Retail For Amazon, the Internet was its only distribution channel, and this allowed the company to bypass physical store locations completely. Walmart viewed its online activities as an extension of its physical stores. Amazon began its online business in 1995 with a focus on offering customers a less expensive and increased selection of books. At the time, Walmart’s only worry was that book sales would decline in Walmart stores as Amazon’s popularity grew. Although book sales represented a meaningful revenue stream for Walmart, they were in no way the company’s core business. Walmart’s initial website in 1996 was awkward and featured a digital version of a Walmart store greeter that drew ridicule from across the tech community as an embarrassing design blunder. It was clear that Walmart’s expertise in retailing failed to translate into online success. The company’s online fulfillment system was so dysfunctional that in 1999 the company announced that it could not guarantee pre-Christmas delivery of any online orders made after December 14.16 Walmart executives, however, didn’t seem to notice the company’s digital shortcomings. With Walmart expanding and building supercenter stores across the country at a rapid pace, company leaders had their plates full with the challenges of blazing growth in other areas. Many seemed to consider web sales an unproven and futuristic growth strategy, and they appeared to steer clear of a technology they didn’t quite understand. After a few years of successfully gaining market share in book sales, Amazon founder Jeff Bezos started to target brick-and-mortar retail stores. Bezos, who had been named Time’s Man of the Year in 1999 for popularizing online shopping, began to call for Amazon to become the “Everything Store.”17 Amazon expanded its original books-only model, slowly rolling out options to purchase CDs, DVDs, clothes, and even food online. Bezos recruited 15 Walmart Information Systems Division employees to work at Amazon, including Walmart’s former chief information officer, Richard Dalzell, to help the e-commerce retailer “expand its internet retailing system for selling books, compact discs, and drugs.”18 Walmart took notice of Amazon selling the same products online that it offered in its stores, and it filed a lawsuit, claiming Amazon had recruited Walmart employees in order to steal trade secrets. Although the two companies later settled out of court, the fierce competition between them became public. In 2000, Amazon added another innovation by allowing third-party retailers to sell on its site. These sellers—often direct competitors with Amazon—sold products on Amazon.com in order to take advantage of the higher website traffic. In addition, Amazon started an affiliate sellers program in which small websites that advertise or refer products found on Amazon.com would receive a finder’s commission.19 Walmart.com did not introduce its own third-party marketplace until 2009.20

Walmart.com’s Spinoff from Walmart In 2000, Walmart decided to spin off its website into a separate e-commerce business, Walmart .com, partnering with Accel Ventures, a Silicon-Valley-based venture capital firm that focused on investing in technology-based companies.21 The new company moved from Arkansas and established its headquarters in Silicon Valley. The move to California was made in hopes that proximity to the nation’s top hotbed of technology and talent would fuel an online experience that more closely matched customer preferences. Shortly after setting up shop in San Bruno, California, in the fall of 2000, managers at Walmart.com shut down the website for a month to revamp.22 The shutdown also came at a time when most retailers were ramping up operations in preparation for the holidays. Many internet savvy companies mocked Walmart for taking its site offline.23 Other e-commerce websites usually continued to operate while small updates and improvements were made to a site. By shutting down for an entire month, Walmart missed out on a month’s worth of sales (see Exhibit 7). In 2001, Walmart bought out Accel Venture’s ownership in Walmart.com to have complete control of its website.24 The retail giant announced the move was made to better integrate online and offline sales by removing any outside company’s ulterior motives. Historically,

5

6

Amazon Verses Walmart: The Battle for Online Dominance

E XH IB IT 7

Top Ten Holiday Retail Websites, Christmas Day 2012 (total US visits)

Rank

Websites

Visits

1

Amazon.com

2

Walmart

7,359,685

3

Target

3,591,384

4

BestBuy

3,431,900

5

Macy’s

1,949,547

6

Sears

1,881,690

7

Fandango

1,802,465

8

Kohls.com

1,738,424

9

Apple Store

1,728,247

10

J. C. Penny

1,576,870

24,657,838

Source: Experian Marketing Services.

in-store sales at Walmart had been backed by one of the strongest procurement and fulfillments systems, but online sales had frequently encountered hiccups in fulfilling orders through Walmart.com and were unable to do so in a timely and low-cost manner. By 2002, Walmart had yet to realize synergies between online and offline retail outlets. Physical store sales and locations continued to expand at a rapid pace, but Walmart.com grew only modestly. Although Walmart pulled in over $219 billion in gross revenues in 2002, earning the top spot on the Fortune 500 list25 and making it the only retailer in the list’s top 10, its website lagged when compared to those of other online retailers. In a 2002 comScore report that ranked e-commerce sites based on site traffic, Walmart came in number 13, trailing Yahoo Shopping, Dell, Barnes & Noble, and MSN Shopping.26 The list’s number one and number two spots were claimed by eBay and Amazon, respectively. The study results showed that Walmart .com had a long way to go if it ever wanted to compete favorably with Amazon.com. Analysts and the business world in general were baffled over Walmart’s inability to successfully make the transition to e-commerce. Surely, the company had enough expertise to be able to handle the logistics required to keep shipping costs low for online orders. And with the revenue from the stores and their stockpile of cash, Walmart could easily afford to invest in better technology to support its online push. But Walmart.com failed time and again to make any significant advances. Contributing to the holdup was a clash of cultures between store headquarters in Arkansas and e-commerce leadership in California. The website’s engineers were focused on generating high revenues and growing as sales continued to rise. Company executives in Walmart’s headquarters, however, looked at the online business in a totally different light. Historically, Walmart’s success had been driven by an intense and unrelenting focus on profits. The first stores were so successful because Walmart founder Sam Walton and other executives drove huge cost reductions from suppliers due to the increased demand its low prices sparked in customers. Since the 1960s, all business decisions had been made with one goal firmly entrenched in every Walmart executive’s mind: Reducing costs drives profitability. By contrast, tech companies often operated on net losses for years. In many cases, as a site built its user base and delivered true value to customers, it eventually became profitable. In fact, Amazon operated for years without making a profit. Walmart.com’s engineers, many recruited from successful tech companies, expected enough funding to get the website off the ground and running smoothly. Walmart executives, however, were unwilling to commit the funds that engineers thought were necessary for the website to gain real traction. One former executive said that each year Walmart.com would begin a “five-year planning exercise, but the plans were never executed and management would say the sales weren’t there to justify the

The Battle for Online Dominance

capital investment.”27 The bottom line was that Walmart.com’s slow growth owed in part to the fact that it did not have the funding it needed from Walmart headquarters. Headquarters would not give its online business the funding it asked for because it had not yet proven its success. The two conflicting viewpoints of conservative, cost-cutting headquarters and “spend big, earn big” Walmart.com created a major culture clash and significantly hampered Walmart’s efforts to establish an online presence.28

Prime, Ship-to-Store, and Other Services Both Amazon and Walmart introduced new services and products with the hopes of enticing customers to make purchases on their respective sites. Feeling the pressure to respond to Amazon’s expanding business, Walmart introduced two new services in 2002. The first, a stripped-down and low-priced version of America Online’s (AOL) Internet service, lacked features such as instant messaging (included in AOL’s $20/month version) but allowed users access to an unlimited dialup connection for under $10 per month.29 In addition to inexpensive Internet service, Walmart also started a Netflix-like DVD rental service that allowed subscribers to receive DVDs via email and keep them as long as they liked without late fees. Walmart.com priced this offering at a dollar under Netflix’s price at the time. Three years later, Walmart announced it would shut down its movie rental business in order to focus on selling instead of renting movies.30 Amazon also looked for new ways to increase demand for its products and grab more market share from other online shopping sites. In 2005, it launched Amazon Prime, announcing it as “Amazon.com’s first ever membership program. For a flat membership fee of $79 per year, [Prime] members get unlimited, express two-day shipping for free, with no minimum purchase requirement. Members also get one-day, overnight shipping for only $3.99 per item.”31 Prime later expanded its offerings, in 2011, to include instant video streaming for its members.32 Amazon hoped a flat membership fee would be more appealing to customers who had previously avoided or limited their use of online shopping due to high shipping costs. Executives at Amazon had expected Prime to break even in two years and were astounded to reach break-even after just three months.33 Prime subscribers increased purchases on Amazon by an average of 150 percent.34 In 2007, Walmart decided to leverage its existing physical store locations for shipping in hopes of boosting online sales.35 That year, Walmart.com began offering free shipping for any product a customer ordered online but picked up in their local Walmart store.36 Physical stores became a means of boosting sales on Walmart.com by catering to customers who wanted the convenience of ordering a product online without paying for the extra shipping cost. Walmart executives hoped that, by drawing more customers into stores to pick up online deliveries, they would also increase in-store sales. In the four months following the launch of the “Site to Store” program, Walmart announced customer savings in shipping fees of over $5 million. The company also announced that within the same period Site to Store orders had accounted for one-third of all Walmart.com purchases, with half of these purchases being made by first-time buyers on the site. These customers, Walmart reported, spent an additional $60 in stores while picking up their orders.37

Day of Reckoning Although the 2008 economic downturn helped Walmart in-store sales grow, it did little to reinforce the company’s gaping deficiency in e-commerce. Furthermore, as the country emerged from the effects of the recession, consumers flocked to online shopping in greater numbers than ever before (see Exhibit 3). More and more traditional Walmart Stores customers complemented or even replaced in-store purchases with online orders from its rival, Amazon.38 As sales in the physical stores leveled off, Walmart’s rapid store building push also tapered off. From 2009 to 2010, Walmart cut its new store development rate in half.39 Sensing that a seismic shift toward online commerce was underway following the recession, Walmart committed to expanding online sales by appointing Eduardo Castro-Wright, the

7

8 Amazon Verses Walmart: The Battle for Online Dominance

former head of Walmart Stores in the United States, as the new CEO of Walmart.com in 2010. As customers continued to grow more tech-savvy, Walmart’s goal was to integrate the customer shopping experience across every channel of the business, including online. Castro-Wright said, “It’s fair to say that up until about a year ago, when Mike Duke defined what we call the next generation of Walmart as a major initiative for the company, that probably we were not as keenly devoted to creating the kind of shopping experiences across all channels that we are doing today.” Walmart executives hoped an integrated buying experience would help it develop the know-how and experience Walmart.com needed to compete with Amazon and other successful e-commerce sites (see Exhibits 8 and 9). However, given its poor online track record, many analysts were doubtful that Walmart could catch up. “They’re definitely late to the game,” Natalie Berg, co-global research director at London researcher Planet Retail, commented. “And it does not sound like they have a coherent strategy in place.”40 Ignoring the naysayers, Walmart began a new chapter for its online presence by aggressively acquiring new technologies, restructuring its organization, and experimenting with new innovations in its product offerings and supply chain.

Technology Acquisitions Aware that its online shopping experience lagged behind many competitors, Walmart began to acquire small technology companies in hopes of quickly ramping up its technological capabilities. EXHIBIT 8

Online Traffic Trends, 2012–2013

Amazon

Walmart

Sep-12

98,627,108

58,203,957

Oct-12

103,664,423

59,653,716

Nov-12

119,781,871

87,939,359

Dec-12

138,392,869

82,083,892

Jan-13

119,200,891

58,542,307

Feb-13

109,368,101

55,865,635

Mar-13

129,671,037

61,998,068

Apr-13

121,683,470

57,936,534

May-13

122,637,206

59,454,896

Jun-13

126,463,100

59,487,868

Jul-13

130,783,521

61,312,322

Aug-13

133,023,878

62,524,970

Sep-13

128,903,291

57,381,622

Source: siteanalytics.compete.com.

EXHIB IT 9

Top Internet Properties in Revenue, October 2007 and June–August 2013

Oct-07 Rank

Domain

June–August 2013 Visits/Market Share

Rank

Domain

Visits/Market Share

11.52%

1

Amazon.com

9.75%

1

Amazon.com

2

Walmart

5.37%

2

eBay

8.12%

3

Target

4.81%

3

Craig’s List

3.01%

4

Half.com

4.45%

4

Walmart

2.03%

5

Dell USA

3.49%

5

MonsterMarketplace.com

1.33%

Source: Hitwise.

The Battle for Online Dominance

It invested in Chinese e-commerce giant Yihaodian, which sold over 180,000 products, employed over 4,000 workers, offered same-day-delivery for essential daily items, and generated $130 million dollars in annual revenue in China.41 However, one of the first acquisitions, Kosmix, a small social media company from Mountain View, California, proved to be most crucial to Walmart.com’s efforts. Kosmix had developed “a social media technology platform that filters and organizes content in social networks to connect people with real-time information that matters to them.”42 Kosmix founders, Venky Harinarayan and Anand Rajaraman, had sold their first company Junglee, which allowed online shoppers to compare prices from other online stores,43 to Amazon in 1998. Walmart purchased their next venture for a sum of $300 million in hopes that this new technology platform would allow it to better match offerings to customer preferences by relying on an algorithm that sought to understand what a user wants “rather than just matching a search query.”44 The acquisition, Walmart claimed in the press release announcing the deal, underscored “its commitment to social and mobile commerce.”45 In order to further what it called its “global multi-channel strategy,”46 Walmart.com launched a subunit within its online business committed to creating “technologies and businesses around social and mobile commerce”47 called @WalmartLabs. The Kosmix team led the research and development efforts. @WalmartLabs was structured into miniature startup groups, each with its own project and business goal. A group leader acted as the unit’s CEO and was responsible for driving innovation for the team. These small groups developed ideas including a “Scan and Go” smartphone app that allowed users to scan items as they shopped, paying for them at the register by simply scanning one barcode at a special checkout, and an app called Shopycat that suggested holiday gifts for friends based on their social media profiles.48 One of the Kosmix team’s first tasks at Walmart.com was to unify e-commerce sites run by various national business units. When it joined Walmart.com, Kosmix discovered that, on a global scale, Walmart’s e-commerce division was run more like an IT organization than a tech startup. Outsourced projects by each national business unit had led to over 15 e-commerce websites globally. None of them were able to communicate with each other, and all had a different look and feel. The Kosmix team worked to develop a uniform global technology platform called Pangaea.49 In addition, the @WalmartLabs team integrated technology from Kosmix to rebuild a dysfunctional website search function. After revamping its internal search engine and site conversions, the number of visitors who actually bought products on the website increased by 20 percent in eight months.50 Not to be outdone by Walmart.com, Amazon continued to broaden its appeal to online shoppers by expanding into new areas. In 2012, Amazon aggressively moved to buy two companies Walmart.com had initially approached. The first company, Diapers.com, sold diapers and other frequently purchased personal items online. Catching wind that Walmart was negotiating to acquire Diapers.com, Jeff Bezos contacted the owners of Diapers.com with his own offer and started selling diapers on Amazon.com at a loss. In a matter of weeks, Diapers.com’s owners saw the company’s market share eroding so fast that they had no choice but to sell to Bezos. Later that year, Amazon beat out Walmart.com’s efforts to acquire automated shipping company, Kiva Systems, which utilizes robots to fulfill orders in its warehouses.51

Walmart’s Reorganization Prior to 2011, Walmart’s e-commerce heads in each country had reported directly to the global Walmart.com CEO, Eduardo Castro-Wright, in San Bruno, California. In late 2011, however, Walmart headquarters announced a shuffling in the reporting structure in some of its strongest foreign markets. E-commerce leaders in Canada and the United Kingdom would now report directly to the head of each country’s Walmart business unit.52 The retailer hoped the reorganization would create better synergies between physical and online store sales. Castro-Wright announced his plans to retire in October 2011, after less than two years on the job.53 Many speculated his retirement had been mandated by Walmart executives as a result of lackluster online sales and an inability to bring e-commerce initiatives in its foreign business units to fruition. Neil Ashe, former president of CBS Interactive, was hired to take his place.

9

10

Amazon Verses Walmart: The Battle for Online Dominance

Ashe believed in the importance of online expansion and criticized the lack of priority Walmart executives had given online efforts in the past. His plan was to gradually transform Walmart into a fully integrated on- and offline experience. When asked how long it would take to achieve this goal, Ashe replied, “It will take the rest of our careers and as much as we’ve got. This isn’t a project. It’s about the future of the company.”54

Innovating to Compete With a new, aggressive leader at the head of Walmart.com, the battle between Walmart and Amazon for online domination intensified over the next few years. Each company sought to gain an online leg-up through product and supply chain innovations. Amazon continued to venture into new business areas in order to provide more and better products to its customers. In 2007, it introduced the Kindle, one of the first e-book readers, as a platform to sell e-books. In 2008, Amazon started to focus its “internetification” on the grocery business. AmazonFresh, a same-day grocery delivery service, was available to customers in the Seattle, Washington, area. Food and groceries sales were expected to grow over 20 percent from 2013 to 2017, as compared to an increase of 11 percent for e-commerce in general during the same time period.55 In June 2013, Amazon announced it would expand its AmazonFresh service to Los Angeles, California. Amazon, it was rumored, planned to further expand its grocery delivery business to 20 additional cities in 2014 and 20 more soon after, a move some thought was necessitated by the fact that margins on Amazon’s groceries were one-sixth those of Walmart’s in-store grocery sales.56 In a delayed response to AmazonFresh, Walmart piloted an online-grocery, same-day delivery service in San Jose, California, in 2011. Walmart’s UK subsidiary, Asda, had successfully operated a grocery delivery business in Great Britain for a number of years. Although the San Jose initiative proved successful, Walmart.com waited to expand in the United States because the low population density in the US market made delivering groceries ordered online more difficult and expensive to roll out.57 Hoping to provide greater convenience and security for online shoppers, Amazon and Walmart employed innovative technology and delivery systems to ensure customers actually received their online orders. Walmart expanded its “Site to Store” model to over 660 FedEx office stores across the country. Customers could select the nearest FedEx or Walmart store as the shipping address and pick up packages at their convenience. Customers who worried that packages might be stolen off their doorsteps now had a convenient delivery option, and packages were never left unattended. Amazon responded that year with delivery lockers in convenience and grocery stores, offering similar delivery convenience and security as Walmart’s program.58 In 2013, Walmart also announced plans to install its own delivery lockers in Walmart retail stores.59 Amazon hoped the small fees it paid each month for stores to house its lockers would be offset by increased purchases and decreased shipping costs by delivery companies such as FedEx, which charged up to 20 percent less for locker deliveries over residential drop-offs. Delivery companies found it cheaper to deliver multiple packages to one location than to take many individual parcels to each customer’s house. Walmart had an advantage over Amazon in locker deliveries, however, because each of its over 4,000 retail locations could be used as a pickup point for customers wanting the convenience and security of locker pickup. Walmart, unlike Amazon, also did not have to worry about renting space for its lockers. In addition to more convenient and secure deliveries, both Walmart.com and Amazon wanted to get packages to customers even faster. In order to get a package to a customer in 24 hours, Amazon invested heavily in new warehouses located near major metropolitan areas. In 2013, it was reported that Amazon had “invested roughly $13.9 billion since 2010 to build 50 new warehouses, more than it had cumulatively spent on storage facilities since its 1994 founding, bringing the total to 89 at the end of 2012.”60 In late December 2013, Amazon CEO Jeff Bezos even announced plans to begin using drones for package delivery starting in 2015 at the earliest.61

References

11

Walmart.com executives, on the other hand, sought to redefine the company’s traditional approach for online deliveries. In 2013, the retail giant sought to further leverage its expertise in physical store sales to boost online units with a new strategy called “Ship from Store.” When a customer placed an order online, instead of shipping from a warehouse in another state, with the “Ship from Store” system, a Walmart employee in a retail store would take the ordered item off a shelf, box it up, and give it to a FedEx or UPS truck for local delivery. The delivery would then take a few minutes or hours instead of a few days, thereby improving the customer’s online shopping experience on Walmart.com.62 Walmart even toyed with the idea of using its own customers to deliver online orders to other customers for a small fee.63

Conclusion By 2013, Walmart.com and Amazon had spent years in a back-and-forth competitive match as both companies looked to leverage their individual strengths in order to grow online revenues. Challenged in the past by a lack of funding, Walmart.com had finally seized on the imperative to grow and to reclaim much of what Amazon had taken by attracting customers to Walmart’s traditional product categories. Yet, although the company had made great strides, Amazon’s revenues were still eight times those of Walmart.com in 2013.64 Walmart executives wondered if the company was destined to be locked in a back-and-forth battle that might result in only incremental gains without ever being able to take significant points out of Amazon’s market share. In the midst of these challenges, Walmart announced its intention to further embrace the growing trend in China toward online shopping by opening 110 new facilities for shipping online orders. The company simultaneously announced the closing of up to 30 additional brickand-mortar stores in China.65 Despite these efforts, a crucial question remains: Can Walmart .com make up for lost time?

References 1 D. Davis, “Wal-Mart: ‘We Can Do What No One Else Does,’” Internet Retailer (March 26, 2013), http://www.internetretailer.com/2013/03 /26/wal-mart-we-can-do-what-no-one-else-does, accessed October 10, 2013. 2

Ibid.

Ibid.

3

S. Banjo, “Wal-Mart’s E-Stumble with Amazon,” Wall Street Journal (June 19, 2013), http://online.wsj.com/news/ articles/SB10001424127 887323566804578553301017702818, accessed October 10, 2013.

4

Walmart Stores Inc., financial statements, fiscal year 2013.

5

Walmart Stores Inc., “Corporate History Timeline,” http:// corporate. walmart.com/our-story/heritage/history-timeline, accessed October 24, 2013. 6

Ibid.

7

Ibid.

8

Ibid.

9

Ibid.

10

Ibid.

11

Ibid.

12

J. Spiro, “The Great Leaders Series: Jeff Bezos, Founder of Amazon .com,” Inc.com (October 23, 2009), http://www.inc.com/30years/articles /jeff-bezos.html, accessed October 25, 2013.

13

B. Stone, “The Secrets of Bezos: How Amazon Became the Everything Store,” Bloomberg BusinessWeek (October 10, 2013), http:// www.businessweek.com/articles/2013-10-10/jeff-bezos-and-the-age -of-amazon-excerpt-from-the-everything-store-by-brad-stone#p1, accessed October 24, 2013.

14

Amazon.com, financial statement, fiscal year 2012.

15

J. Maguire, “Case Study: Walmart.com,” eCommerce-Guide.com (November 15, 2002), http://www.ecommerce-guide.com/news /trends/article.php/1501651/Case-Study-Walmartcom.htm, accessed October 29, 2013.

16

Stone, 2013.

17

News Services, “Wal-Mart Sues Online Bookseller,” The Washington Post (October 17, 1998), http://www.washingtonpost.com/wp-srv /washtech/daily/oct98/walmart101798.htm, accessed October 25, 2013.

18

G. Bensinger, “Competing with Amazon on Amazon,” Wall Street Journal (June 27, 2012), http://online.wsj.com/news/ articles/SB100014 24052702304441404577482902055882264, accessed November 5, 2013.

19

12

Amazon Verses Walmart: The Battle for Online Dominance

20 Walmart Stores Inc., “Walmart.com Adds Nearly One Million New Items with the Launch of Walmart Marketplace” [Press Release] (August 30, 2009), http://news.walmart.com/news-archive/2009/08/31/walmartcom -adds-nearly-one-million-new-items-with-the-launch-of-walmart -marketplace, accessed July 31, 2017.

CrunchBase, “Accel Partners,” http://www.crunchbase.com/financial -organization/accel-partners, accessed July 31, 2017. 21

Maguire.

22

Ibid.

23

Ibid.

24

Fortune 500 database, 2002, http://money.cnn.com/ magazines/fortune /fortune500_archive/full/2002/1.html, accessed October 31, 2013. 25

Maguire.

26

M. Foley, “Did Walmart’s E-Commerce Stumble Put Its Future at Risk?,” wallstreetcheatsheet.com (June 22, 2013). Available at http:// wallstcheatsheet.com/stocks/did-wal-marts-e-commerce-stumble -put-its-future-at-risk.html/?a=viewall, accessed October 25, 2013.

27

28

Ibid.

Maguire.

29

PRNewswire, “Walmart.com and Netflix Announce New Promotional Agreement; Online Retail Companies Team to Promote Each Other’s Core Businesses” (May 19, 2005), http://www.prnewswire.com /news-releases/walmartcom-and-netflix-announce-new-promotional -agreement-online-retail-companies-team-to-promote-each-others -core-businesses-67048857.html, accessed July 31, 2017.

30

Amazon.com, “Amazon.com Announces Record Free Cash Flow Fueled by Lower Prices and Free Shipping; Introduces New Express Shipping Program—Amazon Prime” [Press Release] (February 2, 2005), http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-newsA rticle&ID=669786&highlight=, accessed October 31, 2013.

31

Amazon.com, “Amazon Prime Members Now Get Unlimited, Commercial-free, Instant Streaming of More Than 5,000 Movies and TV Shows at No Additional Cost” [Press Release] (February 22, 2011), http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-news Article&ID=1531234, accessed July 31, 2017.

32

B. Stone, “What’s in Amazon’s Box? Instant Gratification,” Bloomberg BusinessWeek (November 24, 2010), http://www.businessweek .com/magazine/content/10_49/b4206039292096.htm#p2, accessed July 31, 2017. 33

Stone, 2010.

34

Walmart Stores Inc., “Wal-Mart Completes National Rollout of Site to StoreSM Service” [Press Release] (July 13, 2007), http://news.walmart .com/news-archive/2007/07/13/wal-mart-completes-national-rollout -of-site-to-storesm-service, accessed January 9, 2014.

35

Davis.

36

Walmart Stores Inc., July 13, 2007.

37

M. Boyle, “Walmart’s Magic Moment,” Bloomberg Business-Week (June 15, 2009).

38

M. Boyle and D. MacMillan, “Walmart’s Rocky Path from Bricks to Clicks,” Bloomberg BusinessWeek (July 21, 2011), http://www .businessweek.com/magazine/walmarts-rocky-path-from-bricks-to -clicks-07212011.html, accessed October 15, 2013.

39

Boyle and MacMillan.

40

M. Brohan, “China Green Lights Wal-Mart’s 51% Stake in Yihaodian,” Internetretailer.com (August 14, 2012), http://www.internetretailer .com/2012/08/14/china-green-lights-wal-marts-51-stake-yihaodian, accessed October 15, 2013.

41

Walmart Stores Inc., “Walmart Announces Acquisition of Social Media Company Kosmix” [Press Release] (April 18, 2011), accessed October 25, 2013. 42

43 F. Manjoo, “Walmart’s Evolution from Big Box Giant to E-Commerce Innovator,” Fast Company (November 26, 2012), http://www .fastcompany.com/3002948/walmarts-evolution-big-box-giant -e-commerce-innovator, accessed October 15, 2013.

Manjoo.

44

Walmart Stores Inc., April 18, 2011.

45

Ibid.

46

47

Ibid.

Manjoo.

48

L. Heller, “Walmart vs. Amazon: It’s About to Get Interesting,” Forbes (March 29, 2013), http://www.forbes.com/sites/lauraheller/2013/03/29 /walmart-vs-amazon-its-about-to-get-interesting/, accessed July 31, 2017.

49

Davis.

50

P. M. Reyes, “Amazon Goes on a Building Spree,” Bloomberg Business Week (September 2, 2013), accessed October 10, 2013.

51

M. Townsend and A. Lutz, “Wal-Mart Shakes Up E-Commerce, Execs Leave,” Bloomberg News (August 12, 2011), http://www.bloomberg .com/news/2011-08-12/wal-mart-shakes-up-e-commerce-execs-leave .html, accessed October 15, 2013. 52

“Global Ecommerce Expansion Said to Bedevil Wal-Mart,” LexisNexis (October 3, 2011), accessed October 15, 2013.

53

Banjo.

54

C. O’Connor, “Wal-Mart vs. Amazon: World’s Biggest E-Commerce Battle Could Boil Down to Vegetables,” Forbes (April 23, 2013), http:// www.forbes.com/sites/clareoconnor/2013/04/23/wal-mart-vs-amazon -worlds-biggest-e-commerce-battle-could-boil-down-to-vegetables/, accessed October 10, 2013. 55

R. Smith, “Who’s Going to Deliver Your Groceries: Walmart, Amazon, or . . . ?,” Dailyfinance.com (July 9, 2013), http://www.dailyfinance .com/2013/07/09/grocery-delivery-walmart-amazon-peapod/, accessed October 10, 2013.

56

Smith.

57

G. Bensinger, “Amazon’s New Secret Weapon: Delivery Lockers,” Wall Street Journal (August 7, 2012), http://online.wsj.com/news/articles/SB1 0000872396390443545504577567763829784538, accessed November 4, 2013. 58

K. Talley, “Wal-Mart to Use In-Store Lockers for Web Order Pickups,” Wall Street Journal (May 1, 2013), http://online.wsj.com/article/BT -CO-20130501-710606.html, accessed November 4, 2013.

59

Reyes.

60

Bloomberg News, “Amazon Tests Drones for Same-Day Parcel Delivery, Bezos Says,” Bloomberg Technology (December 2, 2013), http://www .bloomberg.com/news/2013-12-02/amazon-testing-octocopters-for -delivery-ceo-tells-60-minutes-.html, accessed December 9, 2013. 61

References 62 A. Barr, “Retail Stores Become Shipping Hubs to Battle Amazon,” USA Today (October 6, 2013), http://www.usatoday.com/story/tech/2013/09 /28/retailers-ship-from-store/2862405/, accessed October 10, 2013.

D. Rousmaniere, “Morning Advantage: Walmart Wants You to Deliver Packages,” HBR (March 29, 2013), http://blogs .hbr.org/2013/03/morning -advantage-walmart-want/, accessed October 9, 2013. 63

13

64 Amazon reported revenue of $74.4 billion, divided by Walmart’s projected 2013 revenue of ~$9 billion.

Reuters, “Walmart Plans More Stores and E-Commerce in China,” New York Times (October 24, 2013), http://www.nytimes.com/2013/10 /25/business/international/wal-marts-china-plan-to-focus-on-e -commerce.html?_r=0, accessed November 9, 2013.

65

ONLINE CASE Intel (A): Dominance in Microprocessors Paul Otellini gazed out the window of his new office at Intel’s headquarters and was struck by how much Silicon Valley, Intel Corporation, and he had changed. San Jose and the surrounding communities were no longer the sleepy towns of orchards they had been when he began at Intel in 1974. Intel had evolved from a cutting-edge memory company into a dominant player in the computer industry value chain. Otellini also had moved from a functional staff position in finance through a number of operating and marketing roles to become the first nonengineer to serve as Intel’s CEO. His tenure included roles as the general manager of Intel’s Architecture Group and Microprocessor Products Group, where he led the introduction of the Pentium chip that redefined the company in the early 1990s.1 As Otellini pondered those significant changes since 1974, he wondered what Intel would need to make to maintain its position of industry leadership in microprocessors and how should he respond.

Intel: The Early Days The beginning of Intel Corporation (NASDAQ symbol: INTC), arguably one of Silicon Valley’s dominant and most successful companies in the mid-2000s, differed from the mythical founding of Hewlett Packard in a garage or the youthful exuberance of Apple’s Steve Jobs and Steve Wozniak. When Robert Noyce and Gordon Moore formed Intel, they were already in middle age, were considered experts in their field, and raised over $2 million in start-up capital in one afternoon.2 Noyce had been one of the inventors of the integrated circuit, and Moore was a talented, visionary engineer and problem solver. It was Moore who noted in 1965 that every 18–24 months the number of transistors placed on an integrated circuit would double. Dubbed “Moore's Law,” this prediction had driven competition and strategy in the industry since its inception. In fact, experts predicted the rate of doubling would continue well into the 2020s.3 Intel was not the first entrepreneurial venture for Noyce or Moore; the two had helped found Schockley Labs in 1956, and they had bolted Shockley a year later as members of the “traitorous eight” that founded Fairchild Semiconductors. Fairchild had operated for over a decade as a subsidiary of the Fairchild Camera and Instrument Corporation, an East Coast manufacturing company. The corporate parent never truly understood the semiconductor business, and corporate policies meant that emerging and lucrative technological advances, often designed by Moore and his team, were not exploited. Noyce and Moore founded Intel with two goals: to work with and commercialize high quality, exciting new technologies and to make money. On Moore’s office wall hung a plaque that said, “this is a profit making organization. That’s the way we intended it . . . and that’s the way it is.”4 Intel’s culture, operating policies, and competitive position built on Moore and Noyce’s fascination with great semiconductor technology. However, their first hire, Andy Grove, would have equal, if not greater, influence on Intel’s culture and capabilities. Grove was born in Hungary as 1

2 Intel (A): Dominance in Microprocessors

András Gróf, but he Americanized his name shortly after arriving in the United States in 1957. He earned a PhD in chemical engineering from UC Berkley in 1963 and worked with Noyce and Moore at Fairchild. Grove joined the company as Director of Operations; he became the COO shortly thereafter and CEO upon Moore’s retirement in 1987. Grove’s fanatical attention to detail, his penchant for disciplined, data-driven action and conduct, and his style of constructive conformation soon permeated the company, its operations, and its processes. Despite the company’s technological prowess in engineering and innovation, Grove worked tirelessly to make Intel a world-class manufacturing organization, often combining a new product generation with a new fabrication process.5 Intel’s first product was a memory chip that integrated existing memory cell technology with the rest of an integrated circuit. The result was a more powerful and useful chip that improved performance for users. The company pursued three equally promising technological platforms to create memory chips—Silicon Gate MOS, Multichip Memory modules, and the Schottky Bipolar Process. The founders would commercialize whichever technology could be mass-produced, thereby driving the cost per chip to its minimum. The Silicon Gate process won out, and the process created another win for Intel. The company’s technology strategy revolved around hiring the brightest engineers they could find, promising them stock options, and putting them to work at the basic tasks, often using competing teams and platforms to enhance the development process. Intel’s first chip, the 1101 static memory chip, appeared on the market in 1969, as did their  first money-making product, the 3101 static random access (SRAM) memory chip (see Exhibit 1). In 1970, Intel introduced the 1103, the first dynamic random access memory (DRAM)

EXHIB IT 1

Year

Key Events for Intel

Intel Key Products

1968 1969

Key Events Intel founded

3101, first bipolar memory 1101, first CMOS memory

1970

1103, first dynamic memory

1971

4004, first 4-bit microprocessor 1702, first EPROM (erasable memory)

1972

8008, first 8-bit microprocessor

1974

8080, first 8-bit microprocessor for computing

1976

8085, integrated 8-bit microprocessor

1978

8086, low-cost 16-bit microprocessor

1979

8088, low-cost 16-bit microprocessor

1981

IBM PC with 8088 processor and DOS

1982

80286, 16-bit microprocessor with memory management

1985

386, 32-bit processor

1986 1989

Intel went public

Intel exited memory business to focus on microprocessors Compaq announces first 386 PC

486, 32-bit microprocessor with integrated cache memory and floating point processor

1990

Microsoft announces Windows 3.0

1991

Intel launches “Intel Inside” campaign

1993

Pentium processor: superscalar technology

Microsoft announces Windows NT

1995

Pentium Pro processor: Dynamic Execution and Dual Independent Bus

Microsoft announces Windows 95

The Rise of the Microprocessor and Intel’s Dominance

Year

Intel Key Products

1996 1997

Key Events 25th anniversary of the microprocessor

Pentium processor with MMX technology Pentium II processor: Dynamic Execution, Dual Independent Bus, and MMX technology

1999

Pentium III processor

2004

Pentium 4 next-generation processor

2001

Itanium 64-bit processor

2002

Pentium M processor: 90 nm process technology

2003

Intel introduces the Centrino mobile chip

2005

Pentium D processor: 3.2 GHz clock speed

US recession causes 4.6% decline in PC sales

Source: Albert Yu, Creating the Digital Future (New York: Free Press, 1998) and Intel product release data.

chip. The 1103 offered customers a stable memory chip that met two key objectives for Intel: (1) the chip could be produced cheaply in mass quantities and (2) it offered the promise of technical improvements in future generations. With the 1103 chip, Intel would begin to conquer the memory market. Intel began producing its chips in a renovated factory the company had purchased from Union Carbide. Intel was hungry for new revenue and in 1969 Gordon Moore accepted a development project for Busicom, a Japanese calculator company. Busicom wanted a custom chip for its programmable calculators. Moore wanted much more, however: generic chips that could be produced and sold in mass quantities.6 Intel engineer Ted Hoff resolved the conflict when he proposed a four-chip set that performed multiple tasks. One chip would act as the CPU, another would be a memory chip for working with active data, one would be a ROM memory chip where the program would be stored, and one would handle the input/output (I/O) interface. The product was the Intel 4004 chip, a 4-bitI chip that packed as much processing power as the first computer, the 1940s ENIAC machine that required a whole room of transistors.7 In August of 1972, Intel introduced a second microprocessor, built on 8-bit technology, and named the 8008. Two Seattle teenage hackers, Bill Gates and Paul Allen, would later purchase an 8008 and try to build a machine for a local traffic consulting company.

The Rise of the Microprocessor and Intel’s Dominance Throughout the 1970s, Intel continued its work in memory chips and produced a number of breakthrough products, including an erasable memory chip (EPROM) that significantly improved customer performance while lowering costs. The microprocessor business continued to grow slowly, and even though the 8008 was a technical marvel, it proved to be a slow and clunky device. Intel’s third-generation chip, the 8080, came to market in 1974. One 8080 customer, MITS, used the chip as the core of a new product, a truly personal computer. Bill Gates and Paul Allen bought one of these new machines, the Altair 800, and developed the A “bit” is short for a binary digit. It is a spot on a silicon chip that can either hold an electric charge or not. Increasing the bits computer chips could string together led to increases in information storage and processing power.

I

3

4

Intel (A): Dominance in Microprocessors

Microsoft Basic language to program the new machines. 1976 also proved to be a watershed year for the industry when Steve Jobs and Steve Wozniak introduced the Apple II computer. The machine was generally regarded as the first personal computer, but the problem for Intel lay in the Apple II’s microprocessor, the MOS Technology 16-bit 6502 processor. Intel had developed the microprocessor but risked being shut out of the new market. Competition in the microprocessor market had always been fierce because many companies, including Motorola, Zilog, and National Semiconductor, all produced 8-bit and then 16-bit processors. In fact, by 1978, Intel was well behind Motorola when it introduced its new 16-bit processors, the 8086 and the 8088. Customers and engineers claimed that Motorola’s 68000 was simply a better chip than Intel’s 8088/8086 line, which is why Apple chose Motorola over Intel. Intel responded with a clever but serious internal sales drive. The “Crush” campaign focused on Intel “crushing” Motorola and taking control of the 16-bit microprocessor market. During this drive, Intel sales engineers got credit for each “design win” they secured. (A design win was a commitment from a customer to use the 8086/8088 architecture in its new products. However, to get credit, the customer had to prove its commitment by purchasing an Intel development system and dedicating its own engineers to the effort.) The Crush campaign succeeded over time in convincing the marketplace that Intel’s architecture provided a superior and complete package compared to the one offered by Motorola. One design win in 1980 would prove more important than all the others: Intel engineers convinced computer giant IBM to use its 8086/8088 architecture as the foundation of its new personal computer (PC).8 Grove said, “The presence of IBM in the early ‘80s was crucial. By winning that contract, we won the whole industry design. . . . This was a huge opportunity, and we took advantage of it.”9 IBM had been the colossus of the information-processing industry since its founding in the late nineteenth century, and the company found itself behind the competition in the emerging microcomputer market. Known as “Big Blue,” IBM focused on selling large computers, or mainframes, to the world’s largest and most prestigious corporations. IBM sold to computing professionals and specialists who ran huge data processing operations, and the microcomputer didn’t fit the company’s initial strategy or its core capabilities. By 1979, however, IBM executives recognized the disruptive power of the PC and sent a dedicated “tiger team” to Boca Raton, Florida, to develop IBM’s entry into the new market. The team, far removed from the company’s Armonk, New York, headquarters, found themselves free from IBM’s internal policies and design constraints. With the overriding objective of bringing a PC to market in less than a year, the IBM team opted for an “open architecture” process that used off-the-shelf components and existing thirdparty vendors to build the new machine. The open architecture meant that IBM did not have to develop its own microprocessor, operating system, or other key inputs, allowing it to enter the market quickly because IBM had only to assemble the final machine. IBM’s PC also stood in stark contrast to Apple’s machines, which used a “closed architecture” of custom-designed chips and operating systems in its machines.10 IBM’s open architecture would have huge implications for Intel. First, many customers faced bosses skeptical of the new technology, and they opted for IBM machines because of the safety and security behind the IBM name and brand. By 1984, almost one-third of the market for PCs belonged to IBM.11 Thus, Intel chips powered the market’s leading computer. Second, IBM’s open architecture allowed other new PC sellers to imitate or “clone” the IBM PC in order to enter the market. By 1987, IBM and clone machines commanded over two-thirds of the market, and that figure jumped to over 90 percent by 1995. Clone makers included Compaq, Hewlett Packard, and an emerging build-to-order manufacturer founded in a University of Texas dorm room, PCs Limited, that would later become Dell, Inc. However, IBM’s PC division dominated the PC market, and by 1985, it had grown to become a Fortune 500-sized company with $5.5 billion in revenues. IBM’s success helped Intel become the market leader in microprocessors. But IBM forced Intel to license its microprocessors to a dozen companies for the 8086 chip to ensure adequate supply. As a result, Intel captured only 30 percent of chip revenues and profits generated through IBM.

The Rise of the Microprocessor and Intel’s Dominance

In March of 1982, Intel introduced its next-generation chip, the 80286. The “286” dramatically increased processing speed and fueled sales of the microcomputer revolution. The 286 processor proved far more powerful than its predecessor, and combined with increasingly sophisticated software programs, PCs provided a cost-effective solution for businesses and their information processing needs. Although the 286 represented a significant advance in technology, the success of Intel’s new chip was muted by one major drawback: Computer manufacturers required that Intel license the 286 architecture to competing chip manufacturer AMD (and three other licensees) as a “second source.” Second-source agreements provided PC manufacturers with greater access to supply, while preventing one company from raising the price of the critical component. The introduction of the 286 had a significant effect on Intel. The 1970s and early 1980s had seen increased competition in the market for DRAM memory. By 1984, Intel only generated 20 percent of its revenue from the memory business, compared to 40 percent from microprocessors. Although microprocessors generated 100 percent of Intel’s profit that year, the company was spending 80 percent of its R&D budget on memory devices.12 Intel had invented the memory business, and the founding team’s loyalties lay deeply entrenched in the memory market. Andy Grove described the decision: Gordon Moore and I were discussing our quandary. Our mood was downbeat. I looked out the window at the Ferris wheel of the Great American amusement park revolving in the distance, then I turned back to Gordon and I asked: “if we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “he would get us out of memories.” I stared at him, numb, and then said, “Why shouldn’t you and I walk out the door, come back and do it ourselves.13 Intel exited the memory business and put all its resources into microprocessors. With 100 percent of its focus on the microprocessor market, Intel jumped the last hurdle in order to dominate the market. The Comdex computer show held in October, 1986, featured an announcement that altered the evolution of the computer industry: Compaq introduced a new computer built on Intel’s newest chip, the 32-bit 80386 chip, or “386.” Competition among PC manufacturers was becoming increasingly fierce, and Compaq hoped to gain a competitive edge by bringing a new product and new architecture to market. Compaq also agreed to a new business model, as it decided to forgo any “second source” requirement for the 386. Intel would be the sole provider of this new, powerful generation of microprocessors. The impact was immediate. Intel made about $40 on each 286 chip, but about $150 on each 386 chip.14 Intel’s most serious competitor in the PC business, AMD, would now have to develop its own next-generation chip rather than merely licensing Intel’s intellectual property. As a result, AMD fell behind for two product generations as it scrambled to develop its own chips. Intel’s bold move to become the sole source supplier (with the one exception of IBM, which still required that Intel license the 386 design to IBM so it could, if desired, provide its own second source) leveled the playing field for PC clones. Compaq became the first PC clone to set the performance standard for a next-generation PC product by introducing the first PC with a 386 chip. Up until the 386, IBM had dominated PC sales and had typically held more than a twothirds share of the market for PCs based on the IBM architecture. But that started to change in the late 1980s. Compaq continued to be a leader in launching new-generation PCs based on the IBM open architecture (called ISA), while IBM tried to introduce closed-architecture products such as the PS/2 to prevent clones from essentially selling identical products. It didn’t work. The PS/2 lines couldn’t provide the backward compatibility that customers wanted. In fact, by 1994, Compaq actually passed IBM as the PC market-share leader. IBM’s share had dropped from almost 40 percent to 10 percent. By 1997, Compaq held 13.1 percent of the market with IBM following at 8.6 percent, followed by Dell (5.5%), HP (5.3%), Packard Bell (5.1%), Gateway (4%), and Apple (4%), with dozens of others holding the remaining 50 percent (see Exhibit 2).

5

6

Intel (A): Dominance in Microprocessors

EXHIBIT 2

Global Market Share of PC Manufacturers (1985–2005)

1985

1990

1995

2000

2005

IBM

30%

13%

8%

7%

–

Commodore 64

26%

4%

–

–

–

Apple

12%

7%

8%

3%

2%

Compaq

3%

4%

10%

13%

–

Packard Bell

2%

2%

7%

4%

–

HP

2%

–

4%

8%

15%

–

–

3%

4%

–

0%

0%

3%

11%

17%

Lenovo

–

–

–

–

7%

Acer

–

–

4%

–

5%

Toshiba

–

–

–

–

4%

Fujitsu

–

–

–

–

4%

Other

25.00%

71%

54%

51%

48%

Total

100%

100%

100%

100%

100%

Gateway Dell

Notes: HP and Compaq merged in 2002. IBM sold its PC business to Lenovo in 2004. Source: Gartner Dataquest Press Releases.

The Semiconductor Industry Competition in the semiconductorII industry was driven by two major forces: technology and economics. Moore’s law, which in 1965 was an empirical observation and extrapolation, had now become something of a self-fulfilling prophecy. Exhibit 3 shows the increases in transistors and clock speed in Intel microprocessors. When microprocessor producers designed their nextgeneration products, the standard assumption was that the new chip would have twice the number of transistors as its predecessor. Intel’s first chip, the 4004, contained only 2,300 transistors, the 8086 carried 29,000 transistors; the 286 held 134,000, and the 386 used 275,000 transistors!15 Intel and its competitors spent millions of dollars and several years developing the next generation of chips, moving from design to manufacturing and resolving the challenges presented by the chemistry and physics of silicon, heat transfer, and miniaturization. As each generation became more complex, Intel used a “two-in-a-box” management structure. One engineer managed the architecture and design process, while another simultaneously focused on implementation, or moving the chip from design to manufacturing.16 The economics of semiconductor production were fairly straightforward: A company incurred the vast majority of costs in the design, development, and marketing of the chip itself, as well as in building the fabrication facility to produce the chips. The raw inputs of silicon and transistors were fairly commoditized. However, the quality and uniformity of each silicon wafer ultimately influenced the yield each chip would produce. The cost of building a fabrication facility (known as a “fab”) was astronomical. In the mid-1990s, a fab cost about $1 billion, depending on capacity, and by 2001, that figure had risen to well above $2.5 billion.17 (This did not include the design costs for each new-generation chip, which were typically in the range

A semiconductor is a material that conducts electricity. Silicon is the most common major component in semiconductors. Semiconductors include integrated circuits, memory chips, and microprocessors. II

The Semiconductor Industry

Intel Product Features Panel A: 4004-386 Transistors and Clock Speeds 18.0

300.0

16.0

Transistors (000)

250.0

14.0

200.0

12.0 10.0

150.0

8.0

100.0

6.0 4.0

50.0

Clock Speed (MHz)

EX HIB I T 3

Transistors (000) Clock Speed (MHz)

2.0

–

– 4004 8088 8080 8086 286 386 Processor Generation Panel B: 486-Pentium D Transistors and Clock Speeds 3,500.0

350,000.0 300,000.0

3,000.0

250,000.0

2,500.0

200,000.0

2,000.0

150,000.0

1,500.0

Transistors (000)

100,000.0

1,000.0

Clock Speed (MHz)

500.0

50,000.0

4004

1971

8008

Transistors

D m

nt

iu

4

um ni

Ita

Pe

III

m iu nt

II nt

Pe

Pe

iu

m

m

Pr

iu

Pe

m iu

nt

Pe

Year

nt

m iu

nt

48

Pe

Product

o

–

6

–

Clock Speed

Product

Year

2

0.108

Pentium

1993

3100

66

1972

3.5

0.8

Pentium Pro

1995

5500

200

8080

1974

4.5

2

Pentium II

1997

7500

300

8086

1978

29

5

Pentium III

1999

9500

500

286

1982

134

6

Pentium 4

2000

42000

1500

386

1985

275

16

Itanium

2002

220000

1000

486

1989

1200

25

Pentium D

2005

291000

3200

Source: Intel internal product release documents

of $50–100 million.) Increasingly specialized equipment was the most costly item. In the mid1970s, equipment constituted about 40 percent of the total cost of a fab; by the mid-1990s, that share had risen to 70 percent.18 A new generation of chips could use the same land and buildings, but it required new equipment to inscribe ever smaller transistors in ever tighter spaces on the chip. Put simply, microprocessor manufacturers incurred huge fixed and sunk costs before they sold a single chip, but the input costs of each individual chip were negligible. The implication: The semiconductor business is a volume game with the company selling the most chips in any generation making the most money.

Transistors

Clock Speed

7

8 Intel (A): Dominance in Microprocessors

Three factors influenced chip volume: cyclicality among buyers, speed to market with a new generation of chips, and the yield obtainable from each silicon wafer. Although computer purchases appear to be necessary to both business and household productivity, they closely follow the general health of the economy. When times are tough, both families and firms delay upgrading their technology. The recession of 2001 saw PC sales decline by 4.9 percent, compared to a 118.7 percent gain for 2000 (see Exhibit 4).19 If a company introduced a new chip platform at the beginning of a recession, it ran the risk of low volume for that generation. Speed to market mattered because the cost, and hence profitable price, of each chip followed a learning curve trajectory. Manufacturing costs fell systematically as volume increased (see Exhibit 5 for a sample of data on how the cost of a chip declines with increases in volume). The first entrant could either charge high prices for its chips or it could price lower in anticipation of volume-based cost savings. Lower prices would spur demand for the chip and would also discourage later movers because they would have to price at or below the initial cost.20 Being first to market with a high quality chip, such as Intel’s 286 and 386 generations, could provide a firm with a sales and revenue lead that competitors might be unable to overcome. E XH IB IT 4

Total PC Shipments, 1999–2005

Year

PC Shipments (M)

% Change

1999

113.5

21.7

2000

134.7

14.5

2001

128.1

−4.6

2002

132.4

2.7

2003

168.9

10.9

2004

189

11.8

2005

218.5

15.3

Source: Gartner Dataquest Press Releases.

EXHIBIT 5

Semiconductor Cost Decreases with Cumulative Volume Increases

Semiconductor Industry Year 1993

1994

1995

1996

Unit Volume

Cumulative Unit Volume

Avg. Cost ($) (per unit)

Proportion of Original Cost

Q3

438736.5

438736.5

50.00

1.00

Q4

446911.7

885648.2

44.16

0.88

Q1

341142.6

1226790.8

38.03

0.76

Q2

324665.0

1551455.8

31.90

0.64

Q3

304038.0

1855493.8

32.82

0.66

Q4

340532.2

2196026.0

34.51

0.69

Q1

333919.3

2529945.3

33.93

0.68

Q2

337897.9

2867843.2

32.24

0.64

Q3

390800.7

3258643.9

31.18

0.62

Q4

366612.9

3625256.8

27.08

0.54

Q1

350698.5

3975955.3

26.50

0.53

Q2

318833.3

4294788.7

20.95

0.42

Q3

285434.9

4580223.5

22.01

0.44

Source: Case writer dissertation data drawn from Berkeley Semiconductor Manufacturing Study.

The Semiconductor Industry

Yield refers to the number of functional chips produced from each silicon wafer. Wafer sizes increased over time from an average of 150 mm in the 1980s, 200 mm in the 1990s, and 300 mm at the turn of the millennium.21 Using a 300 mm wafer instead of a 200 mm wafer meant that a manufacturer could more than double the number of potential chips.III Not every chip would be functional, however, because small defects in the silicon, contaminants in the air, or glitches in the manufacturing process resulted in nonfunctional chips. As the number of wafers produced increased, engineers usually eliminated process and design bugs. Yields generally increased with volume, which lowered the cost per chip. Intel had also implemented what it called the “copy exactly” manufacturing methodology to increase yields and lower the cost of each chip. Copy exactly manufacturing started with Intel perfecting, in a prototype plant, the processes that could minimize defects and maximize yield. Intel then cloned the processes—or copied them exactly—in plants around the world. Intel now also uses identical production lines to find the root causes of lower yields. In one recent puzzler, identical tools in two factories kept producing different defect rates. By swapping the workers who maintained the tool, Intel learned that one group was cleaning the tool by wiping a towel in a circular motion; the other wiped back and forth. One motion went against the grain of the metal, spreading dirt particles rather than removing them. Intel’s attention to detail in manufacturing was credited with helping the company consistently achieve among the highest yields and lowest costs in the industry.22 During the 1970s and 1980s, microprocessor buyers were typically design engineers or executives of computer manufacturers. The microprocessor was a critical component of computers and computerized electronics, and there were no viable substitutes. These sophisticated buyers purchased on technical grounds such as chip performance, future product expansions, backward capability with existing products, product quality, manufacturing capability, and price. Until the frame-breaking move by Compaq to sole-source the 386 chip, the standard industry practice required microprocessors to have a second source. Large manufacturers such as IBM could always produce chips themselves, which gave them some pricing leverage over companies such as Intel. Intel faced many competitors over the years, from established companies such as Motorola, National Semiconductor, and Zilog, as well as foreign, often Japanese, chip manufacturers. In fact, the ability of the Japanese to drive down costs in the memory business had prompted Grove and Moore to exit the business. Intel would have to invest billions in R&D and facilities to remain competitive in a business with increasingly thin margins. In the industry’s early days, patent protection and enforcement of intellectual property claims were rare—that’s how Intel got its start in the industry. Intel, however, vigorously enforced patents and other intellectual property claims it viewed as central to its business plan. Cross-licensing and partnership agreements also provided a way to prevent competitors from reverse engineering chip architectures or other features. Advanced Micro Devices, or AMD, represented Intel’s most formidable and consistent competitor. Founded in 1969 by former Fairchild marketing director Jerry Sanders, AMD began its life in a manner similar to Intel, by using technology developed but never commercialized at Fairchild. AMD’s strategy involved becoming a second-source provider for manufacturers; AMD either signed a formal licensing agreement with the primary source company, or it simply reverse engineered the product and introduced its own, lower-priced version. AMD had been somewhat successful competing with Intel throughout the 1970s and early 1980s, and it was the logical choice for IBM as a second source for the 8086/8088 processors in the original PC. AMD formally cross-licensed the architecture for the 286 from Intel, but Andy Grove decided early in the 386 development cycle to exclude AMD from the 386 market. The two companies went to court over the issue of the 286 and 386 licensing agreement, and AMD won the right to a royalty-free license for the 386 technology, but Intel’s legal hardball delayed AMD’s entry into the 386 market for a year. AMD would live on, however. In the mid-1990s, AMD introduced a line of microprocessors that brought the retail price of a PC to below $1,000. The radius of the larger wafer is 1.5 times that of the smaller one, and so the area would be 1.52, or 2.25 times the area. III

9

10

Intel (A): Dominance in Microprocessors

By the turn of the millennium, AMD had introduced a chip that featured the first 1 GHz (1 gigahertz means 1 billion clock cycles per second) chip.23 However, even with some of these technology wins, over the years Intel produced six to eight times the volume of chips as AMD, which gave Intel a significant cost, and profit, advantage.

Intel Inside, Pentium, and Beyond AMD won the right to use the 386 moniker on its chips in 1991; two years later, Intel brought the next-generation 486 to market. The 486 chip had done well in the market, driven by early 486-adopter Dell. Competition intensified among PC manufacturers as the market continued to expand, but Intel faced a new, technology-based challenge. A new generation of chips using RISC (reduced instruction set computing) architecture offered the promise of substantially faster chips with less complexity than Intel’s CISC-based (complex instruction set computing) x86 architecture. Intel’s fifth-generation chip, logically the 586, was in development with a go-to-market projection for 1993. Intel engineers toyed with the idea of moving to the RISC architecture; however, they developed a CISC-based architecture that allowed the new chip, code named P5, to double the speed of the best RISC-based chip. The P5 contained 3.1 million transistors, almost three times the number of transistors on the 486, and it operated at 66 MHz, more than double the speed of the 486. The P5 dramatically expanded the power of microprocessors, as can be seen in Exhibit 3. Technical specifications and professional buyers, or corporate purchasing agents, dominated the first 20 years of the microprocessor business. By the early 1990s, however, prices for PCs had fallen far enough, and software was increasingly sophisticated enough, that retail customers now represented a huge market for Intel’s products. With AMD and other microprocessor manufacturers able to mimic Intel’s numbering system, retail customers could no longer rely on the x86 numbering system to ensure an Intel chip. Intel shifted strategy to respond to the new competitive reality. The company chose to abandon the 586 moniker in favor of its own branded product, the Pentium®, in order to create greater product differentiation in the mind of customers. The company also embarked on a radical plan to create a brand for the company with its Intel Inside campaign. Intel executive Dennis Carter convinced Andy Grove that, although product generations come and go, a unique Intel brand would stay with customers across product generations.24 The Intel Inside campaign began in 1991 with a budget of almost $150 million, a huge investment considering that consumers would never purchase a microprocessor in the same way they would buy a Coke or a Disney movie. Intel spent $20 million on print and broadcast media and ran ads that used the science-fiction style of movies Star Wars and Star Trek. The company dedicated $125 million in channel support for PC manufacturers who agreed to place the “Intel Inside” logo on their products and engage in joint advertising. The campaign succeeded beyond Intel’s expectations. By 1993, Intel’s brand preference, the percentage of people expressing a preference for Intel chips inside their computers, reached 80 percent. Intel’s worldwide sales rose 63 percent in 1992, and by 1994, over 1,200 PC manufacturers had signed up for Intel Inside marketing dollars. The campaign had one unintended consequence, however. Compaq’s CEO Eckhard Pfeiffer resented the intrusion of Intel’s brand on his own company’s moniker, believing that Intel Inside made Compaq less distinctive and valuable. Pfeiffer began negotiations with AMD to provide compatible, but lower cost, chips for Compaq’s products.25 The Pentium clearly redrew the lines of competition within the industry; companies could no longer compete on technical specifications alone but had to develop skills in advertising, branding, and marketing. Intel’s next generation, the P6, also reshaped the nature of competition within the industry. Each generation of microprocessors relied on its own architecture,

11

Intel in 2005

and Intel tried to use a new architecture to generate a family of related chips, not just a single microprocessor. The P6 came to market in 1995 as the Pentium Pro, but it would compete in a vastly different computing environment. With the commercialization of the Internet beginning in the early 1990s, buyers wanted computers that could incorporate multimedia applications, with mobile access to the Internet. The explosive growth of the Internet created explosive growth in the market for servers, dedicated computers that provide the nexus of a network of connected computers. The Pentium Pro architecture enabled Intel to effectively compete in each of these new markets: multimedia with the Pentium MMX, mobile computing with its Centrino® line of processors, and the server market with its Xeon® product group. The P6 epitomized Intel’s product development goal to create a platform architecture that supported a number of different chip families.26

Intel in 2005 Paul Otellini had overseen the original Pentium project and had observed the power of the company’s triple focus on technological innovation, continuous improvement in process technologies, and branding and marketing. The 2001 recession had hit Intel hard, but the company had resumed its solid performance. The Intel Inside campaign created a brand ranked as the fifth most valuable global brand, with an estimated value of $35.5 billion.27 Intel’s revenue had grown substantially throughout the early 2000s, and other financial metrics revealed a very healthy company (see Exhibit 6). Intel held 57 percent of the global PC market28 and 88 percent of the server market.29 Although there was much to celebrate, Otellini thought about the challenges ahead. AMD held the remaining 43 percent of the market and had proven quite capable of competing with Intel on price and technology. Intel was clearly a valuable brand, but was it time to update and refresh the brand? In May of 2005, sales of mobile, notebook computers exceeded the sales of desktop machines.30 How would Intel’s Centrino® brand of mobile processors compete in the new space? Finally, at a technology conference in late 2004, the term Web 2.0 had been introduced.31 EX HIB I T 6

Intel Financial Performance, 1980–2005

Year Net Revenue ($ Billions) Growth Rate Earnings per Share ($) Growth Rate Operating Income (%) Growth Rate Return on Equity (%) Growth Rate Capital Expenditures ($ Billions) Growth Rate Research and Development ($ Billions) Growth Rate Marketing, General and Administrative (% of Sales) Growth Rate

1980

1985

1990

1995

2000

2001

2005

.855

1.4

3.9

16.2

33.7

26.5

38.8

29.29%

−16.21%

25.39%

40.63%

14.63%

−21.36%

13.45%

2.21

0.01

.80

4.03

1.51

0.19

1.4

19.46%

−99.41%

53.85%

53.82%

43.81%

−87.42%

20.69%

21.7

−0.4

21.9

32.4

30.8

8.5

31.1

−3.56%

−102.19%

23.03%

10.20%

−7.23

−72.40%

5.03%

26.3

0.1

21.2

33.3

30.2

3.5

23.2

−16.35%

−99.38%

25.44%

21.98%

15.27%

−88.41%

17.77%

.156

.236

.680

3.6

6.7

7.3

5.8

60.82%

−39.18%

61.14%

50.00%

97.06%

8.96%

52.63%

.096

.195

.517

1.3

3.9

3.8

5.1

44.53%

8.33%

41.64%

16.65%

25.81%

−2.56%

6.25%

20.6

20.5

15.7

11.1

15.1

17.0

14.7

3.15%

5.67%

1.95%

−11.90%

14.39%

12.58%

7.30%

Source: Intel Corporation, Annual Reports, 2005, 2001, 2000, 1995, 1990, 1985, 1980.

12

Intel (A): Dominance in Microprocessors

The term captured the increasing sophistication of Internet hardware and software that would enable a dramatic increase in interactivity between consumers and others over the Internet. Intel owned the server business, but was the company well positioned as central to consumer’s web experiences?

References Paul Otellini, Reference for Business, Encyclopedia of Business, 2nd Edition, http://www.referenceforbusiness.com/biography/M-R/Otellini -Paul-1950.html, accessed July 29, 2013. 1

2 Tim Jackson, Inside Intel: Andy Grove and the Rise of the World’s Most Powerful Chip Company (New York, NY: Dutton, 1997), p. 17–18.

Matt Peckham, “Could Nanowire Transistors Rescue Moore’s Law from Obsolescence?,” Time (May 1, 2013), http://techland.time.com /2013/05/01/could-nanowire-transistors-rescue-moores-law-from -obsolescence/, accessed July 29, 2013. 3

Jackson, p. 179.

4

Juan Chaia, Paulo Marchesan, and Bernardo Neves, The Future of the Microprocessor Industry (Cambridge, MA: MIT, 2005), http:// dspace.mit .edu/bitstream/handle/1721.1/56570/15-912Spring-2005/NR/rdonlyres /Sloan-School-of-Management/15-912Spring-2005/163D6F92-8636 -4B61-9F3B-724B2E8EC8C8/0/intel_stne_ch_ma.pdf, accessed July 30, 2013. 5

Albert Yu, Creating the Digital Future: The Secrets of Consistent Innovation at Intel (New York, NY: Free Press, 1998), p. 15. 6

Jackson, p. 74.

7

Yu, p. 27.

8

Jackson, p. 203.

9

“Computer History 101: The Development of the PC,” http://www .tomshardware.com/reviews/upgrade-repair-pc,3000-4.html, accessed July 29, 2013.

10

Casewriter estimates based on data from Jeremy Reimer, “Total Share: 30 Years of Personal Computer Market Share Figures,” ARSTechnica (December 14, 2005), http://arstechnica.com/features/2005/12/total -share/5/, accessed July 29, 2013.

11

Yu, p. 124.

12

Jackson, p. 253.

13

Jackson, p. 278.

14

Data from http://download.intel.com/pressroom/kits/IntelProcessor History.pdf, accessed July 30, 2013.

15

Yu, p. 159.

16

Data taken from http://en.wikipedia.org/wiki/List_of_semiconductor_ fabrication_plants for the 1990s figure and Jason Mick, “Intel Announces $5B USD 14nm Fab, 4,000 New Arizona Jobs,” Daily Tech (February 21, 2011), http://www.dailytech.com/Intel+Announces+5B+USD+14nm+Fab+ 4000+New+Arizona+Jobs/article20954.htm, both articles accessed July 30, 2013. 17

Michael Smith, “Estimation of Future Manufacturing Costs for Nonelectronics Technology,” Master’s thesis at the Virginia Polytechnic Institute and State University (May 1996), http://scholar.lib.vt.edu /theses/public/etd-154317559631561/etd.pdf, accessed July 30, 2013.

18

Data for 2001: Gartner Press Release, “Gartner Dataquest Says 2001 Is a Year Battered PC Vendors Would Rather Forget,” January 17, 2002, http://en.wikipedia.org/wiki/Market_share_of_personal_computer_ vendors. Data for 2008: Gartner Press Release, “Gartner Says in the Fourth Quarter of 2008 the PC Industry Suffered Its Worst Shipment Growth Rate Since 2002,” http://www.gartner.com/newsroom/id /856712. Both sites accessed July 30, 2013.

19

G. Dan Hutcheson, Economics of Semiconductor Manufacturing, Handbook of Semiconductor Manufacturing, 22nd Edition, eds. Yoshio Nishi and Robert Doering (CRC Press, 2007), p. 35–10.

20

Data taken from http://www.sumcosi.com/english/products/next_ generation/large_diameter.html, accessed July 30, 2013.

21

Don Clark, “Intel Clones Its Past Factories, Right Down to Paint,” Wall Street Journal (October 28, 2002), Technology section.

22

http://www.amd.com/us/aboutamd/corporate-information/Pages /timeline.aspx, accessed July 30, 2013.

23

Yu, p. 46.

24

Jackson, pp. 313–316.

25

Robert P. Colwell, The Pentium Chronicles: The People, Passion, and Politics Behind Intel’s Landmark Chips (Hoboken, NJ: John Wiley and Sons, 2006).

26

Data available at http://www.interbrand.com/en/best-global-brands /previous-years/best-global-brands-2005.aspx, accessed July 31, 2013.

27

Data available at http://www.cpubenchmark.net/market_share.html, accessed July 31, 2013. 28

Data available at http://www.trefis.com/stock/intc/articles/11657 /featured-forecast-intel-will-continue-to-lose-server-processor-market -share/2010-02-22, accessed 31 July, 2013.

29

Michael Springer, “PC Milestone—Notebooks Outsell Desktops,” CNET News (June 3, 2005), http://news.cnet.com/PC-milestone--notebooks -outsell-desktops/2100-1047_3-5731417.html, accessed July 31, 2013.

30

Tim O’Reilly, “What Is Web 2.0” (September 30, 2005), http://oreilly .com/web2/archive/what-is-web-20.html, accessed July 31, 2013.

31

ONLINE CASE Intel (B): Responding to the Smart Phone Threat Paul Otelleni was getting ready to leave his position as CEO of Intel and turn over the reins to Brian Krzanich, who was currently Intel’s COO.1 Looking back, Otellini was proud of his accomplishments at Intel over the past eight years. Although revenue and the company’s stock price had been flat during Otelleni’s watch, shareholder dividends had grown at an average rate of over 13 percent, and he had positioned the company for the future by growing capital investments and research and development expenditures in the face of slower sales and stock price growth. Exhibit 1 displays Intel’s financial performance over Otelleni’s tenure. The company’s biggest bets had come in diversification through acquisition; between 2005 and his retirement in 2013, the company purchased a dozen companies. By far the largest of these acquisitions was the 2011 purchase of McAfee for $7.68 billion.2 McAfee represented a huge gamble by Intel to enter the software security business, and whether Intel could create value through the purchase was an open question. Otelleni realized it may be the biggest challenge his successor would face as he tried to regain Intel’s leadership in a rapidly changing semiconductor business.

EX HIB I T 1

Intel Financial Performance, 2005–2012

Year

2005

2006

2007

2008

2009

2010

2011

2012

Net Revenue ($ Billions)

38.8

35.4

38.3

37.6

35.1

43.6

54

53.3

−8.76%

8.19%

−1.83%

−6.65%

24.22%

23.85%

−1.30%

0.86

1.18

0.92

0.77

2.01

2.39

2.13

−38.57%

37.21%

−22.03%

−16.30%

161.04%

18.91%

−10.88%

0.4

0.45

0.55

0.56

0.63

0.78

0.87

25.00%

12.50%

22.22%

1.82%

12.50%

23.81%

11.54%

5.9

5

5.2

4.5

5.2

10.8

11

0.00%

−15.25%

4.00%

−13.46%

15.56%

107.69%

1.85%

5.9

5.8

5.7

5.7

6.6

8.4

10.1

15.69%

−1.69%

−1.72%

0.00%

15.79%

27.27%

20.24%

19.27

23.88

21.57

17.04

19.25

22.53

26.51

−26.48%

23.92%

−9.67%

−21.00%

12.97%

17.04%

17.67%

Growth Rate Earnings per Share ($)

1.4

Growth Rate Dividends per Share Paid

0.32

Growth Rate Capital Expenditures ($ Billions)

5.9

Growth Rate Research and Development ($ Billions)

5.1

Growth Rate Closing Stock Price ($, 01 July) Growth Rate

26.21

CAGR 4.05%

5.39%

13.32%

8.10%

8.92%

0.14%

Source: Intel Corporation, Annual Reports, 2008, 2012, stock price data from Intel Corporation.

1

2 Intel (B): Responding to the Smart Phone Threat

A Changed Industry: The Rise of Arm-Powered Smart Devices When Paul Otelleni became CEO of Intel, the company was the undisputed market leader in both the personal computer (PC) and server markets. The PC market had grown from 218 million units shipped in 2005 to almost 353 million units in 2012 (6.2% CAGR), but it represented a declining share of the overall computing device market. Yet, since Apple introduced its revolutionary iPhone in June of 2007, the market for “smart phones” had grown from almost nothing to 700 million units shipped in 2012 (a CAGR of over 126%)!3 Tablet computers had also displaced the traditional PC, with Apple’s iPad leading the way. Introduced in April of 2010, the iPad shipped over 3 million units in its first quarter. By the end of 2012, there were over 121 million iPads in use,4 and every major computer company introduced its own version of a tablet computer. Although Intel’s core market for PCs had grown at a respectable rate, in 2013, the PC market was widely considered to be an industry in long-term decline. Exhibit 2 shows projections for sales of different platforms of computing devices. When Otelleni assumed command at Intel in 2005, the company enjoyed huge margins and, in spite of the cyclical nature of semiconductor sales industry, robust and profitable sales growth. Intel had almost no market share in the new market for smart phones and tablets, with sales barely reaching 1 percent of the mobile market in 2012.5 How had Intel missed the boat in this new industry? After all, Intel had created the microprocessor, the basic component that powers PCs, smart phones, and tablet computers. Since the introduction of the first chipset, the 4004 processor, Intel had relentlessly pursued a simple strategy: Obey Moore’s law, which states that every 18–24 months the number of transistors on a silicon chip doubles, dramatically increasing performance while halving the real cost of that performance. Intel had followed Moore’s law, with the result being a product line of very powerful chips for a wide array of users. The Achilles heel in the Intel strategy could be found in the power usage of its chips. In the PC world of the 1980s to the 2000s, when PCs were all plugged into a EXHIBIT 2

Growth in PC Market and Related Industries (all numbers in millions)

Device Type

2012

2013

2014

2017

CAGR

PC (Desktop & Notebook)

341,263

315,229

302,315

271,612

−3.73%

9,822

23,592

38,687

96,350

46.31%

116,113

197,202

265,731

467,951

26.15%

1,746,176

1,875,774

1,949,722

2,128,871

3.36%

2,215,386

2,413,810

2,558,469

2,966,801

4.99%

Ultramobile (e.g., Chromebook) Tablet Mobile Phone Total 3,500,000 3,000,000 2,500,000

Mobile Phon e

2,000,000

Tablet

1,500,000

Ultramobile (e.g., Chromebook)

1,000,000

PC (Desktop & Notebook)

500,000 – 2012 Source: Data from the Gartner Group.

2013

2014

2017

Intel’s New Competitor: ARM

wall socket, a power drain didn’t matter. Intel’s processors, the Core i7 line, introduced in 2008, had a thermal design power of between 95 and 150 watts.6 Thermal design power refers to the amount of power a computer’s cooling system requires to dissipate the heat generated by the microprocessor. In chasing increased processor performance, Intel had created a product line that consumed massive amounts of battery power. In contrast, Intel’s new competitor in the mobile space, ARM, had chips in use that required only 1.9 watts. In a word, Intel had seen its growth potential disrupted.7 Mobile device users valued a sustainable “untethered experience,” the ability to use the device for long periods of time without draining the battery. In the power-rich world of PCs, performance mattered, and the greater the performance a chip could provide, the more intensive the software applications could be. Complex and sophisticated programs such as Microsoft Office ran very well on Intel’s high-performance chips. Mobile devices such as smart phones used very simple mobile apps and downloaded basic versions of websites and other Internet material. Performance, rather than being a competitive advantage, now became a disadvantage because unneeded capacity simply exhausted the battery more quickly.

Intel’s New Competitor: ARM The company that would become ARM Holdings, PLC, began operations in 1979 as Acorn Computers, a company hoping to create—and cash in on—what it believed would be a huge demand for very low-priced personal computers.8 By 1981, the company produced a computer sold as a kit to be assembled by the end user. The kit sold for £40 (about $80).9 To reach such a low price point, Acorn designed all of its components in-house. Acorn won a contract with the British Broadcasting Corporation (BBC) to produce a new computer, the BBC Micro. The company assigned two engineers, Sophie Wilson and Steve Furber, to design a new microprocessor for the machine. As a part of the design process, Wilson and Furber visited the Western Design Center in Phoenix, Arizona, a company that had been working on a similar chipset. They expected to find a large engineering center and fabrication facility. What they found was a very small operation and no production facility. As Furber later recalled, “A couple of senior engineers, and a bunch of college kids. . . . were designing this thing. . . . We left that building utterly convinced that designing processors was simple.”10 Furber and Wilson also realized that, to be profitable, a company did not need to incur all the expenses of production; licensing their designs to others and earning a nice royalty could be a path to profit. Wilson did most of the design work for the new chip back in England. The new 32-bit chip, developed by 1984, used 25,000 transistors. By contrast, Intel’s 286 Chip, introduced in 1982, featured 134,000 transistors. The goal of the design process had been to produce a very inexpensive chip, so the team used plastic packaging, which meant the chip needed to have thermal resistance somewhere under 1 watt. When Wilson and Furber tested the chip, they had the surprise of their professional lives. The power meter they used to test the equipment didn’t even register: The pair had designed a chip that ran on no more than one-tenth of a watt! The Acorn chip was a simple chip that ran with very little power. Acorn Computers did not survive, but the chip would live on as the design team subsisted on design work for other chip manufacturers and small sales throughout the 1980s. In 1990, ARM incorporated, with Apple and VLSI (their fabrication partner) as the major investors in the new company.11 ARM’s big break came in 1993 when Apple decided to use its chip design in the Newton, the first personal digital assistant. Although the Apple device flopped (it was 5–10 years ahead of its time), ARM also had a toehold in the market, with contracts to power Samsung phones. The company also sold chips to Texas Instruments and became a fixture in the Nintendo DS handheld gaming system in 2004. ARM chips powered the Nokia 6110 phone, introduced in 1997. The phone featured several firsts. It was the first phone that worked on both analog and digital networks, the first phone to feature visual menu icons, and the first phone to include a game built in to the device.12

3

4 Intel (B): Responding to the Smart Phone Threat

EXHIB IT 3

ARM Selected Financial Data

Year

2005

2006

2007

2008

2009

2010

2011

2012

Net Revenue (£ Millions)

232.4

263.3

259.2

298.9

305

406.6

491.8

576.9

13.30%

−1.56%

15.32%

2.04%

33.31%

20.95%

17.30%

56

45.1

63.2

47.2

110.1

156.9

221

38.27%

−19.46%

40.13%

−25.32%

133.26%

42.51%

40.85%

12.4

18.5

26.4

29

34.3

42.2

51.8

19.23%

49.19%

42.70%

9.85%

18.28%

23.03%

22.75%

8.6

5.4

8.7

6.9

7.4

13

33.2

41.91%

−37.21%

61.11%

−20.69%

7.25%

75.68%

155.38%

84.9

84

87.6

112.2

139.7

165.4

166.3

5.73%

−1.06%

4.29%

28.08%

24.51%

18.40%

0.54%

Growth Rate Profit Before Tax (£ Millions)

40.5

Growth Rate Dividends Paid (£ Millions)

10.4

Growth Rate Capital Expenditures (£ Millions)

6.06

Growth Rate Research and Development (£ Millions) Growth Rate

80.3

CAGR 12.04%

23.63%

22.23%

23.69%

9.53%

Source: All data taken from ARM, Annual Report, 2008, 2012.

The Nokia phone ushered in the dawn of the smart phone era. ARM became the chip of choice for the emerging market and was a natural choice for the original Apple iPhone. By 2007, ARM chips would command 98 percent of the smart phone market, and in 2011, the company shipped over 8 billion chips.13 ARM took a radically different approach to the chip business than Intel. Intel essentially chose to vertically integrate chip production and to control the process from design through manufacture and on to marketing. ARM has always specialized in design work, and it invested £166 million in design activities for 2012. Following the lesson learned by Wilson and Furber, ARM licensed its chip designs to others for production. ARM focused solely on design and testing, avoiding the expense of building fabrication (fab) facilities. A new fab cost upwards of $5 billion in 2013, and ARM avoided the upfront costs, as well as the huge engineering and staffing costs. The company built a very strong and profitable business based on this model. Exhibit 3 shows financial data for 2005–2012.

Intel Responds Intel found itself locked out of the smart phone market by 2007. The company did not sit idly by as it watched the industry migrate toward lower power chips and an Internet, software-centric consumer world. Intel responded to the ARM entry in two ways, through internal product development and acquisition. Product Development. Intel recognized as early as 2004 the need to create a low-powered chip to compete in mobile devices.14 The new chip had to meet three difficult objectives for Intel: Low heat and power requirements that would facilitate use in mobile devices, low fabrication costs to produce a chip that would compete with ARM’s products, and compatibility with other Intel chips used in traditional PCs.15 The requirement for backward compatibility had been an organizational constant at Intel since the earliest days of the 80286 chipset; Intel believed that customers would be more likely to buy new Intel products as long as their current products would continue to work on the new platform. The new chip, codenamed Silverthorne, had a head start when it began design. Intel had produced a lower-powered version of many of its chipsets, dating back to the 80386 in the mid1980s. Unfortunately, as the company moved beyond its original Pentium chip in the 1990s, low power usually meant stripping down the complex architecture of the chip. The chips used less

Intel Responds

power but ran very slowly. The new Silverthorne project built on the x86 chip architecture; however, the ingrained habit of trying to maximize chip performance created its own momentum, producing chip “creep up” in terms of power usage. In 2008, Intel introduced its Atom® line of chips to the market. The chips were close to ARM chips in power management; the Atom N200 used 2 watts, compared to ARM’s products that used 1.9 watts. The N200 retailed for $44, although customers could purchase a slightly more power-hungry 4-watt chip for $29. Because the Atom was built on the same architecture, or platform, as the Intel x86 line of chips (essentially everything in Intel’s line of PC processors from the early 1990s until the present), the Atom also fit into the Intel chip ecosystem. Customers had access to related processors and components from Intel, as well as Intel’s library of development software.16 Sales of the new processor showed early promise as notebook and ultralight device manufacturers adopted the product. Atom had a much harder time overcoming the industry’s emerging preference for ARM chips in order to penetrate the tablet and smart phone markets; the Atom chip had been adopted in only six smart phones by late 2012.17 Exhibit 4 provides data on quarterly sales of the Atom chipsets. The Atom seemed unlikely to capture a share of the critical markets of the early twenty-first century. Acquisition. Between 2004 and 2012, Intel purchased 12 companies. Exhibit 5 provides details about these acquisitions. Many of these acquisitions had a specific goal in mind: to build Intel’s capability and presence in the software industry. The company had a long history in software, dating back to the original 4004 microprocessor introduced in 1970. Intel provided developers with a “blue box,” the SIM 4-01, of read-only memory that provided engineers with the software tools to program the chips for their particular application.18 Each generation of chip included its own basic programming instruction set, and Intel also provided software developers with compilers, instruction sets, and tools that allowed them to write applications for each new generation of chips. With the advent of Web 2.0 in the early 2000s, the need for advanced software capabilities grew. Web 2.0 was a series of software advances that allowed web page sponsors, such as companies, to provide users with a more dynamic experience. New features included secure product ordering and payment, video streaming, and rapid website customization (such as Amazon’s recommended reading list for customers based on their earlier purchases). Intel found it quicker to purchase these new, dynamic software capabilities rather than develop them in-house. Intel began to branch out from producing the basic software that allowed programmers to write applications compatible with the x86 architecture. Intel also ran its own program for independent software developers and vendors. The company had

Atom CPU Sales ($ Millions) 500 450 415

400 362

350 300

438

413 355

391

370

352

300 269

250 200

396

200

219 167

150 100 50

20 08 Q 3 20 08 Q 4 20 09 Q 1 20 09 Q 2 20 09 Q 3 20 09 Q 4 20 10 Q 1 20 10 Q 2 20 10 Q 3 20 10 Q 4 20 11 Q 1 20 11 Q 2 20 11 Q 3 20 11 Q 4

0

EXHIBIT 4

Quarterly Sales of Atom Chipsets, 2008–2011

Source: Anton Shilov, “Intel Atom Technology Continues to Lose Popularity and PC Market,” Xbit laboratories (January 20, 2012).

5

6 Intel (B): Responding to the Smart Phone Threat

EXHIBIT 5

Intel’s Recent Acquisitions

Year

Target

Business

2004

Elbrus/Unipro

Compilers (Russia)

2005

Sarvega

XML code, engineers and IP

2007

Neoptica

Visual recognition software

2007

Havok

Computing game engine, middleware

2008

OpenedHand

Linux User Interface, Mobile experience

2009

Offset

Computing game visuals and middleware

2009

Wind River

Embedded devices software

2009

Click Arts

Parallel programming for multi-core processors

2010

Virtutech

Virtualized systems development

2011

Nordic Edge

Security solutions, identity management, authentication

2011

McAfee

Security, spyware, virus protection

2011

Telmap

Navigation and location services, search

Source: Caulfield, 2012.

trained over 20,000 vendor software engineers by 2012 to write for the Intel hardware platform. Intel pushed hard to create a set of software applications for supercomputers, very high-end and complex computers that ran the most sophisticated scientific programs, such as weather modeling and forecasting. Intel had also entered software markets targeted at end users. For example, the company had a team of engineers to support the development and diffusion of Linux, the public domain (free) operating system. Intel provided software packages and support to almost 3,000 schools and other educational institutions. By 2011, the company generated almost $2 billion in revenue from software sales, making Intel one of the 10 largest software vendors in the United States.19 Intel’s 2009 purchase of Wind River Systems exemplifies the company’s strategic thrust into software. Intel purchased the company in an all-cash deal valued at $884 million. The purchase price represented Intel’s largest acquisition in over a decade. Wind River writes software for “embedded devices”—electronic modules that function within larger machines. Embedded devices include many non-PC applications, such as smart phones, automobile entertainment systems, other consumer electronic goods, and a broad range of robots. Renee James, the Intel executive in charge of the software business at the time, said, “This acquisition will bring us complementary, market-leading software assets and an incredibly talented group of people to help us continue to grow our embedded systems and mobile device capabilities. Wind River has thousands of customers in a wide range of markets, and now both companies will be better positioned to meet growth opportunities in these areas.”20 Intel typically integrated acquisitions in one of three ways.21 A full acquisition meant that the  acquired company would be absorbed into the larger Intel structure; all the operating elements of the business become fully integrated with existing Intel systems, reporting structures, and goals. The acquired company ceased to exist. In a partial, or hybrid, integration, Intel integrated certain components into the company—usually on the operational, or noncustomer-facing “back-end.” The hybrid model allowed Intel to capture and develop things such as engineering talent, patented technologies, or important processes, while leveraging the existing brand and marketing abilities of the acquired company. Finally, Intel also managed acquisitions as a standalone business; the acquired company became a wholly owned subsidiary of Intel but did not integrate any systems with Intel. When Intel purchased Wind River, 85 percent of the company’s business did not use Intel architectures, and Wind River customers were rightly concerned about the company’s commitment to their platforms. Intel chose to run Wind River as an independent, wholly owned

The McAfee Acquisition

subsidiary. Ken Klein, Wind River CEO, commented on the value of this arrangement: “We’ve been able to cement the level of trust that our customers and partners have in Wind River. Because we’ve been allowed to operate independently, we’ve been able to win over customers not only on Wind River, but I think [the acquisition] also helped to improve Intel’s reputation in the industry.”22 Intel hoped to create synergy in the future in three ways. First, by leveraging Wind River’s learning in the embedded and mobile device market, Intel hoped to better serve these markets with its other software and hardware offerings. Second, Intel believed that over time Wind River would migrate its software platform to the Intel architecture and bring Wind River’s customer base into the Intel family. Finally, Wind River was a large contributor to Linux; one motivation for the purchase was to leverage Wind River’s knowledge in Linux and other operating systems to develop superior products in the future. Intel’s strategy of acquisitions had many critics. Some noted that Intel had gone on an acquisition spree in the early 1990s, and most of those acquisitions had failed, costing shareholders billions. Intel’s rich corporate culture often led to a “not invented here” (NIH) mentality; Intel engineers frequently failed to fully utilize superior hardware or software solutions just because they had been developed outside the company. Intel’s corporate culture of harddriving excellence came at a steep price.23 As a hardware company, Intel lacked deep and expert technical knowledge in new areas, such as communications and networking chips.24 Some acquisitions just died on the vine. Other critics questioned Intel’s real commitment to acquisitions. Intel seemed comfortable in its dominant hardware business and often exhibited little tolerance for risk in new technologies and businesses. Acquisitions appeared to fill things in at the margin, without penetrating the Intel core.25 Finally, critics accused Intel of acting opportunistically but not strategically. The company often bought revenue, or it overpaid for intellectual property.26

The McAfee Acquisition In August 2010, Intel announced the largest acquisition in its history, an all-cash deal to purchase software security maker McAfee for $7.68 billion. The deal closed in the first quarter of 2011. Like Wind River, McAfee would operate as an independent subsidiary. McAfee’s 2009 sales of $2 billion would add to Intel’s top line growth, but Intel intended to purchase more than just revenue or intellectual property. With its own acquisitions of Trust Digital and TenCube, McAfee had a presence in the market for smart phone security software. Paul Otelleni stated the rational for the acquisition: Security represented “the third pillar of what people demand from all computing experiences” in the emerging mobile market. The other two pillars were energyefficient devices and connectivity.27 McAfee enjoyed a colorful history. McAfee was founded in 1987 when software genius John McAfee brought an excellent security software package to market. McAfee sales skyrocketed in 1992 based on the fear of infection by the “Michelangelo” virus, a virus so deadly it would completely erase the hard drive of infected computers. Information about the Michelangelo virus originated with John McAfee, and the predicted computer calamity never occurred. The computing world would not see another panic like this one until Y2K doomsday scenarios appeared at the end of the decade.28 The incident illustrated McAfee’s unconventional views of appropriate business activity, and many customers denounced McAfee for creating a crisis just to sell software. In fact, McAfee had always run second to the much larger Symantec Corporation and its Norton Antivirus suite, a market position that would never change. In spite of its unique founder, McAfee proved to be a reliable competitor. The company offered a suite of security products for consumer and business applications, had very high brand recognition, had a stable market share, and consistently owned just over 25 percent of industry sales. Symantec, under its Norton brand, commanded another 33 percent of the market; interestingly, software leader Microsoft had proven unable to penetrate the market and competed in fourth place, with less than 10 percent of the market.29 Symantec and McAfee

7

8 Intel (B): Responding to the Smart Phone Threat

competed head to head in most markets, and neither competitor had the ability to deliver a knockout punch to the other. For Intel, the McAfee acquisition presented two intriguing options. First, McAfee’s presence in all facets of software security, including mobile devices, provided Intel with another point of entry into the mobile market. The real prize for Intel, however, was the possibility of a game changer: the ability to encode security features directly onto a chip. The potential of hardwareencoded security would be huge: Customers would operate at a level of safety and security that would be much more difficult for hackers and others to penetrate; rather than merely exploiting gaps, or holes, that left software vulnerable, viruses would need to access the computer’s hardwired foundations. A hardware solution protects at a deeper level than the computer’s operating system, and a hardware-driven security platform offered the potential to root out, in real time, the most persistent and troublesome viruses.30 Of course, a hardware-based security system had never been created before, and it raised a number of questions: • Could Intel and McAfee overcome the hurdles involved with creating a new security platform? • Could two large companies, each with huge investments in their current business models and operations, overcome their corporate inertia and cultures to create such a product? • Would the structure of the acquisition—keeping McAfee as a standalone unit of Intel—prevent the type of communication and knowledge sharing needed to develop new products? • How would the market react? For example, updating software was a rather simple process for most consumers. What would the update path look like in a hardware-based world? Would customers need to purchase new chips rather than update? • Why should Intel worry about security systems for mobile devices if it had almost no presence in this market? • How would the acquisition affect the McAfee–Symantec competition? Would McAfee’s access to Intel technology and funding allow them to finally dominate this market? Conversely, would McAfee become so absorbed with Intel that it would fail to keep pace with Symantec?

Conclusion In his last days as CEO of Intel, Paul Otelleni felt a sense of pride and relief: pride at what he had accomplished during his tenure in the CEO’s chair and relief that he would not have to face the new competitive environment in which Intel operated. He had inherited the world’s leading semiconductor company, one with an unmatched record for innovation and technological dominance. He had seen that dominance erode through the Great Recession of 2007–2009. However, the greatest challenges to Intel had come from the relentless “gale of destruction” that Joseph Schumpeter had written about a half century earlier.31 Those winds had blown Intel from an impregnable position to a very exposed one. Intel faced a set of nimble, talented, and well-funded competitors in the emerging markets for its products. Otelleni believed he had positioned the company to withstand the long-term trends in the industry and to eventually regain its dominance.

References David Goldman, “Intel Names Brian Krzanich New CEO,” CNN Money  (May 2, 2013), http://money.cnn.com/2013/05/02/technology /enterprise/intel-ceo-krzanich/, accessed February 5, 2014. 1

Ashlee Vance, “With McAfee Deal, Intel Looks for Edge,” New York Times (August 19, 2010), http://www.nytimes.com/2010/08/20/ technology /20chip.html?_r=0, accessed September 4, 2013. 2

References C-9 3 Data from Andy Boxall, “Smartphones Were Crazy Popular in 2012, 700+ Million Sold with Samsung in the Lead,” Digital Trends (January 25, 2013), http://www.digitaltrends.com/mobile/global-smartphone -sales-figures-show-huge-growth-in-2012/, accessed September 4, 2013.

Data taken from http://aaplinvestors.net/stats/iphonevsipod/, accessed September 4, 2013. 4

Tim Jackson, Inside Intel: Andy Grove and the Rise of the World’s Most Powerful Chip Company (New York, NY: Dutton, 1997).

18

Brian Caulfield. “Intel: The Biggest Software Company You’ve Never Heard Of,” Forbes (May 9, 2012), http://www.forbes.com/sites /briancaulfield/2012/05/09/intel-is-the-biggest-software-company -youve-never-heard-of/, accessed September 9, 2013.

19

5 Brian Deagon, “Intel Seen Gaining Mobile Market Share with New Chips,” Investors Business Daily (June 27, 2013), http://news.investors .com/technology/062713-661649-intel-mobile-market-share-growing .htm, accessed September 4, 2013.

20

6 A compilation of chipset thermal design specifications can be found at http://en.wikipedia.org/wiki/List_of_CPU_power_dissipation_figures, accessed September 4, 2013.

21

See Clayton Christensen, The Innovators Dilemma (Cambridge, MA: Harvard Business Press, 1997). 7

Wind River Corporation Press Release, “Intel to Acquire Wind River Systems for Approximately $884 Million,” June 4, 2009, http://www .windriver.com/news/press/pr.html?ID=6921, accessed September 9, 2013. IT@Intel Brief, “Adding Value to Acquisitions with IT,” January 2012.

Unknown, “Intel’s Wind River Acquisition: A Lesson in Independence,” Intel Free Press (October 12, 2010), http://www.intel freepress.com /news/intels-wind-river-acquisition-a-lesson-in-independence/68, accessed September 9, 2013.

22

8 Chris Bidmead, “ARM Creators Sophie Wilson and Steve Furber,” The Register (U.K.) (May 2, 2012), http://www.theregister.co.uk/2012/05/02 /unsung_heroes_of_tech_arm_creators_sophie_wilson_and_steve_ furber/?page=2, accessed September 4, 2013.

23

Bidmead notes that the Acorn machine cost about £120 in 2012 dollars. Using a conversion factor obtained at http://www.measuring worth.com/ukcompare/relativevalue.php, the relevant cost for 1980 would be about £40.

Michael Kanellos, “Perspective: Intel’s Failure to Communicate,” CNET (December 24, 2003), http://news.cnet.com/Intels-failure-to -communicate/2010-1006_3-5132994.html, accessed September 5, 2013.

9

Steve Cheney, “Why Intel’s M&A Binge Will Fail—Buying Growth Is Not a Strategy,” TechCrunch (September 19, 2010), http:// techcrunch .com/2010/09/19/why-intels-ma-binge-will-fail-buying-growth-is-not -a-strategy/, accessed September 5, 2013.

24

Chris Bidmead, “ARM Creators Sophie Wilson and Steve Furber, Part Two: The Accidental Chip,” The Register (U.K.) (May 3, 2012), http://www .theregister.co.uk/Print/2012/05/03/unsung_heroes_of_tech_arm_ creators_sophie_wilson_and_steve_furber/, accessed September 4, 2013.

Jay Chatzkel, “M&A Is Not a Strategy—Taking a Look at Intel, and Hyper-Social Organization,” Beyond the Deal Blog (September 27, 2010), http://beyondthedeal.net/blog/2010/09/27/ma-is-not-a-strategy -taking-a-look-at-intel-and-hyper-social-organization-cont/, accessed September 5, 2013.

11

Jonathan Weber, “Apple to Join Acorn, VLSI in Chip-Making Venture,” Los Angeles Times (28 November, 1990), http://articles.latimes .com/1990-11-28/business/fi-4993_1_arm-chips, accessed September 30, 2014.

26 Stephen Grocer, “Investors Don’t Like Intel-McAfee. Here’s why,” WSJ Deal Journal (August 20, 2010), http://blogs.wsj.com/deals /2010/08/20/investors-dont-like-intel-mcafee-heres-why/, accessed September 5, 2013.

Scott Calonico, “Retro Cell Phone Salute: The Nokia 6110,” The Full Signal (August 16, 2011), http://www.thefullsignal.com/products /10031/retro-cell-phone-salute-nokia-6110, accessed September 4, 2013.

27

10

12

See http://ir.arm.com/phoenix.zhtml?c=197211&p=irol-homeprofile, accessed September 4, 2013.

13

Scott Wasson, “Intel’s Atom Processor Unveiled,” The Tech Report (April  2, 2008), http://techreport.com/review/14458/intel-atom -processor-unveiled, accessed September 5, 2013.

14

25

Leena Rao, “Intel Buys Cyber Security Giant McAfee for $7.68 Billion in Cash,” Tech Crunch (August 19, 2010), http://techcrunch .com/2010/08/19/intel-buys-cyber-security-giant-mcafee-for-7-68 -billion-in-cash/, accessed September 9, 2013. Andrew Couts, “From Malware to Madman: A Brief History of John McAfee’s Lunacy Binge,” Digital Trends (December 7, 2012), http:// www.digitaltrends.com/computing/malware-to-madness-a-brief -history-of-john-mcafees-lunacy-binge/, accessed September 9, 2013.

28

Data on market shares taken from the NPD group and based on 2011 data, https://www.npd.com/wps/portal/npd/us/news/press-releases /pr_110907/, accessed September 9, 2013.

Pierre Dandumont, “Intel Atom CPU Preview,” Tom’s Hardware (June 5, 2008), http://www.tomshardware.com/reviews/ intel-atom-cpu, 1947.html.

29

R. Colin Johnson, “Has ARM Won the Processor War? Hardly!” EE Times (July 4, 2012), http://www.eetimes.com/author.asp?section_ id=36&doc_id=1266119, accessed September 5, 2013.

30

15

16

Trevis Team, “Can Intel Challenge ARM’s Mobile Dominance?” Forbes (November 9, 2012), http://www.forbes.com/sites/great speculations /2012/11/09/can-intel-challenge-arms-mobile-dominance/, accessed September 5, 2013.

17

Matthew Schwartz, “McAfee DeepSafe Promises Better PC Security,” Information Week (September 15, 2011), http://www.informationweek .com/security/intrusion-prevention/mcafee-deepsafe-promises -better-pc-secur/231601530, accessed September 9, 2013. Joseph A. Schumpeter, Capitalism, Socialism and Democracy (New York, NY: Routledge, 2012).

31

ONLINE CASE Tabitha’s Way Local Food Pantry Entrepreneurship in Feeding the Hungry There was a believer in Joppa named Tabitha. . . . She was always doing kind things for others and helping the poor. Acts 9: 36 (The Bible, New Living Translation1) Wendy Osborne swiveled in her well-used office chair and turned to look at the patron shopping area of Tabitha’s Way Local Food Pantry, an independent food bank serving hungry families in Spanish Fork, Utah. Looking past the well-stocked shelves and out the storefront windows, she watched the wind whip falling leaves all along the town’s Main Street. Those falling leaves meant that Thanksgiving was just around the corner, and visits to the pantry would pick up over the next few weeks as needy families hoped to celebrate the holidays. Wendy had much to be thankful for as 2016 headed into the homestretch. Her dedicated work over the last six years had, quite literally, turned an inspired idea into a flourishing reality— Tabitha’s Way Local Food Pantry had grown from nothing to serving more than 4,000 families each month. Tabitha’s Way had just opened its second location in American Fork, giving the organization coverage of the entire county. Thoughts of the new location brought feelings of gratitude for success, but also trepidation about climbing the hills just ahead. Wendy wondered how her role needed to change as she tried to oversee locations more than twenty miles apart.

Hunger Defining hunger requires going beyond the transitory, uneasy state we all feel when our bodies desire food and nutrition. Those involved in the fight against hunger define it as food insecurity, or a state where “consistent access to [adequate] food is limited by a lack of money and other resources at times during the year.”2 Adequate means enough food to enable an active and healthy life. Individuals and households might experience food insecurity rarely or regularly. The more regular a family’s challenges with adequate nutrition are, the greater the health and other problems that family faces.

Causes and Consequences Food insecurity is a natural consequence of low household income, and rates of food insecurity correlate strongly with other measures of poverty. About 17 percent of households below 50 percent of the US poverty line experienced some challenge with hunger, compared to only 1 percent of households earning more than 185 percent of the poverty line.3 The link between hunger and poverty is far from absolute, however, and a focus solely on poor households would lead researchers or service providers to miss a large swath of the food insecure. Income insecurity, in addition to chronically low income, drives food insecurity. Families with seasonal incomes, for example, can experience hunger at predictable times of year; job loss, temporary disability, 1

2 Tabitha’s Way Local Food Pantry

relocation (moving), and family break-up (temporary or permanent) all threaten food security. Even positive events, such as the birth of a new child, can upset the delicate balance that provides a family with food security. As with most societal ills, the costs of food insecurity fall most heavily upon children. The negative effects of hunger on children trace back to a nutritional source—the physiological effects of low and/or poor calorie intake—and a caregiver stress pathway, the social and psychological disruptions that accompany hunger. Nutritionally, hunger often causes families to substitute calorie quantity for quality and, paradoxically, these nutrient-poor, calorie-dense foods increase the risk of childhood obesity, high cholesterol, and vitamin and mineral deficiencies from a lack of fresh fruits and vegetables. Hunger weakens the body, leaving it more vulnerable to both illness and injury. Hunger stresses parents and increases their likelihood of depression and anxiety. Higher stress levels increase the difficulty parents face in productive work and holding jobs. Stress reduces the quantity and quality of parent–child interactions: parents have less time to spend with, and fewer emotional resources to support, their children.4

Prevalence in the United States and Utah County Hunger is as old as humanity. For most of the world’s history, chronic poverty left people haunted by the specter of constant hunger and starvation. Famine represented one of the Four Horsemen of the Apocalypse and rode with Death, Pestilence (disease), and War. The four constituted major, and constant, plagues for individuals and societies. The industrial revolution brought slow but steady relief from hunger to Western Europe and the United States, with average incomes rising from about $3 per day in 1800 to $120 (United States) or $137 (Norway) today.5 As incomes rose, calorie consumption went up. With incomes below $3 per day in many places in the world, the threat of starvation continues to be very real for billions of the world’s inhabitants. Even in the industrialized, high-income United States, hunger continues to be a problem. Eighty-six percent of Americans enjoyed food security in 2014, but 14 percent were food insecure at some point during the year. A little more than one-third of those experienced severe food insecurity, in which their normal diet was affected: food intake was reduced and normal eating patterns were disrupted. While these percentages seem low at first glance, they mask a sobering number of Americans struggling with hunger: 17.4 million households (about 45 million people, or the combined total population of the smallest twenty-five US states) experienced food insecurity at some point during 2014, and 6.9 million households (17.5 million people, or the equivalence of the population of the states of Illinois and Louisiana) were severely affected.6 Food security varies by region. While the national average for food insecurity was 14.3 percent (about 1 in 7 people) between 2012 and 2014, North Dakota had the lowest rate of food insecurity (8.4 percent or about 1 in 12 people), while Mississippi had the highest (22 percent or more than 1 in 5). Utah fared better than the national average, with 13.3 percent of households (127,000) experiencing food insecurity, and 4.7 percent of households (44,000) experiencing severe food insecurity.7 Because households in Utah are larger than the national average, about 400,000 people lived with food insecurity, and about 138,000 experienced severe food insecurity. Rates of food insecurity were higher in Utah County, with 14.2 percent of households facing hunger.8 With a little more than 148,000 households in the county, about 21,000 of them, or about 76,000 people, experienced food insecurity at some point during the year. The county faced two additional challenges. First, its population grew rapidly from 2011 to 2015, 11.3 percent, adding almost 60,000 new residents during the period.9 Second, services to provide for the hungry could barely keep up with the need. The county’s largest religious denomination, the Mormons, operated two full-time pantries that primarily focused on its own members, and three other local churches had part-time pantries. Only one non-profit food bank, Community Action Services, operated in the county. As time went by, Utah County needed more resources to feed a greater number of hungry people.10

Tabitha’s Way

Tabitha’s Way Origins In late 2009, Wendy Osborne, a woman deeply committed to her evangelical Christian faith, found herself reading the Bible during a time of deep self-reflection. She describes her experience: I was praying and meditating on a scripture in Acts 9:36 and it talks about a woman who is called Tabitha. What she did was help people in her community. I was envisioning this woman and the relationship she had with the people and her community. I was meditating on that scripture and God spoke to my heart and said, “I want you to leave your job and I want you to go do this. I want you to start Tabitha’s Way. I want you to start a food pantry and provide food for people.” Wendy began working almost immediately. Her first task was to tell her husband, who said, “If that’s what God told you to go do, do it.” Other family and close friends weren’t as supportive, offering either indifference or skepticism about the wisdom of her venture. Undaunted, Wendy gave her work thirty days’ notice that she would be leaving and continued to move ahead with Tabitha’s Way. To save money, Wendy filed her own application to incorporate as a 501c-3 organization, a miraculous feat for a woman who by her own admission couldn’t figure out a simple tax form. She continued to reach out to family, friends, and neighbors in the community to gather resources. She found some people energized by her cause and mission, and others doubting either the prevalence of the need or Wendy’s ability to meet it. A critical first task involved finding the right location for the pantry. The location had to be zoned for food storage/ commercial use, and needed adequate space and power for refrigeration and other inventory needs, a front end area to distribute food, and proximity to public transportation, a necessity in accessibility for many of the food insecure. And the price and lease terms had to fit Wendy’s shoestring budget. The power of the Tabitha’s Way message opened doors among the receptive, often in unexpected ways. Wendy’s best friend’s husband’s mother’s boyfriend’s former business partner had space for lease that met all the criteria Tabitha’s Way needed, and that rather extended connection solved her first problem. With a legal organization in progress and a building in need of cleaning and organizing, Wendy set about securing the two next important resources—money to pay the lease and buy other supplies, and food to provide to those in need. As she began to learn about the nonprofit world, especially during the Great Recession that began in 2009, Wendy saw that nonprofits that relied on government funding lived a precarious life—they had all seen their government funding reduced or eliminated because of budget cuts. Government funds seemed to provide a false sense of security. Wendy decided that Tabitha’s Way would rely only on private funding. To solve the cash problem, Wendy dedicated the front end of the facility to support a small thrift store. Serendipity continued to play a role when a local ministry decided to close its own clothing operation. It provided Tabitha’s Way with clothing racks, an initial stock of clothing, and other supplies needed to open and run the thrift store. Wendy went on the road, visiting local community organizations, business, and schools in search of both food and clothing. Community members generously donated clothing to help needy local residents, and Tabitha’s Way soon had more than enough inventory to stock the shelves. Online research by Wendy’s husband revealed a market for bulk used clothing that could generate cash for the organization. If Tabitha’s Way could provide a constant supply of clothes into this channel, the pantry could contract with vendors for a stable cash flow at a higher price per pound than selling clothes on an ad hoc basis. During the next two years, Tabitha’s Way would install more than 100 neighborhood bins to collect used clothing for sale in the secondary market. The organization would soon be selling 20 tons of clothing every quarter.

3

4

Tabitha’s Way Local Food Pantry

Wendy had approached two local grocers in the hopes of setting up a grocery rescue program. Grocery stores have to discard nutritious perishables that hadn’t sold or prepared foods approaching the sell-by date, and nonprofits provide a service by rescuing this very safe and edible food and putting it into the hands of needy families instead of the trash. Both local stores, however, declined Wendy’s offer because they were already involved in other programs. Tabitha’s Way’s first food donation was a case of Top Ramen and a few cans of soup, hardly enough to provide food for many hungry families. That same week, however, a local school called to donate 4,000 pounds of canned food, and the two local grocers called back with an offer—Tabitha’s Way was welcome to rescue food on the weekends, holidays, and other times left uncovered by the stores’ other commitments. The food rescue program would eventually grow to cover most of South Utah County and would generate from 35,000 to 40,000 pounds (17.5–20 tons) of food each month. In June 2010, Wendy and her volunteers began distributing food packages to the few local families that happened by the store. By October, when all the necessary licenses had been approved and the official ribbon cutting ceremony took place, Tabitha’s Way had a regular clientele that kept Wendy and other volunteers busy throughout the day. Wendy felt that she had, to this point, answered God’s call to feed the hungry.

Growth With the pantry up and running, Wendy faced a new challenge: keeping up with growth. Each milestone she hit (staying open all day, creating a contract to sell bulk clothing) represented a success and helped meet the mission of Tabitha’s way, but each milestone created a new set of operational challenges. Up to this point, she had relied on family, friends, a few volunteers, and the positive word of mouth the food bank had received in the local community. Word of mouth brought in donations and volunteers, usually 1–2 per week. Volunteers helped staff the thrift store, unload and sort food, and help pick up clothing from the neighborhood donation bins. Wendy needed to learn how to transform an occasional and sporadic pool of volunteers into an ongoing and stable one. In the early days, it was easy to manage a few volunteers—what needed to be done was pretty clear to all. As the operation grew and became more sophisticated, making sure volunteers ended up doing productive work took more and more of Wendy’s time. Tabitha’s Way organized and sponsored several events to reach out to the hungry and to the local community. In the late summer, the organization sponsored a backpack give-away for children and youth in preparation for back-to-school. Children received a new backpack loaded with socks, underwear, notebooks, crayons, and other school supplies. Kids would start school on a better footing and the give-away gave needy families a reason to come to the pantry where they would receive food packs and necessary clothing items. The give-away also brought awareness within the larger community, and an increasing number of volunteers. From this pool, Wendy began to find a core group of regular, stable, and talented volunteers who could help manage her burgeoning operation. Tabitha’s Way held other events to help families prepare for winter, giving away coats and turkeys in early November, and hosting a Christmas toy event in December. Each March, the pantry organized HFAN, Homeless for A Night, at Spanish Fork High School. Students paid an entry fee and participated in a night full of activities to raise money for Tabitha’s Way. In addition to fundraising, HFAN gave students an opportunity to learn more about hunger and food insecurity; Wendy hoped that knowledgeable students would be more likely to reach out to the hungry and homeless at the high school. By 2015, HFAN involved more than 900 students (almost three-quarters of the student body) and raised more than $14,000 to feed the hungry.11 Clothing provided operating funds for Tabitha’s Way to pay for the building, heat, lights, and other operating expenses as well as the purchase of perishable food items (dairy products, meat, and some fruit) that families needed but were difficult to obtain through donations. Clothing donations stocked the thrift store and provided Tabitha’s Way with additional funds through bulk resale. In 2012, Wendy signed a five-year contract with a company to provide

Tabitha’s Way

200 clothing bins to accept donations. The company took a cut of the bulk revenue to cover the cost of the bins, and Tabitha’s Way received the rest of the money. When the contract expired in 2017, Wendy would own the bins outright, and all proceeds from bulk sales would flow to Tabitha’s Way. Although the deal had limited immediate benefits to her organization, Wendy hoped that by the time her financial base expanded, she’d have an organization that could effectively use the funds. Wendy began her operation with a used Chevy Silverado 1500 pickup. The truck would do grocery rescue in the morning and clothing pick-up in the afternoons. The supply of clothing soon exceeded the truck’s capacity and Tabitha’s Way bought a used horse trailer for $400. Within few months the organization needed even more capacity. Wendy applied for a $20,000 grant from Walmart to buy a new truck. With the grant money, Tabitha’s Way bought a Toyota Tundra capable of carrying a couple tons of clothing, and an 18-foot storage trailer. Volunteers would sort the clothes, saving the best to stock the thrift store and put the rest in the trailer for bulk sale. Wendy ran her operation for almost three years relying on family, friends, and volunteers. By 2013, operations had become large enough, and generated enough cash flow, to justify hiring an employee to run the thrift store. As the operation became more complex, the thrift store needed attention that Wendy did not have the bandwidth to provide. Another employee was hired to run the pantry operations. Wendy added two part-time employees in 2014 to coordinate the pantry’s grocery rescue program. With the grocery rescue program and an ongoing agreement with the Utah Food Bank (located in Salt Lake City), Tabitha’s Way was bringing in and distributing from 40 to 45 tons of food each month. In mid-2015, Wendy was approached by the owners of a local business. The owners indicated that they had watched her organization for the past five years. Their initial skepticism about Tabitha’s Way had transformed into a glowing respect. They had witnessed Wendy’s ingenuity and perseverance, and were especially impressed by her ability to get the maximum impact from the resources she was given. The company told Wendy they would donate $1 million to Tabitha’s Way over the next five years. Wendy saw that donation as another wonderful blessing that would allow her to pursue her vision to feed the hungry. Wendy felt she needed to reevaluate the thrift store in terms of that vision. While it provided funds to support the organization, she realized that the thrift store took the time of staff members and volunteers in addition to funds to run the store and pay employees. Wendy remembered some wise council she received from a local pastor when she first opened Tabitha’s Way: “If God called you to feed the hungry, then only feed the hungry.” The thrift store had always been a means to an end, and Wendy and the board decided that the thrift store was not mission central—Tabitha’s Way provided food to the hungry. In early 2016, the front end of the Spanish Fork pantry transformed from a clothing outlet to more of a grocery store. Food replaced clothing on all shelves and Tabitha’s Way moved from distributing prepackaged food boxes to a self-shop pantry. Self-shopping provided two advantages: when patrons chose their own food, waste decreased because families took food they would actually eat. Second, self-shopping for food provided greater dignity and respect for patrons, their circumstances, and their needs. Wendy believed deeply that choice empowered people, even if that choice was limited to which food items a family would choose. The end of 2015 and the first half of 2016 brought more change and professionalism to Tabitha’s Way. Wendy had established a board of directors in 2010, composed of other leaders of nonprofits and community leaders. The board had always been helpful, but because these were all busy people their ability to help was bounded by multiple time commitments, and a lack of knowledge about the exact needs of the organization. Sometimes it was easier just to do the work herself rather than relying on board members. Wendy, who had never served in an executive position, had to learn to manage the board and not be managed by it. This meant replacing some members, but mostly learning to communicate her needs and desires more effectively. Managing the board helped—and forced—Wendy to become more strategic in her management of the operation. By 2016, she had come down the learning curve enough to have a stable board with the expertise she needed to move the Tabitha’s Way forward. She was also able to carve out time in her busy schedule to work on longer term, strategic challenges and plans.

5

6 Tabitha’s Way Local Food Pantry

Wendy helped the board break into effective committees to manage ongoing operations and strategic priorities. Board members teamed up with employees, and even volunteers, to run several committees: food drives, operations (including training employees and volunteers), volunteer coordination, special events, and development (fundraising). Wendy began to focus her efforts more on leadership (doing the right things to create organizational effectiveness) rather than management (doing things right to create organizational efficiency). An organization chart as of mid-2016 can be found in Exhibit 1. With an active board and enough staff, many traditional-looking management systems began to emerge. Financial record keeping, for example, moved beyond meeting tax and banking requirements, and Tabitha’s Way began to record and track a variety of measures that made a difference in the lives of patrons. A part-time staff member measured a series of key outcomes to help the pantry know how it was doing and what it needed. Exhibit 2 displays some of E XH I B I T 1

Tabitha’s Way Organization Chart, 2015–2016 Board of Directors

DirectorWendy Osborne

Food Drive Committee

Volunteer Committee

Operations Committee

Special Events Committee

Development Committee

Community Relations

Recruiting

Staffing

Training

Scheduling

Accounting and Reporting

Planning Source: Internal documents

EX H I B I T 2

Food Intake Data, Late 2016, in Pounds

Monthly Inventory Report 2016 May

June

July

August

September

October

November

Food Drive

2,460

65

0

317

1,262

1,178

22,924

Utah Food Bank

43,657

41,319

30,973

27,741

22,003

21,889

27,603

Private donations

5,152

11,059

2,557

831

2,045

1,905

3,292

Grocery rescue

37,605

41,212

39,923

43,375

37,566

33,587

38,750

0

0

0

4,532

Total in

88,874

93,655

73,453

77,156

62,876

58,559

92,569

Total out

87,640

97,132

77,982

79,117

59,989

56,806

73,872

In stock beginning

15,288

16,522

13,045

8,516

6,555

9,442

11,195

In stock end

16,522

13,045

8,516

6,555

9,442

11,195

29,892

6

8

10

10

10

10

12

NC Transfer

Farmer food %

Tabitha’s Way

this data about food, both collections and distributions. The volunteer committee developed a volunteer application and handbook to bring on the right people, put those people on the right tasks, and instill the vision, values, and principles of the organization. Exhibit 3 describes the different volunteer positions available at the pantry, and Exhibit 4 presents parts of the volunteer handbook.

EX HIB I T 3

Volunteer Opportunities and Job Descriptions

Volunteer Opportunities Volunteers are the heart of our organization. They are essential to any food pantry and to any noble cause. Most volunteer sessions are two or three hours. Working at the food pantry is more than just handing out food it is helping change people’s lives. We have several amazing opportunities to choose from. The shifts we need assistance with are: Monday Family Night from 6 pm to 7 pm Tuesday Adopt A Pantry Night the hours of 6 pm to 8 pm (Groups Only) Tuesday through Friday between the hours of 8 am to 5 pm Saturday between the hours of 8 am to 12 pm Need a family project? Want meaningful service for your family? Come help us prepare our pantry for distribution and learn how this simple service has a huge impact on those in need in our community. Volunteer Orientation not required for this opportunity. Reserve your Monday night now! Mondays only from 6 pm to 7 pm. Join our Grocery Rescue Team Are you a foodie? Do you enjoy grocery shopping? Then this job is for you! Once per week assist our team by going to local grocery stores and supermarkets to collect the food they are donating. All that is required is a vehicle. Opportunities are available daily in three hour shifts Monday through Saturday 8 am to 11 am. Client Intake Representatives  Have you been told that you are a great listener? Do you have great problem solving skills? We would love to talk with you about this opportunity! Our Client Intake Representatives meet one on one with our new clients to establish services with them at the pantry and help refer them to other sources that they may qualify for in the community. We have opportunities are available. Tuesdays through Fridays from 11 am -2 pm and Saturdays 10 am-Noon. Shopping Assistant  Are you a coupon guru? Do you know how to turn a can of chili into a feast for 10? Then this job will be perfect for you. Help our clients navigate through our client choice pantry. Some clients need assistance through the process or ideas on staples that can turn into great meals. Opportunities are available in 2 hour shifts. Tuesday between 11 am to 2 pm and 6 pm to 8 pm. Wednesday through Friday 11 am to 2 pm and Saturday 10 am to 12 pm. Volunteer Group Leaders Are you a natural born leader? Can you delegate tasks like a pro? Then this one is for you! On any given day there may be a dozen volunteers working in the pantry. We need volunteers with leadership experience who can guide, support, schedule and help praise our volunteers for all the tremendous service that they provide. Opportunities are available in two hour shifts. Tuesday between 11 am to 2 pm and 6 pm to 8 pm. Wednesday through Friday 11 am to 2 pm and Saturday 10 am to 12 pm. Help as Ambassadors with Groups in the Community Do you have a lot of connections? Can you rally up a group with ease? Then we want you! Help coordinate and support groups like scouts, churches, and schools to provide volunteers and help with Donation Drives (food, hygiene kits, baby supplies). Positions available as needed with a time dedication of two to eight hours per week.

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Tabitha’s Way Local Food Pantry

E XH I B I T 4

Volunteer Handbook, Selected Sections

June, 2016 Dear Tabitha’s Way Local Food Pantry Volunteer, Thank you for being a part of our food pantry volunteer team and for helping make possible the services we offer to those in need in our community. We couldn’t provide our many services without the generous support of our volunteers. This packet has been created to give you the information that you may need during your time of volunteering at our pantry. Please watch for information on the bulletin board at our new Volunteer information Center. If you have any questions or concerns, please don’t hesitate to ask. Again, thank you for your service. Sincerely, Wendy Osborne Executive Director

Melissa Prins Market & Events Manager

Mark Driggs Inventory Manager

Vision • Be a model pantry in the eyes of our clients, our peers, community leaders and key partners. • Be recognized as a community leader in South Utah County in helping clients move towards self-sufficiency. • Have a relationship with donors that includes food, time and money. • Have a significant presence in the South Utah County area in multiple ways: Client awareness Donor awareness (time, money and food) Volunteer awareness • Be Financially strong. • Primarily engage with volunteers for tasks that need to be done to accomplish the mission. Operating Principles • All efforts should be directed towards relieving hunger and food insecurity for those in need living in South Utah county. • Funds should be managed with a high level sense of responsibility to donors’ intent. • Operations are primarily carried out by volunteers with employees providing leadership and oversight. • Community awareness of Tabitha’s Way services and needs is critical to our ability to fulfill our mission. • Positive relationships with key partners and community leaders is critical to our ability to fulfill our mission. Policies • We are an Equal Opportunity pantry. Please treat all donors, clients and volunteers with respect and dignity. Procedures • Please be sure to sign-in/sign-out and wear your badge each time you are here to volunteer.

Tabitha’s Way

Expansion into North County As the evolution of Tabitha’s Way into a vibrant and capable organization took place, Wendy realized Tabitha’s Way needed to expand its operation. The Spanish Fork location was, figuratively if not literally, bursting at the seams. The Main Street location provided patrons with easy access and helped embed Tabitha’s Way in the community, but the back end of the building was horrible. The building had no loading dock and the lack of a real warehouse meant that 40 tons of food had to be unloaded, stored, and moved to the front by hand. Most of the storage was in a cramped basement, and the freezers and refrigerators needed for cold storage taxed the electrical system. Tabitha’s Way leased the space and paid monthly rent, which meant that cash went out without building any equity. In early 2015, Wendy began actively searching for a new location. A local realtor donated time to help find and handle negotiations for a new building. Serendipity played a role again as an old building in downtown Spanish Fork, less than a block away from the current location, came on the market. Tabitha’s Way could purchase the building and convert its rent into an equity-building mortgage. The new building would be easy to access for patrons and met all Americans with Disabilities Act requirements, offered more square footage with a better layout (8,000 square feet spread evenly over two floors), had a loading dock, and came with an attached cold storage facility. Tabitha’s Way closed the deal on the building in the late summer of 2016. With the donated time and expertise of local architects, engineers, and a variety of building contractors, Tabitha’s Way would be able to get into the new facility for a little more than $200,000—a fraction of the full price of such renovations. The building would be ready for occupancy by early 2017 and would dramatically increase the organization’s ability to serve South County residents. As Wendy had learned, moving to a new location would require changes to the operating procedures and routines of the organization. Wendy had also learned another important lesson: a food pantry is an inherently local operation. The weight and cost of transporting food meant that donations usually came from local residents, businesses, or grocery stores. The limited incomes and lack of transportation among those the pantry helped feed meant that a pantry served patrons in a very small area. Tabitha’s Way had grown to serve those living in the South County area, but that meant nothing to the hungry in the North County area. Wendy believed strongly that expanding operations meant finding a way to meet needs of the hungry in Northern Utah County. In mid-2015, two men showed up in Tabitha’s Way’s Spanish Fork location and asked to speak with Wendy. The two, each a successful business owner, had been working for four years to open a pantry in Northern Utah County. Al Switzler and Mike Carter realized the need to feed the hungry in Northern Utah County, but their efforts to start a pantry not borne fruit. Eventually, they realized that although they knew a lot about business, they knew very little about running a food pantry. Their search led them to Tabitha’s Way and Wendy Osborne. Wendy readily agreed to join forces and added the two to her board. The sharing of skills proved mutually beneficial—Wendy, Al, and Mike all supplemented their own skills with the others’. A second pantry in the northern part of the county faced a huge hurdle: finding a building that met all of the requirements. The center of Utah County had always been Provo, with Brigham Young University and Utah Valley University (originally the Central Utah Vocational School) as economic and social anchors. During World War II, the US government subsidized an inland steel mill—beyond the reach of potential Japanese bombers—in Orem and Lindon, just north of Provo. Residential, retail, and light industrial building dominated Northern Utah County, while the southern part of the county had retained its reliance on agriculture. Northern Utah County added a strong technology component to its economic mix in the mid-1990s when the city of Lehi became the site of a Micron, now IM Flash, wafer fabrication facility. Adobe arrived in Lehi in late 2012, and Northern Utah County leaders bought into the moniker of “Silicon Slopes” to describe the emerging technology hub. In terms of community and real estate development, Northern Utah County continued to build out residential spaces, supported by light retail and school properties. Few buildings met the criteria Tabitha’s Way needed for an effective pantry. Al and Mike’s four-year search ended in early 2016, when they found and leased a location that met all the criteria: A loading dock, a large warehouse with adequate cold storage, ADA

9

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Tabitha’s Way Local Food Pantry

compliant accessibility for patrons, and adequate retail and intake space to provide food with dignity. After a few simple changes to the building, the North County pantry opened in July 2016. To mark the event, and to better represent their new mission, the organization changed its name to Tabitha’s Way Local Food Pantry—South (or North) County. The organization planned to implement the same structure in the North County pantry that had proven successful in the South County location. Wendy realized that such a plan looked great on paper, but the South County structure had evolved over more than half a decade, and many elements of the pantry’s operating processes were unique to the building and the community. The operating procedures would need to change to fit the requirements of the new location, and Wendy wondered how to share operational learning and knowledge between the two locations. She also thought deeply about community engagement. Relationships in Spanish Fork had taken years to build and mature, and the pantry worked hard to cultivate and deepen those relationships. The North County operation would be much different. This was a large-scale operation entering a new community. She needed volunteers, staff, donors, and other sources of community support, and she needed all of these soon. As strong gust of wind howled outside, Wendy’s thoughts came back to the tasks at hand. The pantries would both deal with the natural upswing in patron visits for the Thanksgiving holiday, and the upcoming Christmas toy giveaway. These were important events to be sure, but so were the three strategic issues she could not put out of her mind. First, how should she change her own style and routines to lead two operations? How could she transfer her love—the true foundation of Tabitha’s Way—to a new group of employees, volunteers, and community leaders? How could she spend enough time in both locations to make sure her vision and passion continued to drive both pantries? How would she build a new network of volunteers and funders for the North County operation? How could she scale it quickly enough to meet the demands of the new facility? How could she, and her organization, avoid running too fast and burning out?

References Available at http://biblehub.com/acts/9-36.htm, accessed November 29, 2016. 1

Definition taken from the United States Department of Agriculture, available at https://www.feedingtexas.org/learn/food-insecurity/, accessed November 29, 2016. 2

3 D. Rose, “Economic Determinants and Dietary Consequences of Food Insecurity in the United States,” The Journal of Nutrition (1999) (suppl. 1998 ASNS Symposium Proceedings129.2s): 517S–520S, available at http:// search.proquest.com.erl.lib.byu.edu/docview/197442857/fulltextPDF/ D851A5D921EE4603PQ/1?accountid=4488, accessed December 23, 2016.

M. Black, “Household Food Insecurities: Threats to Children’s Well-being,” The SES Indicator (June 2012), available at http://www .apa.org/pi/ses/resources/indicator/2012/06/household-food-insecurities.aspx, accessed December 23, 2016. 4

D. N. McCloskey, Bourgeois Dignity: Why Economics Can’t Explain the Modern World (Chicago: University of Chicago Press, 2010), p. 2. Income figures cited here are in 2010 dollars. That translates into roughly $3.30 for 1800, $151 for Norway, and $133 for the United States. 5

Statistics in this section taken from A. Coleman-Jensen, M. Rabbitt, C. Gregory, and A. Singh, Household Food Security in the United States in 2014. USDA, Economic Research Service (September 2015), available at http://www.arhungeralliance.org/wp-content /uploads/2012/12/USDA-Report-Household-Food-Insecurity-in-2014 .pdf, accessed November 29, 2016. 6

Ibid.

7

Data from Feeding America, available at http://map.feedingamerica .org/county/2014/overall/utah/county/utah, accessed November 29, 2016. 8

Data from the US Census, available at http://www.census.gov /quickfacts/table/PST045215/49049, accessed December 23, 2016. 9

A list of Utah County Food Resources, available at http://www .foodpantries.org/ci/ut-provo, accessed December 29, 2016. 10

Data taken from http://sfhs.nebo.edu/news/201602, accessed December 26, 2016. 11

ONLINE CASE Vivint SmartHome: Finding New Pathways for Growth Prepared by Jeff Dyer, Harrison Miner, Phillip Stafford, and Rachel Durtschi

Introduction On a cloudy afternoon in 2012, Matt Eyring was driving through the mountains near Provo, Utah, as he considered the challenge ahead as chief strategy and innovation officer at Vivint, a would-be smart home services provider. Like the road he was driving, his career had taken many twists and turns to this point. He’d worked as a consultant at Monitor, graduated from Harvard Business School, and co-founded Innosight with Harvard’s famous disruptive innovation professor, Clayton Christensen. Most recently he had worked as managing partner at Innosight, where he had directed an impressive team of consultants delivering innovation results for clients. Recently he’d been offered the position of chief strategy and innovation officer at Vivint, and had decided to jump onboard. Eyring joined during a time of tremendous change for the company. Vivint had been acquired for $2 billion by the Blackstone Group. Investors anticipated a future where the alarm system provider transformed into a provider of a wide variety of “smart home” services. Eyring had been tasked with identifying and piloting Vivint’s strategic direction. How could Vivint morph into a tech company providing an array of smart home solutions? Todd Pederson, the company’s CEO and founder, had conceptualized a future where Vivint provided smart home solutions to all, and Eyring was charged with determining what steps needed to be taken to accomplish this vision. Eyring needed to find—and take advantage of—the most profitable growth options within the smart home arena.

Vivint’s History The founder of Vivint, Todd Peterson, was a business student at Utah Valley University in 1990. One of 10 children, Pederson had to be financially independent from the beginning of college. He worked odd jobs to pay the bills, including construction and cleaning homes in affluent neighborhoods. To find new customers, Pederson began to knock doors in wealthy neighborhoods. He found that he was talented at door-to-door sales; he didn’t mind the rejection associated with the task and quickly honed his sales skills.1 During the summer of 1992, Pederson and a cohort of his friends moved to Arizona to sell pest control door to door for Terminex, a large company in the pest control business. During that summer, Pederson and his cohort were so successful that he was asked by Terminex to hire 80 additional salesmen. This experience prompted Pedersen, along with Keith Nellesen 1

2 Vivint SmartHome: Finding New Pathways for Growth

(also a co-founder of Vivint) to create their own business selling pest control as a third party.2 In the spring of 1993 Pedersen dropped out of school, and began running the operation full time. At the peak of selling pest control, Pederson and Nellesen’s team was identifying 30,000 new customers per year for Terminex and other companies. In 1998 much of that changed, however, when two of Pedersen’s employees tested selling security systems door to door. Ironically, this original test failed, but both salesman came back with a new understanding of the industry and were adamant that home security sales were the next big opportunity for the team. Pederson saw their vision and believed home security systems could be the future of the company. So, APX Alarm security solutions was incorporated in 1999.3 For a time, APX focused primarily on selling security systems. The business grew quickly, with over 900 systems sold in one summer. The security provider partners, however, were overwhelmed and could not provide the customer support and service needed to keep customers happy. Leadership at APX saw opportunity in the challenge—if their customers were experiencing this much pain with current security offerings, there would certainly be a place for APX to install and service home security systems, not just sell them. In 2006 APX began installing and maintaining home security solutions. From the beginning, this product switch came from a desire to better serve customers. Much of this expansion, also licensed to begin in Canada, was possible because of a $75 million credit facility funded by Goldman Sachs, Jupiter Partners, and Peterson Partners. Pedersen wanted to grow the business, and this injection of funding was necessary for APX to move to the next level. In 2010, four years on, Pedersen and his team noticed the stagnation of the security alarm market. There wasn’t much innovation in the business. Security panels were the same as they had been for years, offering only basic alarm information to customers. APX’s team invested heavily in R&D to create a home display panel that would provide more information. APX developed energy management software that allowed customers to manage their thermostats to improve energy efficiency. This innovation was a step forward in transforming APX into an innovative provider of smart home solutions.

Rebranding In 2011, APX Alarms rebranded as Vivint, with a highly recognizable bright-orange logo. The new name represented an overall shift in what Pedersen and his team wanted to achieve.“Vive” is a root that connotes living intelligently. Just one month later, Goldman Sachs led a $565 million debt financing round.4

Vivint Solar and SmartHome At this point, Pederson and his team considered expansion into a new industry: solar panel technology. Vivint had discovered that their new display panel, incorporating SmartHome technology, increased customer retention. This data led to a crucial decision: Vivint would grow smart home solutions for a tech-savvy and changing world. Solar was a logical step forward. Vivint already had a national sales force with experience in energy monitoring via their panel. Moreover, solar was an attractive market, with only regional and local players at the time. With a growing customer base, offering solar panels was a logical next step. Projections looked high for Vivint’s growth, with some analysts believing that Vivint would soon own the largest share of the market.5 Vivint Solar was created as a subsidiary of Vivint, able to function separately but utilize firm resources. Using a $75 million initial investment from US Bancorp, the division began in New Jersey with plans to expand to many other US states. Vivint set up its solar business by allowing customers to pay for its panels in small monthly installments, instead of requiring upfront purchase. This

Commercial Security | Vivint Properties

“third-party” ownership model was popular among major solar carriers and investors as it allowed household consumers to adopt solar energy on a personal level. In 2012, the Blackstone Group acquired Vivint for $2 billion. At this time it had around 675,000 customers and had grown substantially. Further, Vivint Solar was spun off, becoming its own separate, but related, company.6 It continued to grow through 2014, when it went public.7 That was the year Matt Eyring was hired. Though Vivint had been growing substantially, Matt was tasked with transforming the firm to become a technology-oriented smart home solutions provider. In his drive through the canyon, Matt pondered the challenge of growing Vivint sustainably into a tech company that was agile enough to succeed in the industry, while fending off challenges from companies like Amazon and Google. Over the ensuing five years, Eyring and his team pursued a number of different growth options with mixed success.

Commercial Security | Vivint Properties As Vivint continued to sell SmartHome and security packages to residential customers, an opportunity to expand into commercial security systems presented itself. Residential customers and contacts frequently asked if Vivint could provide a security system for their small businesses. Through this indirect sales channel, Vivint had signed up more than 10,000 small business customers by the end of 2013. Because commercial customers had already shown interest in Vivint security, executives determined to launch a dedicated sales channel to focus solely on the commercial market. The initial goal was to sign up 5,000 new customers in 2014. Half of this goal would be achieved through sales reps cold calling on small businesses, and the remaining portion would come through inside sales, where a potential customer would call Vivint looking to buy a commercial security package. Additionally, direct-to-home referrals occurred when a customer who had previously purchased a residential security package requested a security package for their business or office. A pilot sales team was launched in Salt Lake City with the hope of getting 10 sales per month per rep. Sales reps had to be careful about which businesses they approached because the existing residential security product could only service a certain size building. If a commercial building was too large, the sensors were too far apart to function reliably. Moreover, the level of security required for a commercial account was much higher than for a typical residential account. In order to solve this problem, a product manager was hired to develop products that would be more effective for the commercial security business. These products included items such as different door locks, Ethernet-connected cameras, DVRs with 24/7 storage, and outdoor cameras. With these additions, Vivint’s commercial business would be able to provide higher quality service to a wider variety of businesses. But in 2014 Vivint did not yet have a full set of products that were designed to meet the needs of the larger commercial customers. As 2014 progressed, it became apparent that Blackstone, and senior management, wanted to pursue even more aggressive sales and profit targets. The commercial team, with its original goal of 5,000 new customers in 2014, was asked to triple their goal to 15,000 customers in order to support sales and profit goals. In response, the pilot team in Salt Lake City grew and new teams were added in Las Vegas, Nevada, and Modesto, California. As the size of sales teams grew, the quality of salespeople deteriorated. Only the original, top sales people were coming close to the expectation of 10 sales per month. It seemed that the age, experience, and skill set of a successful salesperson for a commercial account was higher than for a residential account. Consequently, the sales team couldn’t scale fast enough to reach 15,000 new customers in 2014 alone. Once the CFO of Vivint realized that the goal of 15,000 new customers was unreachable, the commercial channel became an easy target for budget cuts in order to reach profit targets. Although the commercial venture did reach the original goal of 5,000 new customers, the commercial sales teams were disbanded and resources were diverted to other projects. Vivint still sells existing security system products into the commercial market through inside sales and direct-to-home referrals, but it no longer has a business unit with a salesforce dedicated to growing the commercial segment.

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4 Vivint SmartHome: Finding New Pathways for Growth

Some within Vivint wondered if it was time to create another focused effort on the commercial segment with the resources needed to build the right product mix and a dedicated salesforce with the right skill set to effectively sell to commercial customers. In December 2015, Vivint decided to actively pursue the provision of SmartHome packages to multiunit properties and founded Vivint Properties as a new business unit. The technology required for monitoring a rental apartment and a single home was fundamentally the same. “Apartment residents and homeowners have the same use case for a piece of smart home technology,” said Jeff Evans, a product manager for Vivint Properties. “Whether you are at an apartment or at a home, you want to be able to lock your doors remotely, arm your security system, turn on and off your lights, and check your doorbell cameras.” As Vivint considered the total market for smart home technology, they realized that more than 30 percent of the population was renting, so they decided to target high-end consumers in rental properties to capture an additional 8–40 million households. Users in apartments had the same use cases as those living in homes. The product was the same and was supported by the servers and backend of the Vivint ecosystem. Finally, no large competitors were playing in this space. There were a few start-ups and small players, but none that had installed more than 10,000 units. Vivint felt like they would be able to capture significant market share because of their industry-leading products and salesforce skills.

Building and Testing Leadership in the smart properties initiative wanted to launch the new business unit like a start-up within their company. They started by testing, piloting, and developing a minimum viable product (MVP) before doing a full launch. Vivint quickly realized that this new market would require a different sales approach. The direct sales approach would not work well for properties management. Harrison Jenkins, the product manager over properties, said, “The approach with smart properties would need to rely much more on developing relationships and leveraging the credibility of the company [than the traditional direct-to-home model].” It would also need to show the managers how they could use Vivint technology to justify higher rents and provide value to their renters. This approach required a salesforce that was more acquainted with enterprise sales. This salesforce was created by hiring a team of five additional sales reps who could be successful in B2B sales. The new sales team would scale as the business grew out of the pilot tests with the MVP. Being successful in the multiunit property market would require both vertical and horizontal growth. Tom Few, VP of business development and head of Smart Properties, described what this process would look like for Vivint Smart Properties. “A vertical growth can be the first time that we do business with a building. Each building, however, has on average 200 units. Horizontal growth is expanding into 200 other buildings that have 200 units that the same company manages. Really, in this channel, there are about 100 relationships that you have to own. You own those 100 relationships and you have 80% of the market. This is why we stress that when we go into a building, the experience has to be the best that the property manager has ever had. This will guarantee us everything else. One bad experience will drastically hurt horizontal growth.” Vivint started with a small pilot test in April 2016 after about six months of research installing 10 units into two different apartment complexes. The test allowed Vivint to determine whether the product would meet the needs of the property managers while simultaneously allowing managers to test whether this added service would allow them to charge higher rent. The pilot tested feasibility for both property managers and Vivint itself.

Result As they scaled to larger pilot tests, Vivint realized that property managers wanted at least two things that were not included in the smart home package. The first was cellular-enabled devices. Property managers were not able to rely on Wi-Fi for their devices’ connectivity because often renters would use their own routers, leaving the property managers unable to check on properties remotely. The second discovery was that property managers did not want a monitoring system. The system was

Product Expansion | Internet

too likely to be set off by maintenance. Only the cameras and locks really added value for the property managers. Smart locks enabled managers unlock properties remotely, letting potential tenants tour the property without managers needing to be present. In addition to changes in the product, the tests proved that property managers were able to charge higher rent for each property. In one case, the property was able to increase the entertainment package from $109 to $159 per month. Additionally, adding the SmartHome package resulted in managers receiving significantly fewer complaints and pushback on entertainment package pricing, even though the price had increased. Vivint Properties is still a huge focus for Vivint as they seek mass adoption by expanding their services to one of the largest untapped markets: rental and multifamily units. This area has huge potential for Vivint, and if done right could lead to millions more families adopting this technology in the future.

Product Expansion | Internet The initial push for Vivint to have an ISP (Internet service provider) business unit originated from Kevin Ross, a Vivint employee with previous experience in sales and telecommunications. Kevin believed that Vivint’s strategic assets would be easily leveraged to sell Internet services to new and existing customers. Vivint, through its SmartHome product line, already possessed a skilled direct salesforce as well as field technicians and customer support capabilities. These assets were a necessity for successful Internet service providers. Moreover, a pilot study revealed that the percentage of potential customers contacted (via door-knocking) who would consider switching ISPs was higher than those who would purchase a Vivint SmartHome subscription. In fact, market tests on sales productivity, measured as revenue per doors knocked, showed that selling Internet was two to three times more profitable than SmartHome. Furthermore, research showed that customers who purchased Internet from Vivint were also more likely to sign up for SmartHome. Internet seemed like a natural extension of the Vivint SmartHome product line. Interestingly, Internet service providers had been viewed with contempt by American consumers. For example, Comcast, a massive ISP, was voted the Worst Company in America in 2010 and 2014 and consistently receives rock-bottom customer satisfaction scores.8 Most customers were dissatisfied with their ISP but had few better alternatives. The fact that incumbents weren’t receiving high customer satisfaction ratings made the Internet opportunity seem even more attractive. After finishing its market analysis in 2012, Vivint’s strategic business development team determined that Vivint Internet was a reasonable business opportunity that should be pursued. Although Vivint already possessed assets that would be leveraged in the new Internet business, it still needed to acquire more specialized talent and resources. A small start-up in the Bay Area called SmartRow was identified for acquisition. SmartRow possessed proprietary knowledge with regard to 5 gigahertz Wi-Fi. Vivint hoped to use this technology to become the first WISP (wireless Internet service provider).9 A WISP provides Internet to a home without needing to install cables or fibers in the home. SmartRow was acquired and rolled into the new business unit, Vivint Wireless, Inc. Several expensive vice presidents were hired to manage efforts in engineering, operations, infrastructure development, and so on. in the new Vivint Wireless business unit. Vivint Wireless used a technology called local multipoint distribution service (LMDS) to deliver Internet service to homes. Radios, with fiber connections, were placed on cell-phone towers or other tall buildings. These radios would connect wirelessly to antennas on a “hub home” in a given neighborhood. A hub home was where a customer would allow Vivint to install three radios on the roof in exchange for free Internet for life. A hub home could handle 24 other connections before another hub home would need to be installed in the neighborhood. Each fiber-connected radio could handle 100 hub homes.10 Each paying customer’s home would need an antenna installed on its roof. This antenna would be hardwired via Ethernet cable to the home’s router, distributing wireless network. Due to the network delivery system, Vivint Internet had limitations on what sorts of geographies it could service. Luke Langford, general manager of Vivint Internet, said, “Rural communities with five-acre

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6 Vivint SmartHome: Finding New Pathways for Growth

lots don’t work for us. … And some areas where there are lots of tall mature trees blocking line of sight from cell towers can be problematic. The same goes for densely populated metropolitan areas. We can work in those places, but it’s not as easy. Our service is tailor-made for suburban America.” Vivint Internet service required a two-year contract at $60/month and provided 100 Mpbs speeds.11 After beginning in late 2013, Vivint Internet was operating in markets in Utah and Texas, with roughly 15,000 subscribers by June 2015. Despite what seemed like solid growth, Vivint’s COO demanded higher sales targets and revenue which put pressure on the business unit to generate even faster growth. Vivint sales reps quickly realized that selling internet subscriptions was much easier than selling SmartHome systems. But, as the customer base grew, quality began to deteriorate rapidly. Poorly trained technicians installed radios pointing in the wrong direction, severely decreasing Internet speeds. Some technicians, who were overbooked, rushed through installations and committed errors that would require future attention to fix. Equipment that had been cobbled together in haste in order to get to market frequently malfunctioned. Customers were sometimes left to wait without Internet for several days before technicians could come to the house to fix issues. These quality problems damaged Vivint’s ability to operate as a better alternative to other ISPs like Comcast, Time Warner Cable, or DirectTV. Even as Vivint Internet continued to grow, the business unit’s managers knew that the current infrastructure model, utilizing 5 gigahertz technology, would not be sustainable in the long run. Comcast and Time Warner were making large investments in new technology and could easily eclipse the Internet speeds offered by Vivint. Vivint technicians were installing equipment that would soon be outdated, building a larger and larger “debt” for future upgrades for customers in order to stay competitive. Vivint management realized that they would constantly be in a race with these larger competitors to offer the fastest speeds and latest technology. In 2016, Vivint senior management elected to stop selling new Internet subscriptions until a technology plan for the future could be developed. Vivint Wireless continued servicing existing customers on the legacy networks built in Utah and Texas but did not pursue new customers. This pause was taken to determine whether faster, competitive technology could be developed with an infrastructure that would support profitable growth. Once faster, competitive technology has been developed, Vivint Internet planned to resume expansion into new suburban markets where there are few alternative ISP choices for customers.

Acquisition and Integration | Space Monkey In 2011, Alen Peacock and Clint Gordon-Carroll started a company named Space Monkey to compete with other cloud storage providers such as Dropbox, Box, and Google Drive. Space Monkey sought to create a distributed datacenter through creating a network in the homes of its users by storing enterprise data on the extra space of users’ 2TB hard drives.12 As the number of hard drives increased, the total capacity for enterprise storage would increase. These drives would give the user access to half of the total drive capacity to store videos from their smart home cameras or for the personal storage of photos, documents, and other files. The other half of the hard drive would be used for enterprise storage. This method was significantly cheaper than large database centers which need to be cooled and maintain a high level of physical security. Space Monkey’s enterprise storage would encode and store data on many distributed machines. This system provided high-level security because the different pieces of a file were spread out between many hard drives. As more and more customers bought drives, Space Monkey benefited from a network effect. The network of drives would grow stronger, and the total capacity of storage available to sell to enterprise customers grew. Not long after Space Monkey launched, Vivint developed a relationship with it through an investor in the start-up. The conversation turned to acquisition soon after a meeting with Space Monkey founders and Vivint executives at the Consumer Electronics Show (CES). Executives from the two companies began talking about how Vivint SmartHome and Space Monkey could work together. Originally, the conversation focused around the synergies that Space Monkey had with Vivint Internet. “At the time Vivint was offering the traditional triple play: internet, phone, and television. Our pitch was ‘why not cloud storage as well?’ to protect their photos and videos,” said

Retail Partnership | Best Buy

co-founder Alen Peacock. “We were talking about a partnership with the internet part of the business. Where Space Monkey would be offered as a part of internet.” The companies imagined the drive being installed as a part of the router in every subscriber home, increasing the effectiveness of the mesh network and allowing the smart drive function to be easily activated in any given home. While looking at Space Monkey as a target for acquisition, Vivint also examined how it would fit with their salesforce and integrate with their current SmartHome package. According to Alen Peacock, “[At Space Monkey] we had to be really tech heavy. That meant we neglected distribution and marketing. We didn’t spend a lot of time figuring out which channels were really going to get us long term to the right place. So Vivint seemed very complementary in that way. They had a really strong sales channel that was proven . . . they knew how to plug stuff in and get it in front of customers.” Vivint also thought that this would be an easy sell for the salesforce as an add-on to SmartHome for customers who wanted local back-up of their valuable files. Looking to the future, Vivint was attracted by the idea that a smart home generates a lot of data and would need to store that data somewhere. Space Monkey drives would be a solution to that problem. In addition to the storage, they also saw the potential for a playback DVR feature. This feature would store video footage from a doorbell camera and other household cameras for 24/7 playback. Finally, Vivint had a strong desire to be more of a tech company. The company started as a door-to-door security sales company, and that business model had shaped the culture and business practices of the company. Vivint hoped that acquiring Space Monkey would help them to evolve and become more of a tech company. The acquisition of Space Monkey took place over the course of four to five months, followed by a difficult process of integration. Both Space Monkey founders came with the company and continued to lead the business unit. As with Vivint Solar, Vivint allowed Space Monkey to continue operating as they had prior to the acquisition. In the beginning, Space Monkey kept the same branding and the same teams. This allowed them to act autonomously from Vivint in building new products while still receiving funding from their new parent company. This approach led to many benefits, but it also led to some resentment from within the company. Space Monkey’s founder, Peacock, referred to this process as “host rejection.” “We were a foreign object within the Vivint ecosystem,” says Peacock. “You could tell, it was pretty thick at times, some resentment from other groups that we were operating that way. The benefit of operating autonomously was that we didn’t slow down at all once we joined. We were able to release new versions of our apps within months of joining. We launched a new product in the second year. That is stuff that wouldn’t have happened if we had to stop and integrate.” Eventually, in 2017, the company changed the name and branding from Space Monkey to Smart Drive and moved founders Peacock and Gordon-Caroll to different roles in the company. Since being acquired, the Smart Monkey business has been split into two different functions; the DVR function and the enterprise storage function. Vivint uses the Smart Drives as a part of its SmartHome package. These drives store the data from all Vivint devices installed in the home, allowing for playback of video content for one month. Since the acquisition of Space Monkey, Vivint has increased revenues through upselling customers on SmartDrive for the purpose of the DVR playback function. Vivint’s focus in the years immediately following the acquisition was on building out the DVR playback function as a way to upsell customers. In doing so, they put the enterprise storage functionality of Space Monkey on hold. As Vivint moves forward with the integration of Space Monkey, there are still questions about whether implementing the original enterprise storage functionality of the drives will be a good option for future growth. As customers become more comfortable storing their photos and data in the “cloud,” it may be more difficult in the future to convince them of the value of a local storage option. There are varied views within Vivint on the value of investing to grow the enterprise storage functionality of Space Monkey.

Retail Partnership | Best Buy As Vivint looked to grow, the company sought a partnership that would help it to expand through new channels beyond direct sales. In January 2016, conversations with Best Buy Canada at the Consumer Electronics Show put them in contact with Best Buy’s chief strategy officer. Despite some

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8 Vivint SmartHome: Finding New Pathways for Growth

initial pushback within the company, leadership wanted to try expanding through retail channels. Speaking about this pushback, Tyson Chapman, director of retail operations at Vivint, said, “We had already done some retail stuff. It had gone OK, not great. We had done some stuff with Verizon. There was just kind of a reputation that retail doesn’t work. The funny thing about Vivint, and other places as well, is that you try something once and if people feel that it failed than it gets stamped as a failure.” In mid-2016, Best Buy was selected from a number of candidates as Vivint’s exclusive retail partner. Speaking about this decision, Vivint Director of Business Development Anthony Archibald commented, “We hadn’t reached the customer that was walking into Best Buy in the past, but they are a perfect fit for us. They are customers that are technology minded and are willing to pay up front for technology. Secondly, Best Buy is doing well with traffic unlike some other retailers.” As part of the agreement, Vivint offered a co-branded solution with Best Buy. This solution leveraged the brand name of Best Buy, increasing recognition of the product inside and outside of the store. The new retail approach was not meant to replace their summer sales model but to add another channel to the customer. Leadership also wanted to try a consultative selling experience which would have sales reps explain the benefits of a SmartHome and tailor the experience to each customer. Vivint hoped to find a partner to be able to piggyback off of its success while building out new sales channels.

Pilot Program The partnership between Vivint and Best Buy began as a pilot program in one store in San Antonio. In order to have a successful test, Vivint sent their best sales reps to Texas. Dressed in Best Buy blue, Vivint sales reps went to work. It didn’t take long for headquarters to realize that retail sales required a different approach than direct-to-home summer sales. Additional training was required to help transition the direct-to-home sales representative to a more effective retail sales approach. As Archibald put it, “for the most part, reps that are in stores are more endurance workers than sprinters like the summer sales people.” This was a fundamental change for the retail salesforce. In order to develop this expertise and provide the needed training, management flew to Texas and sold side by side with sales representatives to help them develop an effective sales approach. After a successful test during the holidays in San Antonio, the pilot test was expanded to six additional stores in San Antonio and then to 16 stores in Detroit. This process of systematic testing and expanding continued until Vivint had deployed 400 salespeople in Best Buy stores. While the roll-out did generate new sales, it was not nearly as successful as the first pilot in San Antonio. It was generally believed that the pilot was far more successful than the rollout for three reasons: it was conducted during the holidays when sales are higher, it was staffed with more talented salespeople, and it received a lot of attention from top management. Anthony Archibald noted that, “We would update Alex Dunn (company president) weekly and make decisions about trying out promotions, pricing, and expansion [of the pilot] into stores.” The good news for Vivint was that the successful pilot helped convince Best Buy to expand the partnership to additional stores. The bad news was that the performance of sales reps in other Best Buy stores didn’t come close to matching the performance of the pilot. Thus, both parties had inflated expectations from the pilot that were not realized with the rollout. One of challenges faced by Vivint was the entry of Amazon and Google into some product categories of the SmartHome package. For example, Amazon purchased Ring, a provider of doorbell cameras, and also provided its own door locking/opening products that allowed a customer to let an Amazon delivery person open a locked door to deliver a package. Google purchased Nest, a provider of thermostats, which put Google in direct competition with Vivint’s SmartHome thermostats. At Best Buy, customers often wanted to buy separate components of a basic Vivint home system: security, door locks, cameras, and thermostats. However, Vivint salesmen were not allowed to unbundle the Vivint system, allowing customers to purchase only a doorbell camera or a door lock. The economics of selling a full system was far more profitable than selling a one-off product because once a technician was sent to a home to install one product installing additional products was easy. Some felt that this limited Vivint from generating significant sales through the Best Buy partnership.

Business Partnership | AirBnb

Unfortunately, according to Best Buy CEO Hubert Joy in a call with analysts in late 2017, the Vivint–Best Buy alliance only had a moderate impact on revenue and sales. Within a few months of that analyst call, the companies announced that they had agreed to end the partnership. Despite the setback with Best Buy, Vivint CEO Todd Pedersen still believed that there were opportunities in pursuing a retail channel, saying, “We believe there are opportunities in the retail channel, and are committed to work towards more efficient ways to better help our customers explore, learn about, and buy the latest smart home products and services.”13

Business Partnership | AirBnb As Vivint SmartHome continued to grow, it sought for ways to further establish itself as a leading smart home technology company. Vivint executives were determined to do this through a high-profile partnership with another company in Silicon Valley. In 2015, Laurence Tosi, a Blackstone executive who had worked extensively with Vivint, left to become the CFO of Airbnb. Airbnb, founded in 2008, is a peer-to-peer property rental platform that has exploded in popularity over the past several years. In 2016, Fortune reported that Airbnb had booked more than $100 million in earnings before interest, tax, depreciation, and amortization (EBITDA) on $1.7 billion in revenue. Furthermore, Airbnb expected its EBITDA to swell to $450 million in 2017; a 350 percent increase.14 Vivint had tried previously to meet with Airbnb to propose a partnership but had been unsuccessful. With the help of Airbnb’s new CFO, Vivint secured a meeting and dazzled Airbnb with their vision of a potential partnership (See the pitch video here.) In January 2017, at the Consumer Electronics Show in Las Vegas, Vivint and Airbnb announced their partnership, with Vivint becoming Airbnb’s “preferred smart-home provider.” The partnership agreement contained two key features: host sign-ups and product integration.

Host Sign-Ups Airbnb was drawn to the idea of having Vivint salespeople help find and sign up new hosts on Airbnb’s platform. In certain vacation destinations, there was far greater demand for rentals than available supply. In these areas, Airbnb struggled to find ways to incentivize new people to sign up as hosts and rent out their living space. Airbnb wanted to use Vivint salespeople in targeted areas to knock doors and sign up new hosts. In exchange, Airbnb would allow Vivint to market directly to Airbnb customers. Through trial runs in Los Angeles, Vivint salespeople quickly discovered that they were able to help mitigate common concerns about hosting, such as how to handle security, cleanliness, and potential damages. With the promising results from the trial run, Vivint and Airbnb signed a pilot agreement to set up a Long Beach office with around 25 sales reps focused on signing up new hosts—and selling those new hosts on the benefits of installing a Vivint SmartHome system. Per the agreement, the sales reps would receive a small commission for every new Airbnb host. Furthermore, for every 100 new hosts that signed up, Airbnb would unlock 10 percent of its user base for Vivint to send direct marketing materials to via e-mail.

Product Functionality Vivint envisioned making the Airbnb check-in process simpler through several new product features bundled as “Hands-Free Hosting”. When a guest booked a stay at an Airbnb listing equipped with Vivint SmartHome, the guest would immediately receive a temporary passcode to be used on the door lock upon check-in. Using the Vivint door camera, the Airbnb host would see the guest check-in and be notified when the guest left. The temporary passcode would expire at the end of the guest’s stay, removing any need to meet for a key exchange. Additionally, the Vivint thermostat would efficiently conserve energy while the listing was not being used. Hands-Free Hosting required only

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Vivint SmartHome: Finding New Pathways for Growth

a software iteration and did not need any additional hardware products outside of a typical Vivint SmartHome system package. Additionally, current Airbnb hosts who signed up for Vivint SmartHome (a monthly subscription) would receive some of the equipment free.

Results Both the host sign-up and product functionality portions of the partnership agreement began to experience serious issues after launch. While Vivint had envisioned creating a ‘magical’ experience for Airbnb guests, the actual functionality of “Hands Free Hosting” was unreliable— and sometimes didn’t work at all. Developers were stretched thin across several other Vivint projects and the Airbnb project wasn’t big enough to warrant the developer attention it desperately needed. As a result, Airbnb hosts were reluctant to sign up for a very unreliable service that cost $40-$50/month. The Long Beach sales office quickly became another area of concern. Talented sales reps didn’t want to sell Airbnb because they could make significantly more money selling SmartHome systems. Airbnb paid a commission of just $200 for every new host, but a sales rep could make $600-$800 on just one SmartHome sale. Despite the misaligned incentives, the Long Beach office was able to sign up 160 new host for Airbnb. Airbnb was impressed with the performance and hoped to open more offices elsewhere in the country. Due to the agreement and relative success of the sales teams, Vivint had the opportunity to market directly to a portion of Airbnb customers. Airbnb had never previously marketed to their customers in this way and wanted to firmly control the messaging. As a result, the direct marketing proved to be ineffective, with very few Airbnb customers signing up for Vivint systems. Vivint quickly realized that the host sign-up portion of the partnership agreement largely favored Airbnb. When the Long Beach office closed due to the departure of its management to pursue another opportunity, Vivint elected to not open any more Airbnb sales offices until a better arrangement could be worked out. Vivint SmartHome is still listed as Airbnb’s preferred smart-home provider on Airbnb’s website. Hands-Free Hosting, while still not perfect, is now operational, and the few customers using it are reasonably satisfied. Employees at both companies are still hoping to find a way to make the partnership work better in the future. But what steps should be taken or whether additional investment by Vivint is likely to pay off is unclear.

Taking Stock | Lessons for Finding Profitable Growth As Matt Eyring discussed Vivint’s past growth initiatives with his team, he reflected on several of the lessons that they had learned as the company had pursued various growth options. The team discussed why some of the growth options—which all appeared to be promising at the time they were conceived—had failed to deliver on their promise. One thing was clear: generating new revenues (and profits) from growth options was certainly more difficult in practice than it was in theory. Eyring’s team identified what they thought were some useful lessons as they considered future growth options.

Leveraging Existing Resources and Capabilities Every growth option was designed to leverage some of Vivint’s existing resources and capabilities. In practice, some of the key resources and capabilities did not translate into new ventures as well as they had anticipated. What could Vivint have done differently to more accurately identify what cost synergies existed before investing in a new growth option?

Taking Stock | Lessons for Finding Profitable Growth

Pilots Like most organizations, Vivint had run pilots of its new growth opportunities to test whether it was likely to work. However, experience had taught the team that pilot tests of new initiatives were often misleading. Pilot tests received better resources and extra attention. Not surprisingly, this led to positive results from the pilots and inflated performance expectations associated with the rollout of a new offering. The pilot tests were typically two to three times as productive as the actual rollout. Matt wondered how he could best account for this phenomenon (which has been called the “Hawthorne effect” in academia due to early studies at the Hawthorne plant where increased attention to a pilot resulted in better performance). Was it possible to ensure that pilot tests were representative of the initiative at full scale? Or should Vivint simply discount the results of all pilot tests by a predetermined rate?

Customer Acquisition Costs In most new growth initiatives Vivint was trying to leverage its direct salesforce, but even when leveraging its existing salesforce, customer acquisition costs were usually higher than initial projections. Each new growth option seemed to target new customers instead of relying on existing customers to fuel growth. How could Vivint do a better at tapping into their existing customer base in order to decrease customer acquisition costs? And how could they do a better job at estimating customer acquisition costs for each new growth initiative?

Spread Too Thin? Eyring’s team noted that Vivint had perhaps spread itself too thin at times. Pursuing multiple avenues of growth simultaneously had left some initiatives starved of resources. As promising growth options emerged, they received more time, attention, and company resources. As a result, other ventures with slower growth were neglected before they could be adequately tested. Some experts on creating growth do advocate starting many different ventures because it is difficult to predict which ones will succeed. According to this view, let “1000 flowers bloom” and quantity will ensure quality. The logic behind this approach is to expect that many new ventures fail—but its success requires lots of trials. However, using the analogy, Eyring could see that in many cases the growth of some flowers was an impediment to the growth of others, which were starved for attention and resources. Going forward, he wondered whether Vivint should be more selective in its pursuit of growth options or continue to test multiple growth options simultaneously.

Partnerships Vivint had created two different channel partnerships, with Best Buy and Airbnb, as it pursued new areas of growth. While both partnerships had looked ideal on paper, neither provided as much value to Vivint as expected. Had Vivint overestimated what each side of the partnership could bring to the table? Did Vivint need to develop stronger partnership capabilities? If so, how might Vivint become more effective at creating value through partnerships with other companies?

Going Forward Eyring and his team needed to answer the questions above to learn from their experiences. To best proceed, they needed to answer two other questions: 1. Which, if any, of the recent growth initiatives should be given more attention and resources— or pursued using a different approach? For example, what actions should Vivint take with regard to the future of commercial security? Internet? Space Monkey/Smart Drive? AirBnb? 2. What other growth opportunities, specifically related to SmartHome, should the company pursue as it anticipates competition in the SmartHome arena from giants like Amazon and Google?

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Vivint SmartHome: Finding New Pathways for Growth

References 1 Todd Pedersen addressing students at Utah Valley University, https:// www.youtube.com/watch?v=fCyVXvU5hi8

8 https://www.pcmag.com/news/350979/comcast-is-americas-mosthated-company

Todd Pedersen addressing students at Brigham Young University, https://www.youtube.com/watch?v=tXqvxIWZ0b8

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2

Vivint source on company founding details, https://www.youtube .com/watch?v=z1tlRBDykjY 3

4

http://archive.sltrib.com/article.php?id=51191280&itype=CMSID

https://www.ksl.com/?nid=151&sid=35214807

https://www.techhive.com/article/2939420/vivint-rolls-out-100mbpswireless-home-internet-service-for-60-per-month.html 10

https://arstechnica.com/information-technology/2015/06/100mbps60-per-month-wireless-internet-comes-to-single-family-homes/

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5 https://www.forbes.com/sites/uciliawang/2011/10/19/home-security-firm-enters-solar-market-with-75m-fund/#f9d760121932

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https://www.greentechmedia.com/articles/read/Vivint-a-HomeAutomation-plus-Solar-Player-to-be-Acquired-by-Blackstonef#gs.sG85has

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https://www.forbes.com/sites/uciliawang/2014/10/01/vivint-solarmakes-public-market-debut-shares-up-modestly/#6b999e236df1

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https://www.pcworld.com/article/3212444/wi-fi/mesh-networkexplained.html https://www.securityinfowatch.com/residential-technologies/ news/12426735/vivint-and-best-buy-agree-to-end-retail-partnership http://fortune.com/2017/02/15/airbnb-profits/

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ONLINE CASE Skype: Competing with Free Skype is widely recognized as the first successful “free” telecommunications company. It was founded in 2003 by Niklas Zennström and Janus Friis. A peer-to-peer voice-over-Internetprotocol (“VoIP”) network, Skype experienced incredible growth and wide acceptance, to the point where, five years after its founding, the company was valued at $2.4 billion and was acquired by the multinational online-marketplace corporation eBay. Deriving its name from the combination of “sky” and “peers,”1 Skype was later divested by eBay and subsequently sold to software giant Microsoft in 2011 for $8.5 billion, the largest acquisition in Microsoft’s history.2 The acquisition by Microsoft showed its confidence in Skype’s future potential, but it also highlighted Microsoft’s need to address emerging “free” telecommunication services being offered by some of its primary competitors, including tech giants Google and Apple. With over 663 million registered users worldwide at the time of the Microsoft acquisition, Skype’s market share was dominant to say the least. The question Skype now faced was could this dominance continue with such large new competitors entering the market? Skype’s customer pool had primarily come from converting traditional telecommunications providers’ customers to Skype through the combination of cheaper prices, quality service, and ease of use. Were there more ways to disrupt these existing traditional players and steal further share? And would the company’s “freemium” business model continue to sustain its grand aspirations, or would modifications be necessary in light of evolving market factors?

Background When Niklas Zennström and Janus Friis created Skype in 2003 with $20 million in venture capital funding, their plan was to leverage the existing peer-to-peer (“P2P”) technology they had previously utilized at Kazaa, a P2P file-sharing application they had launched, which became popular as a way to share music over the Internet. Like Kazaa, Skype avoided the traditional client–server architecture by choosing a peer-to-peer model, which allowed for direct communication between users or nodes. Skype argued that decentralized P2P networks had many advantages over client–server networks, including (1) the ability to scale indefinitely without increasing required search time or costly centralized servers and (2) self-sustainability resulting from the fact that end-users’ processing and networking power increased proportionately with the network itself.3 Napster used a client–server network, which is one reason it was able to be shut down—by shutting down the server, federal authorities were able to deactivate the entire system (see Exhibit 1 for a comparison of a P2P versus a client–server network). Skype utilizes two primary IP-based communications techniques: (1) Firewall and Net Address Translation (“NAT”) Traversal and (2) global, decentralized user directory. As described on the company’s website regarding Firewall and NAT Traversal: Non-firewalled clients and clients on publicly routable IP addresses can help NAT’ed nodes communicate by routing calls. This allows two clients who otherwise would not be able to communicate to speak with each other. Calls are encrypted end-to-end and proxies with spare resources are chosen, so the performance for these users is not affected. 1

2 Skype: Competing with Free Traditional Client-Server Network

PC

EXHIBIT 1

P2P Network

Server

Comparison of Client–Server Network Versus P2P Network

A global, decentralized user directory was also imperative to Skype’s technology. Typically, a centralized directory is required for instant messaging and communications software in order to link a user’s identity with a dynamic IP address. However, central directories can be very expensive to maintain as a user base escalates into the millions. In order to avoid this, Skype relies on Global Index P2P, a multi-tiered network in which supernodes communicate in such a way that every node in the network has full knowledge of all available users and resources with minimal latency. A supernode is any node (i.e., connection point, redistribution point, or communication endpoint) that works as a relay for the network, essentially a proxy server, handling data flow and connections for other users.5 According to cofounder Niklas ZennstrÖm, “Our supernode technology allows us to efficiently route calls which improves call speed and quality.”6 Certain high-speed Internet connections, such as those at universities, become susceptible to supernodes and therefore have banned the service.7

Rival Technology Skype uses a proprietary signaling communications protocol while many of its competitors use Session Initiation Protocol (“SIP”), an open network protocol that uses proxy servers to route information to a user’s current location, authenticate users and authorize service for them, and deliver user features. SIP also has a registration function in which proxy servers are used to disseminate requests once a user uploads his or her current location. SIP is a flexible protocol; however, it is hampered by NAT and firewall restrictions.8 Popular SIP providers include Vonage, Jive, and Nextiva. Web Real-Time Communication (WebRTC) is another rival technology that has begun to emerge since its release by Google in 2011 as an open-source project. WebRTC allows for telephony, instant messaging, video, and file transferring, but through web browsers, eliminating the need for softphones.9 One of its biggest benefits is that it does not require plugins, which can be complicated and error-ridden, dissuading users from trying the product.10

Products Skype users must have the company’s downloadable software on their device in order to use the service. Software is available for free and runs on major operating platforms, including Microsoft Windows, iOS, Linux, Android, Blackberry, and Symbian. The technology allows Skype users on computers, mobile phones, tablets, home phones, televisions, and other mobile devices to connect with other Skype users via voice, video, text, and file sharing. For voice calls, Skype users can call anyone else on Skype for free, anywhere in the world. Calls to mobile and landlines worldwide require a fee payable on an as-you-go basis, or on a monthly subscription basis. Skype allows users to have a phone number to receive non-Skype calls, as well as access to call-forwarding, caller ID services, international calling, and group calls with up to 25 people. Video calling (both one-on-one and group) is available in a basic one-on-one format free of charge. The company also offers messaging services through video, instant messaging, text, or voice. File sharing, including photos and video, can also be done by simply adding the file into the Skype chat.

Revenue Model 3

Acquisition History After growing its user base to 54 million registered users, 2.7 million of which were premium service customers, the company was acquired by eBay for $2.6 billion. The transaction also carried up to an additional $1.5 billion of earnouts for ZennstrÖm and Friis, contingent on reaching 2008 profit targets as well as revenue and user count goals. For eBay, the acquisition price, including earnouts, represented approximately 5 percent of its market value.11 eBay’s management noted the following key benefits related to its acquisition of Skype:12 Accelerating existing categories: Categories requiring highly involved, complex, and expensive purchases, such as motor vehicles, business and industrial goods, collectibles, jewelry, sporting goods, and musical instruments, could benefit from connecting buyer and seller directly through Skype. These types of purchases require significant communication about product details, shipping, and so on, and they are less suited to transaction-based monetization. eBay hoped Skype’s features could take over the site’s text messaging system, which had been in place to that point. In addition to accelerating existing categories, eBay hoped that the introduction of Skype would open new categories, such as vacation packages, which required more support than the listing and text messaging available on eBay prior to the acquisition. Expanding global footprint: In many international markets at the time of Skype’s acquisition, eBay was still working to establish its foothold. eBay management believed that Skype, with its stronger worldwide presence, would help the company in its expansion into these markets. They also believed the new communications capabilities Skype provided would provide ways to further build trust between buyers and sellers across borders. Great stand-alone business: Not only was the acquisition seen as having the potential to synergistically help eBay, but the company’s management also looked at Skype’s potential on a stand-alone basis. It pointed to Skype’s large and growing opportunity in the market of global broadband and VoIP usage, its leadership position in the market, and its successful executive team. Despite the fairly convincing arguments in favor of the acquisition, many wondered why eBay chose not to simply license Skype’s technology or use their services, embedding them in the platform. eBay’s own doubts appeared to be confirmed when in 2009, only four years later, it decided to divest the majority (65% stake) of Skype to an investor group including Silver Lake, Index Ventures, and Andreessen Horowitz for $1.9 billion in cash. eBay’s remaining 35 percent stake, however, still allowed it to participate in future profits created by the new owners.13 Less than two years after eBay’s divestiture, Skype found itself with new owners once again, being acquired by software giant Microsoft for $8.5 billion, making it Microsoft’s largest ever acquisition. Although there was much speculation as to whether Microsoft overpaid for the company, which recorded revenues of $860 million the year before in 2010, most agreed that Microsoft’s strategy was to utilize Skype’s popularity to increase appeal across its existing software offerings and to enhance the functionality of its hardware. For example, Skype’s integration in Microsoft’s Outlook software could enhance appeal for business users, and voice and video communication would appeal to Microsoft Xbox gaming enthusiasts as a way to better connect with other online players.14 At the time, Skype had approximately 663 million subscribers worldwide, of which approximately 170 million were active users, and had logged over 207 billion minutes of video and voice conversations the previous year.15

Revenue Model From its inception, Skype has utilized a “freemium” business model in order to generate revenue. “Freemium,” a neologism derived from the combination of “free” and “premium,” is a pricing strategy that involves introducing a free basic product or service to gain widespread

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Skype: Competing with Free

use and then offering users a non-free premium version that includes features not available with the basic offering. Skype offers free computer-to-computer phone calls but makes money on add-ons such as voicemail and calls to landlines or cell phones. Success with a freemium strategy requires either: a. A free product that appeals to a very large product user base (for example, roughly 1.5 billion people with computers are interested in using Skype to make phone calls or Adobe to open PDF files); or b. A high conversation rate, meaning a high percentage of FREE users are willing to pay for premium features. Skype is successful because of the sheer total numbers of users of its free product. Even if Skype only had a low conversion rate (the rule of thumb is 5 percent of free product users tend to become paying customers for companies using freemium), it could make money because it has over 600 million product users. In contrast, Flickr, the photo-sharing site that uses a freemium strategy, has a much smaller total market because the number of camera users that want to use a photo-sharing service is much smaller than the market for making free phone calls. Moreover, the conversion rate to Flickr Pro is relatively low because, for most users, the free version is good enough. The fact that Skype appeals to far more users, with a conversion rate that is better than Flickr’s, translates into a far superior business model. This explains why eBay was willing to pay $2.6 billion for Skype four years after Skype launched, whereas Yahoo paid only $25 million for Flickr four years after it launched. There are a number of ways that companies can distinguish the premium version of the product or service from the free version. They can offer additional or superior features or capacity (as Skype does calling cell phones or Dropbox does with additional online storage), customer class (e.g., free for students or educators), ease of use (e.g., in online games more effort and time is required to obtain in-game currency in the free version), improved support level (e.g., telephone or e-mail support only provided for premium users), or increased time or bandwidth (e.g., limit how often or how much users can play) of a product or service.16 Freemium business models are sometimes mistaken for free trial models. Free trial models allow people to use the product or service for a set amount of time or “trial period,” after which continued use requires payment. Conversely, freemium models always have a free basic offering with charges only coming from users opting for premium features or services. Certain programs, such as Pandora, an Internet radio application, combine the freemium and free trial models by not only limiting the amount of free radio a user can listen to on their program in a month (i.e., the free trial aspect), but also allowing for paid premium service that includes unlimited access (i.e., freemium aspect). The expansion of businesses using freemium, particularly in the digital space, has raised the level of expectations of many consumers. Consumers of digital content are more likely to expect some level of free content prior to encountering fee-based premium content. Much of this is due to the domino effect of one producer choosing to follow a freemium model, forcing its competitors to adopt the model merely to stay competitive. Why pay for one product when another producer offers a similar product for free? With over a million free apps in Apple’s App Store alone, putting a price on downloading an app has become an instant barrier for many consumers.

Skype’s Freemium Model The nature of Skype’s business lent itself well to the freemium business model. Skype’s P2P technology minimized the cost of adding incremental users, thus making it easy to offer it for free. According to ZennstrÖm, “We decided that Skype needed to be free because the marginal cost of placing a phone call for us was basically zero. When the marginal cost of providing a product or service is zero, the price will naturally fall to zero.”17 Furthermore, for the base service of Skype-to-Skype calls and video conferencing to be of value, it required that many people have the software program. Consequently, offering it free of charge made good business

Revenue Model 5

Other “Free” Revenue Models Third-Party Pay (Advertising) Revenue Model Firms utilizing a “third-party pay” strategy provide products for free to a community of product users as a method of generating revenue from a third party (the real customers) who pays to access those users. In the digital age, Google is the poster child for this strategy, offering free Internet search services while companies pay Google to advertise to its millions of product users. Google’s approach works particularly well because, when product users type in key search words, they identify themselves as prime candidates for advertisers (for example, typing in “skis” or “snowboards” allows companies selling or servicing those products to advertise to those targeted customers). The secret to third-party pay is to provide a valuable free service that attracts either: a. A very large community of product users who can then be segmented in a particular way for advertisers (the way Google does with search); or b. A targeted community of users that comprises a “customer segment,” meaning a group of individuals similar on a key dimension (e.g., this similarity could be based upon demographics, for example “teenagers” or “retired people,” or it could be more need-based, such as “video game players” or “new mothers”). Blyk, a Finnish telecommunications company, competes by offering free cell phone service to 16–24 year olds. Product users in the desired demographic fill out a detailed survey on their preferences and are then given 217 free minutes each month if they agree to receive advertisements. Blyk makes money by selling access to that particular demographic and providing information on their preferences. (Blyk also benefits by using freemium because many customers go over their free minutes and end up paying something.) Blyk was acquired by Orange, the key brand of France Telecom. In similar fashion, Ryanair occasionally offers airline seats for free by using a combination of freemium and third-party pay. The company makes money on its add-on services: $25 per customer for checked or carry-on bags, $5 for seat reservations and

credit card use, $4 for priority boarding. Flight attendants sell food, scratch card games, perfume, digital cameras, and MP3 players. Ryanair also uses the flight as a platform for advertisers. When your seat tray is up, you may see an ad for a cell phone from Vodafone, and when it is down, you may see an ad from Hertz. Flyers are a captive audience for advertisers targeting travelers.

Bundling “Free” Revenue Model A bundling strategy involves offering a free product with a paid product or service. For example, Hewlett Packard may give away a free printer with the purchase of a computer, or Verizon may give away a free cell phone with the purchase of a service contract. Of course, the “free” effect here is largely psychological because the customer must actually pay in order to get the product for free. Offering a free product as part of a bundle works well when the product requires ongoing maintenance or complementary goods (e.g., Hewlett Packard makes money by selling ink for their free printers). For example, Better Place is a company that has recently introduced free electric car leases in Israel. They are able to lease the car for free because they bundle it with an energy/maintenance contract. Customers pay 10 cents per mile (less than the cost of gas) to get their electric car battery packs swapped out at a Better Place service station. Instead of stopping for gas, you stop for a battery swap. But the battery swap costs Better Place less than 10 cents per mile, so they make money on the difference. They also make money through third-party pay because governments, trying to clean the air, subsidize their operations. Bundling works particularly well when a company offers a broad array of products or when the products it sells require ongoing maintenance or complementary goods. Banks offer a broad array of financial services and some are increasingly bundling free services—free accounts or free stock trades—when a customer uses other services (e.g., keeps investment balances above some minimum). But the bundled product doesn’t have to be related to the free product. Banks also give away free products, such as iPods or iPads, to customers opening accounts.

sense; it prompted users to contact others they wanted to call using Skype (this is often called a “two-sided market” because one party needs to contact another party and invite them to use the service in order for it to have any value). Skype is also subject to “network effects,” meaning that users have an incentive to bring others into the network because it creates more value for them. (See Exhibit 2 for a list of both free and available-for-purchase services.) The ability to convert free users to paid users is critical for the freemium business model to work. An analysis of Skype’s revenue per user from 2004 to 2008 showed that Skype generated roughly $1.60 per user per year (see Exhibit 3). Although revenues per user were low, Skype was still able to grow revenues at a rapid pace because of the growth in the overall number of users. One challenge for Skype was figuring out how to increase its revenue per user, either by converting more users to paying customers or getting paying customers to use more fee-based services. To date, Skype had little success in its attempts to increase its revenue per user. Skype and other companies using freemium business models, such as Pandora, typically made less money per user than companies such as Google and Yahoo that used a third-party pay or advertising model (see Exhibit 4). Not only did Google make more money per user, but between 2004 and 2014, it was increasing its revenue per user at a faster pace than Skype, Yahoo, or Microsoft (see Exhibit 5).

6

Skype: Competing with Free

EXHIB IT 2

Voice

Telephony Offerings Comparison

Skype

Google

Yahoo!

X

X

X

Domestic

X

X

International

X

X

Conference Calls

X

X

Unique Phone #

X

X

Call Forwarding

X

X

Caller ID

X

X

Call from Mobile Device

X

X

Platform to Platform Video

X

X

X

Group Video

X

X

X

Plat2Plat Video Mess

X

X

X

Plat2Plat IM

X

X

X

SMS

X

X

X

Voice Messages

X

X

Mobile Group Chat

X

X

Platform to Platform Calls Mobile/Landline Calls

Video

Messaging

Voicemail Transcription

Sharing

X

Files

X

X

Screen

X

X

Group Screen

X

X

Source: Skype.com, Google.com, Yahoo.com.

0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0

EXHIBIT 3

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009

Skype Revenue per Unique User

Competition 7 $18.00

Revenues per Unique User per Year

$16.00

$15.96

$14.00 $12.00

$11.18

$10.00 $8.00 $6.00 $4.00

$3.50

$3.09 $1.80

$2.00 $EXHIBIT 4

Google

Yahoo

Facebook

Zynga

Pandora

$1.60

Skype

Revenue per Unique User

Note: Data on Google and Yahoo are from 2005; other data are from 2010.

$20.00 $18.00 $16.00 $14.00 $12.00 Google $10.00

Yahoo Microsoft

$8.00

Skype $6.00 $4.00 $2.00 $– 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 13 13 14 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 Q3 EXHIBIT 5

Revenue per User

Source: Yahoo, Google, and Microsoft Quarterly Reports, 2004–2014; comScore.com.

Competition From the beginning, Skype set out to disrupt the services of traditional telecommunication companies. Offering its services for free was revolutionary in the industry and was the catalyst for Skype’s rapid adoption. Even the company’s fee-based services were able to substantially undercut their traditional competitors. One particular area of competitive advantage was Skype’s popularity as a long-distance provider. Whereas international long distance rates were as high as $50 per hour, Skype was free. In recent years, international phone traffic had seen

Skype: Competing with Free 55 Annual Growth (billions of minutes)

8

International Phone Traffic

50

International Skype-to-Skype

45 40 35 30 25 20 15 10 5 0

EXHIBIT 6

2005

2006

2007

2008

2009

2010

2011

2012

2013

Skype Traffic Growth

Source: Tom Gara, “Skype’s Incredible Rise, in One Image,” wsj.com (January 15, 2014), “Telegeography.” Available at http://blogs.wsj.com/corporate-intelligence/2014/01/15/skypes-incredible-rise-in-one-image/.

overall declines, but international Skype-to-Skype traffic had experienced consistent growth (see Exhibit 6). In order to compete, many traditional carriers lowered rates or bundled phone service in with cable and Internet options. Competition also came in the form of other VoIP providers using SIP, such as Vonage, Nextiva, and Jive. The popular search engine Yahoo!, through its Yahoo! Messenger application, was also a key competitor offering unlimited free PC-to-PC worldwide. Google, the world’s most popular search engine with over a billion unique monthly visitors,18 also allowed users to text, talk, or video chat through its Google Talk application. The instant messaging service was available for download through an independent app or within Gmail, Google’s e-mail service, and provided a simple, user-friendly interface. In May 2013, Google Talk was replaced with Google Hangouts, an updated application that expanded, in particular, the program’s video-conferencing capabilities. Sophisticated technology in the program allowed it to identify and feature the person currently talking in the conversation in the primary window.19 Along with Google Hangouts, the company also offers Google Voice (see Exhibit 7 for a rate comparison between Google Voice and Skype), its VoIP telephony, texting, voicemail, and voicemail-transcription product, which, in 2014, was rumored to be merged with Google Hangouts.20 Google’s massive reach has allowed these products to gain momentum and loyalty. A Google executive, speaking on Google’s “free strategy,” said “We try to make sure our product is orders of magnitudes better than the competition in order to beat them with a free offering.”21 These “magnitudes” of difference are important when two free products are competing with each other. The number of applications that

EXHIBIT 7

Rate Comparison

Per Minute Rates

Skype

Google

US–Mobile

$0.023

Free

Canada–Mobile

$0.023

Free

Mexico–Mobile

$0.035

$0.15

China–Mobile

$0.011

$0.02

India–Mobile

$0.015

$0.02

Unlimited US & Canada (per month)

$2.99

Free

Unlimited World (per month)

$13.99

N/A

Source: Skype.com, voice.google.com.

Competition 9

EX HIB I T 8

Available Web Properties and Services

Google Web Web Search

Yahoo!

Microsoft

Search

Bing

Google Chrome

Internet Explorer

Google Home & Gmail Office Drive

Yahoo!

Microsoft

Mail

Outlook OneDrive

Docs

Notepad

Word

Bookmarks

Sheets

Personal Finance

Excel

Helpouts

Slides

Toolbar

Mobile Mobile

Toolbar Answers Mobile Apps

Windows Phone

Search for Mobile Maps for mobile Business AdWords Google Apps for Business

Advertising Commerce Central Small Business Connected TV

Google Play

Horoscopes

Books

Movies

Forms Drawings

Flickr

Sites

Domains

Calendar

Calendar

Translate

Education

Voice

Web Hosting

Xbox

Google Cloud Print OneNote

Google Keep Social Google+

Celebrity Tumblr

Image Search

Music

Blogger

News

News

Groups

Groups

Video Search

Screen

Hangouts

Messenger

Shine

Orkut

Dating

Picasa

Specialized Blog Search Search Custom Search

TV

Games

Voicess

Sports Fantasy MLB

Health

Fantasy Sports

Homes

Patent Search

Jobs

Google Shopping

Autos

Finance

Finance

Scholar

Local

Alerts

Shopping

Trends

Travel Weather

Calendar

Google Wallet

Stream Ads Media YouTube

PowerPoint

Fantasy Football My Yahoo Innovation Fusion Tables

Developer Network

Code Geo Maps Earth Panoramio

Source: Google.com, Yahoo.com, Microsoft.com.

Google offers contributes to its ability to differentiate from the competition (see Exhibit 8 for a list of online offerings given by Google, Yahoo, and Microsoft). One new concern for Skype was that it was using a freemium model in the United States and Canada, with users having to pay to call from a computer to a landline or cell phone, and Google chose to offer the same service for free (see Exhibit 7). Google used this approach to increase market share with the hope of turning those users into revenues through different freemium upgrades and advertising. Although search engine giants were knocking on the figurative telecommunications door, Microsoft’s chief competitor, Apple, decided to leverage its platform and technologies clout to move into the space. FaceTime, Apple’s video telephony and VoIP application, was released in 2011, allowing users to talk or video conference with other FaceTime users. FaceTime comes preloaded on new iPads, iPhones, and Mac computers. However, it is not compatible with non-iOS devices, so the user must be calling someone else with an Apple device. Originally only available through Wi-Fi, FaceTime now had the ability to work via 3G and LTE data connections.22 Although Apple has been limited by its proprietary operating system, new challengers such as Viber, Tango, and WhatsApp are not. Similar in functionality and features to Skype, all have been gaining momentum with their cross-platform offerings. In February 2014, Facebook

Maps

Skype

10

Skype: Competing with Free

acquired WhatsApp for$19 billion in cash and stock at a time when it had 450 million users. As of April 2014, WhatsApp had passed the half-billion user mark.23 Also in February 2014, at the time of its acquisition by Tokyo-based Internet service company Rakuten for $900 million, Viber had over 300 million registered users.24 As of March 2014, Tango had reported over 200 million users, 70 million of which were active every month.25

Conclusion Aided by the deep pockets and plentiful resources of parent-company Microsoft ($327 billion market cap in April 201426), Skype’s leadership team has reason to be optimistic about the future. However, as the other titans of technology race to launch their own telecommunication applications and businesses, Skype’s lead in the industry is starting to dwindle. Traditional telecommunications firms such as Comcast, Time Warner, and Cox, which have moved into VoIP and offer the advantage of bundling with cable and Internet, are no longer the only competition, and Skype is no longer the new kid on the block. Applications such as Tango, Viber, and WhatsApp, which are very similar in nature to Skype, are not only rapidly increasing their user base, but they are also doing so at a rate much faster than Skype was able to. Tango, for example, grew twice as fast in 2011 as Skype did in its first year, and in only five years, WhatsApp has grown its user base to over 500 million people worldwide.27 How will Skype compete with the increasing popularity of companies, such as Apple and Samsung, which have developed their own applications included on their products? Given the now-saturated VoIP market, can the freemium model continue to be a viable option? Despite its massive user base and dominance in international voice calls, new companies claiming to provide for free what Skype charges money for make freemium’s future uncertain. Furthermore, some in the industry have accused the company of failing to innovate, leaving the door open for younger, more ambitious start-ups. As Skype looks to the future, how can it best compete against giants such as Google and Yahoo? What, if anything, needs to change in order to increase the revenues it generates from each user? Finally, what synergies can Skype and Microsoft generate and what new competitive advantages can they exploit to remain relevant?

References T. Tãnavsuu, “How Can They Be So Good? The Strange Story of Skype,” Arstechnica (September 2, 2013), http://arstechnica.com /business/2013/09/skypes-secrets/.

Voip-info.org, “SIP,” http://www.voip-info.org/wiki/view/SIP.

1

8

2 T. Weber, “Microsoft Confirms Takeover of Skype,” bbc.com News (May 11, 2011), Business, http://www.bbc.com/news/ business-13343600.

S. Anderson, “What’s the Difference between WebRTC and SIP?”, Web RTC World (March 5, 2013), http://www.webrtcworld.com /topics/webrtc-world/articles/329215-whats-difference-between - webrtc-sip.htm.

Skype, “What Are P2P Communications?” https://support.skype.com /en/faq/FA10983/what-are-p2p-communications. 3

4

Ibid.

5

Adapted from Wikipedia, “Supernodes.”

6

Niklas ZennstrÖm interview by Jeff Dyer, May 21, 2007.

P. Coles and T. R. Eisenmann, “Skype,” Harvard Business School Compilation 806–165 (March 2006, revised December 2009). 7

9

S. Dutton, “Getting Started with WebRTC,” html5rocks.com (February 21, 2014), http://www.html5rocks.com/en/tutorials/webrtc /basics/. 10

M. Meeker, “eBay: Acquiring Skype to Help Drive Next Gen Internet,” Morgan Stanley Equity Research (September 12, 2005), p. 2.

11

The following benefits were taken from the eBay Acquisition of Skype management presentation available at http://www.slideshare.net /Cfederman/e-bay-skype-acquisition.

12

References 13 J. C. Abbel, “Ebay Sells 65% of Skype for $1.9 Billion,” Wired (September 1, 2009), http://www.wired.com/2009/09/andreessen -among-buyers-of-skype-new-york-times/.

N. Damouni and B. Rigby, “Microsoft to Buy Skype for $8.5 billion”, Reuters.com (May 10, 2011), http://www.reuters.com/article/2011/05 /10/us-skype-microsoft-idUSTRE7490F020110510. 14

B. Evans, “Microsoft to Acquire Skype,” Microsoft.com News Center (May 10, 2011), https://www.microsoft.com/en-us/news/press/2011 /may11/05-10corpnewspr.aspx.

15

J. Kincaid, “Startup School: Wired Editor Chris Anderson on Freemium Business Models,” Techcrunch.com (October 24, 2009).

16

Interview with Niklas ZennstrÖm by Jeff Dyer, May 21, 2007.

17

eBizMBA, “Top 15 Most Popular Search Engines,” April 1, 2014, http:// www.ebizmba.com/articles/search-engines.

18

The Fuse Joplin, “Google Talk vs Google Hangout—What Makes Them the Best in the Business?” Thefusejoplin.com (March 22, 2014), http:// thefusejoplin.com/2014/03/google-talk-google-hangouts-business/.

19

A. Strange, “Google Voice to Merge into Hangouts, Report Says,” Mashable.com (March 18, 2014), http://mashable.com/2014/03/18 /google-voice-to-hangouts/.

20

11

Interview with Google executive by Jeff Dyer, September 18, 2010.

21

Apple Inc., “iOS: Using Face Time,” http://support.apple.com/kb /HT4319.

22

M. Roppolo, “WhatsApp Reaches 500 Million Active Users after Facebook Acquisition,” cbsnews.com (April 23, 2014), http://www .cbsnews.com/news/whatsapp-reaches-500-million-active-users -after-facebook-acquisition/.

23

Business Wire, “Rakuten Acquires Viber for $900 Million,” Businesswire .com (February 14, 2014), http://www.businesswire.com/news /home/20140213006561/en/Rakuten-Acquires-Viber-900-million# .U1hXAeZdX04.

24

A. Shontell, “Tango, A Messaging App with 200 Million Users, Has Raised a Quarter-of-a-Billion Dollars from Alibaba,” Business Insider (March 20, 2014), http://www.businessinsider.com/tango-raises -280-million-from-alibaba-2014-3.

25

Google Finance, April 24, 2014.

26

E. Schonfeld, “With 17M Registered Users, Tango Is Growing Twice as Fast as Skype Did Its First Year,” Techcrunch.com (July 1, 2011), http:// techcrunch.com/2011/07/01/tango-17-million-skype/.

27

ONLINE CASE Sears Holdings Corporation: In Need of a Turnaround Strategy Founded in 1893, Sears Roebuck grew over the course of the next century to become the world’s largest retailer. Indeed, by 1962—the year that Sam Walton opened his first Walmart discount store—approximately one out of every 200 U.S. workers received a Sears paycheck.1 Even after being surpassed by Walmart as the largest retailer in 1989,2 Sears continued to hold a spot on the Fortune 500 list and was still one of the country’s largest retailers after its merger with Kmart in 2005.3 However, less than 10 years after the merger, the new Sears Holdings Corporation (SHC) found itself in crisis. With intense competition from retail giants such as Walmart and Target (and new competitors such as Amazon and Costco), Sears CEO Edward Lampert faced some serious questions. Eight years into the merger, Sears had closed almost one-third of its stores and had seen annual revenues drop by over 30 percent. Even more concerning, Sears’ operating profits had dropped more than 140 percent (see Exhibit 1; also see Exhibits 2 and 3 for comparative data on Walmart and Target, respectively). Not only had operating profits EX HIB I T 1

Sears Holdings Corporation Financials ($ Millions)

Fiscal Year

2013

2012

2011

2010

2009

2008

2007

2006

2005

$36,188

$39,854

$41,567

$42,664

$43,360

$46,770

$50,703

$53,016

$49,455

Cost of Sales

27,433

29,340

30,966

31,000

31,374

34,118

36,638

37,824

35,743

S&A Expenses

9,384

10,660

10,664

10,425

10,499

11,060

11,468

11,574

10,892

732

830

853

869

894

981

1,049

1,143

942

Operating Profit

(927)

(838)

(1,501)

437

667

302

1,586

2,529

2,123

Interest Expense

(254)

(267)

(289)

(293)

(248)

(272)

(286)

335

328

Income Taxes

(144)

(44)

(1,369)

(27)

(111)

(85)

(550)

933

715

$(1,365)

$(930)

$(3,140)

$133

$235

$53

$826

$1,492

$857

$1,028

$609

$747

$1,359

$1,689

$1,173

$1,622

$3,839

$4,440

Merchandise Inventories

7,034

7,558

8,407

8,951

8,705

8,795

9,963

9,896

9,068

Property & Equipment, Net

5,394

6,053

6,577

7,102

7,709

8,091

8,863

9,113

9,823

18,261

19,340

21,381

24,360

24,808

25,342

27,397

29,906

30,573

8,185

8,414

9,212

8,643

8,786

8,512

9,562

9,912

10,350

16,078

16,168

17,040

15,746

15,373

15,643

16,730

17,200

18,962

2,183

3,172

4,341

8,614

9,435

9,699

10,667

12,706

11,611

Income Statement Items Revenues

Depreciation & Amortization

Net Income Balance Sheet Items Cash and Cash Equivalents

Total Assets Current Liabilities Total Liabilities Total Equity

Source: Sears Holdings Corporation, Annual Reports, 2006–2014.

1

2 Sears Holdings Corporation: In Need of a Turnaround Strategy

EXHIB IT 2

Walmart Financials ($ Millions)

Fiscal Year

2013

2012

2011

2010

2009

2008

2007

2006

2005

$476,294

$468,651

$446,509

$421,849

$408,085

$404,374

$377,023

$348,992

$312,101

358,069

352,297

334,993

314,946

304,106

304,056

284,137

264,152

237,649

Operating, SG&A Expenses

91,353

88,629

85,025

81,361

79,977

77,520

70,934

64,001

55,739

Operating Profit

26,872

27,725

26,491

25,542

24,002

22,798

21,952

20,497

18,713

Interest Expense

2,216

2,063

2,159

2,004

1,884

1,900

1,794

1,529

1,178

Income Taxes

8,105

7,958

7,924

7,579

7,156

7,145

6,889

6,365

5,803

$16,022

$16,999

$15,699

$16,389

$14,370

$13,400

$12,731

$11,284

$11,231

Cash and Cash Equivalents

$7,281

$7,781

$6,550

$7,395

$7,907

$7,275

$5,569

$7,767

$6,193

Inventories

44,858

43,803

40,714

36,437

33,160

34,511

35,180

33,685

31,910

Property & Equipment, Net

115,364

113,929

109,603

105,098

99,544

92,856

93,875

85,390

74,600

Total Assets

204,751

203,105

193,406

180,782

170,706

163,429

163,514

151,587

138,187

69,345

71,818

62,300

58,603

55,561

55,390

58,454

52,148

48,825

123,412

121,367

117,645

109,535

97,777

96,350

98,906

90,014

85,016

81,339

81,738

75,761

71,247

72,929

67,079

64,608

61,573

53,171

Income Statement Items Revenues Cost of Sales

Net Income Balance Sheet Items

Current Liabilities Total Liabilities Total Equity

Source: Walmart Stores, Inc., Annual Reports, 2006–2014.

EXHIB IT 3

Target Financials ($ Millions)

Fiscal Year

2013

2012

2011

2010

2009

2008

2007

2006

2005

Income Statement Items Revenues

$72,596

$73,301

$69,865

$67,390

$65,357

$64,948

$63,367

$59,490

$52,620

Cost of Sales

51,160

50,568

47,860

45,725

44,062

44,157

42,929

40,366

34,927

SG&A Expenses

15,375

14,914

14,106

13,469

13,078

12,954

12,670

11,852

11,185

Depreciation & Amortization

2,223

2,142

2,131

2,084

2,023

1,826

1,659

1,496

1,409

Operating Profit

4,229

5,371

5,322

5,252

4,673

4,402

5,272

5,069

4,323

Interest Expense

1,126

762

866

757

801

866

647

572

463

Income Taxes

1,132

1,610

1,527

1,575

1,384

1,322

1,776

1,710

1,452

$1,971

$2,999

$2,929

$2,920

$2,488

$2,214

$2,849

$2,787

$2,408

Cash and Cash Equivalents

$695

$784

$794

$1,712

$2,200

$864

$2,450

$813

$1,648

Inventory

8,766

7,903

7,918

596

7,179

6,705

6,780

6,254

5,838

Property & Equipment, Net

31,738

30,653

29,149

25,493

25,280

25,756

24,095

21,431

19,038

Total Assets

44,553

48,163

46,630

43,705

44,533

44,106

44,560

37,349

34,995

Current Liabilities

12,777

14,031

14,287

10,070

11,327

10,512

11,782

11,117

9,588

Total Liabilities

28,322

31,605

30,809

28,218

29,186

30,394

29,253

21,716

20,790

Total Equity

16,231

16,558

15,821

15,487

15,347

13,712

15,307

15,633

14,205

Net Income Balance Sheet Items

Source: Target Corporation, Annual Reports, 2006–2014.

Sears Holdings Corporation: In Need of a Turnaround Strategy

declined sharply, but Sears’ return on equity and return on assets had plummeted as well (see Exhibits 4 and 5). In a January 2014 blog post, Lampert said that the poor financial performance did not clearly reflect the company’s true success. In particular, Lampert cited customer engagement growth in Sears’ Shop Your Way program, a digital loyalty program that not only gave customers opportunities to save on Sear’s products, but also served as a social network that allowed shoppers to connect and share their shopping experiences.4 Despite Lampert’s optimism, investors appeared to share analysts’ concerns about Sears’ future: since 2010, SHC market capitalization has fallen nearly 75 percent (see Exhibit 6). As Brian Sozzi of Bellus Capital Advisors put it, “Sears is in crises. Sears is not investing in their name brands so they can keep the customer coming back to the store for them. I view Sears in a slow death spiral.”5

15%

Return on Assets

10% 5% 0% 2005

2007

2009

2011

2013

–5%

SHC Walmart Target

–10% –15% –20% Year

EXHIBIT 4

Return on Assets

Source: Sears Holdings Corporation, Walmart Stores, Inc., and Target Corporation, Annual Reports, 2006–2014.

40%

Return on Equity

20% 0% 2005

2007

2009

–20%

2011

2013

SHC Walmart Target

–40% –60% –80%

EXHIBIT 5

Year

Return on Equity

Source: Sears Holdings Corporation, Walmart Stores, Inc., and Target Corporation, Annual Reports, 2006–2014.

3

Sears Holdings Corporation: In Need of a Turnaround Strategy $30,000 Market Capitalization (M)

$25,000 $20,000 $15,000 $10,000 $5,000 $–

Ap rO 05 ct Ap 0 5 rO 06 ct Ap 0 6 rO 07 ct Ap 0 7 rO 08 ct Ap 0 8 rO 09 ct Ap 0 9 rO 10 ct Ap 1 0 rO 11 ct Ap 1 1 rO 12 ct Ap 1 2 rO 13 ct Ap 1 3 r14

4

Month EXHIBIT 6

Sears Holdings Corporation Market Capitalization

Source: Yahoo! Finance.

Sears, Roebuck & Company In 1893, Richard Sears and Alvah Roebuck founded Sears, Roebuck & Company as a mail order company. In its early years, Sears offered goods that would appeal to the large rural population in America. This catalog targeted the farmers living in rural America where traditional general stores marked up staple goods such as flour by as much as 100 percent. Recognizing that these farmers would respond to goods priced at wholesale, and taking advantage of economies of scale and a more expansive postal system, Sears labeled itself as the “Cheapest Supply House on Earth” on the catalogs it sent out to farmers in rural America. By 1895, the catalog was 532 pages long and contained everything from saddles to musical instruments. By 1900, Sears, Roebuck & Company was nearing one million dollars in annual sales. By the end of 1925, Sears had expanded its exclusive mail-order company to include eight retail stores. Over the next 15 years, Sears opened 600 stores, and soon their retail sales contributed more than mail-order sales to their $180 million in annual revenues. Aboard a train in 1930, an insurance broker named Carl Odell proposed the idea of selling car insurance by direct mail to the president and CEO of Sears, Robert Wood.6 At the time, car insurance companies sold policies primarily through individual agents who received a commission for each policy they sold. Selling policies via direct mail would eliminate the need for individual agents and give Sears a substantial cost advantage. In 1931, Sears began Allstate Insurance Company as a wholly owned subsidiary in order to provide a low-cost insurance alternative. Allstate would advertise policies in Sears’ catalog, and interested customers would mail their information to Sears in order to set up an individual policy. In its second year of operation, Allstate earned $93,000 in profit and had 22,000 active policies. Building on the success of direct mail, Sears began placing Allstate sales offices in Sears stores in 1933. Over the next several decades, Sears continued to expand its product and service offerings. In 1956, Sears began offering nationwide appliance servicing. In 1967, Sears introduced the DieHard battery brand and later opened Sears Automotive Centers. During the early 1980s, Sears formed Dean Witter Financial Services Group and, by 1985, introduced a new credit card: the Discover Card. (See Exhibit 7 for a list of key events in Sears history). By the late 1990s, Sears’ revenues exceeded $41 billion annually, and the company maintained a profit margin of nearly 6 percent.

E XH I B I T 7

Key Events in Sears History

1986

R.W. Sears Watch Company founded

1889

R.W. Sears Watch Co. sold for $72,000 profit

1892

A.C. Roebuck, Inc. formed

1893

Name changed to Sears, Roebuck & Co.

Sears Strategy into the Twenty-First Century 1906

First IPO of Sears stock

1911

Product testing labs open at Sears

1925

Sears opens first retail stores

1927

Sears introduces Kenmore Appliances

1930

Sears opens General Credit Office

1931

Sears launches Allstate Insurance Company

1945

Sears’ sales exceed $1 billion

1946

Sears begins building large stores in suburbs

1953

Sears launches its own credit card

1956

Sears guarantees nationwide appliance service

1967

Sears introduces DieHard batteries

1973

Sears opens Sears Tower HQ, the world’s tallest building

1975

Sears becomes the exclusive supplier of Pong

1985

Sears introduces the Discover Card

2000

Sears launches Sears Gold MasterCard

2002

Sears acquires Lands’ End

2004

Kmart announces intention to buy Sears for $11.5 billion

Source: www.searsarchives.com.

Sears Strategy into the Twenty-First Century By the end of the twentieth century, Sears had grown to over 3,000 stores in North America, and it had 200 locations in Canada. Among these were traditional “full-line” stores that offered both soft goods (e.g., jewelry, apparel, cosmetics, etc.) and hard goods (e.g., home appliances and electronics) and specialty stores such as hardware and automotive stores. In addition to its physical locations, Sears offered a credit service, “Sears Card,” that boasted over 60 million customers (Sears had divested the Discover Card in 1993), and it maintained a 14,000- technician network for product repair services.7 Despite the variety of Sears’ offerings, the company’s profit margins reached a peak in the late 1990s and then began to drop precipitously after 2000. At the same time, Walmart and Target continued to maintain or even improve their operating profits into the twenty-first century (see Exhibit 8). 10% 8%

Profit Margin

6% 4% Walmart

2%

Target

0% –2%

1995

2000

2005

2010

Sears

–4% –6% Year EXHIBIT 8

Retail Stores Operating Profit Margin

Source: Walmart Stores, Inc., Sears Holdings Corporation, and Target Corporation, Annual Reports, 1995–2014.

5

6

Sears Holdings Corporation: In Need of a Turnaround Strategy

In order to combat the drop in profitability, Sears launched a “Sears Gold MasterCard” in 2000 in an effort to continue to grow its credit line of business. Despite the fact that Sears’ credit business became the eighth largest in the United States, the combination of both retail and credit businesses caused investors to have difficulty accurately valuing the company.8 Sears would later sell off its credit and financial products business for $32 billion in November 20039 in an attempt to simplify its business and appease investors. In June 2002, Sears bought clothing merchant Lands’ End for approximately $1.8 billion.10 Sears would keep Lands’ End for 12 years only to spin it off as a publically traded company in order to raise needed cash after experiencing poor sales performance.11 After the first day of trading, the market value of Lands’ End was only $889.7 million, less than half of what Sears had originally purchased it for.12 During that same year, Sears also began to develop and launch an in-house apparel brand—Covington. In addition to adding clothing lines, Sears launched a new store layout in 2003, called “Sears Grand.” This was similar to a normal full-line Sears’ store, but it also included traditional grocery items, such as food, toiletries, and pet supplies.13 Despite these and other changes, investors were pessimistic about Sears’ future. Between 1999 and 2000, Sears’ stock fell by over 50 percent. Although the changes Sears made between 2000 and 2002 initially brought its stock value up to $51.06 per share in May 2002, its stock price eventually dropped to a decade low of $21.76 per share in February 2003. At the time, it seemed that Sears could do nothing to mirror the growth that rivals Target and Walmart were experiencing, and it might even not survive the decade.

KMART and the New Sears While Sears was experiencing a downward spiral in 2000, another large retailer, Kmart, was approaching bankruptcy. Kmart was founded in the late 1800s in Detroit by Sebastian Kresge as a five-and-dime store called “S.S. Kresge.” In 1962, the first Kmart stores were opened and, by the mid-1960s, Kmart was averaging over $1 billion in annual sales. A decade later, in 1977, S.S. Kresge officially became the Kmart Corporation.14 In order to keep up with the fast growing competition in the retail industry, Kmart began making several changes in the early 1990s. In March 1990, Kmart acquired Sports Authority, a privately held chain of sporting goods stores. Over the next three years, the company invested over $1 billion in order to improve and restructure its stores. It also launched BlueLight.com, an independent e-commerce company whose mission was to “open the doors to the dynamic world of information, goods and services of the World Wide Web by providing easyto-use, unlimited free Internet service to the world’s shoppers.”15 Although these investments and changes would help bolster its earnings over the next few years, Kmart was experiencing a net loss of almost $2.5 billion annually by 2001. Unable to recover from its crippling losses, Kmart filed for Chapter 11 bankruptcy protection in January 2002. Charles Conaway, the CEO of Kmart at the time, said of the bankruptcy, “We are determined to complete our reorganization as quickly and smoothly as possible, while taking full advantage of this chance to make a fresh start and reposition Kmart for the future.”16 Kmart Corporation emerged from the bankruptcy in May 2003 as Kmart Holding Corp. Kmart described its strategy coming out of the bankruptcy as building senior management, improving the customer store experience, providing quality products at attractive pricing, and enhancing its service culture. This would include continuing to offer exclusive brands such as Martha Stewart Everyday and Joe Boxer.17 On November 17, 2004, Kmart announced its intentions to merge with Sears, Roebuck & Company to create SHC.18 The merger was initiated by Edward Lampert, who at the time was both the chairman of Kmart and the largest shareholder in Sears.19 Although the leaders of Sears and Kmart were optimistic about the merger, analysts expressed concerns over the viability of merging the two struggling firms. Of the merger, Stephen Hoch, a marketing professor at the Wharton School, said, “Here you have two retailers who are doing badly right now and who don’t really see a clear way to pull themselves out of the downward spiral. It’s hard to fathom how combining them is suddenly going to produce a new entity that will do better. That’s tough to do, especially because the competition, including Wal-Mart and Target, isn’t exactly standing still.” Notwithstanding the concerns, the new company experienced initial cost savings

Sears Holding Corporation

of over $300 million and gained $200 million through cross-selling opportunities between Kmart and Sears’ brands.20 As a result, investors responded positively to the new merger for first few years (see Exhibit 6).

Sears Holding Corporation Shortly after the merger, the new chairman and CEO of SHC, Edward Lampert, said that by leveraging the combined strengths of Kmart and Sears, SHC would have the potential to “be a great company with a truly great retail business.” In order to get to that point, Lampert planned to “offer customers a new, more compelling shopping experience with a differentiated and expanded product range.”21 Over the next several years, SHC began to improve the customer experience at both Sears and Kmart locations by introducing select Sears private label brands such as Kenmore, Craftsman, and DieHard into certain Kmart stores, remodeling Kmart stores, accepting Sears credit cards at all Kmart locations, adding Sears customer services such as Sears Auto Centers and hearing and optical centers to Kmart locations, and improving and combining back-end operations for both Kmart and Sears. In launching all of these initiatives, it was SHC’s goal to improve relationships with its customers and create sustainable top–line growth. In an effort to maximize its revenue, Sears attempted to focus on what it believed its consumers wanted most (see Exhibit 9 for sales breakdown). Despite SHC’s efforts, consumers have not responded as Lambert had hoped they would. In fact, Sears same-store sales growth* has not been positive since the merger in 2004 and substantially lags that of major big box retailers such as Walmart and Target (see Exhibit 10). SHC’s declining revenues have not only been affected by declining same store sales, but also by widespread store closings. According to Lampert, store closings were the company’s only option after efforts to improve sales failed22 (see Exhibit 11). In an attempt to hedge up ever-shrinking sales, SHC launched the “Shop Your Way” loyalty program in late 2009.23 This loyalty program and social network hybrid not only allows SHC shoppers to earn rewards, but it also enables shoppers to connect with each other and discuss their purchases on a personal “newsfeed.”24 Corporate leadership touts the Shop Your Way program as a major success at Sears. In a presentation to investors, Lampert showed that the percentage of total revenues made by Shop Your Way members had increased 10 percent in 2013, from 59 to 69 percent.25 Even with

Percentage of Sales

60% 50% 40% Hardware

30%

Apparel & Soft Goods

20%

Food & Drug Service & Other

10% 0% 2009

2010

2011

2012

2013

Year EXHIBIT 9

Merchandise Sales and Services

Source: Sears Holdings Corporation, Annual Reports, 2009–2014.

*Although the method for calculating same-store sales growth may vary by firm, it is generally the growth in sales for stores that have been in operation for at least 12 months since the reporting period.

7

8

Sears Holdings Corporation: In Need of a Turnaround Strategy Same Store Sales Change by Year

8% Same Store Sales Change

6% 4% 2% 0% –2%

SHC 2005 2006 2007 2008 2009 2010 2011 2012 2013

–4%

Walmart Target

–6% –8% –10%

Year

EXHIBIT 10

Same Store Sales Change by Year

Source: Walmart Stores, Inc., Target Corporation, and Sears Holdings Corporation, Annual Reports, 2006–2014.

EXHIB IT 1 1

Store Closings by Year

Fiscal Year

2013

2012

2011

2010

2009

2008

2007

2006

2005

Kmart Discount

1,135

1,196

1,279

1,278

1,292

1,321

1,327

1,333

1,361

17

25

26

29

35

47

55

55

55

Total Kmart

1,152

1,221

1,305

1,307

1,327

1,368

1,382

1,388

1,416

Full-line Mall

768

788

834

842

848

856

860

861

866

Sears Grand/Essentials

10

10

33

52

60

73

75

74

58

Specialty Stores

50

54

1,338

1,354

1,284

1,233

1,150

1,095

1,128

Total Sears Dom

828

852

2,205

2,248

2,192

2,162

2,085

2,030

2,052

Canada Full-line

118

118

122

122

122

122

121

123

123

Canada Specialty

331

357

378

361

280

266

259

250

252

Total Sears Canada

449

475

500

483

402

388

380

373

375

2,429

2,548

4,010

4,038

3,921

3,918

3,847

3,791

3,843

Kmart Super Centers

Total Stores

Source: Sears Holdings Corporation, Annual Reports, 2006–2014

a net margin of −4 percent for the year, Lampert ended a meeting with investors by saying, “While I am not pleased with our profit performance, I am pleased with the progress we have shown in our transformation by continuing to improve our member engagement by leveraging Shop Your Way and integrated retail. We are working in a very focused and diligent manner to drive this transformation to a member-centric model and achieve improved levels of profit performance.”26 Throughout the years following the merger, Lambert and his team had tried a number of initiatives to improve Sears’ competitive position—with Lambert touting the Shop Your Way program as being among the most important of those initiatives. But despite Lampert’s optimism, many investors and analysts remain pessimistic about Sears’ future. Will the current set of initiatives be enough to turn Sears around? What else might Sears leaders do to dramatically turn around its fortunes and survive the intense competition from Walmart, Target, Amazon, and Costco? Most importantly, what will Sears need to do in order to differentiate itself from its competitors and gain a sustainable competitive advantage?

References

9

References 1 “Sears—Where America Shopped,” Crain’s Chicago Business (April 23, 2012), http://www.chicagobusiness.com/article/20120421/ISSUE 01/304219970/sears-where-america-shopped#

13 L. Yue, “Sears’ Grand Idea Set to Debut,” Chicago Tribune (September 19, 2003), http://articles.chicagotribune.com/2003-09-19/business/ 0309190340_1_sears-grand-sears-grand-one-stop-shop.

J. Macke, “Sears Enters ‘Death-Spiral,’ Retailer Could Be Gone by 2017: Brian Sozzi,” Yahoo! Finance (January 10, 2014), http://finance .yahoo.com/blogs/breakout/sears-enters–death-spiral—retailer - could-be-gone-by-2017–brian-sozzi-151232559.html

14

2

Fortune 500, “Companies by Year, 1955–2005.” Available at http:// money.cnn.com/magazines/fortune/fortune500_archive/letters/S.html 3

E. Lambert, “What Our Reported Financial Results Don’t Clearly Show,” searsholdings.com (January 9, 2014), http://blog.searsholdings.com/ eddie-lampert/what-our-reported-financial-results-dont-clearly-show/. 4

Macke.

5

“The Allstate Corporation,” International Directory of Company Histories (1999), http://www.encyclopedia.com, accessed July 12, 2014. 6

Sears, Roebuck & Company, Annual Report, 1998.

7

Andrew Ross Sorkin, “Sears to Sell Card Portfolio to Citigroup for $3 Billion,” New York Times (July 16, 2003), http://www.nytimes.com/2003/07/16/ business/sears-to-sell-card-portfolio-to-citigroup-for-3-billion.html. 8

Sears, Roebuck & Company, Annual Report, 2004.

9

Sears, Roebuck & Company, Annual Report, 2002.

10

R. Abrams, “Sears to Spin Off Lands’ End,” DealBook (December 6, 2013), http://dealbook.nytimes.com/2013/12/06/sears-to-spin-off-lands-end/. 11

M. J. de la Merced, “Rough First Day of Trading for Lands’ End, and Its Former Parent,” DealBook (April 7, 2014), http://dealbook.nytimes .com/2014/04/07/rough-first-day-of-trading-for-lands-end-and-its-former -parent/?_php=true&_type=blogs&_r=0.

12

Sears Holdings Corporation, “Corporate History,” searsholdings.com., http://www.searsholdings.com/about/kmart/history.htm. Kmart 1999 Annual Report

15

http://money.cnn.com/2002/01/22/companies/kmart/

16

Kmart Corporation, Annual Report, 2004.

17

Kmart Corporation, Annual Report, 2005.

18

Y. Rosenberg, “The Man Behind the Deal,” CNN Money (November 17, 2004), http://money.cnn.com/2004/11/17/news/newsmakers/ lampert/.

19

“Sears-Kmart Merger: Is It a Tough Sell?” Knowledge@Wharton

20

Sears Holdings Corporation, “Kmart and Sears Complete Merger to Form Sears Holdings Corporation,” press release (March 24, 2005).

21

A. Deichler, “Updated: Sears & Kmart Closing 21 Stores; Creating Nearly 2M SF of Vacancy,” CoStar News (March 1, 2010), http://www .costar.com/News/Article/Updated-Sears-Kmart-Closing-21-Stores; -Creating-Nearly-2M-SF-of-Vacancy/118441.

22

Sears Holdings Corporation, Annual Report, 2011.

23

B. Sweeney, “Can This Woman Save Sears?,” Crain’s Chicago Business (July 15, 2013), http://www.chicagobusiness.com/article/20130713/ ISSUE01/307139978/can-this-woman-save-sears

24

“Fourth Quarter & Full Year 2013 Transformation Update & Financial Results,” p. 16.

25

Transcript of SHC Fiscal 2013 Q4 Financial Results Audio Webcast.

26

ONLINE CASE Redbox: What’s Next? Redbox History Redbox launched in 2002 as a venture initially funded by McDonalds. McDonalds was an early investor because it saw the potential of video rental kiosks as well as McDonald’s stores as a key distribution channel. Redbox’s innovative strategy centered on a distribution network of low-cost, self-service vending kiosks. The kiosks allow customers, with a swipe of their credit card, access to a limited selection of the hottest new releases for $1.20 per night (previously $1.00 for the company’s first eight years). A customer may return the title the next day, or keep it with daily rental charges accruing until the customer owns the DVD outright after 25 days. The kiosks were placed in hightraffic locations to encourage impulse rentals and make planned rentals as convenient as possible. Retailers were incentivized to place kiosks by receiving a share of revenue, which was typically based on the retailer’s appeal (e.g., Walmart would receive a larger share than a mom-and-pop store). The customer rental experience was kept simple and convenient. The selection process was simplified by the limited choice of titles (70–200 at most locations,) all of which are prominently displayed on each kiosk. Redbox’s nonsubscription model allowed customers to rent without the hassle of paperwork or membership fees. DVDs could be returned to any kiosk, adding a final touch of convenience to the rental process. Redbox grew quickly from 2003 to 2005, adding over 1,100 kiosks throughout the United States.1 In 2005, Coinstar paid $32 million to acquire 47 percent of the company, and four years later they purchased the remaining equity from McDonalds for approximately $170 million.2 Redbox’s low-cost kiosks model allowed rapid expansion, and by 2012 the company had 43,700 kiosks (see Table 1). The average cost of a Redbox kiosk was only $15,000 with an additional $6,720 for DVD costs to initially fill the kiosk.3 With Redbox fully onboard, Coinstar market value rose from an estimated $800 million in late 2009 to a peak of $2.1 billion in mid-2012.4 By 2012, 68 percent of the US population lived within a 5-minute drive of a Redbox kiosk,5 and the company controlled 47.8 percent of the physical rental market.6 Redbox’s footprint continued to grow throughout the US and Canada with almost 44,000 kiosks in operation in 2012 and more planned. This vast network of kiosks was enabled by a network of regional operations supervisors who were responsible for the maintenance and operation, including stocking, of all kiosks in their assigned geographic region.7 Redbox partnered with Verizon in 2013 to launch a video streaming service called Redbox Instant—a streaming service similar to the one offered by Netflix. For $8 a month, customers enjoy unlimited streaming of more than 4,600 titles and up to four disk rentals from kiosks. The service was offered through Android and iOS mobile apps and on Xbox and PlayStation 4 gaming platforms.8 On October 19, 2014, Redbox entered into an agreement with Verizon to withdraw from the Redbox Instant joint venture due to the service not being “as successful as either partner hoped it would be.”9 During that same year, for the first time in its history, Redbox also shuttered 320 of its kiosks and experienced a decrease in sales (see exhibit A). Redbox continues to face a number of challenges. The decrease in total kiosks and total rentals seems to indicate that its traditional kiosk rental business model has reached its saturation point in the US market, and its venture into video streaming met with unsatisfactory results. These failures present Redbox with its biggest challenge yet: When traditional and digital growth strategies have both failed, what can Redbox do to keep itself afloat in the future and compete with companies such as Hulu (see exhibit B)? 1

2 Redbox: What’s Next?

TA B L E 1

Growth in Number of Redbox Kiosks

Year

Total Kiosks

Total Rentals

2002

12

-

2005

1,200

-

2010

30,200

534,518

2011

35,400

684,000

2012*

43,700

739,761

2013

44,000

775,742

2014

43,680

722,745

Source: Public filings (included in Coinstar Inc. & Outerwall filings), www.redbox.com/timeline *Excludes kiosks and the impact of kiosks acquired as part of the NCR Asset Acquisition.

E XH I B I T A

Redbox Financials ($ Millions)

Fiscal Year

2014

2013

2012

2011

2010

2009

Revenue

1,893.1

1,974.5

1,908.8

1,561.6

1,159.7

773.4

Direct Operating Exp

1,338.9

1,383.6

1,340.9

1,134.2

859.8

585.2

23.9

23.0

20.5

22.0

14.2

8.2

G&A

136.8

166.1

159.9

120.4

94.9

78.5

Operating Income

236.8

239.0

238.7

169.5

190.9

101.6

1,583.3

1,891.3

1,561.7

1,450.8

561.2

468.9

Income Statement Items

Marketing

Balance Sheet Items Total Assets* Source: Outerwall SEC filings *Outerwall Total Assets

E XH I B I T B

Hulu Financials ($ Millions)

Fiscal Year Revenues

2013

2012

2011

2010

2009

1,000.0

695.0

420.0

263.0

108.0

Source: Privco, blog.hulu.com

Other Readings “Redbox Sacrifices Margins to Drive DVD Rentals,” http://www .bloomberg.com/bw/articles/2013-09-17/redbox-sacrifices-margins -to-drive-dvd-rentals “Redbox Raising DVD Rental Price by 25%,” http://www.wsj.com/articles /redbox-raising-dvd-rental-price-by-25-1416834062

“Outerwall Shuts Down Redbox Operations in Canada,” http://www .wsj.com/articles/outerwall-shuts-down-redbox-operations-in-canada -1423181762

References

3

References http://www.redbox.com/timeline

1

Coinstar, Inc. Public Filings.

2

http://www.gurufocus.com/news/125840/coinstar-deep-value-and -exceptional-growth 3

Coinstar, Inc. Public Filings.

4

http://www.redbox.com/facts

5

Coinstar, Inc. Public Filing – Form 10-Q (Q1 2013)

6

7 “A Day in the Life of Redbox Ninja,” April 12, 2010, http://blog.redbox .com/2010/04/a-day-in-the-life-of-a-redbox-ninja.html

“First Look: Redbox Instant Is Like the Old Netflix, but with Kiosks,” http://www.consumerreports.org /cro/news/2013/03/first-look -redbox-instant-is-like-the-old-netflix-but-with-kiosks/index.htm 8

“Redbox Instant to Shut Down October 7,” http://www.cnet.com /news/redbox-instant-to-shut-down-october-7/ 9

ONLINE CASE What Will Happen to Grandma? An Examination of the Long-Term Healthcare Industry in the United States* According to the most recent National Population Projections provided by the United States Census, the following two demographic trends are expected to occur: 1. From 2015 to 2060, the percentage of people aged 65 and older will grow from 14.88 percent to 23.55 percent of the population. It is the only age group that will grow as a percentage of the population [Exhibit 1]. 2. From 2015 to 2060, life expectancy for men will increase from 77.1 to 84 years of age and women’s life expectancy will increase from 81.7 to 87.1 [Exhibit 2]. These trends suggest that there will be increased demand for services that cater to a large demographic of aging people who will live longer than previous generations. As people age, the demand for healthcare increases. One study found that people aged 65 to 74 spend about 3 times more on healthcare-related expenses than 35- to 44-year-olds; those 75 and older spend over 5 times as much.1 Consequently, the size of the long-term healthcare industry has been estimated to be between $210.9 and $317.1 billion,2 and the healthcare and social assistance industry is expected to be the largest employing sector during the next decade.3 Seeing an opportunity to fulfill this need, a host of firms have rushed to take advantage of these changing demographics. EX HIB I T 1

Percent Distribution of the Projected Population by Sex and Selected Age Groups for the United States: 2015 to 2060

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

Under 18 years

22.91%

22.16%

21.60%

21.22%

20.91%

20.56%

20.26%

20.06%

19.90%

19.75%

18 to 64 years

62.20%

60.97%

59.42%

58.16%

57.69%

57.78%

57.98%

57.85%

57.40%

56.70%

65 years and over

14.88%

16.87%

18.98%

20.62%

21.39%

21.66%

21.75%

22.09%

22.70%

23.55%

Data Source: U.S. Census Bureau, Population Division. (2014a). Table 6. Percent Distribution of the Projected Population by Sex and Selected Age Groups for the United States: 2015 to 2060. Retrieved 4/22/2016, 2016, from http://www.census.gov/ population/projections/data/national/2014/summarytables.html.

EX HIB I T 2

Projected Life Expectancy at Birth: 2015 to 2060

2015

2020

2030

2040

2050

2060

Both Sexes

79.4

80.2

81.7

83.0

84.4

85.6

Male

77.1

78.0

79.6

81.2

82.7

84.0

Female

81.7

82.4

83.7

84.8

86.0

87.1

Data Source: U.S. Census Bureau, Population Division. (2014b). Table 17. Projected Life Expectancy at Birth by Sex, Race, and Hispanic Origin for the United States: 2015 to 2060 (NP2014-T17) Retrieved 4/22/2016, 2016, from http://www.census.gov/ population/projections/data/national/2014/summarytables.html.

* This case was contributed by David Thornblad Ph.D. and Zachary Sumner.

1

2 What Will Happen to Grandma?

Health Related Services for an Aging Population General terms for the services these firms provide are “long-term” and “post-acute” healthcare. Post-acute encompasses an array of healthcare services after an injury, illness, or disability. It is estimated that 35 percent of patients need follow-up care after they are discharged from the hospital.4 Some of the common services that are provided include: • Home Healthcare: These services allow patients to remain at home and still receive any medical support they require. Healthcare providers come to the patient’s home to take vital signs (blood pressure, temperature), make sure the patient is eating and drinking, and taking their medication.5 Home healthcare is generally less expensive than a hospital or skilled nursing facility. • Rehabilitation Services: These services can be provided in many settings (hospitals, skilled nursing centers, at home) and seek to restore or improve a patient’s independence after an injury. • Skilled nursing facilities: These facilities provide skilled nurses on a 24-hour basis to patients that do not require more advanced services that a hospital can provide. • Assisted/Senior Living Facilities: These facilities provide simpler services to elderly patients who do not need 24-hour care. These facilities provide meals, medication management, hygiene support/dressing and transportation services. • Hospice Care: Hospice facilities are for terminally ill patients, allowing them to finish their life in as much comfort as possible. Hospice patients do not receive treatments that attempt to cure an illness, but they do provide bereavement services to families and loved ones. As may be deduced from the types of services listed above, the majority of patients for postacute firms are elderly. This is because as people age normally simple injuries, such as injuries due to falling down, can have profound health impacts. Further, elderly people tend to have weakened immune systems and can have difficulty fighting illnesses.6

Industry Participants Three major firms that focus on healthcare for the elderly are Genesis Healthcare, National HealthCare Corporation, and The Ensign Group. Each firm has a slightly different strategy as to how to service the needs of the aging population. Genesis Healthcare offer inpatient services through a network of skilled nursing and assisted/ senior living facilities. Additionally, they supply rehabilitation and respiratory therapy to more than 1,700 locations in 45 states as well as the District of Columbia. Their assisted/senior living facilities are usually located in urban or suburban areas. In terms of strategy, the firm states that it seeks a higher profit margin than some of its competitors. Genesis believes that the most important factors that influence its performance are its reputation, the cost and quality of services, responsiveness to patient/resident needs as well as the ability to provide support in other areas such as third-party reimbursement, information management and patient recordkeeping. The firm also suggests that some competitors may not adhere to the Anti-Kickback Statute that prohibits payments for referrals, which allows these competitors to attract more patients.7 Kickbacks to obtain patients may allow competitors to compete at lower profit margins due to economies of scale. National HealthCare Corp (NHC) was founded in 1971, and its primary business services include skilled nursing facilities in association with assistant living and independent living facilities for seniors. At the end of 2015, NHC operated 74 skilled nursing facilities in nine states with over 9,400 beds. The firm has over 13,000 employees, and NHC offers tuition reimbursement to employees in order to recruit, retain, and maintain a qualified workforce. The company faces

Sources of Revenue

competition in every market in which they have a presence and in which no firm has a monopoly with the exception of some smaller rural markets. NHC attracts patients through referrals from hospitals, doctors, as well as church groups and community service organizations. Their annual report notes that the patients’ families often play a vital role in selecting a nursing home for their loved ones. Therefore, NHC believes their competitive advantages are their reputation and the physical appearance of their facilities in order to encourage family members to take their loved ones to a NHC facility.8 The Ensign Group was started in 1999 with the vision of establishing the standard of excellence in skilled nursing care. During the 2001 recession Ensign acquired multiple facilities that offered skilled nursing, personalized rehabilitation, and technologically advanced medical care services to a wide clientele. With a focus on acquiring underperforming medical facilities and turning them around, Ensign has been adding facilities across the United States.9 Ensign Group follows a differentiation strategy by maximizing the value they can provide to clients and charging them appropriately. The company provides state-of-the-art facilities, in-home therapeutic services for patients who are unable to leave their homes, and tailored care—the focus is providing quality care for patients who do not mind paying for such services and facilities, even if Medicare does pay for part of it. The company has faced criticism and lawsuits, alleging that they filed false claims with Medicare and that they would provide rehabilitative services that the patient did not need, culminating in a $48 million lawsuit settlement in 2013.10 One strategic concern shared by all firms in the industry is that while demand for their services will be growing due to an aging population, it is fairly easy to enter the industry.11 A 2016 report, in association with the U.S. Centers for Disease Control and Prevention, on the long-term healthcare industry found that there were approximately 67,000 regulated providers servicing 9 million people in the country.12

Sources of Revenue Firms in this industry receive the majority of their revenue from government sources, particularly Medicare and Medicaid. However, these revenue sources only cover certain services that these firms provide, therefore it is important to understand the types of Medicare and Medicaid. Medicare is provided by the federal government to people 65 or older as well as the disabled. In general, there are three types, or parts, of Medicare that are important for patients to understand. • Part A—Covers inpatient stays at hospitals, skilled nursing facilities, nursing home care, hospice, and home health services. • Part B—Covers services and supplies needed to treat chronic conditions, as well as preventive care like flu shots. It can also cover obtaining a second opinion from a doctor, as well as laboratory tests and ambulance services. Patients pay a monthly fee for this coverage. • Part D—Provides prescription drug coverage through private insurance companies that have contracts with the government. Medicaid is provided by state governments, with matching funds from the federal government, to patients or families with low incomes or little resources. Elderly patients can receive Medicaid in additional to Medicare, but patients only become eligible for Medicaid once they have exhausted their other assets. Medicare and Medicaid are the main sources of income in the senior and post-acute healthcare industry. As shown on Exhibit 3, in 2015 Genesis Healthcare, Ensign Group, and National HealthCare received an average of 32.93 percent of revenues from Medicare and 37.63 percent of revenues from Medicaid. This totals to 70.57 percent of revenues coming from government-related sources. Complicating the issue for the industry is that Medicare and Medicaid have been steadily lowering reimbursement rates for taking care of patients, or increasing reimbursements by lower rates than expected.13 Given the importance of Medicare and Medicaid, government sources of revenue are uncertain in the long term.

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4 What Will Happen to Grandma?

EXHIB IT 3

Sources of Revenue for Major Senior Healthcare Firms (Percentage of Total Revenue)

Genesis Year ended December 31

Ensign

National HealthCare

Average

2015

2014

2013

2015

2014

2013

2015

2014

2013

2015

2014

2013

Medicare

26

27

28

32.8

34.9

35.8

40

39

40

32.93

33.63

34.60

Medicaid

53

53

52

34.9

35.5

36.4

25

26

25

37.63

38.17

37.80

3rd Party Insurance / Managed Care

11

10

9

15.4

14.2

13.1

11

11

10

12.47

11.73

10.70

Private assets and other

10

10

11

16.9

15.4

14.7

24

24

25

16.97

16.47

16.90

Data Source(s): Ensign Group, 2016; Genesis Healthcare, 2016; National HealthCare Corporation, 2016.

Affordable Care Act President Obama signed the Affordable Care Act into law on March 23, 2010. The law aimed to transform the practices of doctors and hospitals to lower cost while driving better health outcomes for patients. To do so, United States citizens were mandated to have health insurance. This requirement sought to lower healthcare insurance costs since there was a larger pool of consumers, which lowered overall financial risk for insurance companies. It also required that insurance companies could not deny people coverage for pre-existing conditions. A year later, the Congressional Budget office estimated that the Affordable Care Act would “significantly decrease Medicare outlays relative to what they would have been under prior law.”14 The major components of the legislation are as follows: • All individuals were required to obtain healthcare insurance through some entity, which may include their employer’s healthcare plan, Medicare, Medicaid, or another public insurance plan. Individuals that did not do so were subject to a penalty. • A minimum healthcare insurance coverage was established. • Insurance companies were no longer allowed to deny coverage to people with pre-existing conditions, which companies could do before the law took effect. • The government established healthcare exchanges where individuals could purchase healthcare coverage. • Dependents, generally children, could stay on their parent’s healthcare insurance until their 26th birthday. While the legislation is highly controversial, it could be argued to have both positive and negative results for hospitals as well as the long-term and post-acute healthcare industry. On the positive side, when more individuals have insurance, there are more patients that can pay for the services these firms provide. However, if people have insurance, they may go to a doctor for preventative care. Such care may prevent devastating illnesses, which would lower the number of patients that need post-acute healthcare services. When President Trump took office, he and the Republican-controlled Congress worked to repeal or replace Obamacare immediately. Some of the arguments to repeal or replace the Affordable Care Act include: • The cost individuals pay for insurance each year is increasing. • Insurance companies are pulling out of regions that are not profitable enough for them; likely due to a low and decreasing percentage of young and healthy people buying insurance. • The cost the government pays to subsidize low-income individuals, so that they can afford insurance, is increasing. These concerns suggest that the long-term financial feasibility of Obamacare may not be sustainable by the federal government, though this contention is highly debated. Congress was unable to pass repeal or replace legislation within the first 2 years of the Trump presidency.

Future of the Healthcare Industry

EX HIB I T 4

Fiscal Year

Estimated Percentage of GPD of Tax Revenues and Cost of Social Programs

Tax Revenues

Social Security

Medicare

Medicaid, CHIP, and Exchange Subsidies

2015

17.7

4.9

3.0

2.2

2020

18.1

5.2

3.1

2.4

2025

18.3

5.7

3.6

2.5

2030

18.6

6.1

4.2

2.6

2035

19.0

6.3

4.7

2.7

2040

19.4

6.2

5.1

2.9

2045

19.9

6.0

5.5

3.0

2050

20.3

5.9

5.9

3.2

2055

20.8

5.9

6.3

3.3

2060

21.2

6.1

6.7

3.4

Percent Change from 2015 Fiscal Year

Tax Revenues

Social Security

Medicare

Medicaid, CHIP, and Exchange Subsidies

2025

3%

16%

20%

14%

2060

20%

24%

123%

55%

Data Source: U.S. Congressional Budget Office, “Long-Term Budget Projections - June 2015,” 2015, https://www.cbo.gov/ about/products/budget_economic_data, accessed April 22, 2016.

Future of Medicare and Medicaid As noted at the beginning of the case, people aged 65 and older will become the largest population demographic in the United States (Exhibit 1) and people are living longer than ever (Exhibit 2). Given that the US government is paying for the majority of hospital treatments as well as post-acute treatments for this demographic, it is important to understand the stability of Medicare and Medicaid as revenue sources to the industry. As shown in Exhibit 4, the United States Congressional Budget Office estimates that from 2015 to 2025, federal government expenses paid to Medicare will increase 20 percent, and Medicare as well as expenses related to the Affordable Care Act will increase 14 percent, while tax revenues will only increase 3 percent. Additionally, Social Security is paid to individuals over the age of 65, and expenses associated with it will increase 16 percent. When examining the rate of change from 2015 to 2060 (the year in which the demographic changes on page 1 refer), Medicare expenses will increase 123 percent, Medicaid and Affordable Care Act expenses will increase 55 percent, and Social Security expenses will increase 24 percent. However, it is estimated that tax revenues will increase only 20 percent, which may be because the typical tax paying demographic, age 18–64, will become an increasingly smaller percentage of the population (Exhibit 1). This suggests that in the long term, the government may not be able to maintain Medicare, Medicaid, and Social Security without additional tax increases.

Future of the Healthcare Industry Given the increasing costs of healthcare for an aging population, the current healthcare industry model may not be sustainable in the long term. What options do individuals, firms, and the government have to deal with this issue?

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6 What Will Happen to Grandma?

References 1 U. Reinhardt, “Does The Aging of the Population Really Drive the Demand for Health Care?,” Health Affairs, 22(6) (2003), 27–39. doi: 10.1377/hlthaff.22.6.27

L. Harris-Kojetin, M. Sengupta, E. Park-Lee, et al., “Long-term Care Providers and Services Users in the United States: Data from the National Study of Long-Term Care Providers, 2013–2014,” Vital Health Stat 38 (2016). 2

Bureau of Labor Statistics, “Employment Projections: 2014–24 Summary,” 2015. 3

Genesis Healthcare, Inc., 2015 10-K Annual Filing (2016), p. 3.

4

Medicare, “What’s Home Health Care & What Should I Expect?,” 2016, https://www.medicare.gov/what-medicare-covers/home-health-care /home-health-care-what-is-it-what-to-expect.html, accessed April 22, 2016. 5

6 American Accreditation HealthCare Commission, “Aging Changes in Immunity,” Medical Encyclopedia, 2014, https://www.nlm.nih.gov /medlineplus/ency/article/004008.htm, accessed April 22, 2016; Centers for Disease Control and Prevention, “Important Facts About Falls, 2016, http://www.cdc.gov/homeandrecreationalsafety/falls/adultfalls .html, accessed April 22, 2016.

Genesis Healthcare, Inc., 2015 10-K Annual Filing, 2016, p. 31.

7

National HealthCare Corporation, 2015 10-K Annual Filing, 2016.

8

Ensign Group, Inc., 2015 10-K Annual Filing, 2016.

9

US Department of Justice, “Nursing Home Operator to Pay $48 Million to Resolve Allegations That Six California Facilities Billed for Unnecessary Therapy,” 2013, https://www.justice.gov/opa/pr/nursing -home-operator-pay-48-million-resolve-allegations-six-california -facilities-billed 10

Genesis Healthcare, Inc., 2015 10-K Annual Filing, 2016, p. 31.

11

L. Harris-Kojetin et al., op cit.

12

Genesis Healthcare, Inc., 2015 10-K Annual Filing, 2016.

13

D. Elmendorf, “CBO’s 2011 Long-Term Budget Outlook,” Congressional Budget Office, 2011, p. 44.

14

ONLINE CASE Netflix, Redbox, and Hulu Offering New Business Models in Home Video Entertainment

After years of declining revenue and the rise of several innovative competitors, Blockbuster, which had been the long-time market leader in the movie rental industry, had collapsed. James F. Keyes, Blockbuster’s CEO since 2007, had seen the writing on the wall for several years. Rapid technological change had provided inroads for competitors with distinct cost advantages and unique value propositions unmatched by Blockbuster. Upon joining the company, Keyes moved quickly to improve the in-store experience for customers, leveraging Blockbuster’s historic core competency. But new business models launched by competitors Netflix, Redbox, Amazon.com, and others left the box store looking like a high-cost modern artifact. Blockbuster’s bottom line was left bleeding in the face of plummeting revenues, and Blockbuster filed for Chapter 7 bankruptcy protection in 2011. Coming out of bankruptcy, Blockbuster tried to mimic or beat competitive offerings by Redbox, Netflix, and Amazon by growing its kiosk rental business, allowing mail-order DVD rentals to be returned by mail or at the store, and introducing Direct Access, or in-store access to mail inventory.1 But it was too little, too late. Dish Network finally stepped in to purchase Blockbuster’s assets for $320 million in 2012, but it appeared that Blockbuster had lost its death match with smaller, more nimble competitors, armed not with slings and stones, but with kiosks and broadband.

History of the Home Video Entertainment Industry When the first motion pictures were released in the early 1900s, there was only one way to view them—at a theater. It wasn’t until television became popular in the 1940s and 1950s that people could watch some movies at home, although viewing was subject to the schedules of the television networks. In 1975, Sony introduced its Betamax video cassette recorder (VCR) to the American public. This was closely followed by Panasonic (formerly known as Matsushita) launching a Video Home System (VHS) VCR, which was then licensed to many companies, including Philips, GE, and RCA. These products could record and play movies, but they were expensive, selling for roughly $1,000 in 1977.2 In December 1977, the first video rental store, Video Cassette Rentals, opened its doors, offering both VHS and Betamax videos. Customers joined as “members” for a fee of $50 per year (or $100 for a permanent membership), and then paid $10 to rent each video.

1

2 Netflix, Redbox, and Hulu

Soon afterward, video rental stores began cropping up all over the United States, and more and more studios began to enter the home video market.3 The adoption of the VCR by the American public was slow at first. In 1980, only 1.1 percent of US households had a VCR. By 1985, that number had grown to 20.9 percent of US households.4 By the end of the decade, VCR penetration was at 68.6 percent,5 and the price of an average VCR had dropped below $400. As the number of VCRs increased, so did the number of video rental outlets. George Atkinson launched a chain of stores called Video Station, which quickly grew to become the market leader, with a total of 500 stores by 1984. But Video Station was soon challenged by Blockbuster, a video rental chain that opened its first stores in 1985. In 1987, Blockbuster acquired the chain Movies to Go, bringing its total number of stores to 67. During the next two years, Blockbuster grew rapidly through franchising. By 1989, Blockbuster was the largest video rental outlet in the country, with more than 1,000 stores, and it had begun to expand into overseas markets.6 Hollywood Video opened its doors in 1988, following a growth strategy similar to Blockbuster’s. It quickly became the second-largest video rental franchise in the United States. Box rental stores continued to proliferate through the early 1990s, with no apparent technological or competitive threats in sight. Then, in late 1995, a consortium of electronics manufacturers developed the digital versatile disk (DVD). The technology was introduced to the United States in 1997, and by mid-1998, Netflix had launched the world’s first online DVD rental service. Later that year, Amazon opened the first online video store, offering 60,000 titles for purchase, including 2,000 DVDs.7 During this time period, the technological landscape continued to evolve, and in 2002, MGM became the first major studio to allow online pay-per-view consumption.8 Redbox launched the same year, with its kiosks providing head-to-head competition with Blockbuster’s 5,566 domestic box-stores.9 In 2003, the year Netflix surpassed 1 million subscribers, annual DVD rental revenue surpassed annual VHS rental revenue for the first time.10 In 2004, CinemaNow was the first company to introduce a service that allowed customers to purchase and download digital movies for unlimited viewing. By 2005, Apple had launched online digital video services, a move followed by Microsoft and Amazon the next year.11 Viewing quality technology took a leap forward in 2006 with the introductions of high-definition (HD) DVD and Blu-ray. In the same year, PlayStation3 became the first gaming console to feature an HD DVD player. Online providers followed suit, increasing video quality as bandwidth became more widely available.12 The next several years brought a rapid contraction of the physical DVD and VHS rental markets as cost-efficient competitors (most notably Netflix DVD and Redbox) grew, and online content providers lured viewers away from physical rental. Between 2006 and 2013, the physical DVD rental market dropped from $10.7 billion to $4.5 billion.13 During the same years, total physical DVD-rental industry employment plunged from 141,000 to 55,000.14 The growth of online content providers threatened to further shrink the physical rental market. The battle for the growing online market continued to unfold in 2013. Facing continued growth of Netflix’s online streaming business, Redbox and Verizon partnered to launch their own streaming service called Redbox Instant. In similar fashion, NBC and Fox joined forces to launch Hulu, offering free, ad-supported viewing, and later launching a premium subscription service to rival Netflix’s streaming service. In 2013, both Netflix and Hulu began offering original content, a move highlighting the important and sometimes tenuous relationship between content providers and distributors. Throughout the history of the home entertainment industry, content producers had held significant supplier power. Producers, who owned the content rights to their movies, held the power to negotiate hard contract terms with distributors. Additionally, content producers, like consumers, showed little loyalty to specific distributors, switching channels and partners to maximize profits as the technological landscape shifted. For example, in 2007, NBC and Fox, who were key content providers with their Hulu partnership, showed a willingness to sidestep outside distributors altogether in favor of direct, cost-effective online distribution. Netflix’s decision to produce and distribute its own originally produced shows—such as political drama House of Cards, comedy-drama Orange Is the New Black, and historical drama

Major Players

The Crown—was a move to weaken the power of content producers and differentiate its offering from competitors. The initial results from these shows—in terms of positive feedback from consumers and advertisers—have been positive. The battle between content producers and distributors continues to significantly shape the competitive industry dynamics.

Major Players During the history of the home video industry, several players have entered with innovative business models that have changed the competitive landscape. Leaders have been Blockbuster, Netflix, Redbox, Apple, Microsoft, Amazon, and Hulu. A look at each provides insight into the industry’s rapidly changing dynamics and the strategies and business models deployed by its strongest players.

Blockbuster The first Blockbuster store opened in Dallas, Texas, in 1985. The store was successful, which prompted Blockbuster to open several more stores in the area and eventually a local warehouse to provide and manage inventory. Taking a lesson from his previous experience in database management, Blockbuster’s founder, David Cook, designed the warehouse to efficiently stock a selection of titles customized to each store according to its local demographic. This innovation brought a convenient, customized choice of VHS titles to customers in the exciting new arena of home entertainment.15 The company decided it could grow more quickly if it pursued a franchise model like the one used by McDonald’s and many other fast food giants. With a franchise model, individuals in different cities and regions paid an upfront franchise fee (anywhere from $200,000–$400,000),16 which gave them the right to own and operate a Blockbuster store at a specific location. In addition to receiving the fee, Blockbuster received an ongoing percentage of revenues generated from each store. Although the franchise model meant that Blockbuster had to share profits with the franchisees, it allowed Blockbuster to grow at a much faster rate than would have been possible if Blockbuster had tried to finance and build all of its stores. After a period of strong financial performance, Blockbuster was acquired by John Melk and Wayne Huizenga, a successful entrepreneur who had founded Waste Management and AutoNation. Huizenga became CEO and grew the business aggressively, both organically and through the acquisition of key competitors, including a 250-store buyout of mid-Atlantic rival Erol’s.17 Pushing into international markets, Blockbuster purchased the 875-store Ritz video chain of England in 1989. In 1991, Blockbuster entered the Japan and Australia markets through a mix of partnerships and acquisitions.18 By the early 1990s, Blockbuster had come to dominate the home video rental market in the United States, with more than 3,500 stores around the country.19 (See store growth in Exhibit  1). Each store carried more than 1,000 different movie options. Blockbuster needed to make this large investment in stores and inventory in order for customers to be able to conveniently find a store—and a desirable movie to rent. Blockbuster’s growth often came at the expense of traditional mom-and-pop video stores that found it hard to compete on selection and price. Customers often preferred the consistency of experienced, well-trained employees, as well as the variety of locations offered by Blockbuster compared to smaller stores and franchises. Blockbuster quickly discovered that it didn’t make money from the videos sitting on the shelves. It needed to get customers to rent the DVDs and return them as quickly as possible so Blockbuster could rent them to another customer. To encourage customers to return DVDs quickly, it charged late fees. These fees were unpopular with customers, but Blockbuster couldn’t make money if it didn’t get the DVDs back quickly. This pain point would later pave the way for industry disruption through Netflix’s subscription-based model.

3

4

Netflix, Redbox, and Hulu

E XH I B I T 1

Number of Blockbuster Stores over Time

Blockbuster Stores Year

Company-Owned

Franchised Stores

Total

1990

928

654

1,582

1996

4,472

845

5,317

2000

6,254

1,423

7,677

2005

7,158

1,884

9,042

2010

4,322

1,022

5,344

2011

n/a

n/a

1,500

2012

n/a

n/a

575

Source: Public filings; K. Peterson, “More Blockbuster Stores Closing,” http://money.msn.com. Financial information for video rentals is not available for Amazon, Apple, Hulu, or Microsoft.

Blockbuster continued to win market share and was acquired for $8.4 billion by Viacom in 1994. It was only two years later, however, that the company’s market value plummeted to an estimated $4.6 billion because investors were losing confidence and sales were beginning to slip.20 Blockbuster split from Viacom in 2004 and launched Blockbuster Online to compete directly with Netflix’s subscription business. Carl Icahn joined the board in 2005 and began a tenuous relationship with then-CEO John Antioco, who left the firm in 2007.21 Blockbuster’s market value had fallen to approximately $850 million by late 2005.22 After Antioco’s exit, new CEO James Keyes launched initiatives to return the focus to the in-store retail experience. The efforts proved insufficient to turn around the company, which lost $3.8 billion between 2003 and 2010. PricewaterhouseCoopers issued a statement in 2010 expressing doubt that Blockbuster could continue as a growing concern. Blockbuster filed for Chapter 11 bankruptcy that September, citing competition from Netflix and Redbox as the cause of plummeting revenues and its inability to service its $900 million worth of debt.23 Despite its struggles, Blockbuster remained the market leader in the movie rental industry, serving 47 million customers daily in 18 countries. In 2010, however, it lost $20 million following a $310 million loss the year before.24 Lacking the resources to continue restructuring, Blockbuster moved toward Chapter  7 bankruptcy and liquidation in 2011. James Keyes’s bold efforts to increase revenues, improve the customer experience, cut costs, and imitate competitive offerings proved to be too little, too late. Soon after, Dish Network acquired Blockbuster for $320 million. In early 2012, Dish announced that 90 percent of the remaining stores would stay open and continue to rent DVDs and games, while adding sales of wireless products that could be used to stream Blockbuster movies. Dish had initially announced plans to reshape Blockbuster into a head-to-head competitor with Netflix, but it retracted those plans in late 2012.25 At the time of the 2011 bankruptcy filing, Blockbuster was operating a total of 5,220 company stores worldwide,26 a number that fell drastically through the bankruptcy and Dish acquisition process. In November 2013, Dish announced it would close the remainder of its Blockbuster stores and shut down the Blockbuster By Mail service, but the streaming service Blockbuster On Demand would remain intact, and Blockbuster franchises and licensed stores in the United States and internationally would stay open.27

Netflix Reed Hastings launched a company aimed at fulfilling his dream of building the world’s best Internet movie service. The company was incited in part by a $40 late fee charged to Hastings for the video rental of Apollo 13. Inspired by his vision and fueled by his frustration, Hastings created Netflix and the company’s innovative subscription-based rental model that has revolutionized the way many people consume home entertainment.28

Major Players

Netflix’s model was simple: Customers paid a monthly subscription fee for unlimited mail-order DVDs plus unlimited online streaming. Initially, Netflix offered eight subscription plans ranging in price from $8.99 per month to $47.99 per month that allowed customers to rent one to eight DVDs at a time. With a subscription, customers could enjoy unlimited rentals without due dates, late fees, shipping fees, or per-title rental fees. DVDs could be conveniently selected, received, and returned without ever having to walk farther than the mailbox.29 Netflix’s business model was revolutionary. Whereas box-shop competitors such as Blockbuster moved titles from warehouses to store to customer, Netflix shipped directly from the warehouse to the customer. This model eliminated the need for brick and mortar stores, simplifying the value chain, and it allowed Netflix to cut costs and pass the savings on to customers. In 2010, Netflix’s general and administrative costs represented only 3 percent of total revenue, compared to 52 percent for Blockbuster, a cost primarily related to store labor and leases. (See Exhibit  2 for a full income statement).30 Netflix’s low fixed asset requirement allowed capital to be spent elsewhere, such as on expanding content, which furthered its advantage over the box-shop business model. From the customer’s perspective, the downside of renting movies over the Internet was that you had to plan ahead—no impulse movie watching. You couldn’t just pop over to the Blockbuster store and grab a movie to watch. But the upside was the ability to access 90,000 movies shipped from 50 warehouses around the country—warehouses strategically placed to ensure most customers got their orders within two days. This business model gave customers many more movie options to choose from. Offering customers a large selection of DVDs was fundamental to Netflix’s strategy. Titles included new and old Hollywood releases, classics, independent films, documentaries, and TV shows. Netflix invested heavily to maintain a diverse

EX HIB I T 2

Financial Information for Selected Years for Blockbuster ($ millions)

Fiscal Year

2010

2005

2000

1993

$2,125.9

$5,721.3

$4,960.1

$2,227.0

$884.8

$2,564.0

$2,036.0

$430.0

$1,116.8

$2,724.1

$2,174.0

$178.0

Advertising

$50.5

$252.7

$215.3

$50.8

Depreciation & amortization

$76.1

$226.6

$459.1

$396.1

Operating profit

$(2.3)

$(388.0)

$75.7

$423.0

Interest expense

$94.3

$98.7

$116.5

$33.8

$7.4

$63.3

$45.4

$146.2

$(268.0)

$(588.1)

$(75.9)

$243.6

Cash and cash equivalents

$146.5

$276.2

$194.2

$95.3

Merchandise inventories

$242.4

$310.3

$242.2

$350.8

Rental library, net

$269.1

$475.5

$646.7

$470.2

Property & equipment, net

$165.5

$723.5

$1,079.4

$522.7

$1,183.5

$3,179.6

$8,548.9

$3,521.0

$562.3

$1,317.9

$1,123.2

$643.2

Total liabilities

$1,735.5

$2,548.0

$2,540.5

$1,297.6

Total equity

$(552.0)

$631.6

$6,008.4

$2,123.4

Income Statement Items Revenues Cost of sales G&A expenses

Income taxes Net income Balance Sheet Items

Total assets Current liabilities

Source: Blockbuster SEC filings. In 2011, Blockbuster filed for bankruptcy protection and was subsequently purchased by Dish Network.

5

6

Netflix, Redbox, and Hulu

selection and to gain early access to new releases, partnering with content providers through direct purchases, revenue-sharing plans, and licensing agreements. Because Netflix customers paid a monthly fee, the company’s business model made profits in a manner opposite to Blockbuster’s. Netflix made more money when customers didn’t watch the DVDs they ordered. As long as the DVDs sat unwatched at customer’s homes, Netflix didn’t have to pay return postage or mail out the next DVD. Because Netflix didn’t have to build stores, hire sales clerks, or buy a huge inventory of DVDs to put in each store, it had more than a 30 percent cost advantage over Blockbuster. It was able to share some of this cost advantage with customers in the form of lower prices, and keep some of this advantage in the form of higher profits. With a solid value proposition and low costs, Netflix grew quickly, breaking 100,000 subscribers in 1999, renting its one-billionth title in 2007, and climbing to more than 35 million subscribers by 2012 (see Exhibit 3).31 To support the growth, Netflix built more than 50 high-efficiency distribution centers and 50 additional shipping points, placing 97 percent of the company’s customers within a one-day shipping reach. From 2008 to 2012, Netflix experienced a compound annual growth rate (CAGR) in revenues and gross profit of 21.5 percent and 16.7 percent, respectively (see Exhibit 4). Following its IPO in May 2002, the company’s market value was approximately $300 million.32 That value rose to $1.5 billion by the end of 2005 and $9.3 billion by the end of 2010. Following a drop to $5.1 billion in December 2012, which was attributed to a loss of customers when Netflix split its streaming service from its DVD mail service, the market value recovered in January 2013 back to $9.3 billion.33 As Netflix grew, it signed larger traditional licensing agreements and began offering new types of content. In 2010, Netflix announced a $1 billion partnership with Paramount Pictures, MGM, and Lions Gate Entertainment to continue content delivery to its expanding customer base.34 And Netflix began creating its own content (House of Cards, Orange Is the New Black, 13 Reasons Why) in 2013 in a bid to compete with cable and network television. By mid-2013, several Netflix series had received Emmy nominations for original, online-only, and Web television.I By 2017 Netflix offered 27 original programs, more than any other competitor, to drive customers to its streaming service.35

Redbox Redbox launched in 2002 as a venture initially funded by McDonald’s. McDonald’s was an early investor because it saw the potential of video rental kiosks, as well as McDonald’s stores as a key distribution channel. Redbox’s innovative strategy centered on a distribution network of low-cost, self-service vending kiosks. The kiosks allow customers, with a swipe of their credit card, access to a limited selection of the hottest new releases for $1.20 per night ($1.00 per night for the company’s first eight years). A customer can return the title the next day or keep it, E XH IB IT 3

Growth in Netflix Subscribers

Netflix Subscribers Year

Total subscribers (000’s)

2000

292

2005

4,179

2010

20,010

2011

26,253

2012

35,489

Source: Netflix public filings.

B. Stelter, “Netflix Does Well in 2013 Primetime Emmy Nominations,” July 18, 2013. http://artsbeat.blogs.nytimes.com/ 2013/07/18/watching-for-the-2013-primetime-emmy-nominations/?_r=0

I

Major Players

EX HIB I T 4

Netflix Financials ($ millions)

Fiscal Year

2013

2012

2011

2010

2005

2001

Revenues

$4,374.6

$3,609.3

$3,204.6

$2,162.6

$682.2

$74.2

Cost of revenues

$3,083.3

$2,625.9

$2,039.9

$1,357.4

$465.8

$49.9

$378.8

$329.0

$259.0

$163.3

$35.4

$17.7

$3,083.3

$2,625.9

$2,039.9

$293.8

$144.6

$21.0

$180.3

$139.0

$148.3

$70.6

$35.5

$4.7

$(6.1)

$(2.0)

Income Statement Items

Operating expenses Technology and development Marketing General and administrative Gain on disposal of DVDs Operating income

$228.3

$50.0

$376.1

$283.6

$3.0

$(37.2)

Interest expense

$29.1

$20.0

$20.0

$19.6

$407.0

$1,852.0

Income tax

$58.7

$13.3

$133.4

$106.8

$(33.7)

Net income

$112.4

$17.2

$226.1

$160.9

$42.0

$(38.6)

Cash and cash equivalents

$605.0

$290.3

$508.1

$194.5

$212.3

$16.1

Current content library, net

$1,706.4

$1,368.2

$919.7

$181.0

Content library, net

$2,091.1

$1,506.0

$1,046.9

$181.0

$57.0

$3.6

$133.6

$131.7

$136.4

$128.6

$40.2

$8.2

Total assets

$5,412.6

$3,967.9

$3,069.2

$982.1

$364.7

$41.6

Current liabilities

$2,154.2

$1,675.9

$1,225.1

$388.6

$137.6

$26.2

Total liabilities

$4,079.0

$3,223.2

$2,426.4

$691.9

$138.4

$30.3

Total equity

$1,333.6

$744.7

$642.8

$290.2

$226.3

$(90.5)

Balance Sheet Items

Property and equipment, net

Source: Netflix SEC filings and Annual Reports.

with daily rental charges accruing until the customer owns the DVD outright after 25 days. The kiosks are placed in high-traffic locations to encourage impulse rentals and to make planned rentals as convenient as possible. Retailers are incentivized to place kiosks by receiving a share of revenue, which is typically based on the retailer’s appeal (e.g., Walmart receives a larger share than a mom-and-pop store). The customer rental experience was kept simple and convenient. The selection process is simplified by the limited choice of titles (70–200 at most locations), all of which are prominently displayed on each kiosk. Redbox’s nonsubscription model allows customers to rent without the hassle of paperwork or membership fees. DVDs can be returned to any kiosk, adding a final touch of convenience to the rental process. Redbox grew quickly from 2003 to 2005, adding more than 1,100 kiosks throughout the United States.36 In 2005, Coinstar paid $32 million to acquire 47 percent of the company, and four years later, it purchased the remaining equity from McDonald’s for approximately $170 million.37 Redbox’s low-cost kiosks model allowed rapid expansion, and by 2012, the company had 43,700 kiosks (see Exhibit 5). The average cost of a Redbox kiosk was only $15,000 with an additional $6,720 for DVD costs to initially fill the kiosk.38 With Redbox fully onboard, Coinstar’s market value rose from an estimated $800 million in late 2009 to a peak of $2.1 billion in mid-2012 (see Exhibit 6).39 By 2012, 68 percent of the US population lived within a 5-minute drive of a Redbox kiosk,40 and the company controlled 47.8 percent of the physical rental market.41 Redbox’s footprint continued to grow throughout the United States and Canada, with almost 44,000 kiosks in

7

8

Netflix, Redbox, and Hulu

EXH IB IT 5

Growth in Number of Redbox Kiosks

Year

Total kiosks

2002

12

2005

1,200

2010

30,200

2011

35,400

2012*

43,700

*Excludes kiosks and the impact of kiosks acquired as part of the NCR Asset Acquisition. Source: Public filings (included in Coinstar Inc. filings), www .redbox.com/timeline.

E XH I B I T 6

Redbox Financials ($ Millions)

Fiscal Year

2013

2012

2011

2010

2009

2008 $388.5

Income Statement Items Revenue

$1,974.5

$1,908.8

$1,561.6

$1,159.7

$773.4

Direct operating expenses

$1,383.6

$1,340.9

$1,134.2

$859.8

$585.2

$23.0

$20.5

$22.0

$14.2

$8.2

G&A

$166.1

$159.9

$120.4

$94.9

$78.5

Operating income

$239.0

$238.7

$169.5

$190.9

$101.6

$50.2

$1,896.7

$1,561.7

$1,450.8

$561.2

$468.9

$378.1

Marketing

Balance Sheet Items Total assets Source: Outerwall SEC filings.

operation in 2012 and more planned. This vast network of kiosks was enabled by a network of regional operations supervisors who were responsible for the maintenance and operation, including stocking, of all kiosks in their assigned geographic regions.42 Redbox partnered with Verizon in 2013 to launch a video-streaming service called Redbox Instant, which was similar to the one offered by Netflix. For $8 per month, customers enjoy unlimited streaming of more than 4,600 titles and up to four disk rentals from kiosks. The service is offered through Android and iOS mobile apps and on Xbox and PlayStation 4 gaming platforms.43 Redbox Instant, however, lasted for less than two years and was shut down in October 2014. As streaming continued to be a substitute for physical DVD rentals from its Redbox kiosks, Redbox launched its second attempt at streaming, with Redbox Digital, in early 2017. However, it remained unclear how Redbox Digital would successfully compete with Netflix and other streaming competitors.

Apple, Amazon, and Microsoft: Internet Video on Demand Beginning in the mid-2000s, Apple, Amazon, and Microsoft began to leverage their online capabilities and customer bases to win a share of the video on demand (VOD) market. VOD allows customers to rent titles for a single viewing or unlimited viewings within a specified time period (often 24 hours). Pay-TV operators, such as Comcast and Direct TV, traditionally controlled this market, but their stronghold began to erode with the rise of Internet video on demand (iVOD) beginning in 2005. Despite rapid growth of the iVOD segment, Pay-TV operators maintained a 72 percent share of the VOD market in 2012. The balance of the market was split between

Major Players

electronic sell-through (EST), or the digital download and ownership of titles, which comprised 16 percent of the market, and traditional iVOD, with a 12 percent share.44 The EST market had been dominated by Apple, which held a 65 percent share in 2012, with Microsoft controlling a growing 10 percent of the market, and other players including Sony, Amazon, and Walmart. Meanwhile, the iVOD market had been more fragmented, with Apple commanding a 45 percent market share in 2012, followed by Amazon at 18 percent, and other players, including Walmart (through Vudu) and Microsoft (through Xbox video).45 Apple began offering videos through the iTunes music store in 2005, with a narrow selection of TV shows and music videos. One year later, Apple added more than 500 TV shows and began offering movies for download, with prices ranging from $9.99 to $19.99. Apple launched its iVOD service in 2008, allowing customers to rent through iTunes for as little as $0.99 per title. Microsoft launched an iVOD service through its Xbox platform in 2006, offering rentals for $2 to $6. Original content was provided through partnership with several studios, including CBS, MTV, and Paramount Pictures. Amazon followed suit in 2006 with its own iVOD service called Unbox, which was later rebranded as Amazon Video on Demand and then Amazon Instant Video. Amazon pursued a broad selection of movies and, by 2008, offered 5,000 titles as compared to Apple’s selection of 800. In 2011, Amazon began including 5,000 streaming movies and TV shows as a part of its Amazon Prime Membership.46 The offering had grown to 40,000 titles by 2013. Amazon’s VOD services allowed customers to pay and view movies individually or to gain unlimited access to a library of content through an annual membership to Amazon Prime, a bundled service package costing $79 each year, which also included free 2-day shipping on purchases and access to thousands of Kindle eBooks. However, Amazon Prime members were still required to pay a separate rental fee for newer popular titles. In this way, Amazon straddled the subscriptionbased approach of Netflix, while at the same time offering the more flexible membership-free approach of competitors such as Apple.47 Following Netflix’s lead, Amazon jumped into original programming and by early 2017 had a dozen original programs, including Mozart in the Jungle, Sneaky Pete, and Transparent. EST and iVOD offered distinct value propositions and cost advantages that further disrupted the home entertainment industry. EST allowed consumers to purchase videos for unlimited views from the comfort of home, conveniently storing the titles to hard drive or in the cloud. iVOD combined the streaming benefits of Netflix with the financial simplicity of Redbox, allowing home streaming of a range of titles with no subscription required. Both services eliminated the need for physical DVDs and physical distribution channels.

Hulu In a move to connect content providers directly to online consumers, NBC Universal and Fox launched a joint venture in 2007 to offer aggregated, ad-supported streaming online content.48 The deal was backed by Providence Equity Partners, which took a 10 percent stake for $100 million, valuing the company at $1 billion.  49 After a period of development, beta testing, and branding, Hulu launched in the US market in March 2008. NBC used its existing channels to advertise the service, including a spot in its Super Bowl broadcast in February 2009. That spring, Disney joined the venture, committing a significant amount of content and taking a 27 percent equity stake.50 Hulu reached profitability in 2010 and continued rapid growth, with 900 million monthly streams in January, which was triple the figure from a year before. By 2010, Hulu offered content from more than 200 providers, each earning from 50 percent to 70 percent of contentgenerated ad revenues.51 Hulu’s total revenues reached $420 million in 2011 (see Exhibit 7), fueled in part by a rapidly growing paid subscription service—Hulu Plus. Hulu Plus offers customers access to a broad range of premium, though still ad-supported, content for $7.99 per month. Additionally, Hulu Plus customers gain early access to content and are often able to view content within a day of its original broadcast, compared to a week or more for free customers. By the end of 2011, the service boasted more than 1.5 million subscribers with a rapid growth trajectory.52

9

10

Netflix, Redbox, and Hulu

E XH I B I T 7

Hulu Financials ($ Millions)

Fiscal Year Revenues

2013

2012

2011

2010

2009

$1,000.0

$695.0

$420.0

$263.0

$108.0

Source: Privco, blog.hulu.com.

Mirroring moves from Netflix, Hulu announced that it had ordered its first original series in early 2012. The move both created competitive differentiation and began to decrease Hulu’s reliance on outside content from TV and movie studios, the business’ main cost driver. In 2012, Hulu disclosed it would spend more than $500 million to develop original content by 2017, Hulu had at least nine original series, including The Mindy Project, Casuals, and The Wrong Mans. However, its original series had not received the critical acclaim of Netflix’s original series.53 In 2013, Disney, Fox, and Comcast (the acquirer of NBC) explored options to sell Hulu but opted to keep the company, citing optimism in the developing business model. The networks committed $750 million of new capital to broaden content offerings and update the platform, positioning the company to compete directly with Netflix for a share of the online streaming market.54

Conclusion Although James Keyes’s efforts to avert Blockbuster’s demise appeared valiant, they proved no match for the onslaught of technology, value, and convenience offered by its new competitors in home entertainment—competitors with cost structures and competencies specifically developed to support their respective business models. Blockbuster’s attempt to match its competitor’s offerings through its Blockbuster Express kiosk business, its mail-order DVD program, and its digital service, Blockbuster On Demand, was too little, too late. The gale of “creative destruction” described by famed economist Joseph Schumpeter, had resulted in new strategies and business models blowing away Blockbuster. Now the new competitors were left to duke it out to see which companies could ride the new wave of innovation and which companies would sink under the wave. For both Netflix and Redbox, the future of the DVD rental market within the home entertainment industry was becoming unclear as more and more content distributors focused on providing downloaded and streaming content. For Redbox, how long would consumers continue to be willing to physically go out and rent a movie or video game from a kiosk? Would the flexibility of Redbox Digital bundling of digital streaming and complementary credits to rent at physical kiosks provide the right value proposition to consumers? In addition to deciphering the method of delivery, the acquisition and development of content would be another issue facing entertainment distributors. By producing their own content, distributors such as Netflix, Amazon, and Hulu had begun to shift power away from traditional content producers. This upstream expansion into content development had already yielded positive results for each of these companies. Yet, could this threat to producers cause them to more aggressively move downstream into distribution? Could the rise of smaller independent content producers aid distributors in the power struggle against established traditional producers? Technological advances and innovative business models showed little sign of slowing down in the home entertainment industry. How would the current generation of power players address the competitive forces and disruptive innovations they would undoubtedly face? How would the ever-increasing broadband Internet capabilities, a rapidly growing Internet user base, and technologies yet to be discovered affect these players’ strategic directions? Perhaps most importantly, who could adapt to the dynamic environment, and who would be left to join the many companies that had washed up on the shores of the industry for decades?

References

11

References 1 PRN Newswire, “Blockbuster Reports Fourth Quarter and Fiscal-Year 2009 Financial Results” (February 24, 2010), http://investor.blockbuster .com/phoenix.zhtml?c=99383&p=irol-newsArticle&id=1395025, accessed July 31, 2017. 2 Entertainment Merchants Association, “Industry History: A History of Home Video and Video Game Retailing” (2004), http://www.entmerch .org/press-room/industry-history.html, accessed July 31, 2017.

Ibid.

3

TVB, “TV Basics” (2010), http://www.tvb.org/media/file/TV_Basics .pdf, accessed July 31, 2017. 4

Ibid.

5

Entertainment Merchants Association.

6

Ibid.

7

Ibid.

8

Public filing, Form 10-K

9

Entertainment Merchants Association.

10

Netflix, public filings.

29

Ibid.

30

Ibid.

31

“NFLX Market Cap,” http://www.marketcapchart.org/chart.php?symbol= nflx&mc_option=true, accessed July 31, 2017. 32

Netflix and Ycharts, “Netflix Market Cap,” http://ycharts.com/companies /NFLX/market_cap, accessed July 31, 2017. 33

B. Stelter, “Netflix to Pay Nearly $1 Billion to Add Films to On-Demand Service,” New York Times (August 10, 2010), http://www.nytimes .com/2010/08/11/business/media/11netflix.html?_r=0, accessed July 31, 2017. 34

35 B. Stelter, “Netflix Does Well in 2013 Primetime Emmy Nominations,” New York Times (July 18, 2013), http://artsbeat.blogs .nytimes.com/2013/07/18/watching-for-the-2013-primetime-emmy -nominations/?_r=0, accessed July 31, 2017.

Redbox, “The History of Redbox” (2014), http://www.redbox.com /timeline, accessed July 31, 2017.

36

Ibid.

37

Ibid.

38

11 12

http://clients1.ibisworld.com/reports/us/industry/currentperformance .aspx?entid=1370, accessed July 31, 2017. 13

Ibid.

14

“Video Venture: Taking Charge of Blockbuster,” Bloomberg Business Week, http://www.businessweek.com/chapter/chap0009.htm, accessed July 31, 2017.

15

J. Maze, “Want Successful Franchises? Charge Higher Fees,” Franchise Times (April 2013), http://www.franchisetimes.com/finance/April-2013 /Want-Successful-Franchisees-Charge-Higher-Franchise-Fees/, accessed July 31, 2017.

16

Entertainment Merchants Association.

17

Blockbuster Inc., public filings.

18

Ibid.

19

“Blockbuster Inc. History,” http://www.fundinguniverse.com/company -histories/blockbuster-inc-history/, accessed July 31, 2017. 20

Blockbuster Inc., public filings.

21

J. Goldsmith, “Blockbusted,” Variety (October 9, 2005), http://variety .com/2005/biz/news/blockbusted-1117930420/, accessed July 31, 2017.

22

Blockbuster Inc., public filings.

23

Ibid.

24

Ibid.

25

Ibid.

26

P. de Hahn, “Blockbuster to Shutter All U.S. Stores,” CNN Money (November 6, 2013), http://money.cnn.com/2013/11/06/news /companies/blockbuster-stores-closing/; A. Vuong, “Dish to Close 300 Blockbuster Stores,” Denver Post (January 21, 2013), http://www .denverpost.com/ci_22419439/dish-close-300-blockbuster-stores, accessed July 31, 2017.

27

A. Abkowitz, “How Netflix Got Started,” CNN Money (January 27, 2013), http://money.cnn.com/2009/01/27/news/newsmakers/hastings _netflix.fortune/, accessed July 31, 2017.

28

Coinstar Inc., public filings.

A. Fardshisheh, “Coinstar: Deep Value and Exceptional Growth,” Gurufocus.com (March 4, 2011), http://www.gurufocus.com/news /125840/coinstar-deep-value-and-exceptional-growth, accessed July 31, 2017. Coinstar Inc., public filings.

39

Redbox, “Facts about Redbox” (2014), http://www.redbox.com /facts, accessed July 31, 2017.

40

Coinstar Inc., public filing, Form 10-Q, Q1 2013.

41

“Redblog: A Day in the Life of Redbox Ninja” (April 12, 2010), http:// blog.redbox.com/2010/04/a-day-in-the-life-of-a-redbox-ninja.html, accessed July 31, 2017.

42

J. Wilcox, “First Look: Redbox Instant Is like the Old Netflix, but with Kiosks,” Consumer Reports (March 15, 2013), http://www .consumerreports.org/cro/news/2013/03/first-look-redbox-instant-is -like-the-old-netflix-but-with-kiosks/index.htm, accessed July 31, 2017.

43

S. Sanger, “Apple iTunes Break Through as VOD Leader,” worldtypc .com (February 2, 2013), http://www.worldtvpc.com/blog/apple -itunes-break-through-as-vod-leader/, accessed July 31, 2017.

44

PRWeb, “The NDP Group: Apple iTunes Dominates Internet Video Market” (April 23, 2013), http://www.prweb.com/releases/2013/4 /prweb16659785.htm, accessed July 31, 2017.

45

Amazon Press Releases, http://phx.corporate-ir.net/phoenix.zhtml?c= 176060&p=irol-news&nyo=0, accessed July 31, 2017.

46

Amazon.com, “Amazon Prime” (2014), http://www.amazon.com/dp /B00DBYBNEE?_encoding=UTF8&*Version*=1&*entries*=0, accessed July 31, 2017. 47

Hulu, “NBC Universal and News Corp. Announce Deal with Internet Leaders AOL, MSN, MYSPACE, and YAHOO! to Create a Premium Online Video Site with Unprecedented Reach” [Press Release] (March 22, 2007), http://www.hulu.com/press/new_video_venture.html, accessed July 31, 2017.

48

CrunchBase, “Hulu,” http://www.crunchbase.com/company/hulu, accessed July 31, 2017.

49

12

Netflix, Redbox, and Hulu

50 Hulu, “About Us,” http://www.hulu.com/about/news, accessed July 31, 2017.

N. Carson, “Hulu CEO Talks IPO, We Reveal How Much Money Hulu Makes,” Business Insider (July 7, 2010), http://www.businessinsider.com /hulu-ceo-talks-ipo-here-are-the-financials-2010-7, accessed July 31, 2017. 51

J. Kilar, “2011, 2012 and Beyond” (January 12, 2012), http://blog .hulu.com/2012/01/12/2011-2012-and-beyond/, accessed July 31, 2017.

52

53 J. Van Grove, “Hulu CEO Jason Kilar: Original Programming Is an Important Part of the Agenda,” venturebeat.com (January 31, 2012), http:// venturebeat.com/2012/01/31/hulu-jason-kilar/, accessed July 31, 2017.

G. Hall, “Disney and Fox CEOs Realize What They Have in Hulu,” bizjournals.com (August 8, 2013), http://www.bizjournals.com /losangeles/news/2013/08/08/disney-and-fox-ceos-realize-what -they.html, accessed July 31, 2017. 54

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