Finance - CT 4

Case studies Introduction A summary of the case

analysis process C-2

Preparing an effective case analysis – the full story C-5

Case 1 Hearing with the aid of implanted technology: The case of Cochlear™, an Australian high-technology leader C-19

Case 2 The Australian retail wars: Coles Myer and Woolworths battle for brand value C-26

Case 3 eBay.com: Profitably managing growth from start-up to 2000 C-32

Case 4 Gillette and the men’s wet-shaving market C-50

Case 5 Gunns and the greens: Governance issues in Tasmania C-70

Case 6 Growth at Hubbard’s Foods? C-79

Case 7 Incat Tasmania’s race for international success: Blue-riband strategies C-89

Case 8 The Golden Arches in India: A case of strategic adaptation C-95

Case 9 Monsanto: Better living through genetic engineering? C-106

Case 10 Nucor Corporation and the US steel industry C-121

Case 11 Philip Condit and the Boeing 777: From design and development to production and sales C-152

Case 12 Resene Paints C-168

Case 13 Sony Corporation: The vision of tomorrow C-184

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Introduction

A summary of the case analysis process Dallas Hanson University of Tasmania

Case analysis is an essential part of a strategic man- agement course and is also perhaps the most enter- taining part of such a course. The ‘full story’ that follows this summary gives you considerable detail about how to go about a case analysis, but for now here is a brief account.

Before we start, a word about attitude: make it a real exercise; you have a set of historical facts and use a rigorous system to work out what strategies should be followed. All the cases are about real companies, and one of the entertaining bits of the analysis pro- cess is to compare what you have said they should do with what they really have done. So, it is best not to check the Net to see current strategies until you have completed your analysis.

What follows is one analytical system, a fairly tight one that you may want to adapt according to how much time you have and the style of the case.

External analysis

Step 1 What industry is it? You must decide on this early. This is an important step, because it changes the analysis – for example, your industry analysis will yield different conclusions depending on what industry you determine.

Step 2 General environment analysis Analyse the six generic elements – economic, socio- cultural, global, technological, political/legal and demographic – and work out what the important facts are. There may be many issues and facts in each element, but you put down only the important ones. It is also important to avoid the common error of over- emphasis on the firm in question. So, assuming the firm operates in the Australian ice-cream industry, the demographic analysis may have this comment: ‘A large baby boomer generation is now becoming more health-conscious. This presents opportunities in health foods and healthy alternatives for conventional foods. It also presents opportunities for low-fat ice creams.’ Or, in analysing the demographics of the Cochlear™ firm, you may conclude that there is a global market of 1.8 million profoundly deaf people and that this pro- vides a huge undeveloped market for the implantable hearing devices industry.

Step 3 The industry environment Analyse the five forces (that is, supplier power, buyer power, potential entrants, substitute products and rivalry among competitors) and explain briefly what is significant for each. For example, what are the issues involved in new entrants into the industry? For

Introduction • A summary of the case analysis process C-3

the implantable hearing devices industry, these may include the need for understanding of intricate new technology, possession of a reputation in the global deaf community for safe and effective product devel- opment, and links to research institutions. This makes the industry hard to enter. Each force needs a brief dis- cussion followed by a short conclusion.

One extra consideration before you pull the anal- ysis together and work out if this is an attractive industry (the main conclusion) is: Is there a key force or forces in your industry? Porter argues that there is a key force in any industry, one that exerts more influ- ence than the other forces.

Now, is it an attractive industry? You need to explain, briefly, why or why not. Bear in mind that it is often not a clear decision because the forces are mixed – for example, there may be little concern about new entrants, suppliers or substitutes, but buyers may be fickle and rivalry high. In such cases, the key force analysis is very important

Remember: it is the industry you analyse, not the firm.

Step 4 Competitive environment Is there a strategic group that you need to take account of? What is the rivalry like in this group? What capa- bilities do the relevant firms have? What strategies do they follow? What threats do they represent?

Step 5 You now have material about opportunities and threats

It is easy to pull this together from the four steps you have now completed.

Internal analysis

Step 6 The firm’s resources, tangible and intangible

List all relevant resources. It is useful to distinguish between tangible and intangible resources. Remem- ber: firms have many resources.

At this point, if you have the skills and time, you can analyse the financial information that almost all cases provide. This provides material for a financial resources paragraph.

Step 7 Capabilities identification Here you make a list of capabilities. Capabilities tell you what the firm can do.

Remember: each firm may have a dozen or more capabilities, so include some that are very unlikely to be core competencies. This is a difficult step, because you must explain the capabilities carefully to indicate what the firm really does. For example, Cochlear has a capability for research in cochlear-related technol- ogy. It does not have a generic research capability.

Step 8 Core competency analysis For each capability, indicate which of the four tests for a core competency it meets. An easy way to do this is through use of a table. For example:

Rare? Valuable? Costly to imitate?

Non- substitutable

Logistics management in cochlear technologies Yes Yes No No

Research knowledge and skill in cochlear- related areas Yes Yes Yes Yes

Etc.

This is an important step, because the core compe- tencies are fundamental in the strategies you suggest – firms use their core competencies.

Step 9 Weaknesses What major weaknesses does the firm have – for example, old technology, very limited finance and poor cash flow, no succession planning?

Step 10 Pulling it together You now have all the material for an excellent SWOT (strengths/weaknesses, opportunities/threats) analysis. Pull together the earlier identification of opportunities and threats (step 5) with the internal analysis you have done. This resources-based, theory- oriented system gives you a powerful vocabulary to describe what simpler systems call ‘strengths’, and the other elements of the system allow you to systematically identify other significant factors in the mix.

C-4 Introduction • A summary of the case analysis process

Step 11 Current strategies Work out the firm’s current strategies.

Step 12 Strategies Here you take advantage of opportunities and handle threats. You should be able to make use of core com- petencies to do this.

You may need strategies at the business level, cor- porate level and international level (but it depends on the industry and on whether all are required). Also, bear in mind that you may need to specify functional- level strategies to fit the generic strategies at the business level. For example, if your ice-cream compa- ny adopts a differentiation strategy, you must specify how it is differentiated (on what grounds – low fat?) and there must be associated innovation and market- ing strategies (or, in the corporate-level strategy, a supporting acquisition strategy may be used to handle the innovation issue).

Make a list of alternative possibilities and use the external and internal analyses that you have con- ducted to assess them. Choose one set of alternatives. How do these differ from current strategies?

Make sure the strategies chosen fit in with your earlier analysis. Use all the conclusions in the earlier analysis. For example (and bear in mind that this is simplified to make the idea clearer), if you are in a rivalrous industry which has good growth prospects because of useful demographic change and you have good financial resources, you may argue for expan- sion into the new segment using available resources. If the finances were not there, this strategy would be difficult to support.

Using the Cochlear™ case as a training case This case analysis process is easy to use once you have learned it, and the best way to learn is to try it out. The Cochlear™ case in this book is designed as a training case to help you do this. Don’t be concerned if you get a slightly different analysis to other people: one of the glories of case analysis is that they are never ‘right’; some are, however, more plausible than others.

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Preparing an effective case analysis – the full story

In most strategic management courses, cases are used extensively as a teaching tool.1 A key reason is that cases provide active learners with opportunities to use the strategic management process to identify and solve organisational problems. Thus, by analysing situations that are described in cases and presenting the results, active learners (that is, students) become skilled at effectively using the tools, techniques and concepts that combine to form the strategic manage- ment process.

The cases that follow are concerned with actual companies. Presented within the cases are problems and situations that managers and those with whom they work must analyse and resolve. As you will see, a strategic management case can focus on an entire industry, a single organisation, or a business unit of a large, diversified firm. The strategic management issues facing not-for-profit organisations also can be examined using the case analysis method.

Basically, the case analysis method calls for a care- ful diagnosis of an organisation’s current conditions (as manifested by its external and internal environ- ments) so that appropriate strategic actions can be recommended in light of the firm’s strategic intent and strategic mission. Strategic actions are taken to devel- op and then use a firm’s core competencies to select and implement different strategies, including business- level, corporate-level, acquisition and restructuring, international and cooperative strategies. Thus, appro- priate strategic actions help the firm to survive in the long run as it creates and uses competitive advantages as the foundation for achieving strategic competitive- ness and earning above-average returns. The case

method that we are recommending to you has a rich heritage as a pedagogical approach to the study and understanding of managerial effectiveness.2

As an active learner, your preparation is critical to successful use of the case analysis method. With- out careful study and analysis, active learners lack the insights required to participate fully in the discussion of a firm’s situation and the strategic actions that are appropriate.

Instructors adopt different approaches in their application of the case analysis method. Some require active learners/students to use a specific analytical procedure to examine an organisation; others pro- vide less structure, expecting students to learn by developing their own unique analytical method. Still other instructors believe that a moderately structured framework should be used to analyse a firm’s situa- tion and make appropriate recommendations. Your lecturer or tutor will determine the specific approach you take. The approach we are presenting to you is a moderately structured framework.

We divide our discussion of a moderately struc- tured case analysis method framework into four sections. First, we describe the importance of under- standing the skills active learners can acquire through effective use of the case analysis method. In the sec- ond section, we provide you with a process-oriented framework. This framework can be of value in your efforts to analyse cases and then present the results of your work. Using this framework in a classroom set- ting yields valuable experiences that can, in turn, help you to successfully complete assignments that you will receive from your employer. The third section

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is where we describe briefly what you can expect to occur during in-class case discussions. As this descrip- tion shows, the relationship and interactions between instructors and active learners/students during case discussions are different than they are during lectures. In the final section, we present a moderately struc- tured framework that we believe can help you to pre- pare effective oral and written presentations. Written and oral communication skills also are valued highly in many organisational settings; hence, their develop- ment today can serve you well in the future.

Skills gained through use of the case analysis method The case analysis method is based on a philosophy that combines knowledge acquisition with significant involvement from students as active learners. In the words of Alfred North Whitehead, this philosophy ‘rejects the doctrine that students had first learned passively, and then, having learned should apply knowledge’.3 In contrast to this philosophy, the case analysis method is based on principles that were elab- orated upon by John Dewey:

Only by wrestling with the conditions of this

problem at hand, seeking and finding his own way

out, does [the student] think ... If he cannot devise

his own solution (not, of course, in isolation, but

in correspondence with the teacher and other

pupils) and find his own way out he will not learn,

not even if he can recite some correct answer with

a hundred percent accuracy.4

The case analysis method brings reality into the classroom. When developed and presented effectively, with rich and interesting detail, cases keep conceptu- al discussions grounded in reality. Experience shows that simple fictional accounts of situations and collec- tions of actual organisational data and articles from public sources are not as effective for learning as fully developed cases. A comprehensive case presents you with a partial clinical study of a real-life situation that faced managers as well as other stakeholders, includ- ing employees. A case presented in narrative form provides motivation for involvement with and analy- sis of a specific situation. By framing alternative stra- tegic actions and by confronting the complexity and ambiguity of the practical world, case analysis pro- vides extraordinary power for your involvement with a personal learning experience. Some of the poten- tial consequences of using the case method are sum- marised in Exhibit 1.

As Exhibit 1 suggests, the case analysis meth- od can assist active learners in the development of their analytical and judgement skills. Case analy- sis also helps students to learn how to ask the right questions. By this we mean questions that focus on the core strategic issues that are included in a case. Active learners/students with managerial aspirations can improve their ability to identify underlying prob- lems rather than focusing on superficial symptoms as they develop skills at asking probing, yet appropriate, questions.

The collection of cases your instructor chooses to assign can expose you to a wide variety of organisa- tions and decision situations. This approach vicari- ously broadens your experience base and provides insights into many types of managerial situations,

Exhibit 1

1 Case analysis requires students to practise important managerial skills – diagnosing, making decisions, observing, listening and persuading – while preparing for a case discussion.

2 Cases require students to relate analysis and action, to develop realistic and concrete actions despite the complexity and partial knowledge characterising the situation being studied.

3 Students must confront the intractability of reality – complete with absence of needed information, an imbalance between needs and available resources, and conflicts among competing objectives.

4 Students develop a general managerial point of view – where responsibility is sensitive to action in a diverse environmental context.

Source: C.C. Lundberg and C. Enz, 1993, ‘A framework for student case preparation’, Case Research Journal, 13 (summer), p. 134.

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tasks and responsibilities. Such indirect experience can help you to make a more informed career deci- sion about the industry and managerial situation you believe will prove to be challenging and satisfy- ing. Finally, experience in analysing cases definitely enhances your problem-solving skills, and research indicates that the case method for this subject is better than the lecture method.5

Furthermore, when your instructor requires oral and written presentations, your communication skills will be honed through use of the case method. Of course, these added skills depend on your prepara- tion as well as your instructor’s facilitation of learn- ing. However, the primary responsibility for learning is yours. The quality of case discussion is generally acknowledged to require, at a minimum, a thorough mastery of case facts and some independent analysis of them. The case method therefore first requires that you read and think carefully about each case. Addi- tional comments about the preparation you should complete to successfully discuss a case appear in the next section.

Student preparation for case discussion If you are inexperienced with the case method, you may need to alter your study habits. A lecture- oriented course may not require you to do intensive preparation for each class period. In such a course, you have the latitude to work through assigned read- ings and review lecture notes according to your own schedule. However, an assigned case requires signifi- cant and conscientious preparation before class. With- out it, you will be unable to contribute meaningfully to in-class discussion. Therefore, careful reading and thinking about case facts, as well as reasoned anal- yses and the development of alternative solutions to case problems, are essential. Recommended alterna- tives should flow logically from core problems iden- tified through study of the case. Exhibit 2 shows a set of steps that can help you to familiarise yourself with a case, identify problems and propose strategic actions that increase the probability that a firm will achieve strategic competitiveness and earn above- average returns.

Exhibit 2

Step 1: Gaining familiarity

a In general – determine who, what, how, where and when (the critical facts of the case). b In detail – identify the places, persons, activities and contexts of the situation. c Recognise the degree of certainty/uncertainty of acquired information.

Step 2: Recognising symptoms

a List all indicators (including stated ‘problems’) that something is not as expected or as desired. b Ensure that symptoms are not assumed to be the problem. (Symptoms should lead to

identification of the problem.)

Step 3: Identifying goals

a Identify critical statements by major parties (e.g. people, groups, the work unit, etc.). b List all goals of the major parties that exist or can be reasonably inferred.

Step 4: Conducting the analysis

a Decide which ideas, models and theories seem useful. b Apply these conceptual tools to the situation. c As new information is revealed, cycle back to sub-steps (a) and (b).

Step 5: Making the diagnosis

a Identify predicaments (goal inconsistencies). b Identify problems (discrepancies between goals and performance). c Prioritise predicaments/problems regarding timing, importance, etc.

Step 6: Doing the action planning

a Specify and prioritise the criteria used to choose action alternatives. b Discover or invent feasible action alternatives. c Examine the probable consequences of action alternatives. d Select a course of action. e Design an implementation plan/schedule. f Create a plan for assessing the action to be implemented.

Source: C. C. Lundberg and C. Enz, 1993, ‘A framework for student case preparation’, Case Research Journal, 13 (summer), p. 144.

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Gaining familiarity The first step of an effective case analysis process calls for you to become familiar with the facts featured in the case and the focal firm’s situation. Initially, you should become familiar with the focal firm’s general situation (for example, who, what, how, where and when). Thorough familiarisation demands apprecia- tion of the nuances, as well as the major issues, in the case.

Gaining familiarity with a situation requires you to study several situational levels, including interactions between and among individuals within groups, busi- ness units, the corporate office, the local communi- ty and the society at large. Recognising relationships within and among levels facilitates a more thorough understanding of the specific case situation.

It is also important that you evaluate information on a continuum of certainty. Information that is verifiable by several sources and judged along similar dimensions can be classified as a fact. Information representing someone’s perceptual judgement of a par- ticular situation is referred to as an inference. Infor- mation gleaned from a situation that is not verifiable is classified as speculation. Finally, information that is independent of verifiable sources and arises through individual or group discussion is an assumption. Obviously, case analysts and organisational decision makers prefer having access to facts over inferences, speculations and assumptions.

Personal feelings, judgements and opinions evolve when you are analysing a case. It is important to be aware of your own feelings about the case and to evaluate the accuracy of perceived ‘facts’ to ensure that the objectivity of your work is maximised.

Recognising symptoms Recognition of symptoms is the second step of an effective case analysis process. A symptom is an indi- cation that something is not as you or someone else thinks it should be. You may be tempted to correct the symptoms instead of searching for true problems. True problems are the conditions or situations requiring solution before the performance of an organisation, business unit or individual can improve. Identifying and listing symptoms early in the case analysis process tends to reduce the temptation to label symptoms as

problems. The focus of your analysis should be on the actual causes of a problem, rather than on its symptoms. Thus, it is important to remember that symptoms are indicators of problems; subsequent work facilitates discovery of critical causes of problems that your case recommendations must address.

Identifying goals The third step of effective case analysis calls for you to identify the goals of the major organisations, business units and/or individuals in a case. As appro- priate, you should also identify each firm’s strategic intent and strategic mission. Typically, these direc- tion-setting statements (goals, strategic intents and strategic missions) are derived from comments made by central characters in the organisation, business unit or top management team as described in the case and/or from public documents (for example, an annual report).

Completing this step successfully can sometimes be difficult. Nonetheless, the outcomes you attain from this step are essential to an effective case analysis because identifying goals, intent and mission helps you to clarify the main problems featured in a case and to evaluate alternative solutions to those problems. Direction-setting statements are not always stated publicly or prepared in written format. When this occurs, you must infer goals from other available fac- tual data and information.

Conducting the analysis The fourth step of effective case analysis is concerned with acquiring a systematic understanding of a situ- ation. Occasionally, cases are analysed in a less-than- thorough manner. Such analyses may be a product of a busy schedule or of the difficulty and complexity of the issues described in a particular case. Sometimes you will face pressures on your limited amounts of time and may believe that you can understand the sit- uation described in a case without systematic analy- sis of all the facts. However, experience shows that familiarity with a case’s facts is a necessary, but insuf- ficient, step in the development of effective solutions – solutions that can enhance a firm’s strategic com- petitiveness. In fact, a less-than-thorough analysis typically results in an emphasis on symptoms, rather than on problems and their causes. To analyse a case

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effectively, you should be sceptical of quick or easy approaches and answers.

A systematic analysis helps you to understand a situation and determine what can work and prob- ably what will not work. Key linkages and under- lying causal networks based on the history of the firm become apparent. In this way, you can separate causal networks from symptoms.

Also, because the quality of a case analysis depends on applying appropriate tools, it is important that you use the ideas, models and theories that seem to be use- ful for evaluating and solving individual and unique situations. As you consider facts and symptoms, a useful theory may become apparent. Of course, hav- ing familiarity with conceptual models may be impor- tant in the effective analysis of a situation. Successful students and successful organisational strategists add to their intellectual tool kits on a continual basis.

Making the diagnosis The fifth step of effective case analysis – diagnosis – is the process of identifying and clarifying the roots of the problems by comparing goals with facts. In this step, it is useful to search for predicaments. Predica- ments are situations in which goals do not fit with known facts. When you evaluate the actual perfor- mance of an organisation, business unit or individual, you may identify over- or under-achievement (relative to established goals). Of course, single-problem situa- tions are rare. Accordingly, you should recognise that the case situations you study probably will be com- plex in nature.

Effective diagnosis requires you to determine the problems affecting longer-term performance and those requiring immediate handling. Understanding these issues will aid your efforts to prioritise prob- lems and predicaments, given available resources and existing constraints.

Doing the action planning The final step of an effective case analysis process is called action planning. Action planning is the process of identifying appropriate alternative actions. In the action planning step, you select the criteria you will use to evaluate the identified alternatives. You may derive these criteria from the analyses; typically, they are related to key strategic situations facing the focal

organisation. Furthermore, it is important that you prioritise these criteria to ensure a rational and effec- tive evaluation of alternative courses of action.

Typically, managers ‘satisfice’ when selecting courses of action; that is, they find acceptable courses of action that meet most of the chosen evaluation criteria. A rule of thumb that has proved valuable to strategic decision makers is to select an alternative that leaves other plausible alternatives available if the one selected fails.

Once you have selected the best alternative, you must specify an implementation plan. Developing an implementation plan serves as a reality check on the feasibility of your alternatives. Thus, it is important that you give thoughtful consideration to all issues associated with the implementation of the selected alternatives.

What to expect from in-class case discussions Classroom discussions of cases differ significantly from lectures. The case method calls for instructors to guide the discussion, encourage student participation and solicit alternative views. When alternative views are not forthcoming, instructors typically adopt one view so that students can be challenged to respond to it thoughtfully. Often students’ work is evaluated in terms of both the quantity and the quality of their contributions to in-class case discussions. Students benefit by having their views judged against those of their peers and by responding to challenges by other class members and/or the instructor.

During case discussions, instructors listen, ques- tion and probe to extend the analysis of case issues. In the course of these actions, peers or the instructor may challenge an individual’s views and the validity of alternative perspectives that have been expressed. These challenges are offered in a constructive man- ner; their intent is to help students develop their ana- lytical and communication skills. Instructors should encourage students to be innovative and original in the development and presentation of their ideas. Over the course of an individual discussion, students can develop a more complex view of the case, benefiting from the diverse inputs of their peers and instructor.

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Among other benefits, experience with multiple-case discussions should help students to increase their knowledge of the advantages and disadvantages of group decision-making processes.

Student peers as well as the instructor value com- ments that contribute to the discussion. To offer relevant contributions, you are encouraged to use independent thought and, through discussions with your peers outside of class, to refine your thinking. We also encourage you to avoid using ‘I think’, ‘I believe’ and ‘I feel’ to discuss your inputs to a case analysis process. Instead, consider using a less emotion-laden phrase, such as ‘My analysis shows’. This highlights the logical nature of the approach you have taken to complete the six steps of an effective case analysis process.

When preparing for an in-class case discussion, you should plan to use the case data to explain your assessment of the situation. Assume that your peers and instructor know the case facts. In addition, it is good practice to prepare notes before class discus- sions and use them as you explain your view. Effective notes signal to classmates and the instructor that you are prepared to engage in a thorough discussion of a case. Moreover, thorough notes eliminate the need for you to memorise the facts and figures needed to dis- cuss a case successfully.

The case analysis process just described can help you prepare to effectively discuss a case during class meetings. Adherence to this process results in consid- eration of the issues required to identify a focal firm’s problems and to propose strategic actions through which the firm can increase the probability that it will achieve strategic competitiveness.

In some instances, your instructor may ask you to prepare either an oral or a written analysis of a particular case. Typically, such an assignment demands even more thorough study and analysis of the case contents. At your instructor’s discretion, oral and written analyses may be completed by individuals or by groups of two or more people. The informat- ion and insights gained through completing the six steps shown in Exhibit 2 are often of value in the development of an oral or written analysis. However, when preparing an oral or written presentation, you must consider the overall framework in which your

information and inputs will be presented. Such a framework is the focus of the next section.

Preparing an oral/written case strategic plan Experience shows that two types of thinking are nec- essary in order to develop an effective oral or written presentation (see Exhibit 3). The upper part of the model in Exhibit 3 outlines the analysis stage of case preparation.

In the analysis stage, you should first analyse the general external environmental issues affecting the firm. Next, your environmental analysis should focus on the particular industry (or industries, in the case of a diversified company) in which a firm operates. Finally, you should examine the competitive environ- ment of the focal firm. Through study of the three levels of the external environment, you will be able to identify a firm’s opportunities and threats. Following the external environmental analysis is the analysis of the firm’s internal environment, which results in the identification of the firm’s strengths and weaknesses.

As noted in Exhibit 3, you must then change the focus from analysis to synthesis. Specifically, you must synthesise information gained from your analy- sis of the firm’s internal and external environments. Synthesising information allows you to generate alter- natives that can resolve the significant problems or challenges facing the focal firm. Once you identify a best alternative, from an evaluation based on prede- termined criteria and goals, you must explore imple- mentation actions.

Exhibits 4 and 5 outline the sections that should be included in either an oral or a written strategic plan presentation: introduction (strategic intent and mission), situation analysis, statements of strengths/ weaknesses and opportunities/threats, strategy for- mulation and implementation plan. These sections, which can be completed only through use of the two types of thinking featured in Exhibit 3, are described in the following discussion. Familiarity with the con- tents of your textbook’s 13 chapters is helpful because the general outline for an oral or a written strategic plan shown in Exhibit 5 is based on an understand- ing of the strategic management process detailed in those chapters.

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External environment analysis As shown in Exhibit 5, a general starting place for completing a situation analysis is the external envi- ronment. The external environment is composed of outside conditions that affect a firm’s performance. Your analysis of the environment should consider the effects of the general environment on the focal firm. Following that evaluation, you should analyse the industry and competitor environmental trends.

These trends or conditions in the external environ- ment shape the firm’s strategic intent and mission. The external environment analysis essentially indi- cates what a firm might choose to do. Often called an environmental scan, an analysis of the external envi- ronment allows a firm to identify key conditions that are beyond its direct control. The purpose of studying the external environment is to identify a firm’s oppor- tunities and threats. Opportunities are conditions in the external environment that appear to have the potential to contribute to a firm’s success. In essence, opportunities represent possibilities. Threats are conditions in the external environment that appear

to have the potential to prevent a firm’s success. In essence, threats represent potential constraints.

When studying the external environment, the focus is on trying to predict the future (in terms of local, regional, and international trends and issues) and to predict the expected effects on a firm’s oper- ations. The external environment features conditions in the broader society and in the industry (area of competition) that influence the firm’s possibilities and constraints. Areas to be considered (to identify opportunities and threats) when studying the general environment are listed in Exhibit 6. Many of these issues are explained more fully in Chapter 2.

Once you analyse the general environmental trends, you should study their effect on the focal indus- try. Often the same environmental trend may have a significantly different impact on separate industries, or it may affect firms within the same industry differ- ently. For instance, with deregulation of the airline industry in the United States, older, established air- lines had a significant decrease in profitability, while many smaller airlines, such as Southwest Airlines,

Exhibit 3 Types of thinking in case preparation: Analysis and synthesis

ANALYSIS

External environment

General environment Industry environment

Competitor environment

Internal environment

Statements of strengths, weaknesses, opportunities and threats

Alternatives Evaluations of alternatives

Implementation

SYNTHESIS

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Exhibit 5 Strategic planning and its parts

• Strategic planning is a process through which a firm determines what it seeks to accomplish and the actions required to achieve desired outcomes

✓ Strategic planning, then, is a process that we use to determine what (outcomes to be reached) and how (actions to be taken to reach outcomes)

• The effective strategic plan for a firm would include statements and details about the following:

✓ Opportunities (possibilities) and threats (constraints)

✓ Strengths (what we do especially well) and weaknesses (deficiencies)

✓ Strategic intent (an indication of a firm’s ideal state)

✓ Strategic mission (purpose and scope of a firm’s operations in product and market terms)

✓ Key result areas (KRAs) (categories of activities where efforts must take place to reach the mission and intent)

✓ Strategies (actions for each KRA to be completed within one to five years)

✓ Objectives (specific statements detailing actions for each strategy that are to be completed in one year or less)

✓ Cost linkages (relationships between actions and financial resources)

Exhibit 4 Strategic planning process

Strategic intent

Strategic mission

Strategies • 1 to 5 years • Cost linkages

Objectives • 1 year or less • Cost linkages

Key result areas • Required efforts • Cost linkages

External environment • Opportunities (possibilities) • Threats (constraints)

Internal environment • Strengths • Weaknesses

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with lower cost structures and greater flexibility, were able to aggressively enter new markets.

Porter’s five forces model is a useful tool for ana- lysing the specific industry (see Chapter 2). Careful study of how the five competitive forces (that is, sup- plier power, buyer power, potential entrants, substi- tute products and rivalry among competitors) affect a firm’s strategy is important. These forces may cre- ate threats or opportunities relative to the specific business-level strategies (that is, differentiation, cost leadership, focus) being implemented. Often a stra- tegic group’s analysis reveals how different environ- mental trends are affecting industry competitors. Strategic group analysis is useful for understanding the industry’s competitive structures and firm con- straints and possibilities within those structures.

Firms also need to analyse each of their primary competitors. This analysis should identify their com- petitors’ current strategies, strategic intent, strategic mission, capabilities, core competencies and compet- itive response profile. This information is useful to the focal firm in formulating an appropriate strategic intent and mission.

Internal environment analysis The internal environment is composed of strengths and weaknesses internal to a firm that influence its strategic competitiveness. The purpose of completing an analysis of a firm’s internal environment is to iden- tify its strengths and weaknesses. The strengths and weaknesses in a firm’s internal environment shape the strategic intent and strategic mission. The inter- nal environment essentially indicates what a firm

Exhibit 6 Sample general environmental categories

Technology • Information technology continues to become cheaper and have more practical applications

• Database technology allows organisation of complex data and distribution of information • Telecommunications technology and networks increasingly provide fast transmission of all

sources of data, including voice, written communications and video information Demographic trends • Computerised design and manufacturing technologies continue to facilitate quality and

flexibility • Regional changes in population due to migration • Changing ethnic composition of the population • Ageing of the population • Ageing of the baby boomer generation

Economic trends • Interest rates • Inflation rates • Savings rates • Trade deficits • Budget deficits • Exchange rates

Political/legal environment • Antitrust enforcement • Tax policy changes • Environmental protection laws • Extent of regulation/deregulation • Developing countries privatising state monopolies • State-owned industries

Socio-cultural environment • Increasing proportion of women in the workforce • Awareness of health and fitness issues • Concern for the environment • Concern for customers

Global environment • Currency exchange rates • Free trade agreements • Trade deficits • New or developing markets

Introduction • Preparing an effective case analysis

C-14

can do. Capabilities or skills that allow a firm to do something that others cannot do or that allow a firm to do something better than others do it are called strengths. Strengths can be categorised as something that a firm does especially well. Strengths help a firm to take advantage of external opportunities or over- come external threats. Capabilities or skill deficien- cies that prevent a firm from completing an important activity as well as others do it are called weaknesses. Weaknesses have the potential to prevent a firm from taking advantage of external opportunities or suc- ceeding in efforts to overcome external threats. Thus, weaknesses can be thought of as something the firm needs to improve.

Analysis of the primary and support activities of the value chain provides opportunities to understand how external environmental trends affect the spe- cific activities of a firm. Such analysis helps to high- light strengths and weaknesses. (See Chapter 3 for an explanation of the value chain.) For the purposes of preparing an oral or written presentation, it is impor- tant to note that strengths are internal resources and capabilities that have the potential to be core com- petencies. Weaknesses, on the other hand, have the potential to place a firm at a competitive disadvantage in relation to its rivals.

When evaluating the internal characteristics of the firm, your analysis of the functional activities emphasised is critical. For example, if the strategy of the firm is primarily technology-driven, it is important to evaluate the firm’s R&D activities. If the strategy is market-driven, marketing functional activities are of paramount importance. If a firm has financial diffi- culties, critical financial ratios would require careful evaluation. In fact, because of the importance of financial health, most cases require financial analysis. The appendix lists and operationally defines several common financial ratios. Included are exhibits des- cribing profitability, liquidity, leverage, activity and shareholders’ return ratios. Other firm characteristics that should be examined to study the internal environ- ment effectively include leadership, organisational culture, structure and control systems.

Identification of strategic intent and mission Strategic intent is associated with a mind-set that managers seek to imbue within the company. Essen- tially, a mind-set captures how we view the world and our intended role in it. Strategic intent reflects or identifies a firm’s ideal state. Strategic intent flows from a firm’s opportunities, threats, strengths and weaknesses. However, the main influence on strate- gic intent is a firm’s strengths. Strategic intent should reflect a firm’s intended character and a commitment to ‘stretch’ available resources and strengths in order to reach strategies and objectives. Examples of strate- gic intent include: • The relentless pursuit of perfection (Lexus). • To be the top performer in everything that we do

(Phillips Petroleum). • We are dedicated to being the world’s best at

bringing people together (AT&T). The strategic mission flows from a firm’s strate-

gic intent; it is a statement used to describe a firm’s unique intent and the scope of its operations in prod- uct and market terms. In its most basic form, the stra- tegic mission indicates to stakeholders what a firm seeks to accomplish. An effective strategic mission reflects a firm’s individuality and reveals its leader- ship’s predisposition(s). The useful strategic mission shows how a firm differs from others and defines boundaries within which the firm intends to operate. For example: • Cochlear’s mission is to have ‘clinical teams and

recipients embrace Cochlear as their partner in hearing for life’.

• Coca-Cola Amatil’s mission is to have market leadership in every territory.

Hints for presenting an effective strategic plan There may be a temptation to spend most of your oral or written case analysis on the results from the analysis. It is important, however, that the analysis of a case should not be over-emphasised relative to

Introduction • Preparing an effective case analysis

C-15

the synthesis of results gained from your analytical efforts – what does the analysis mean for the organi- sation (see Exhibit 3)?

Strategy formulation: Choosing key result areas Once you have identified strengths and weaknesses, determined the firm’s core competencies (if any), and formulated a strategic intent and mission, you have a picture of what the firm is and what challenges and threats it faces.

You can now determine alternative key result areas (KRAs). Each of these is a category of activi- ties that helps to accomplish the strategic intent of the firm. For example, KRAs for Cochlear may include to remain a leader in hearing implant technology and to build links with hearing clinicians in Southeast Asia. Each alternative should be feasible (that is, it should match the firm’s strengths, capabilities and, especially, core competencies), and feasibility should be demonstrated. In addition, you should show how each alternative takes advantage of the environmental opportunity or avoids/buffers against environmental threats. Developing carefully thought-out alternatives requires synthesis of your analyses and creates greater credibility in oral and written case presentations.

Once you develop a strong set of alternative KRAs, you must evaluate the set to choose the best ones. Your choice should be defensible and provide benefits over the other alternatives. Thus, it is impor- tant that both the alternative development and evalu- ation of alternatives be thorough. The choice of the best alternative should be explained and defended. For the two Cochlear KRAs presented earlier, the strategies are clear and in both cases they take advan- tage of competencies within the company and oppor- tunities in the external environment.

Key result area implementation After selecting the most appropriate KRAs (that is, those with the highest probability of enhancing a firm’s strategic competitiveness), you must consider effective implementation. Effective synthesis is impor- tant to ensure that you have considered and evaluated all critical implementation issues. Issues you might

consider include the structural changes necessary to implement the new strategies and objectives associ- ated with each KRA. In addition, leadership changes and new controls or incentives may be necessary to implement these strategic actions. The implementa- tion actions you recommend should be explicit and thoroughly explained. Occasionally, careful evalua- tion of implementation actions may show the strat- egy to be less favourable than you originally thought. (You may find that the capabilities required to imple- ment the strategy are absent and unobtainable.) A strategy is only as good as the firm’s ability to imple- ment it effectively. Therefore, expending the effort to determine effective implementation is important.

Process issues You should ensure that your presentation (either oral or written) has logical consistency throughout. For example, if your presentation identifies one purpose, but your analysis focuses on issues that differ from the stated purpose, the logical inconsistency will be apparent. Likewise, your alternatives should flow from the configuration of strengths, weaknesses, opportunities and threats you identified through the internal and external analyses.

Thoroughness and clarity also are critical to an effective presentation. Thoroughness is represented by the comprehensiveness of the analysis and alterna- tive generation. Furthermore, clarity in the results of the analyses, selection of the best alternative KRAs and strategies, and design of implementation actions are important. For example, your statement of the strengths and weaknesses should flow clearly and logically from the internal analyses presented, and these should be reflected in KRAs and strategies.

Presentations (oral or written) that show logi- cal consistency, thoroughness and clarity of purpose, effective analyses, and feasible recommendations are more effective and will receive more positive evalua- tions. Being able to withstand tough questions from peers after your presentation will build credibility for your strategic plan presentation. Furthermore, devel- oping the skills necessary to make such presentations will enhance your future job performance and career success.

Introduction • Preparing an effective case analysis

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Appendix: Financial analysis in case studies Exhibit A-1 Profitability ratios

Ratio Formula What it shows

1 Return on total assets Profits after taxes

Total assets

The net return on total investment of the firm

or or

Profits after taxes + interest

Total assets

The return on both creditors’ and shareholders’ investments

2 Return on shareholders’ equity (or return on net worth)

Profits after taxes

Total shareholders’ equity

How effectively the company is utilising shareholders’ funds

3 Return on ordinary equity Profit after taxes – preference share dividends

Total shareholders’ equity – par value of preference shares

The net return to ordinary shareholders

4 Operating profit margin (or return on sales)

Profits before taxes and before interest

Sales

The firm’s profitability from regular operations

5 Net profit margin (or net return on sales)

Profits after taxes

Sales

The firm’s net profit as a percentage of total sales

Exhibit A-2 Liquidity ratios

Ratio Formula What it shows

1 Current ratio Current assets

Current liabilities

The firm’s ability to meet its current financial liabilities

2 Quick ratio (or acid-test ratio) Current assets – inventory

Current liabilities

The firm’s ability to pay off short-term obligations without relying on sales of inventory

3 Inventory to net working capital Inventory

Current assets – current liabilities

The extent to which the firm’s working capital is tied up in inventory

Introduction • Preparing an effective case analysis

C-17

Exhibit A-3 Leverage ratios

Ratio Formula What it shows

1 Debt-to-assets Total debt

Total assets

Total borrowed funds as a percentage of total assets

2 Debt-to-equity Total debt

Total shareholders’ equity

Borrowed funds versus the funds provided by shareholders

3 Long-term debt-to-equity Long-term debt

Total shareholders’ equity

Leverage used by the firm

4 Times-interest-earned (or coverage ratio)

Profits before interest and taxes

Total interest charges

The firm’s ability to meet all interest payments

5 Fixed charge coverage Profits before taxes and interest + lease obligations

Total interest charges + lease obligations

The firm’s ability to meet all fixed-charge obligations, including lease payments

Exhibit A-4 Activity ratios

Ratio Formula What it shows

1 Inventory turnover Sales

Inventory of finished goods

The effectiveness of the firm in employing inventory

2 Fixed assets turnover Sales

Fixed assets

The effectiveness of the firm in utilising plant and equipment

3 Total assets turnover Sales

Total assets

The effectiveness of the firm in utilising total assets

4 Accounts receivable turnover Annual credit sales

Accounts receivable

How many times the total receivables have been collected during the accounting period

5 Average collection period Accounts receivable

Average daily sales

The average length of time the firm waits to collect payments after sales

Introduction • Preparing an effective case analysis

C-18

Exhibit A-5 Shareholders’ return ratios

Ratio Formula What it shows

1 Dividend yield on ordinary shares

Annual dividends per share

Current market price per share

A measure of return to ordinary shareholders in the form of dividends

2 Price–earnings ratio Current market price per share

After-tax earnings per share

An indication of market perception of the firm. Usually, the faster-growing or less risky firms tend to have higher PE ratios than the slower- growing or more risky firms

3 Dividend payout ratio Annual dividends per share

After-tax earnings per share

An indication of dividends paid out as a percentage of profits

4 Cash flow per share After-tax profits + depreciation

Number of ordinary shares outstanding

A measure of total cash per share available for use by the firm

Notes 1 M. A. Lundberg, B. B. Levin and H. I. Harrington, 2000, Who

Learns What from Cases and How? The Research Base for Teaching and Learning with Cases (Englewood Cliffs, NJ: Lawrence Erlbaum Associates).

2 L. B. Barnes, A. J. Nelson and C. R. Christensen, 1994, Teaching and the Case Method: Text, Cases and Readings (Boston: Harvard Business School Press); C. C. Lundberg, 1993, ‘Introduction to the case method’, in C. M. Vance (ed.), Mastering Management

Education (Newbury Park, Calif.: Sage); C. Christensen, 1989, Teaching and the Case Method (Boston: Harvard Business School Publishing Division).

3 C. C. Lundberg and E. Enz, 1993, ‘A framework for student case preparation’, Case Research Journal, 13 (summer), p. 133.

4 J. Solitis, 1971, ‘John Dewey’, in L. E. Deighton (ed.), Encyclopedia of Education (New York: Macmillan and The Free Press).

5 F. Bocker, 1987, ‘Is case teaching more effective than lecture teaching in business administration? An exploratory analysis’, Interfaces, 17(5), pp. 64–71.

Introduction • Preparing an effective case analysis

C-19

Case 1

Hearing with the aid of implanted technology: The case of Cochlear™, an Australian high-technology leader Dallas Hanson Mark Wickham University of Tasmania University of Tasmania

The Cochlear company of Australia: The situation Cochlear™ is a leading Australian company specialis- ing in cochlear devices – that is, implantable hearing devices. It is the world leader in this market and a pro- minent innovator in the high-technology niche within which it operates. Cochlear originated in Australia but now sells globally in an increasingly competitive market.

There are several problems currently facing the company. Within the global deaf community there is a serious debate about the use of technology to aid hearing in the profoundly deaf, and this obviously threatens the market. Second, and more significantly, in 2002 there was a major issue when the US Food and Drug Administration (FDA) issued a notification that it had received news of possible associations between cochlear implants and meningitis. In late 2003 a new CEO, Chris Roberts, took over. What are his options?

The Cochlear implant technology A cochlear implant is a small electronic device that helps a profoundly (completely) deaf person to have a sense of sound. It is different from a hearing aid because it helps to compensate for damaged or non- functional parts of the ear, while a hearing aid ampli- fies sound. The implant has four parts: • a tiny but sensitive microphone that picks up

sound • a speech processor that selects and arranges

useful sounds • a transmitter and receiver that turns these

sounds into electrical impulses • a series of electrodes that are surgically

implanted in the inner ear, which pick up the receiver’s impulses and transmit them to the brain. (This process is analogous to how hearing people hear sounds.) The cochlear implant technology is getting more

sophisticated all the time. It is a fast-moving technol- ogy, and changes are further enhancing the capacity

C-20 Case 1 • Hearing with the aid of implanted technology: Cochlear

of the devices as well as making them smaller and therefore more socially acceptable.

Implanting the devices is a surgical procedure that has some risks. It is also expensive because it requires an experienced surgeon. Exhibit 1 is a diagrammatic representation of the device.

A recent Cochlear company annual report out- lines the details of this technology and indicates its intricacy:

Introduction to the Nucleus® 3 system The unique features of the Nucleus® 3 system include:

Longest battery life on the market: The ESPrit™ 3G speech processor is the only processor on the market with a battery life that lasts up to three days. Few interruptions and clear sound means better hearing.

Unique Whisper setting provides more sound: The ESPrit 3G is the only speech processor on the market that features a special Whisper setting designed to make soft sounds more audible – like rain falling or a person calling from another room.

Wireless FM and in-built telecoil: An in-built telecoil allows you to use the telephone with no additional attachments. The wireless FM provides

access to sound in a variety of settings including

cinemas, museums, meetings, classrooms, and

wherever an FM system is in place for hearing-

impaired participants. No additional cables are

necessary.

The only pre-curved (contoured) electrode array on the market: The Nucleus® 24 Contour™ implant is the first implant choice for surgeons.

It features a pre-curved electrode array, which

has two important benefits: 1) The curve of the

array puts the electrodes as close as possible to

the hearing fibers in the cochlea to allow for the

distinct sound. 2) The pre-curved shape of the

array matches the shape of the cochlea, which

helps to protect its delicate structure.

Titanium implant casing for best reliability: Nucleus® implants are durable and reliable and

are made from Titanium. The Nucleus 24 Contour

has never fractured on impact. Nucleus is built for

a lifetime of use.

Removable magnet for safe MRI: Nucleus is the first implant to feature the removable magnet for

MRI. This allows recipients to have a full-strength

MRI if they require one.1

Exhibit 1 How the Nucleus® 3 system works

1 A directional microphone picks up sound. 2 Sound is sent from the microphone to the speech processor. 3 The speech processor analyses and digitises the sound into coded

signals. 4 Coded signals are sent to the transmitter via radio frequency. 5 The transmitter sends the code across the skin to the internal

implant. 6 The internal implant converts the code to electrical signals. 7 The signals are sent to the electrodes to stimulate the remaining

nerve fibres. 8 The signals are recognised as sounds by the brain, producing a

hearing sensation.

Case 1 • Hearing with the aid of implanted technology: Cochlear C-21

Cochlear, the company The history of Cochlear’s Nucleus® device goes back to 1967, when Graeme Clark started research on multi- channel cochlear implants. In 1978, Professor Clark implanted Rodney Saunders with a multi-channel cochlear device, and by 1982 a 22-channel device was implanted in Graham Carrick. (The more chan- nels, basically, the better the hearing.) In 1985 the 22-channel Nucleus device was approved by the FDA for use in adults, and in 1990 for use in children. By 1998, 10 000 children had been implanted, and by 2001 more than 36 000 adults and children had been implanted.2

Cochlear’s technology has kept improving, and each component improvement improves the overall system. In 2003 the company announced a further

significant improvement to its basic product: the Nucleus® 24 Contour Advance™ was designed to minimise trauma to the delicate cochlear structures during implant surgery. It also developed a new Micro- Link Adaptor for use with the speech processor and receiver. (This was a product of the alliance Cochlear has with European technology firm Phonok AG.) In recent years the company has continually enhanced the capacity, and further minimised the size, of its Nucleus devices. Cochlear has won many awards for innovation – for example, the Medical Design Excel- lence Award in 2001 (an internationally prestigious achievement).

The 2002/03 financial year also included a record result financially. Profit after tax increased by 45 per cent to A$58.2 million and earnings per share were up 44 per cent. There were also record unit sales, up

Exhibit 2 Statement of financial performance

Cochlear Limited and its controlled entities for the year ended 30 June 2003

Consolidated Company

2003 $000

2002 $000

2003 $000

2002 $000

Revenue from ordinary activities 290 045 256 201 205 044 187 752

Expenses 209 239 204 021 131 110 136 448

Borrowing costs 796 1 150 153 195

Profit from ordinary activities before related income tax expense 80 010 51 030 73 781 51 109

Income tax expense relating to ordinary activities 21 797 10 920 19 892 11 952

Net profit attributable to members of the parent entity 58 213 40 110 53 889 39 157

Non-owner transaction changes in equity

Translation adjustment in general reserve (8) 3 – –

Net (decrease)/increase in retained profits on the initial adoption of:

Revised AASB 1028, ‘Employee Benefits’ (116) – (90) –

AASB 1044, ‘Provisions, Contingent Liabilities and Contingent Assets’ 311 – 2 411 –

Net exchange difference relating to self-sustaining foreign operations (4 737) 2 507 – –

Total changes in equity from non-owner related transactions attributable to the members of the parent entity 53 663 42 620 56 210 39 157

Basic earnings per share (cents)

Ordinary shares 110.0 76.6

Diluted earnings per share (cents)

Ordinary shares 110.0 76.6

C-22 Case 1 • Hearing with the aid of implanted technology: Cochlear

19 per cent on the previous year. Sales in the United States were strong; in Europe they were steady; and in Asia there was strong growth before the SARS out- break of 2002 affected the market. Some 9328 devices were sold during the financial year, and at A$50 000 for lifetime care this indicated a very good year. It took Cochlear 20 years to sell 30 000 systems, but in the last couple of years it has sold another 20 000.3 Exhibit 2 shows the statement of financial perfor- mance for the 2002/03 financial year.

Cochlear’s manufacturing facilities are world class and have had repeated upgrades in order to maintain this status.

The firm is very focused on R&D and devotes 15 per cent of total revenue to research. As well as 220 research staff, it has major long-term research links with the CRC (Co-operative Research Centre) for Cochlear Implant and Hearing Aid Innovation in Melbourne, as well as with the University of Melb- ourne itself. In addition, Cochlear has collaborative research arrangements with 90 other partners in 35 countries.4

The organisation is very determined to maintain excellent links with implant recipients and the sur- geons and audiologists that work with them. In 2002, 70 surgeons attended the Sydney facility through Cochlear’s ongoing visiting surgeon program.

Cochlear has 630 staff in 70 countries. It has an excellent training system for new staff. For exam- ple, in 2002, 43 new staff attended the Sydney head- quarters for intensive training in the technology of implants and all aspects of the implantation process, including surgery. Cochlear is proud of the ethnic diversity of its staff – the Sydney office includes staff from 60 nations.

The board is made up of eight independent non- executive directors, the CEO, and one other execu- tive director. Cochlear has a great committee system and all meetings are well documented. In September 2002, Cochlear was named in the top three Australian companies for best corporate governance by Investor Relations Magazine.

The external world for the industry Hearing impairment Hearing impairment ranges from mild to profound, and some people can hear some frequencies but not others. Mild hearing loss means that people can hear in quiet, one-to-one, situations but have problems in noisy environments such as cafés and bars. At the moderate level of loss, people find difficulty in hear- ing normal speech at any distance over a metre and are unlikely to hear well in crowded social situations. Profound hearing loss means that a person cannot hear a normal speaking voice or normal sounds. They may be helped by hearing aids, but tend to rely heav- ily on speech reading or sign language. Those with high-frequency loss (often caused by exposure to loud noises) can hear the person speaking but have diffi- culty hearing all the sounds. For example, the higher- pitched consonants such as P, S, F and CH may be confused, so ‘sun’ may be heard as ‘fun’ or ‘pat’ heard as ‘sat’.5

The market for cochlear devices is the pro- foundly deaf. The number of such people is diffi- cult to determine. The UK National Deaf Children’s Society (NDCS) suggests that one in 1000 children are born with severe/profound hearing problems.6 The (Australian) Bionic Ear Institute estimates the potential market in the West plus Japan as 3 million devices. In China, there are possibly 35 000 people born each year who would benefit from the device.7 Even when discounted for unwillingness to risk the operation or lack of money, the numbers are huge. The companies competing in the industry concen- trate on the United States and European markets and have barely penetrated the wider global market.

The political/legal environment The cochlear industry is part of the general medical technology industry. Regulation is therefore signifi- cant and the US Food and Drug Administration is

Case 1 • Hearing with the aid of implanted technology: Cochlear C-23

the most significant regulator because its findings have weight worldwide. The FDA must approve new devices before they can be sold in the United States. The FDA was also the initiator of the 2002 meningitis scare, which affected the whole industry.

The global aspect The cochlear market has gradually expanded beyond Australia, the United States and Europe. Cochlear itself established its European offices in 1987 and an office in Japan and Hong Kong in the 1990s, while China was a major target in 2001. Cochlear devices are now sold in more than 60 nations. Given that profound deafness is a problem globally, it can be expected that the global market will continue to expand.

Economics and cochlear devices Cochlear devices cost around A$50 000 for a life- time service.8 Demand worldwide therefore comes from relatively affluent individuals, medical insur- ance companies and government organisations. It is possibly limited in poorer nations. However, within the OECD the middle to upper income groups are increasingly prosperous and these people are a poten- tial market without government help. On the other hand, medical and insurance systems are gradually coming under increasing pressure as government tax incomes struggle to cope with competing demands for health, education and welfare services.9

In 2003 the global economy was expected to take an upturn, while Australia continued a phase of con- tinued prosperity and Europe and the United States were basically stable in economic terms.

The meningitis crisis in the Cochlear implant industry On 24 July 2002 the FDA issued a notification that it had reports of a link between cochlear implants and bacterial meningitis (a potentially fatal infection of the lining of the surface of the brain). There were 43 such cases and 11 people died. There were reports that implants had been withdrawn from sale in Germany,

France and Spain. On 25 July the FDA updated its warning and said it had now learned of 118 cases.10

Cochlear responded to the crisis quickly. Graeme Clark claimed that the infection was related to a design change by their competitor, Advanced Bionics, that created ‘dead space’ within the ear, thus provid- ing a home for bacteria. Professor Clark commented that, ‘It is a very great problem of engineers per se designing something without due recourse to biolo- gists and medical people.’11 Advanced Bionics tempo- rarily withdrew its product from sale.

The neuro-technology industry (the generic industry for implantable devices) bulletin commented on this scare: ‘One side benefit of the relative lack of media exposure that the neural prosthesis industry receives is that this crisis has not gained the inten- sive public scrutiny that has greeted other industries when confronted with unflattering data or allega- tions.’12 The scare nevertheless received significant media attention and Cochlear’s share price dropped sharply. Advanced Bionics advanced a reputation for crisis management with its suspension from sales and detailed explanations of problems to its stakeholders.

The meningitis scare has had a long-term ripple effect on the industry, and doubt remains despite a climb in share prices to those similar to levels prior to the scare. The deaf community and the medical profession have an ongoing debate about cochlear implants. For example, Blake Papsin, the director of the Cochlear implant program in Toronto, Canada, in early 2003, said:

In coming to terms with the relation between cochlear implants and meningitis, we should not lose sight of the benefit of this technology. For many children, the cochlear implant is a marvel that has allowed them to attain or regain hearing and speech. The growing number of candidates for cochlear implants, at least in Canada centres, reflects a conservative application of this technology based on the responsible evaluation of outcomes.13

This debate simmers in deaf culture. It is made more complex by advances in other areas of neuro- technology that are leading to useful devices such

C-24 Case 1 • Hearing with the aid of implanted technology: Cochlear

as artificial sight. In addition, the increasing accep- tance of altered body technology may impact on the cochlear industry: many now feel it is normal to alter body parts by surgery – for example, with pectoral enhancement or breast enlargement – and this could affect the ‘normality’ of a cochlear implant in the wider (as distinct from deaf) culture.

Debate about the idea of Cochlear implants in the deaf community The background to a vigorous debate about the active benefits of a cochlear implant is encapsulated in a 2002 letter from Robert Adam, President of the Australian Association of the Deaf:

The truth is obvious: a cochlear implant is not a cure for deafness. Let me expand on this a little.

The Royal Institute for the deaf in the UK has a fact sheet which mirrors the Australian Association of the Deaf’s view succinctly: A child with an implant will still be profoundly deaf when not wearing the implant. When wearing the implant, the child will be considered hard of hearing, or severely deaf, in the sense that a person with a hearing aid is described as hard of hearing.

The deaf culture is not just about a language – it is also about community, history and art. Like many minority cultures, there is a strong tradition of stories and folklore that is passed on from one generation to the next. There have been many captivating and moving stories about the way deaf people lived in the past and about how deaf culture has endured despite attempts to ‘cure’ deafness.14

In 2000 in the United States the debate was high- lighted by a film documentary called Sound and Fury, which portrayed the Artinian family. The father, Pete, is deaf and has three deaf children. His family includes brother Chris and his wife Mari. They had a deaf baby and decided to have an implant. Pete and his wife Nita, leading anti-implant campaigners, object- ed but were then astonished when their own daughter requested an implant. Pete and Nita were afraid that their daughter would lose contact with deaf culture if

she had an implant, so they decided to move to a more deaf-culture-oriented community. This complex fam- ily drama appealed to the US media, and the idea of a deaf culture contrasted with the benefits of cochlear implants became a subject of general debate.

In 2003 the tenor of the debate in the United States changed with the entry of Miss USA 1995, Heather Whitestone McCallum. She became profoundly deaf in infancy and had an implant in 2002. She then sprang into action, lobbying federal politicians for the industry, appearing on top-rating television shows, such as Good Morning America, and appearing in print media such as the bestselling USA Today. She has been credited with helping to change the US gov- ernment’s mind on cochlear support: the government had been talking in 2002 of reducing funding for the implant procedure but ended up increasing it.15

Competitors in the industry Advanced Bionics is a private US company founded in 1993, which is dedicated to the development of neuron-stimulation products – implantable devices that direct electrical impulses to nerves and muscles. The chairman, Alfred Mann, says the company aims to ‘enable the deaf to hear, the blind to see, and the lame to walk’. The company originated when Dr Robert Schindler from the University of California’s San Francisco cochlear program approached Mann for funding. Mann was already highly successful in implantable devices, the founder of a major heart pacemaker company (Pacemaker Systems) and high- tech wearable insulin-delivering pumps (MiniMed). In 2003 the Alfred Mann Foundation (Mann’s phil- anthropic research organisation) was working with Robert Greenberg, the CEO of Mann’s company Second Sight, a company devoted to the development of implants to enable vision. The implants would enable people with retinal disintegration to see. Greenberg claimed in 2003 that three people have been implanted and that the results were ‘pleasing’.16 Advanced Bioniocs has developed and sold the Clar- ion cochlear implant. This had, in 2002, about 15 per cent of the US market.

Case 1 • Hearing with the aid of implanted technology: Cochlear C-25

AllHear Inc. Designs This company manufactures and sells cochlear implants. The founder, Dr William House, produced a cochlear device in 1984 in conjunction with the 3M Corporation, one of the world’s leading innovation- driven corporations. The AllHear cochlear implant is unique because it uses a single short electrode that apparently does not destroy residue of hearing.17 In 2003, AllHear’s cochlear implants were not approved by the FDA for general sale in the United States.

Med-El Med-El produces the COMBI-40+ cochlear implant system. It has collaborative arrangements with a range of universities. Med-El has eight subsidiaries and nine service centres throughout the world. It is a fierce competitor.

Back to Cochlear, the company The previous CEO, Jack Mahoney, was a successful leader after succeeding the well-known Catherine Liv- ingstone in 2001. He delivered on ambitious growth and profit targets in 2002/03. He received a pack- age in 2002 worth $1.8 million, including a $416 845

performance-based bonus and had $100 000 in stock options, which remained unaffected by the new plan.

In late 2003 he announced his resignation and a new CEO, Chris Roberts, took over in February 2004. Roberts faced the classic challenges of the new CEO of a reasonably successful company – how to continue a record of advancing sales, profits and inno- vation. In addition, he must cope with the competi- tion and the social and medical issues that threaten the industry. Roberts had been CEO of ResMed, an Australian company that makes and innovates in sleep apnoea products. (Sleep apnoea is a condition where a person’s airways become blocked, often as a result of being overweight, causing them to wake up, some- times many times a night. It is a good area for busi- ness, as cases of apnoea are on the increase. ResMed is number one in Europe for these products.

Soon after Roberts took over at Cochlear, the share price dropped by 30 per cent. The European markets were worse than expected, and the American market was tight because the federal health budget was tighter, and the major competitor in the United States, Advanced Bionics, had been rejuvenated. Cochlear is still the market leader, but its competitors are coming on strong.18

What strategies do you suggest CEO Chris Roberts use to achieve his aims?

Notes 1 www.cochlear.com. 2 Ibid. 3 N. Gluyas, ‘Cochlear’, The Australian, 1 December 2003. 4 www.cochlear.com. 5 Australian Association of the Deaf, 2003. 6 NDCS, 2003. 7 Gluyas, ‘Cochlear’. 8 Ibid. 9 OECD, 2002.

10 www.lieffcabrasser.com/cochlear.htm. 11 Quoted in ibid. 12 Neurotech Business Report, August 2003. 13 MAT, accessed on www.cmaj.ca. 14 Herald-Sun, 26 March 2002. 15 Australian Financial Review, 20 August 2003. 16 www.healthyhearing.com. 17 Ibid.; www.allhear.com. 18 B. Foley, 2004, ‘Cochlear needs a good doctor’, Australian

Financial Review, 4 February, p. 21.

C-26

Case 2

The Australian retail wars: Coles Myer and Woolworths battle for brand value Mark Wickham Dallas Hanson University of Tasmania University of Tasmania

Introduction Throughout the 1990s, the chronic poor performance of Australia’s largest ‘food’ and ‘general merchan- dise’ retail firms, Coles Myer and Woolworths, led analysts and investors alike to abandon their shares in droves. Both chains were dogged by underperform- ing divisions, global economic uncertainty, and a lack of strategic vision perceived as endemic to the sector. Since 2000, however, both companies have managed to implement significant strategic changes to their business operations, and by 2003 had once again found favour with the investment community. The strategic changes have included diversification into new retailing sectors such as petrol and credit cards, the restructuring of their supply chain logis- tics, and the advancement of their information tech- nology capabilities. Each move has been greeted with increased earnings and the associated investor opti- mism, although the question remains as to how Coles Myer and Woolworths can continue to deliver the outstanding results of 2003 in an uncertain economic future.

The Australian ‘food’ and ‘general merchandise’ retail sectors, 1996–2002 Despite the global economic decline experienced since the Asian financial crisis of 1997/98, and the economic and social shocks of the World Trade Center attacks in 2001, the Australian retailing sector has experienced robust year-on-year growth since 1995/96. Exhibit 1 indicates the robust nature of Australian retail spend- ing during this period. The strength of Australia’s retail spending has been attributed to relatively high consumer and business confidence, relatively low offi- cial interest rates and stable employment levels.1 The food and general merchandise retail sectors have con- tributed significantly to Australia’s retailing success story, and closely reflect the success, and dominance, of Coles Myer’s and Woolworths’ branding strategies since 2000. Coles Myer’s and Woolworths’ domina- tion of the food and general merchandise sectors is reflected by their combined revenues, which in the financial year ended 2003 accounted for close to 80 per cent of the sector’s total.2

Case 2 • The Australian retail wars: Coles Myer and Woolworths C-27

Exhibit 1 Australian retail sales figures, 1995/96–2001/02

Food retailing

General merchandise

Clothing and soft goods

retailing

Household goods

retailing

Recreational goods

retailing Other

retailing Hospitality

and services Total

$mn $mn $mn $mn $mn $mn $mn $mn

1995/96 57 996 12 315 8 882 12 591 7 623 12 307 25 002 135 885

1996/97 58 406 12 241 8 758 13 795 7 251 12 742 23 603 136 411

1997/98 60 453 12 593 8 989 14 314 7 391 13 835 23 965 141 220

1998 /99 61 482 12 994 10 068 14 717 7 492 14 639 26 007 147 081

1999/00 62 218 13 768 10 781 17 344 7 612 15 863 27 363 154 884

2000 /01 62 004 13 140 10 213 17 972 7 310 17 020 27 563 155 222

2001/02 63 340 13 714 11 005 20 554 7 393 18 785 25 584 163 374

Source: Commsec.

The best of times: A tale of two retailers The Australian food retailing industry consists of a virtual duopoly between Coles Myer and Wool- worths. The combined sales of the two retail giants exceed A$55 billion, and provide employment for some 300 000 workers.3 The Coles Myer empire was established in 1985 with Coles’ acquisition of Grace Brothers, and by 2003 consisted of 14 distinct busi- ness units spanning both the food and general mer- chandise retailing sectors. In its food division are the Coles Supermarket chain of stores, its Bi-Lo discount supermarkets, and the Internet-based Coles Online and Shopfast Online. In its general merchandise divi- sion are the Myer’s Grace Brothers department store, the Megamart chain of electrical and furniture retail- ers, the Target department stores, Kmart’s cut-price department store, the OfficeWorks chain and Harris Technology. Recently, the company also launched its Coles Express stores, which merchandise a limited range of grocery items from selected petrol stations in Victoria.4

In 2003, the Woolworths retailing empire con- sisted of three food and four general merchandise businesses. Woolworths’ food businesses included their Woolworths and Safeway supermarkets, and the BWS (Beer, Wines and Spirits) chain of liquor outlets. Its general merchandise businesses include the Big W

chain of discount department stores, the Dick Smith chain of electronic equipment stores, the Tandy chain of electrical merchandise stores, and the Plus Petrol service stations.5

Despite the fact that Coles Myer remains the coun- try’s largest food retailer, its growth year on year lags behind that of Woolworths, which has delivered 22 per cent increases in its earnings for the period 2000 to 2002. Coles Myer, on the other hand, has achieved growth rates that are commensurate with CPI increas- es, and has tended to play ‘catch-up retailing’ on everything from supply chain management to fuel dis- counts. One strategy that Coles Myer uses that acts as a real point of difference in the supermarket game is its concentration on the development of house brands (that is, its Coles, Reliance and Farmland brands). Currently, house brands account for approximately 8 per cent of Coles Myer’s store-keeping units (SKUs), with the company planning to increase these to 15 per cent over the next three years. Woolworths, on the other hand, is concentrating on the promotion of everyday low price (EDLP) points for well-established national brands, a strategy that it borrowed heavi- ly from the success of the Wal-Mart chain of stores in the United States.6 By taking on the demonstra- bly successful aspects of Wal-Mart’s EDLP strategy, Woolworths has turned around its loss-making gen- eral merchandise operations and has streaked ahead of its major competitors.7 In particular, Woolworths’ EDLP has worked well in its Big W chain, where it has

C-28 Case 2 • The Australian retail wars: Coles Myer and Woolworths

proven to be a competitive advantage against Coles’ Kmart and Target divisions, which maintained a ‘high–low’ pricing strategy.8

A question of leadership and strategy Despite the multi-point competition that exists between the two companies, their leadership could not be any more divergent. In September 2001, and without any prior experience in the industry, John Fletcher was appointed as the chief executive officer of Australia’s largest retailer, Coles Myer Ltd. Before his appointment at Coles Myer, Fletcher spent almost his entire professional career at Brambles Industries, a resource sector firm that supplied on- and off-site logistics for mining companies operating in Austra- lia.9 Early in his career, Fletcher was charged with accounting responsibilities at Brambles, but his man- agerial skills were soon recognised and developed by the company, who promoted him to CEO in 1993. By comparison, Roger Corbett, the CEO of Woolworths Ltd, has been involved in the Australian retail indus- try for more than 30 years, initially working as a ser- vice assistant for Grace Brothers in the 1960s, which, ironically, became part of the Coles Myer empire in 1985. Corbett has also been heavily involved with the management of the Wal-Mart chain of supermarket and general merchandise stores in the United States, where he has attended annual general meetings and other pivotal strategy meetings. It was from this inter- action that Corbett adopted the Australian version of the EDLP strategy that has to date been highly valu- able for the Woolworths business.10

Fletcher assumed the CEO position at Coles Myer during a very interesting time for the company. Aside from its supermarket division, which had experi- enced strong growth since Dennis Eck took control in the mid-1990s, the remainder of the group was dogged by well-documented, and seemingly chronic, underperformance. In addition, Fletcher’s arrival was met with a series of boardroom upheavals and the culmination of years of shareholder discontent.11 The eight years’ experience at the helm of one of Australia’s largest resource companies between 1993 and 2001, however, did little to prepare him for the tumultuous

period that he would endure at Coles Myer during 2002, a year that he was to describe as ‘as tough as any year that I have had in my professional life’. At the same time, Roger Corbett was enjoying a third consec- utive year-on-year profit growth of approximately 10 per cent, and had plans to acquire the Franklins’ chain of supermarkets to further its growth ambitions. The source of Woolworths’ much-heralded performance has been attributed to Corbett’s implementation of a strategy named ‘Project Refresh’ in 1999. Project Refresh sought to restructure the company’s supply chain, and to introduce new technology and the new EDLP structure to its supermarkets. Added to this was its successful foray into the petrol-retailing sector in 1997 (a strategy that drew no competitive response from Coles Myer at the time), which resulted in Wool- worths capturing valuable market share points from Coles Supermarkets between 1999 and 2002. By the end of 2002, the Australian food and general mer- chandise retail sectors were valued at approximately $75 billion, and Woolworths had managed to cap- ture 40 per cent compared with Coles’ 36 per cent, a fact reflected in Woolworths’ share price which had grown from $4.20 in 1999 to $13 in 2002. Coles’ share price during the same period had fallen from $9 to $6.

2003: The Coles Myer empire strikes back After indications that the Coles Myer empire might be broken into its constituent ‘parts’ due to the chronic underperformance of a number of its divisions,12 John Fletcher instead announced a bold plan to confront Woolworths head-on in the war for corporate brand value in early 2003. The corporate brand ‘battles’ had been comprehensively won by Woolworths between 1997 and 2002, with the company achieving 400 per cent sales growth on their multi-point direct compe- tition items during this time. Woolworths had also managed to position itself as The Fresh Food People during this period, a marketing triumph not matched by the Coles Myer food retailers. In response to Coles Myer’s relatively poor performance and its ‘second mover’ status in the food and general merchandise sectors, Fletcher promised his shareholders that by

Case 2 • The Australian retail wars: Coles Myer and Woolworths C-29

2007, Coles Myer would become the leaders of retail- market innovation and value, and double the com- pany’s profit levels achieved in 2003. The first broad- side in this ‘battle of the brands’ was to occur early in 2003 in the liquor segment of the food-retailing sector.

In April 2003, Coles Myer announced that it had acquired the Theo’s chain of ‘premium’ liquor out- lets located in Sydney and Melbourne. Woolworths had already been in control of the Cheaper Liquor Company in various states, but had not been involved with this premium end of the market. Almost imme- diately, Woolworths undertook a similar acquisition of the Dan Murphy’s franchise (for a reported $260 million), also located in Sydney and Melbourne.13 The move almost immediately resulted in the reduction of prices charged by both outlets. Coles Myer had acquired Theo’s as a real point of difference between the two companies’ offerings; however, Woolworths’ implementation of its EDLP strategy forced Coles Myer to similarly cut its prices as a competitive neces- sity. Woolworths’ ability to minimise its supply chain costs (a benefit of the four-year-old Project Refresh strategy) enabled the company to maintain greater margins in this price war than Coles Myer could man- age, a fact reflected in the two companies’ 2002/03 financial reports (see Exhibit 2 later in this case).

In May 2003, some six years after Woolworths’ initial foray into the retail petrol sector had seen it capture 11 per cent of the market, Coles Myer agreed to pay $94 million to Shell Petroleum for the right to operate its own petrol discount chain in 584 of Shell’s service stations. The alliance between the two compa- nies was negotiated on the understanding that the relationship would last for 20 years. Up until this point, Coles Myer had undertaken a token competi- tive response to Woolworths’ 1997 Plus Petrol scheme by offering its customers discount vouchers to the Mobil chain of petrol retailers. The problem with this initial response was that, unlike Woolworths’ Plus Petrol stations, which were located in close proximity to its stores, the Coles–Mobil discount offer did not allow the customer to ‘cash in’ on the value-adding offer at the point of purchase. Of the company’s even- tual strategic move into retail petrol, Fletcher stated: ‘Coles [does] not want a price war, but will react to Woolworths’ pricing in this market.’14 In response to

this competitive action, Woolworths reversed its long- running ‘house-brand’ fuel strategy by unveiling an equity joint venture with the Caltex franchise of petrol retailers in August 2003 – a move that closely mimicked Coles Myer’s alliance with Shell. The equi- ty joint venture was the company’s response to the Coles–Shell alliance, a move that the company had widely criticised at its launch in July 2003.15 In line with the announcement was a commitment by the company to wind down its home brand Plus Petrol service stations in favour of re-branding them as Caltex service stations.16 The deal with Caltex was to add an additional 180 retail petrol outlets to Wool- worths’ existing 287 Plus Petrol outlets. Essentially, this move ensured that Woolworths would have 450 outlets in head-to-head competition with Coles Myer’s 580 outlets nation-wide.17 Roger Corbett claimed that the joint venture with Caltex had nothing to do with Coles Myer’s alliance with Shell, instead stating that the strategy overcame the difficulties the company was having in finding new retail outlet sites for its growing Plus Petrol division.18

The new financial year 2003/04 began with two important announcements from Fletcher. The first concerned a Coles Myer alliance with the Nation- al Australia Bank to revamp the company’s long- running Fly Buys reward program. The second was the introduction of a major cost-cutting strategy that mirrored Woolworths’ Project Refresh launched some four years earlier. In July 2003, Coles Myer and the National Australia Bank announced that they had signed an agreement to revamp the Fly Buys loyalty program to include a credit card facility. Jon Wood, a senior Coles Myer executive, said that the enhance- ment of the Fly Buys card was an important part of Coles Myer’s strategy to provide a comprehensive and valuable offer for all of its customers, especially given the announcement that the company’s famous share- holder discount card was to be discontinued. Of the Fly Buys strategy, Wood stated: ‘Fly Buys is Austra- lia’s largest loyalty program and we are moving to put more value into the program for our customers. Together with our partners at the National [Australia Bank], we will be revamping the program to offer more points, better rewards and other benefits.’19 The replacement card was to be known as the Source card, and included a credit facility that represented

C-30 Case 2 • The Australian retail wars: Coles Myer and Woolworths

Exhibit 2 Financial results for Woolworths Limited and Coles Myer Limited, 2001/02 and 2002/03

Woolworths financials 28 Coles Myer financials29

(A$ million) 2001/02 2002/03 2001/02 2002/03

Sales 25 239.4 26 321.4 25 688.7 27 016.6

Pre-tax profit 782.2 (3%) 906.0 (3.4%) 491.0 (1.9%) 617.2 (2.3%)

Net profit 564.4 (2.2%) 650.6 (2.5%) 353.8 (1.4%) 429.5 (1.6%)

EPS 50.2 58.1 26.1 32.2

Dividend 15.0 18.0 25.5 26.0

Sources: Commsec Securities Home Page, www.commsec.com.au.

Coles Myer’s initial foray into Australia’s $100 bil- lion Capital Card Market (that is, credit cards). Coles Myer already operates a loyalty card program that con- sists of 1.7 million Coles Myer Card holders (a chain- specific line of credit) but did not have the ‘universal usage capability’. The company’s new Source credit card meant that Coles Myer could differentiate itself from Woolworths by offering a full credit card capa- bility alongside a long-standing and valued rewards program and a private label store credit card.

Fletcher’s second announcement was his inten- tion to emulate the success of Woolworths’ Project Refresh, a plan that would entail major cost-cutting strategies within the company.20 Fletcher planned to save up to $1 billion by making its 65 000 suppliers shoulder more of its supply chain costs in a program designed to close the performance gap with Wool- worths. Fletcher intended to change the way Coles Myer buys its $18 billion of merchandise by cutting its stock on hand and by forcing its suppliers to move to a just-in-time approach to delivery. The company flagged to its employees that it intends to cut the num- ber of its distribution centres from 41 to 24, and will use improved technology to reduce costs and stream- line deliveries to stores.21 Also part of this strategy are plans to pressure its suppliers to adopt the same IT systems that it uses in its warehouses and stores so that it can build a more efficient e-trading platform. Fletcher said that the company would invest between $800 million and $900 million over the next five years as part of this cost-cutting strategy that is expected to deliver benefits of $425 million a year from 2007/08 onwards.22

By August 2003, there was already some evidence that Coles Myer’s strategies were bearing fruit for

Fletcher’s shareholders. Sales in the group lifted by a substantial 6.1 per cent at $27 billion, marginally ahead of Woolworths’ $26.3 billion. The stock mar- ket also responded well to Fletcher’s performance, with Coles Myer shares rising 29 per cent during the year, while Woolworths’ shares remained steady.23 Still a concern for the company was the food and liquor sales, which grew by only 1.5 per cent, as opposed to Woolworths’ 5.4 per cent.24 The statistics served to underline the competitive advantage that Woolworths had over the Coles Myer empire. Exhibit 2 presents the economic results for both firms dur- ing the 2002/03 financial year. Despite the appar- ent success of Coles Myer’s strategies in address- ing its performance gap with Woolworths, Corbett was confident that Woolworths would continue to achieve its recent double-digit profit growth. Indeed, despite Coles Myer’s seemingly effective strategis- ing, the financial year ended 2003 witnessed Wool- worths notching up its best annual result in five years. The company’s 16.5 per cent increase in profit to $610 million was powered by higher margins in its supermarket, liquor, petrol and general merchan- dise operations.25 Corbett also revealed that its cost savings program, Project Refresh, had delivered the promised savings to the company of some $1.7 billion over the previous four years.26 Corbett announced that the company would maintain its profit growth forecasts of between 10 and 15 per cent for the 2003/04 financial year, despite the uncertain outlook for the food and liquor divisions, and the increased competition from Coles and the German outfit, Aldi.27 Corbett stated that Woolworths’ strategy to remain differentiated from Coles Myer while adding greater value to their customers’ shopping experience

Case 2 • The Australian retail wars: Coles Myer and Woolworths C-31

was of utmost importance in Australia’s retailing industry, and flagged a possible diversification into the pharmaceutical market. In November 2003, Corbett solidified this by announcing that Wool- worths planned to open a number of fully stocked pharmacies and ‘health and beauty stores’ in its super- market chain.30

The challenge for both Fletcher and Corbett in 2004 centres on their ability to continue to add value

to their customers’ shopping experience while simul- taneously maintaining shareholder returns. The ques- tion, therefore, is how the two men might best strat- egise for this result given the increasing market power of the two dominant firms, and the multi-point com- petitiveness inherent to their operations.

Notes 1 L. Schmidt and S. Lloyd, 2003, ‘Monsters of retail’, Business

Review Weekly, 13–19 November, p. 38. 2 Ibid. 3 P. Switzer, 2003, ‘Call for codes to curb growth of retail giants’,

The Australian, 2 September, p. 29. 4 ‘Our brands’, 2003, Coles Myer Home Page, 10 November,

www.coles.com.au. 5 ‘Our brands’, 2003, Woolworths Home Page, 10 November,

www.woolworths.com.au. 6 ‘Woolies and Coles both forging ahead’, Australian Financial

Review, 15 August, p. 76. 7 S. Mitchell, 2003, ‘Roger Corbett’s other BIG W ’, BOSS

Magazine, October. 8 N. Shoebridge, 2003, ‘Woolies stands by its low-price strategy’,

Australian Financial Review, 18 August, p. 45. 9 S. Evans, 2003, ‘Coles targets $1 billion squeeze on suppliers’,

Australian Financial Review, September, p. 1. 10 Mitchell, ’Roger Corbett’s other Big W’. 11 S. Long, 2002, ‘Mayhem in the Coles-Myer boardroom’, ABC

PM, 10 September. 12 R. Gluyas, 2002, ‘Coles Myer break-up looms’, The Australian,

7 June, p. 19. 13 M. Westfield, 2003, ‘Woolies squeezes rivals, suppliers’, The

Australian, 25 March, p. 19. 14 K. Jiminez, 2003, ‘Coles in discount fuel link ’, The Australian,

28 May, p. 21.

15 G. Elliott, 2003, ‘Woolies ties up Caltex deal’, The Australian, 22 August, p. 17.

16 T. Hardcour t, 2003, ‘Woolies changes tack – and to Caltex’, Australian Financial Review, 22 August, p. 56.

17 Elliott, ‘Woolies ties up Caltex deal’. 18 I. Howar th and S. Mitchell, 2003, ‘Corbett defends petrol

strategy’, Australian Financial Review, 25 August, p. 14. 19 ‘Coles Myer and National increase Fly Buys commitment’,

2003, National Australia Bank Home Page, 1 July, 11 November, www.national.com.au.

20 ‘Woolies and Coles both forging ahead’, p. 76. 21 CNN News Service, 2003, ‘Australia’s biggest retailer Coles

Myer says a transformation of its supply chain will help its profit goal of Aust. $ 800 million ($536 million) by 2006’, 25 September.

22 Ibid. 23 S. Mitchell, 2003, ‘ Woolies vows to beat Coles threat’,

Australian Financial Review, 26 August, p. 1. 24 S. Evans, 2003, ‘Sales rise lifts Coles profit’, Australian Financial

Review, 15 August, p. 55. 25 Mitchell, ‘Woolies vows to beat Coles threat’, p. 1. 26 Ibid. 27 Ibid. 28 Woolworths Home Page, www.woolworths.com.au. 29 ‘Corporate Repor t 2002– 03’, 2003, Coles Myer Home Page,

10 November, http://corporate.colesmyer.com.au. 30 Schmidt and Lloyd, ‘Monsters of retail’, p. 38.

C-32

Case 3

eBay.com*: Profitably managing growth from start-up to 2000 Dale Pudney Marius van der Merwe Gary J. Stockport University of Cape Town University of Cape Town University of Western Australia

* This case study was written by Dale Pudney and Marius van der Merwe, MBA students at the University of Cape Town, under the supervision of Professor Gary J. Stockport, Graduate School of Management, University of Western Australia. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. This case was compiled from published sources. © 2001 G. J. Stockport, University of Western Australia, Perth, Australia.

Introduction It was 21 November 2000, and Meg Whitman was considering the events of the last few days. As the chief executive officer (CEO), she had led eBay.com to its position as the world’s largest person-to-person (P2P) trading community, but the share price had just fallen 20 per cent to US$34.75 when eBay’s share was downgraded from a ‘buy’ to a ‘neutral’ by Lehman Brothers, a global investment bank, because of con- cerns over eBay’s aggressive sales forecasts. The pre- vious day, eBay had announced the launch of a new product, application programming interface software that would enable other web companies to display eBay auctions on their sites.

The company had experienced explosive growth from start-up when the founder and current chair- man, Pierre Omidyar, launched eBay in September 1995. While most e-commerce companies were mak- ing significant losses by spending aggressively to build their customer and revenue bases, eBay had remained

profitable since the beginning. In the three-month period to September 2000, US$1.4 billion worth of goods were transacted on eBay, with items listed in more than 4320 categories. The company had 18.9 million registered users at the end of the period and had captured over 80 per cent of the on-line auction market with its closest competitors being Yahoo! and Amazon.com.

Background to eBay Pierre Omidyar Pierre Omidyar was born in Paris, France in 1967 and moved to Washington, DC in the United States with his parents at the age of six. From an early age he was interested in computers and he wrote a program to print catalogue cards for the school library at the age of 14. In 1988, he graduated with a Bachelor’s degree in Computer Science from Tufts University. He ini- tially worked as a developer of consumer application

Case 3 • eBay.com C-33

software such as MacDraw, for Claris, a software subsidiary of Apple Computer. In 1991, he was one of the founders of Ink Development, which later became eShop, an early e-commerce site that was bought by Microsoft in 1996.

Person-to-person (P2P) trading prior to 1995 In traditional P2P trading forums, it is sometimes dif- ficult for buyers to find pricing benchmarks to ensure that the prices that they pay correspond to the proper value of the item. It was estimated that in 1995, US$100 billion was traded annually in the following forums: • Newspaper classifieds: Users listed items that

were for sale or wanted, normally in locally distributed newspapers. The classifieds typically generated more than 50 per cent of local newspapers’ revenues from listing fees. The buyers usually inspected the items before purchasing and may have collected and paid for the items in person. As a consequence of the proximity of buyers and sellers, the items could have been larger items that were difficult to transport over long distances.

• Flea markets and garage sales: Sellers stocked items for sale either at their homes or at organised markets. Buyers were typically looking for bargains or interesting artefacts. The buyers were able to inspect the items and needed to pay for them before they could collect.

• Auction houses: Sellers took items that were for sale to auction houses where buyers could inspect them before the auction. Buyers needed to pay a registration fee in order to bid and were required to be at the auction or have a proxy bidder. The highest bidder won the auction and normally paid the auction house. The auction house typically deducted a percentage of the sale price and paid the balance to the seller.

The opportunity In the early 1990s, Silicon Valley was quickly turning its attention away from electronics manufacturers towards new Internet-based start-ups that married existing technology to new business models. Internet usage growth and the provision of the infrastructure

required to ensure acceptable data transmission speeds were, however, uncertain. Analysts were also unsure whether people would purchase goods of value from distant strangers without seeing them beforehand. Omidyar was writing code for communications- software maker General Magic in 1995 when he started to think about the possibility of on-line auctions. He said the following about his idea:

I had been thinking about how to create an effi cient marketplace – a level playing field, where everyone had access to the same information and could compete on the same terms as everyone else. Not just a site where big corporations sold stuff to consumers and bombarded them with ads, but rather one where people ‘traded’ with each other … I thought, if you could bring enough people together and let them pay whatever they thought something was worth … real values could be realised and it could ultimately be a fairer system – a win-win for buyers and sellers.1

Start-up in 1995 eBay (then AuctionWeb) was launched on Labour Day, 1 September 1995, using a website that was hosted by Omidyar’s US$30 per month Internet ser- vice provider (ISP). The site was located at www.ebay. com. The company operated from Omidyar’s apart- ment with only the website, a filing cabinet, an old school desk and a laptop computer. The site was not much more than a simple marketplace where sellers listed items and buyers bid for them. Omidyar made no guarantees about the goods being sold, took no responsibility and settled no disputes. There were no fees, no registration, no search engine and, for the first month, no customers.

Omidyar’s only attempt at marketing was to list eBay on the National Center for Supercomputing Applications’ What’s Cool site. Despite this, so many people visited the site that by February 1996 Omidyar had to institute a fee of 10 cents per listing to recoup the ISP costs which by then had risen to US$250 per month. By the end of March 1996, eBay showed a profit. Omidyar had kept his day job at General Magic, but the traffic to the site became so intense that he had to concentrate on eBay full-time and the

C-34 Case 3 • eBay.com

ISP asked him to take the site elsewhere. He there- fore bought his own web server and installed it in his apartment.

Omidyar developed software that was capable of supporting a robust scalable website and transac- tion processing system to provide real-time reporting on the current auctions. The system was scalable to reduce the initial investment but enabled expansions when an increasing number of auctions demanded it.

By July 1996, Omidyar needed to move the operation to a one-room office and hire a part-time employee. The risks that the business faced at that stage were substantial and with barriers to entry being low there was nothing to stop the large Internet

players such as America Online (AOL) (ISP and Inter- net portal), Amazon.com (on-line book retailer) and Yahoo! (search engine and Internet portal) from stealing the opportunity. As the business was based on collectors’ items, changes in the current fads could have affected the revenues significantly. At one stage, trading of Beanie Babies generated 7 per cent of eBay’s revenues.

The business concept Omidyar asked one of his friends, Jeff Skoll, to join the company as its first president in August 1996 and his role was to turn the concept into a business. He had a Master’s in Business Administration (MBA) degree

Exhibit 1 Quarterly financial results and statistics

1998 1999 2000

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

Financial data

Revenue (’000) 13 998 19 480 21 731 30 930 42 801 49 479 58 525 73 919 85 753 97 399 113 377

Gross profit (’000) 16 194 17 364 24 980 34 824 38 534 41 444 52 334 62 481 73 756 89 465 Gross margin (%) 83.1 79.9 80.8 81.4 77.9 70.8 72.9 75.7 78.9 Operating expenses (’000) 11 996 15 504 21 365 27 063 43 166 46 478 51 883 62 029 65 026 75 149 Net income (’000) 2 279 461 2 639 3 765 816 1 186 4 895 6 288 11 590 15 211 Net profitability (’000) 14.0 2.1 8.5 8.8 1.6 2.0 6.6 7.3 11.9 13.4 Registered users (mn) 0.85 1.3 2.2 3.8 5.6 7.7 10.0 12.6 15.8 18.9 No. of auctions (mn) 6.6 9.2 13.6 22.9 29.3 36.2 41.0 53.6 62.5 68.5

Growth (%)

Revenue (per quarter) 39 12 42 38 16 18 26 16 14 16

Net income –83 472 43 –78 45 313 28 84 31

Registered users 53 69 73 47 38 30 26 25 20

No. of auctions 39 48 68 28 24 13 31 17 10 Auctions/ registered user 7.1 6.2 6.0 5.2 4.7 4.1 4.3 4.0 3.6 Revenue/auction 2.95 2.36 2.27 1.87 1.69 1.62 1.80 1.60 1.56 1.66

Notes: All figures in US dollars. Source: eBay financial statements. The registered users figures include everyone who had ever registered on the site and does not reflect currently active users. Growth figures are growth per quarter. Revenue figures exclude refunds to sellers due to site outages.

Case 3 • eBay.com C-35

from Stanford University and had wide experience in managing distribution channels of on-line news infor- mation, computer consulting and computer rentals.

The business concept was to provide P2P auctions on the Internet. Using the Internet, buyers and sellers could access a larger market, which was important for those collectors who could not find people with simi- lar interests in their areas. By providing a marketplace for buyers and sellers to trade their collectibles on the Internet in an auction format, the buyers set the price for items based on demand. When more potential buyers bid on the items, sellers received higher prices. As the buyers and sellers may be from different parts of the United States and even the world, the items that were sold were typically collectibles that were easy to deliver long distances.

The eBay process was simple and easy to under- stand. Sellers could list items for sale and pay a small listing fee, which depended on where and how the listing was presented and whether the seller required a reserve price. The seller chose the auction duration during which buyers could bid for the item. At the end of the auction, eBay notified the seller and the winning bidder, following which they made their own

arrangements for payment and delivery of the goods. The seller was also charged a percentage of the final value of the transaction. Over time, eBay added ser- vices to this simple model to improve the user experi- ence and thereby increase user loyalty and retention. eBay has been profitable from start-up and although its business was seasonal with volatile revenues, the company had maintained high gross margins of about 70–80 per cent (see Exhibit 1). The only costs of goods sold were computing infrastructure and customer ser- vice expenses. eBay’s business model did not require it to keep any inventory, establish an extensive distri- bution network or have a large staff complement. Its product range was also determined by the size of its community and their listings and not by eBay’s prod- uct development staff.

The listing fees and final value fees charged by eBay are shown in Exhibits 2 and 3. For example, if a seller listed a collection of rare stamps on eBay and the maximum bid is US$24, they would have paid a 50 cent insertion fee when they listed the item, assum- ing that the listing was not emphasised in any way. They would also have paid 5 per cent of the final sale price if the item was sold. eBay would have received

Exhibit 2 Fee to place an item listing

Opening value or reserve price Insertion fee $0.01 – $9.99 $0.25 $10.00 – $24.99 $0.50 $25.00 – $49.99 $1.00 $50.00 and up $2.00 Real estate and automotive categories $50.00 Reserve price less than $25.00 $0.50 Reserve price of $25.00 or more $1.00

Notes: Source: www.eBay.com, November 2000. 1 All prices in US dollars. 2 Additional fees are charged for enhancing the listing in any way.

Exhibit 3 Additional fee if the item sells

Closing value Final value fee $0 – $25.00 5% of the closing value $25.01 – $1000 5% of the initial $25.00 ($1.25), plus 2.5% of the remaining closing balance Over $1000 5% of the initial $25.00 ($1.25), plus 2.5% of the initial $25 – $1000 ($24.38),

plus 1.25% of the remaining closing value balance

Notes: Source: www.eBay.com, November 2000. 1 All prices in US dollars. 2 There is no final value fee for the real estate and automotive categories. 3 Sellers may have the final value fee refunded if the high bidder does not pay.

C-36 Case 3 • eBay.com

US$1.60 for the listing if the auction closed. If the seller had a reserve price of US$24.50 on the item, the auction would not have closed, so eBay would have received the insertion fee and a 50 cent fee for the reserve price which was only payable if the item did not sell.

Building the team In June 1997, Omidyar and Skoll realised that they would need capital and management expertise if eBay was to realise its full potential. They approached venture capitalists Benchmark Capital who invested US$5 million for shares and warrants worth 22 per cent of the company. Bob Kagle, a partner at Bench- mark Capital, became a board member of eBay. This money was never used, but the agreement gave them access to Benchmark’s network of potential CEOs, marketing gurus, consultants and bankers. eBay needed this to help them build the business and recruit talented management. One of the first mem- bers of the management team was Gary Bengier, who was hired in November 1997 as the chief finan- cial officer (CFO). He was responsible for develop- ing the financial strategy and vision of the company and maintaining a corporate culture of financial dis- cipline and prudence, and for equipping eBay for an eventual public offering of its shares.

Benchmark persuaded Meg Whitman to leave her job as general manager of Hasbro’s pre-school divi- sion to become president and CEO of eBay. She was a strong and decisive executive without the need-to- dominate personality, which meant that there was a good fit with eBay’s existing culture of being open to the voices of customers and employees. Whitman was impressed by the fact that eBay was doing some- thing that could not be done effectively off-line and by the emotional connection between the eBay users and the service. Whitman brought global marketing and brand management experience with her when she joined in February 1998. Her previous work included being a vice president at Bain & Company and devel- oping Stride Rite’s Internet strategy. She had an MBA from Harvard Business School and a BA in Econom- ics from Princeton.

Whitman recognised the need for other advis- ers on the board who understood the challenges of expanding into new markets and could provide advice

and feedback. Again, Benchmark was instrumental in finding people such as Howard Schultz, chairman and CEO of Starbucks, and Scott Cook, chairman of Intuit. Whitman also went on to build her manage- ment team, and details of the other top-level manage- ment at eBay are given in Exhibit 4.

Building the community of users Many of eBay’s early customers were the result of referrals. eBay’s loyal customers performed the mar- keting and sales function through word of mouth to bring new customers to the community. eBay under- took limited marketing but had entered into cross- promotional agreements with the following: • Banner advertisement on web portals such as

Netscape, Excite and Yahoo!. • America Online (AOL) – provided an auction

service for AOL’s classified section which gave eBay access to AOL’s more than 10 million users.

• ZAuction, a vendor-sourced auction site, which was a leading provider of computer products, electronic equipment and other brand name consumer goods.

Omidyar created a platform where ‘anybody could sell anything’ and did not interfere in the user trans- actions. Most of eBay’s sellers were serious collectors and small traders who used eBay as their storefront to access a large market across the United States and the world. eBay provided a facility whereby users could interact with each other through the use of discussion boards and later through a chat room called the eBay Café. The eBay Café was similar to a traditional cof- fee shop where users could relax, catch up on news and hearsay, and exchange information. It brought users back to the site every day and they sometimes communicated directly with each other. One frequent user of the eBay Café described it as follows:

At the eBay Café you will meet a bunch of caring and friendly folks talking, helping, laughing, and at times even complaining about varied subjects. I have found and met some great folks here. If you ever need help with almost ANYTHING, if you have some tips, tricks or a good story or two to share … the Café is the place.2

Case 3 • eBay.com C-37

When eBay tried to impose changes on users, such as pricing changes, the users expressed their disap- pointment through these discussion forums. eBay trusted its users’ suggestions for improving the site, and by giving its customers what they wanted, eBay was improving both customer retention and loyal- ty. One analyst commented that eBay’s community was critical for attracting and retaining buyers and sellers:

eBay has found a natural feedback loop where creating a critical mass of bidders increases the price obtained by sellers, which increases the

number of sellers, which attracts more bidders, et

cetera.3

Initially, there was no way to ensure that what was being bought was real or that the goods would be paid for. The anonymity and physical distance between buyers and sellers on the Internet encour- aged counterfeiting and fraud. In message-board post- ings to Omidyar, the eBay users suggested that he set up a system for buyers and sellers to rate each other. This became known as the Feedback Forum and was a peer-review reporting system. Buyers and sellers rate each other and comment on how their business

Exhibit 4 Summary of eBay management at November 2000

Pierre Omidyar (33), founder and chairman, oversees strategic direction and growth, model and site development, and community advocacy. He has a BS in Computer Science from Tufts University. His previous jobs include founder, Ink Development Corp., developer of consumer applications for Claris, a subsidiary of Apple Computer, and General Magic.

Meg Whitman (43), president and CEO, is responsible for building a successful business while delivering on customer needs and expectations. Her focus is on the user experience, creating a fun, efficient and safe forum for on-line person-to-person trading. She develops the work ethic and culture of eBay as a fun, open and trusting environment and keeps the organisation focused on the big picture objectives and key priorities. She has an MBA from Harvard and a BA in Economics from Princeton. Previous jobs include general manager for Hasbro Inc.’s pre-school division, global marketing of Playskool and Mr. Potato Head brands; president and CEO of Florists Transworld Delivery; president of Stride Rite and executive vice president at Keds Division; senior vice president of marketing for the Walt Disney Company’s consumer products; vice president at Bain & Company; and brand manager at Procter & Gamble.

Gary Bengier (45), chief financial officer, is responsible for developing the financial strategy and vision as well as maintaining a corporate culture of financial discipline and prudence for eBay. He has an MBA from Harvard and a BBA in Computer Science and Operations Research, Kent State University. Previous jobs include CFO, Vxtreme, financial officer at Compass Design Automation, and senior financial posts at Kenetech Corp. and Qume Corp.

Brian Swette (45), chief operating officer, helps to build the eBay community as well as creating an environment for trade by responding to the community and introducing new categories. He has a BA in Economics from Arizona State University. His previous jobs include executive vice president and chief marketing officer, Pepsi-Cola Company, responsible for worldwide marketing and advertising efforts for Pepsi, and brand manager at Procter & Gamble.

Maynard Webb (43), president, eBay Technologies, oversees eBay’s technology strategies, engineering, architecture and site operations. He has a BA from Florida Atlantic University. Previous jobs include senior vice president and CIO at Gateway, Inc.

Mike Wilson, chief scientist, is responsible for site architecture. Previous jobs include chief architect and project manager at Ink Development Corp.

Jeff Skoll (35), vice president, strategic planning and analysis, is responsible for competitive analysis, new business planning and incubation, as well as overall strategic direction. He has an MBA from Stanford University and a BS in Electrical Engineering from the University of Toronto. His previous jobs include manager of the distribution channels of on-line news information for Knight- Ridder Information and founder of Skoll Engineering.

Steve Westly, senior vice president, international and general manager of premium services, is responsible for business development, corporate communications, mergers, acquisitions and partnerships. He has an MBA and a BA from Stanford University. Previous jobs include vice president, WhoWhere?

Jeff Jordan, vice president and general manager of regionals and services, oversees eBay’s regional business and end-to-end services which has the goal of making it easier to trade on the site. He has an MBA from Stanford University and a BA in Political Science and Psychology from Amherst College. Previous jobs include president of Reel.com.

Source: www.eBay.com, November 2000.

C-38 Case 3 • eBay.com

together went. When launching this, Omidyar laid out eBay’s guiding philosophy:

eBay wouldn’t exist if it wasn’t for our community

… At eBay, our customer experience is based on

how our customers deal with our other customers.

They rarely deal directly with the company. So

how do you control the customer-to-customer

experience? We can’t control how one person

treats another … The only thing we can do is

to influence customer behaviour by encouraging

them to adopt certain values. And those values are

to assume that people are basically good, to give

people the benefit of the doubt, and to treat people

with respect.4

Company values Omidyar hoped that his auction community would reflect the values of honesty, openness, equality, empowerment, trust, mutual respect and mutual responsibility. eBay’s Mission Statement says:

eBay was founded with the belief that people are

honest and trustworthy. We believe that each

of our customers, whether a buyer or a seller, is

an individual who deserves to be treated with

respect.5

To instil these values into the community, Omidyar maintained that they had to be embraced by the com- pany and its employees because everything that the company did, such as the website, press releases and strategic partnerships, indirectly influenced the com- munity. When Meg Whitman joined eBay, her chal- lenge was to develop the work ethic and culture of eBay as a fun, open and trusting environment and keep the organisation focused on the big-picture objectives and key priorities. eBay had a ‘no penal- ty’ operating culture where there were no penalties for making mistakes or being on the wrong side of an issue which could muzzle employees or suppress new ideas. Whitman met with all new recruits and other staff on Mondays to tell them about the culture and make sure that they knew what was expected of them. eBay also brought some of its customers to the head offices regularly to talk to employees about their experiences.

Coping with customer service By the end of 1997, more than 3 million items worth US$94 million had been sold on eBay, resulting in total revenues of US$5.7 million and US$900 000 profit. eBay had achieved these results with only 76 employ- ees. The average value of each item sold was about US$31, with 6 per cent of this going to eBay’s reve- nues. The number of auctions per day had increased from 1500 at the end of 1996 to about 150 000 at the end of 1997. As the number of users increased, eBay started to find it difficult to provide customer service to the members of the community. Simple questions such as ‘How do I list an item?’ or ‘How do I buy an item?’ were answered using a self-service on-line help function which had prominent links from the eBay home page. Other queries were more difficult and needed knowledgeable users or service agents to answer. Users placed queries on bulletin boards dedi- cated to the discussion of specific issues of the busi- ness, such as help, registration, listing and shipping, which were sometimes answered by other members of the community and at other times by eBay. As part of building their on-line community, eBay had con- tracted active, enthusiastic and knowledgeable users of the site to respond to requests for help. These inde- pendent contractors worked from home to answer emailed questions and those that were posted on the bulletin boards. eBay also decided to employ and supervise the customer service representatives directly to better understand customers’ problems and control the quality of customer service. Nevertheless, not all of the users were satisfied with the customer service that eBay offered.

Building trust and loyalty To work with the community to improve the services that were offered and develop trust and loyalty, eBay launched SafeHarbor in February 1998. SafeHarbor included the following elements: • Verified User Program: eBay verified user

information during registration and had partnered with Equifax to provide a higher level of verification if required.

• Feedback Forum: buyers and sellers rated their experience with each other as positive, neutral or negative. The user profile followed the user

Case 3 • eBay.com C-39

everywhere on eBay. Estimates suggested that users were willing to pay up to 30 per cent more in certain markets for items sold by someone with a high feedback rating.

• Insurance: Lloyds of London provided insurance for users with a net non-negative feedback rating on their auctions up to US$200 subject to an excess of US$25.

• Shill Bidding Policy: suspended users who bid on an item with the intent to drive up the price without buying it.

• Non-paying Bidder Policy: non-paying bidders were warned and then suspended. eBay’s policies and service had helped them to

develop a loyal community of buyers and sellers. One user described the eBay experience as follows.

I visit eBay to transact auction business because it has a superior universe of sellers and bidders and quality and quantity of listings. The people visiting eBay are generally loyalists, while the average person visiting Amazon.com is there to buy a book, but I’d hazard a guess that he isn’t going to stick around for an hour.6

eBay also provided facilities that users could per- sonalise, such as the ‘My eBay’ and ‘About Me’ sec- tions. ‘My eBay’ was a tool that users could person- alise to keep track of their favourite categories, view items they were selling or bidding on, check their recent account balance and feedback, or update their contact information. An ‘About Me’ page could be set up by users to tell other eBay users about themselves and their feedback rating, which helped to improve the credibility and trust among the users. Not all users were happy with the services, however, and this can be seen in the following message taken from the discussion boards.

Am I the only one that thinks the ‘Watch This Item’ link in auctions is driving sellers to the poorhouse? Geez … Bidding is bad enough without encouraging bidders not to bid.7

Brand building In a company that had always disdained advertis- ing, Whitman employed Pepsi’s head of marketing, Brian Swette, as senior vice president of marketing

in October 1998 to oversee international expansion, marketing and customer support efforts for eBay. He had worldwide brand-building experience with both the Pepsi-Cola Company and Procter & Gamble. His focus was on increasing brand awareness both nation- ally and internationally and on making eBay one of the most accessible and successful e-commerce sites on the Internet.

eBay found that small traders and serious collec- tors were the most active site users. Many of the trad- ers were small businesses who had used eBay as their storefront or as a supplement to their existing stores. These users contributed 80 per cent of the total reve- nues but only constituted 20 per cent of the registered users. As a result, eBay decided to reduce its presence in broadband portals and concentrate its marketing and brand-building resources on these users. This included advertising in many niche publications read by serious collectors and exhibiting at collectors’ trade shows. eBay subsequently launched its first national print and broadcast advertising campaign in October 1998 in order to increase awareness of the compa- ny’s brand with The Acme Idea Company, a strategic and creative consultancy committed exclusively to the building of brands. The national radio campaign was aired on more than 12 000 stations across the Unit- ed States for five weeks. The print campaign includ- ed adverts in Parade, People, Entertainment Weekly, Newsweek and Sports Illustrated and over 70 distinct collecting publications, reaching people who had an active passion – for example, for coins, stamps, dolls or photography.

eBay also instituted the PowerSellers program to benefit the bulk sellers. The program was designed to meet the needs of users who were running a full-time on-line trading business on eBay with benefits and privileges designed to make selling easier and more profitable. There were three different program levels, – namely: Bronze, Silver and Gold – which were achieved with minimum monthly sales on eBay of US$2000, US$10 000 and US$25 000, respectively. eBay offered these users additional services depend- ing upon the level that they had achieved. These ben- efits included the PowerSellers logo to distinguish users on the site, dedicated email customer support, participation in the eBay Success Stories program (to be profiled for use in press-related events), invitations

C-40 Case 3 • eBay.com

to special events, specialist customer phone support, dedicated account managers and support hotlines.

A member of the PowerSellers customer-service program complained that her email and phone calls regularly went unanswered: ‘I feel like I’m in a co- dependent relationship. I write to them, I get no response. I e-mail them, nothing. I’m being abused.’8

On 25 March 1999, eBay and AOL expanded their existing relationship and announced a four-year strategic alliance to expand person-to-person com- merce and community building on AOL and its fam- ily of brands. The agreement gave eBay prominent presence across the domestic and international AOL family of brands, including AOL, AOL.com, Com- puServe, Netscape’s Netcenter, ICQ and Digital City. According to the agreement, eBay was to pay AOL US$75 million over the term of the agreement and AOL was entitled to all advertising revenues gener- ated by the co-branded sites and to act as the exclusive third-party advertising sales force for advertising sold on eBay’s website. They created customised and co- branded sites for AOL’s multiple brands that included comprehensive listings, feedback and ratings, message boards and select content from eBay. eBay was to pro- mote AOL as its preferred Internet ISP and enable its users to download ICQ (communication software that enables chat, voice, message board, data conferenc- ing, file transfer or games on the Internet) on its web- site as well as to integrate AOL’s ‘My News’ feature into its ‘My eBay’ feature. AOL, in return, undertook to promote eBay to its member community of over 16 million. As a part of the agreement, the companies were to work together to facilitate eBay’s expansion into international markets, and AOL helped to launch eBay’s expansion into regional markets through the promotion of eBay on Digital City, a complete guide to activities in the US’s largest cities.

The challenges of growth Exhibit 1 contains eBay’s key quarterly financial results from the beginning of 1998 to the third quar- ter of 2000, indicating its growth and profitability during this period. eBay never had any formal plan to develop the business, but rather took advantage of opportunities as they arose. Opportunistic behaviour was bound by a clear goal to be ‘the world’s largest

P2P online auction company’ and a focused strategy with five elements: • strengthening the eBay brand • expanding the user base • broadening the trading platform by increasing

product categories and promoting new ones • fostering community affinity • enhancing site features and functionality.

International expansion While the Internet was available to users around the world, trading goods across borders involved diffi- culties such as currency conversions, different duties, taxes and regulations, as well as high delivery costs. To build their user base and access the users in other countries, eBay needed to open country-specific sites. It started to expand into the international markets early in 1999. The company identified the following possible strategies to enter these new markets: • building a new user community • acquiring a company that was already in the

local trading market • partnering with strong local companies.

eBay started its international expansion in the UK and Canada (www.ca.ebay.com). eBay’s community in the UK (www.ebay.co.uk) was built from the grass- roots by local management with on-line marketing and local events. eBay rolled this service out to Aus- tralia (www.ebay.com.au), Japan (www.ebayjapan. co.jp) and France (www.fr.ebay.com).

In March 1999, some German entrepreneurs cop- ied eBay’s source code and set up a mirror-image of the eBay site under the name of Alando.de in Germa- ny. The site quickly established itself as the leading on-line trading company among Germany’s 10 mil- lion Internet users and soon attracted eBay’s atten- tion. When it acquired Alando on 22 June 1999, it had 50 000 registered users and 80 000 items listed in 500 categories. The site was later renamed www. ebay.de, which gave German users access to eBay’s worldwide community of active buyers and sellers.

eBay launched its local site in Australia in October 1999 in a joint venture with a leading Internet media company in Australia, PBL Online. To promote the launch of the website, eBay Australia waived all list- ing fees for a limited period and this provided sell- ers with an even greater reason to list their items on

Case 3 • eBay.com C-41

www.ebay.com.au. In February 2000, eBay Japan was launched as a joint venture with NEC. The deal brought together eBay’s unrivalled trading presence and NEC, one of the world’s most innovative technol- ogy companies with a commanding presence in the Japanese market. As part of the agreement, NEC took an equity stake in eBay Japan and promoted the site in many ways, including through its BIGLOBE ISP, personal computer products and off-line marketing campaigns. The international sites contain: • country-specific categories and content,

reflecting popular local collectibles • the ability to trade local items in the local

currency with content in the local language • access to a worldwide community of traders.

International sellers can list their item so that it can be viewed from any eBay site, and buyers can view items listed anywhere in the world, with items denominated in the local currency and in US dollars

• local discussion boards that allow the country’s community to get the most out of the website and a country-specific chat room.

Amazon.com enters the on-line auction market New competitors in the on-line auction market were surfacing every day, encouraged by the low barriers to entry and eBay’s success. The first major competitor was Onsale, which was already an established B2C site. Yahoo!, Lycos, Excite, Microsoft’s MSN and many smaller niche competitors followed, but all of them found that attracting buyers and sellers was dif- ficult. Exhibit 5 compares a few of the major on-line auctions sites as at October 2000 by their inventory of listed items, bidding activity, services and fees, design and functionality, customer support and the commu- nity.

In April 1999, Amazon.com launched its auction site which was remarkably similar to eBay’s and made it easy for buyers and sellers to move across to Ama- zon. Amazon did not charge any fees for the first few months and offered additional services such as cross- promotion to relevant Amazon retail sites, credit card payments and buyer guarantees by underwriting the

risks of a seller failing to send an item or where the item is ‘materially different’ from the description. Amazon achieved 100 000 auctions per day within a few months, but the number of listings started to fall when Amazon introduced charges. While the services it offered were superior to eBay’s, it was not able to break into the market that was already dominated by eBay. One of the sellers summarised his reasons for staying with eBay:

I’ve posted auctions on just about every site you can imagine (but) I pretty much stick with eBay. The buyers are there. I’m established there. My feedback rating establishes me as an upstanding member of the community. I don’t have those ratings on other sites because I don’t do much business on any of them. I’d rather stay where I’m known.9

By being the first on-line auction to be able to scale up and acquire a critical mass of buyers and sell- ers in its community of users, eBay was able to suc- cessfully fend off attacks from Internet brands that were better recognised and offered better services. eBay’s community of buyers meant that sellers were less likely to move to competitor sites.

Improved customer service required Following Amazon’s launch with superior services, eBay launched services to assist its community with shipping (April 1999), credit card payments, escrow services, electronic stamps and a customer support centre (May 1999). These services were offered by entering into alliances with the following: • iShip.com provided information to e-merchants

and buyers regarding shipping costs and options. • MBE provided the bricks-and-mortar support

for packing and shipping. • Billpoint facilitated person-to-person credit card

payments on the Internet. • iEscrow enabled buyers to pay an escrow service

when they bought an item. This was when a buyer placed money in the custody of a trusted escrow service. The money was then paid to the seller once a specified set of conditions was met, such as the buyer receiving and approving the goods.

C-42 Case 3 • eBay.com

Exhibit 5 Auction site competitor comparisons

Auction site Inventory Bidding activity

Services & fees

Customer support

Design & functionality Community

321Gone ● ● Amazon.com ■ ■ ● ■ AuctionAddict.com • ● ● Auctions.com ● ● ● ● • Bid.com • • ● ● N/A Bidbay.com • ● ● BoxLot ● ● ● CityAuction ● ● ● CNET Auctions ● ● • Collecting Nation ● ● ● Comic Exchange ● ● ● Dell Auction ● ● ● • eBay ■ ● ● ● ■ edeal ● ● ● eHammer ● ■ ● ● • eOrbis.com • ● ■ ● • eRock.net • ● ● eWanted.com ● ● ● Excite Auctions ■ ● • First Auction ● ● ● N/A Gavelnet.com • ● ● GoAuction ● ● ● ● • Gold’s Auction • ■ ● ● ● Go Network Auction • ● ● ● Haggle Online ● Lycos Auctions ● ■ ● MSN Auctions ● ● ● Musichotbid.com ● • ■ • Onsale ● ● ● N/A Popula ● ● ● ● Pottery Auction ● ■ ● Sothebys.com ■ ● ● ● ● N/A SportsAuction ● N/A ● ● N/A Teletrade N/A ● ● N/A uBid ● ● ● ■ ● N/A Up4Sale ● ● Wantads.com ● ● ● • Xoom.com Auctions ● ● ● ● Yahoo Auctions ■ ● ● • ■ Yahoo Store ● N/A ● ■ N/A

ZDNet Auction ● ● ●

Excellent = ■, good = ●, average = , below average = •. Source: www.auctionwatch.com/awdaily/reviews/ratings.html, November 2000.

Case 3 • eBay.com C-43

• e-Stamp allowed people to buy and print postage on-line to avoid queues at post offices where sellers needed to hand letters that weigh more than 16 ounces directly to a postal clerk. eBay established its first remote customer support

centre in Salt Lake City in order to stay ahead of the needs of the on-line community. Its main responsibil- ity was to interact via email with the eBay community on a 24-hour basis and provide live customer support on eBay’s customer support bulletin boards, such as the ‘Support Q&A Board’, ‘Support Q&A For New Users’ and ‘Help with Images and HTML’. One user described his experience of eBay’s customer support.

I think we should spread the word for people to start using Amazon.com. Maybe then eBay will increase their customer service and see to it that their system is working instead of pissing people off. No wonder they are offering Billpoint for free. You can’t count on it. eBay is not there to help. At least not readily. I have sent 3 emails to support and have heard NOTHING.10

eBay still did not have its customer support up to the level of its competitors and this remained a prob- lem for the users.

eBay acquires bricks-and-mortar businesses With the on-line auction market being so competitive, eBay found it difficult to increase its fees. The only way to increase its revenues was to improve the traffic volumes by deepening the penetration into the North American market, expand internationally and raise the average price of goods sold. On 26 April 1999, eBay announced that it had agreed to acquire San Francisco-based Butterfield & Butterfield (B&B), one of the world’s largest and most prestigious auction houses. This acquisition enabled eBay to accelerate its penetration into higher-priced items on a global basis because of B&B’s expertise in premium mar- kets and extensive relationships with dealers, auction houses and individuals throughout North America, Europe and Asia. B&B had begun providing auctions over the Internet through its relationship with a local company, but ended the arrangement three weeks prior to the announcement in order to work with eBay. eBay used this acquisition to start its ‘great col-

lections’ speciality site and other antique categories. Prior to this acquisition, eBay’s average auction closed at only about US$47, of which eBay’s fee was about US$3. The average B&B auction closed at US$1400, of which the house’s fee was almost US$400. Buy- ing into the high-end auction business might not have increased the amount of interaction on the discus- sion boards or chat rooms, but it promised to boost eBay’s revenues. Shortly afterwards, on 18 May 1999, eBay announced that it had acquired Kruse Interna- tional, one of the world’s most respected and well- established brands in the collector automobile mar- ket. This strategic acquisition enabled eBay to move into this market and continue to offer higher-priced items to its community. Kruse participated in approx- imately 40 car auctions each year and had held events in 46 US states, the United Kingdom and Japan. eBay used expertise gained through this acquisition and other alliances with CarClub.com and Autotrader. com to introduce a new automotive section on the eBay site for collectable and other used cars and offer users related additional services.

eBay introduces local sites To further increase eBay’s penetration into higher- priced goods, eBay accessed the market for goods that were difficult to ship long distances, such as cars and large appliances that would have normally been sold through the local newspaper classifieds owing to their size or fragile nature. Late in 1999, eBay launched ‘eBay: Go Local’ with a campaign called ‘from our homepage to your hometown’ whereby eBay toured 30 communities across the United States, and intro- duced a pilot site in Los Angeles. At the end of 1999, there was a local site for 63 cities in the US and others internationally, with a regional flavour in order to connect local buyers and sellers. Buyers could also inspect the goods before they bid. The separate local sites were accessible through the ‘Go Local’ area on the eBay home page.

eBay Local featured local categories and allowed members to browse through and trade items of local interest, such as memorabilia from popular regional sports teams, political collectibles and antique post- cards celebrating the region’s heritage. The local site was completely integrated into eBay’s worldwide

C-44 Case 3 • eBay.com

listings so sellers could list locally while everyone on eBay could see the item.

Computing infrastructure The aggressive marketing and expansion during late 1998 and early 1999 resulted in rapid increases in demand upon the computing infrastructure that sup- ported the on-line auctions. By the end of June 1999, eBay had 5.6 million registered users and had con- ducted 29.4 million auctions (about 250 000 per day) with gross merchandise sales of US$622 million dur- ing the previous three-month period. The increas- ing traffic to the website required constant expan- sion and upgrading of the technology. Frequent site outages and downtime for maintenance was a seri- ous problem for the growing company. A number of the small traders, who depended on eBay for a living, attributed the ‘downs’ in their business to site crashes, pages not loading, system slowdowns and slow end- of-auction notices. During June 1999, eBay experi- enced a three-day string of outages because of prob- lems with its server operating system software which corrupted their databases. A report of the event even appeared on the front page of the New York Times and it was estimated that these outages cost the com- pany US$3–5 million in refunds to sellers. The share price fell by 25 per cent and the web page viewing fig- ures halved for the week after the outage. Other costs that could not be quantified were the lost revenues from those customers who got frustrated with the site and defected to competitors’ sites. eBay instituted an automatic auction extension policy which meant that any outage lasting for two hours or more resulted in an automatic lengthening in the time allowed to place bids. As a result of the outages, Whitman decided to build excess capacity, but she decided that the addi- tional cost would be small when compared to the cost of outages and poor site performance. She set the goal of building the infrastructure to 10 times the required capacity.

In October 1999, eBay outsourced its back-end Internet technology to AboveNet Communications and Exodus Communications. It outsourced its web servers, database servers and Internet routers, and relied on the companies to provide increased network bandwidth for its millions of active buyers and sell- ers. These companies had front-end web servers that

were linked to eBay’s proprietary database and appli- cation servers and were all located at AboveNet’s and Exodus’s locations. The servers were located in tem- perature-controlled facilities with superior fire con- trol, security and redundant power systems, and were housed in seismically braced racks. These companies were also the primary service provider for Yahoo!, Lycos and other major on-line companies.

Expanding the product range As of August 1999, eBay’s brand was recognised by 91 million US adults, compared to 118 million for Amazon.com. eBay’s challenge, however, was to turn this awareness of its brand into registered users (7.7 million at the time) and revenues. This was becoming more difficult as new competition was entering the market all the time. In September 1999, FairMarket. com announced that it would form an auction net- work including Microsoft’s MSN, Excite@Home and Lycos. Alta Vista, Xoom.com, Outpost.com, ZDNet, CompUSA and Ticketmaster soon joined the net- work. Each of the networked sites accessed a single database, so any auction that was listed on one of the sites was automatically listed on all of the other part- ner sites which increased the number of buyers that was available for each member. The FairMarket net- work was intended to appeal to the big brand names that did not want their items listed next to collect- ibles and other ‘junk’. The eBay share price dropped 7 per cent on the news. Amazon had also launched its zshops whereby merchants could retail their goods in a fixed-price format which competed with the many small traders who used eBay as their storefront but did not require the sale to be in an auction format.

In order to increase its revenues with this increased competition, eBay acquired Half.com in June 1999, a fixed-price, person-to-person trading marketplace to broaden the buying and selling choices for eBay’s trading community and expand eBay’s trading plat- form. Half.com had created an efficient, user-friendly marketplace where buyers and sellers could trade used books, CDs, movies and video games at fixed prices that were at least half of the list price. In the first quarter of 2000, eBay also launched its Business Exchange site, which was to enable small businesses to trade with each other in business-related categories such as computer and industrial equipment, power

Case 3 • eBay.com C-45

tools, office furniture, and consumables such as print- er toner. While some business-to-business trading had always taken place on the site, the intention of this site was to expand this and further increase eBay’s reach into higher-priced goods.

On 8 February 2000, eBay and the Walt Disney Corporation announced a comprehensive four-year agreement in which eBay would ultimately become the on-line trading service across all of Disney’s Inter- net properties, including the GO Network portal. The companies intended to develop, implement and promote a co-branded person-to-person trading site for the GO Network at www.ebay.go.com. In addi- tion, the companies collaborated on the development of several merchant-to-person trading sites in an auc- tion format for Disney.com, ESPN.com and ABC. com that showcase unique, exclusive and authenticat- ed products, props and memorabilia from throughout The Walt Disney Company, including Walt Disney Studios, Disneyland and Walt Disney World, ESPN Cable Networks and ABC Television.

On 20 November 2000, eBay launched its Appli- cation Programming Interface (API) that would allow other companies to display eBay auctions on their independent websites. Companies would be able to subscribe to specific auction and fixed-price catego- ries on the eBay site. eBay had developed the software itself and the software made it easier for program- mers to create software applications without having to write all the code for basic features such as screen menus and printing capabilities. eBay executives believed that the syndicated listings would appeal to other Internet commerce and media sites that wanted to give users more shopping options without build- ing their own stores. Websites that wanted eBay list- ings would not receive any fees of transactions exe- cuted through their site unless they owned the listed items. The company believed that it would eventually be able to persuade some sites that already sold goods to replace their in-house e-commerce systems with eBay’s technology.

eBay at the end of 2000 eBay had created a convenient, efficient and enter- taining marketplace where buyers and sellers could list, bid for and trade goods. eBay was the intermedi-

ary and only provided the marketspace for buyers and sellers to trade and did not take any responsibility for the actual transaction. To attract and retain buyers and sellers, eBay gave users access to value-added ser- vices that made the transaction simpler. To improve loyalty to the site, eBay had also developed an on-line community where collectors and other users could interact. The site created excitement for buyers who searched for and bid on items that they hoped would be bargain buys. As one customer noted:

I’d recommend eBay Auction services to everyone! I attend many estate auctions on a regular basis in the Kentucky area. I have found the same thrills on eBay as I do at the real estate public auctions.11

Most trading took place in an auction format where the trade took place between the seller and the highest bidder, if the bid was above the reserve price (where applicable). More details of the different auc- tion formats are contained in Exhibit 6. eBay did not take any ownership in or agency for the goods. Its neutrality eliminates some of the concerns that face other businesses, such as sourcing and supplying goods, inventory, responsibility, payment collections or shipping. This was important for eBay to maintain, as implementing systems to perform these functions would have significant costs associated with them and would require additional resources.

Auction aggregators introduce a new threat At the end of 1999, auction aggregators such as Auc- tionWatch.com started to pose a threat to individ- ual on-line auctions such as eBay. These sites acted as a portal and they collected data on the auctions that were available on the individual auction sites and displayed similar items from the competing sites together. Buyers could therefore see all of the required items at one time and compare prices. This was a sig- nificant threat to eBay, whose success in the past was due to its established community of buyers and sellers choosing eBay over other competitors. eBay installed technical measures to try to block AuctionWatch servers from accessing its website. This only worked for about a month, until AuctionWatch designed soft- ware to get through the security features. eBay con- sequently threatened legal action, claiming that these

C-46 Case 3 • eBay.com

sites were illegally accessing its site, making unautho- rised copies of its content, and displaying the content in incomplete and confusing ways. While the users provided most of the content on its site, such as item descriptions and photographs, eBay maintained that the content that it generated (number of bids, length of the auction, etc.) was its property.

Counterfeit, illegal and other questionable listings While on-line publishers are responsible for the con- tent of their sites as an on-line venue, eBay was not, according to the Digital Millennium Copyright Act (DMCA) of 1998. People were, however, selling ille- gal items such as human kidneys, marijuana and counterfeit software, and controversial items such as Nazi memorabilia and pornographic material. While eBay had adopted a hands-off approach to what its customers sold on the site, Shultz advised the board that these items affected the character of the com- pany. eBay consequently changed its description to a ‘venue where anybody can sell practically anything on

earth’ and issued a list of items that were restricted on the site.

eBay had faced several lawsuits questioning the eBay business model where people claimed that eBay should take responsibility for the authenticity of items sold on the site. An example of this was where eBay was sued by someone who bought a collector’s base- ball card that turned out to be a fake. Checking every item that is listed on the site would have required an army of content checkers, and if eBay had tried to verify the legality of all of the items it probably would have been liable for those items that slipped through its inspections. On 21 November 2000, a French judge ordered Yahoo! to block French users from visiting websites that sold Nazi memorabilia. This ruling meant that all websites would be subject to the laws and norms of all other countries in the world, which was a move away from the US-inspired openness and freedom ethos. Critics suspected that this ruling may have prompted other governments to police websites in an attempt to get them to comply with their local laws.

Exhibit 6 Comparison of auction formats

Dutch auction: The seller places one or more identical items on sale for a minimum price for a set time. When the auction ends, the highest bidder wins the item(s) at their bid price. Remaining items are sold to other bidders in order of price, quality and time.

Reserve price: The seller lists a ‘reserve bid price’. Buyers are allowed to place bids for any amount above or below the reserve price, but the seller has the option to disregard any of the bids below the reserve price. The bidders do not normally know the reserve price.

Express auction: Short timed auctions generally lasting between one-half to one hour. The quick turn-around offers a heightened auction experience.

Reverse auction: The seller and not the buyer bears the risk of not being successful. The buyer lists what is required at the price they are willing to pay for it. Sellers bid for the business. The bidder can remain anonymous, and a maximum price can be established to maintain the price within a budget. This type of auction format is not offered by eBay. Priceline.com is well known for offering reverse auctions.

Sealed bid auctions: Bidders are only aware of the reserve price and bid without knowing the amounts of other incoming bids. All bids are automatically opened at the end date of the auction and the highest bidder wins.

Sniping: Placing a bid in the closing minutes or seconds of an auction. Any bid placed before the auction ends is allowed on eBay but not on some other sites.

Proxy bidding: Placing a proxy bid at the maximum limit users are willing to bid for an item will result in the system bidding on the bidder’s behalf each time a new bidder places a bid. The system will ensure that the proxy bidder’s bid is one increment higher than the previous bid until the user’s maximum limit is reached.

Source: Various.

Case 3 • eBay.com C-47

Exhibit 8 Comparison of financial performance of dotcoms

Performance measure eBay Yahoo! Priceline Amazon

Revenues1 (mn) 113.4 295.5 341.3 637.9 Net income1 (mn) 15.2 47.7 (191.9) (240.5) Gross margin2 (%) 74.58 85.45 15.40 21.06 Operating margin2 (%) 2.35 27.46 –97.04 –33.08 Profit margin2 (%) 7.50 21.33 –96.18 –35.79 Recent share price3 36.94 40.88 2.53 28.94 Market capitalisation3 (mn) 9 895.62 22 825.54 426.50 10 306.96 Number of employees4 138 1 992 373 7 600

Notes: Source: www.marketguide.com, November 2000. 1 All amounts in US dollars. 2 Revenue and net income for three months to 30 September 2000. 3 Margins for 12 months to 30 September 2000. 4 Share price as at 24 November 2000. 5 Employees as at 31 December 1999.

Exhibit 7 Websites’ audiences and average time per month

Ranking Website Unique audience (’000) Time per person

(hrs:min:sec)

1 AOL Websites 64 744 00:43:29 2 Yahoo! 63 720 01:41:00 3 MSN 51 424 01:19:37 4 Microsoft 34 614 00:12:31 5 Lycos Network 33 708 00:21:28 6 Excite@Home 32 085 00:35:09 7 Walt Disney Internet Group 27 076 00:33:41 8 Time Warner 23 250 00:24:14 9 About the Human Internet 22 262 00:10:45 10 Amazon 21 837 00:16:06 11 AltaVista 18 560 00:21:41 12 CNET Networks 18 525 00:16:06 13 NBC Internet 18 423 00:14:51 14 eBay 17 010 02:10:49 15 eUniverse Network 16 003 00:18:01 16 LookSmart 15 840 00:07:39 17 Ask Jeeves 14 671 00:10:30 18 Real Network 12 265 00:06:46 19 American Greetings 11 856 00:11:49 20 Earthlink 11 602 00:17:15 21 AT&T 11 196 00:15:45 22 Uproar 11 113 00:42:35 23 The Go2Net Network 10 752 00:13:25 24 GoTo.com 10 564 00:04:15 25 Viacom International 10 178 00:14:21

Source: Nielsen NetRatings.

C-48 Case 3 • eBay.com

The future In the third quarter of 2000, US$1.4 billion worth of goods were traded on eBay in 68.5 million auc- tions, which generated US$113.4 million of revenue and US$15.2 million in net profit for the company. At the end of September 2000, eBay had 18.9 million registered users. When releasing these results, eBay announced a revenue goal of US$3 billion in 2005, with sites in 25 countries, representing the majority of the world’s Internet users. Exhibit 7 gives the Nielsen NetRatings of the top 25 websites for October 2000 (combined at-home and at-work data), where eBay received 17 million unique visitors who spent an aver- age of 2 hours 10 minutes on the site for the month. What was important to Whitman was the fact that eBay was making a profit, while many other e-com- merce companies were making significant losses while building their user base and establishing distribution networks (see Exhibit 8).

However, on 20 November 2000, Lehman Brothers downgraded eBay’s share from a ‘buy’ to a

‘neutral’, citing eBay’s ‘aggressive 2005 sales projec- tion’ as a concern. The share price fell 20 per cent on the news. The analyst at Lehman Brothers said that eBay’s core business was slowing down and that the new business initiatives were more costly than initial estimates. The staff complement had increased with the growth, which meant that the company was being challenged to maintain the culture and values among the new recruits. Whitman knew that her greatest challenge would be to keep eBay focused while grow- ing the company. Considering the share downgrade, Whitman was sure that the analyst was over-reacting on the forecasts. Over the past five years, eBay had been an example of e-commerce success for Internet and bricks-and-mortar companies alike. It had trans- formed the auction business, which had allowed it to become the world’s largest P2P on-line auction com- pany, achieving a higher value than many established Fortune 500 companies. Overcoming challenges was an everyday part of the environment, for which eBay had set the example. But the future may bring as many threats as previously there were opportunities.

Exhibit 9 A brief history of auctions

The auction format of selling emerged almost from the beginning of time, when people first began to barter trade with each other. The word ‘auction’ is derived from a Latin word, which means a gradual increase.

The earliest record of an organised auction was of the annual marriage market of Babylon in about 500 BC. Once a year the men of Babylon would gather around while a herald (auctioneer) would accept bids for maidens. The herald would begin the auction with the most ‘beautiful’ girls and work his way through to the ‘ugliest’. Ancient Romans also auctioned goods. One of the most astonishing auctions in history occurred in the year AD 193 when no less than the entire Roman Empire was ‘tossed on the block’ by the Praetorian Guard. First they killed Pertinax, the emperor, and then they announced that the highest bidder could claim the empire. As the Roman Empire came to an end, there were fewer and fewer auctions.

The earliest reference to the auction as practised in Great Britain is from 1595, but there are no more references until the end of the 17th century. At that time, auctions were held in taverns and coffee houses to sell art. At the beginning of the 17th century, four types of auctions developed which shaped how current auctions are conducted today. The four types were: 1 Auctions using a ‘hammer’ as we know it today. 2 Hourglass auctions: Bids were accepted until the last grain of sand was left at the top of the hourglass. The last bid called

before the glass was empty, won. 3 Candle auction: The same idea as the hourglass auction. 4 Dutch auction: This is when the auctioneer begins at a higher price and quotes smaller and smaller bids until there

is a buyer.

Sotheby’s and Christies were founded in 1744 and 1766, respectively.

Sources: www.bendisauctions.com/orgin.htm; http://iml.jou.ufl.edu/projects/Spring2000/McKenzie/History.html; www.webcom.com/agorics/ auctions/auction9.html.

Case 3 • eBay.com C-49

References The Australian eBay site can be explored at www.ebay.com.au. Users can search for items in Australia or worldwide, and can set up the ‘My eBay’ function to track auctions.

Alsop. S., 1999, ‘Contemplating eBay’s funeral’, Fortune Magazine, 139(11).

Amazon.com Auctions, 2000, www.amazon.com. AuctionGuide.com., 2000, www.auctionguide.com. AuctionWatch, 2000, www.auctionwatch.com. Bloomberg News, 1999, ‘eBay founders give up billions to repay

loans’, Cnet.com, June, viewed 23 September 2000, www.cnet. com.

Butterfield & Butterfield, 2000, www.butterfields.com. CiscoWorld, 2000, Case Study: ‘Keeping outages at bay at eBay’,

5 October, www.ciscoworldmagazine.com. Clampet, E., 1999, ‘eBay enhances services with acquisitions’, May,

viewed 23 September 2000, www.internews.com. Cohen, A., 1999, ‘The eBay revolution: How the online auctioneer

triggered a revolution of its own’, Time Magazine, viewed 16 October 2000, www.time.com.

Dayal, S., H. Landesberg and M. Zeisser, 2000, ‘Building digital brands’, The McKinsey Quarterly 2, pp. 42–51.

eBay Annual Report, 1999, Form 10-K: Annual Report for eBay Inc. for fiscal year ended December 31, 1998.

eBay Annual Report, 2000, Form 10-K: Annual Report for eBay Inc. for fiscal year ended December 31, 1999.

eBay Quar terly Financial Statements, 2000, Form 10-Q: Quarterly Report for eBay Inc. for the quarterly period ended June 30, 2000.

eBay Quarterly Financial Statements, 2000, Form 10-Q: Quarterly Report for eBay Inc. for the quarterly period ended March 31, 2000.

eBay Quar terly Financial Statements, 2000, Form 10-Q: Quarterly Report for eBay Inc. for the quarterly period ended September 30, 2000.

eBay.com, 2000, www.ca.ebay.com (Canada). eBay.com, 2000, www.ebay.co.uk (United Kingdom). eBay.com, 2000, www.ebay.com.au (Australia). eBay.com, 2000, www.ebayjapan.co.jp (Japan). eBay.com, 2000, www.fr.ebay.com (France). Ellington, D., D. Ficeli, P. Jaturaputpaibul and K. Kellam, 1999, Issues

Facing Consumer-Oriented Online Auctions (MBA, Owen Graduate School of Management, Vanderbilt University), 17 October 2000, http://mba99.vanderbilt.edu.

Forrester Research, 2000, ‘Forrester findings: Internet commerce’, 17 September, www.forrester.com.

For tune, 2000, ‘America’s for ty under 40’, Fortune Magazine, June, viewed 23 October, www.fortune.com.

For tune, 1999, e50, Company Index, 29 September 2000, www. fortune.com.

Himelstein, L., 1999, ‘Q&A with Meg Whitman: What’s behind the boom at eBay’, Business Week, www.businessweek.com.

Interagency Government Asset Sales Team (IGAST), 2000, ‘The vendor pilot asset sales and auction’, US Chief Financial Officer’s Council Auction White Paper, 13 October, www. financenet.gov.

InternetNews Staff, 1998, ‘eBay gets personal’, InterNews.com, October, viewed 23 September 2000, www.internews.com.

InternetNews Staff, 1998, ‘eBay launches national adver tising campaign’, InterNews.com, October, viewed 23 September 2000, www.internews.com.

Jannarkar, S., 1999, ‘eBay buys Butterfield & Butterfield’, Cnet.com, April, viewed 26 September 2000, www.cnet.com.

Kruse International, 2000, www.kruseinternational.com. Lee, J., 1998, ‘Why eBay is flying’, Fortune Magazine, 138(11). Moran, S., 1999, ‘The pro: Meg Whitman’, Business 2.0, June, viewed

2 October 2000, www.business2.com. Nielsen/NetRatings Global Internet Index, 2000, ‘Top 25 web sites

by proper ty’, October, viewed 28 November 2000, www. nielsen-netratings.com.

Reichheld, F. R and P. Schefter, 2000, ‘E-Loyalty: Your secret weapon on the web’, Harvard Business Review, July–August, pp. 105–13.

Roberts, L., 2000, ‘eBay thinks global, big-time’, 25 September, www. marketwatch.com.

Roth, D., 1999, ‘Meg muscles eBay uptown’, Fortune Magazine, 140(1).

Sellers, P., 1999, ‘Powerful women: These women rule’, Fortune Magazine, 140(8).

Silicon Valley, 1999, ‘Return to 1st person : Pierre Omidyar’, Siliconvalley.com, 23 September 2000, www.sv.com.

Street, D., 1999’, Amazon.com: From start-up to the new millennium (MBA Research Report, University of Cape Town).

Tedeschi, R., 1999, ‘Using discounts to build a client base’, New York Times, 31 May.

The Standard, 1999, ‘Profile: Pierre Omidyar’, 15 September 2000, www.thestandard.com.

Wall Street Journal, 2000, ‘Stocks declined, dragged down by analyst downgrades, election’, Wall Street Journal, 20 November, www. wsj.com.

Wingfield, N., 2000, ‘eBay aims to be operating system for all e-commerce on the Internet’, Wall Street Journal, 20 November, www.wsj.com.

Yahoo! Auctions, 2000, auctions.yahoo.com.

Notes 1 D. Bunnell, 2000, The eBay Phenomenon: Business Secrets Behind

the World’s Hottest Internet (New York: John Wiley & Sons, Inc.). Copyright John Wiley & Sons Limited. Reproduced by permission.

2 Ibid. 3 Ibid. 4 Ibid. 5 Various, 2000, Epinions.com – Reviews of eBay, 21 November,

www.epinions.com. 6 K. Harrod, 1999, ‘Amazon.com vs. eBay’, Letter to Fortune, 5 July

1999, viewed 23 October 2000, www.fortune.com. 7 Bunnell, The eBay Phenomenon. 8 Ibid. 9 Ibid. 10 www.ebay.com. 11 Various, 2000, Epinions.com – Reviews of eBay.

C-50

Case 4

Gillette and the men’s wet-shaving market Lew G. Brown Jennifer M. Hart University of North Carolina at Greensboro University of North Carolina at Greensboro

SAN FRANCISCO

On a spring morning in 1989, Michael Johnson dried himself and stepped from the shower in his San Fran- cisco Marina District condominium. He moved to the sink and started to slide open the drawer in the cabi- net beneath the sink. Then he remembered that he had thrown away his last Atra blade yesterday. He heard his wife, Susan, walk past the bathroom.

‘Hey, Susan, did you remember to pick up some blades for me yesterday?’

‘Yes, I think I put them in your drawer.’

‘Oh, okay, here they are.’ Michael saw the bottom of the blade package and pulled the drawer open.

‘Oh, no! These are Trac II blades, Susan, I use an Atra.’

‘I’m sorry. I looked at all the packages at the drug- store, but I couldn’t remember which type of razor you have. Can’t you use the Trac II blades on your razor?’

‘No. They don’t fit.’

‘Well, I bought some disposable razors. Just use one of those.’

‘Well, where are they?’

‘Look below the sink. They’re in a big bag.’

‘I see them. Wow, 10 razors for $1.97! Must have been on sale.’

‘I guess so. I usually look for the best deal. Seems to me that all those razors are the same, and the drug- store usually has one brand or another on sale.’

‘Why don’t you buy some of those shavers made for women?’

‘I’ve tried those, but it seems that they’re just like the ones made for men, only they’ve dyed the plastic pink or some pastel colour. Why should I pay more for colour?’

‘Why don’t you just use disposables?’ Susan contin- ued. ‘They are simpler to buy, and you just throw them away. And you can’t beat the price.’

‘Well, the few times I’ve tried them they didn’t seem to shave as well as a regular razor. Perhaps they’ve improved. Do they work for you?’

‘Yes, they work fine. And they sure are better than the heavy razors if you drop one on your foot while you’re in the shower!’

‘Never thought about that. I see your point. Well, I’ll give the disposable a try.’

Case 4 • Gillette and the men’s wet-shaving market C-51

History of shaving Anthropologists do not know exactly when or even why men began to shave. Researchers do know that prehistoric cave drawings clearly present men who were beardless. Apparently these men shaved with clamshells or sharpened animal teeth. As society developed, primitive men learned to sharpen flint implements. Members of the early Egyptian dynas- ties as far back as 7000 years ago shaved their faces and heads, probably to deny their enemies anything to grab during hand-to-hand combat. Egyptians later fashioned copper razors and, in time, bronze blades. Craftsmen formed these early razors as crescent- shaped knife blades, like hatchets or meat cleavers, or even as circular blades with a handle extending from the centre. By the Iron Age, craftsmen were able to fashion blades that were considerably more efficient than the early flint, copper and bronze versions.

Before the introduction of the safety razor, men used a straight-edged, hook-type razor and found shaving a tedious, difficult and time-consuming task. The typical man struggled through shaving twice a week at most. The shaver had to sharpen the blade (a process called stropping) before each use and had to have an expert cutler hone the blade each month. As a result, men often cut themselves while shaving; and few men had the patience and acquired the nec- essary skill to become good shavers. Most men in the 1800s agreed with the old Russian proverb: ‘It is eas- ier to bear a child once a year than to shave every day.’ Only the rich could afford a daily barber shave, which also often had its disadvantages because many barbers were unclean.

Before King C. Gillette of Boston invented the safety razor in 1895, he tinkered with other inventions in pursuit of a product which, once used, would be thrown away. The customer would have to buy more, and the business would build a long-term stream of sales and profits with each new customer.

‘On one particular morning when I started to shave,’ wrote Gillette about the dawn of his inven- tion, ‘I found my razor dull, and it was not only dull but beyond the point of successful stropping and it needed honing, for which it must be taken to a bar- ber or cutler. As I stood there with the razor in my hand, my eyes resting on it as lightly as a bird settling

down on its nest, the Gillette razor was born.’ Gillette immediately wrote to his wife, who was visiting rela- tives, ‘I’ve got it; our fortune is made.’

Gillette had envisioned a ‘permanent’ razor han- dle on to which the shaver placed a thin, razor ‘blade’ with two sharpened edges. The shaver would place a top over the blade and attach it to the handle so that only the sharpened edges of the blade were exposed, thus producing a ‘safe’ shave. A man would shave with the blade until it became dull and then would simply throw the used blade away and replace it. Gil- lette knew his concept would revolutionise the process of shaving; however, he had no idea that his creation would permanently change men’s shaving habits.

Shaving in the 1980s Following the invention of the safety razor, the men’s shaving industry in the United States grew slowly but surely through the First World War. A period of rapid growth followed, and the industry saw many product innovations. By 1989, US domestic razor and blade sales (the wet-shave market) had grown to a US$770 million industry. A man could use three types of wet shavers to remove facial hair. Most men used the dis- posable razor – a cheap, plastic-handled razor that lasted for eight to 10 shaves on average. Permanent razors, called blade and razor systems, were also pop- ular. These razors required new blades every 11 to 14 shaves. Customers could purchase razor handles and blade cartridges together, or they could purchase packages of blade cartridges as refills. The third cate- gory of wet shavers included injector and double-edge razors and accounted for a small share of the razor market. Between 1980 and 1988, disposable razors had risen from a 22 per cent to a 41.5 per cent market share of dollar sales. During the same period, cartridge systems had fallen from 50 per cent to 45.8 per cent and injector and double-edge types had fallen from 28 per cent to 12.7 per cent. In addition, the develop- ment of the electric razor had spawned the dry-shave market, which accounted for about US$250 million in sales by 1988.

Despite the popularity of disposable razors, manufacturers found that the razors were expen- sive to make and generated very little profit. In 1988, some industry analysts estimated that manufacturers

C-52 Case 4 • Gillette and the men’s wet-shaving market

earned three times more on a razor and blade system than on a disposable razor. Also, retailers preferred to sell razor systems because they took up less room on display racks and the retailers made more mon- ey on refill sales. However, retailers liked to promote disposable razors to generate traffic. As a result, US retailers allocated 55 per cent of their blade and razor stock to disposable razors, 40 per cent to systems and 5 per cent to double-edge razors.

Electric razors also posed a threat to razor and blade systems. Unit sales of electric razors jumped from 6.2 million in 1981 to 8.8 million in 1987. Low- priced imports from the Far East drove demand for electric razors up and prices down during this period. Nonetheless, fewer than 30 per cent of men used elec- tric razors, and most of these also used wet-shaving systems.

Industry analysts predicted that manufacturers’ sales of personal care products would continue to grow. However, the slowing of the overall US econo- my in the late 1980s meant that sales increases result- ing from an expanding market would be minimal and companies would have to fight for market share to continue to increase sales.

By 1988 the Gillette Company dominated the wet- shave market with a 60 per cent share of worldwide razor market revenue and a 61.9 per cent share of the US market. Gillette also had a stake in the dry-shave business through its Braun subsidiary. The other play- ers in the wet-shave market were Schick with 16.2 per cent of market revenues, BIC with 9.3 per cent, and others, including Wilkinson Sword, with the remain- ing 12.6 per cent.

The Gillette Company King Gillette took eight years to perfect his safety razor. In 1903, the first year of marketing, the Amer- ican Safety Razor Company sold 51 razors and 168 blades. Gillette promoted the safety razor as a saver of both time and money. Early ads proclaimed that the razor would save US$52 and 15 days’ shaving time each year and that the blades required no strop- ping or honing. During its second year, Gillette sold 90 884 razors and 123 648 blades. By its third year, razor sales were rising at a rate of 400 per cent per year, and blade sales were booming at an annual rate

of 1000 per cent. In that year, the company opened its first overseas branch in London.

Such success attracted much attention, and com- petition quickly developed. By 1906, consumers had at least a dozen safety razors from which to choose. The Gillette razor sold for US$5, as did the Zinn razor made by the Gem Cutlery Company. Others, such as the Ever Ready, Gem Junior and Enders, sold for as little as US$1.

With the benefit of a 17-year patent, Gillette found himself in a very advantageous position. However, it was not until the First World War that the safety razor gained wide consumer acceptance. One day in 1917, King Gillette had a visionary idea: have the govern- ment present a Gillette razor to every soldier, sailor and marine. In this way, millions of men just entering the shaving age would adopt the self-shaving habit. By March 1918, Gillette had booked orders from the US military for 519 750 razors, more than it had sold in any single year in its history. During the First World War, the government bought 4 180 000 Gillette razors as well as smaller quantities of competitive models.

Although King Gillette believed in the quality of his product, he realised that marketing, especially dis- tribution and advertising, would be the key to suc- cess. From the beginning, Gillette set aside 25 cents per razor for advertising and by 1905 had increased the amount to 50 cents. Over the years, Gillette used cartoon ads, radio shows, musical slogans and theme songs, prizes, contests and cross-promotions to push its products. Perhaps, however, consumers best remem- ber Gillette for its Cavalcade of Sports programs that began in 1939 with the company’s sponsorship of the World Series. Millions of men soon came to know Sharpie the Parrot and the tag line, ‘Look Sharp! Feel Sharp! Be Sharp!’

Gillette had always been an industry innovator. In 1932, Gillette introduced the Gillette Blue Blade, which was the premier men’s razor for many years. In 1938, the company introduced the Gillette Thin Blade; in 1946, it introduced the first blade dispenser that eliminated the need to unwrap individual blades; in 1959, it introduced the first silicone-coated blade, the Super Blue Blade. The success of the Super Blue Blade caused Gillette to close 1961 with a command- ing 70 per cent share of the overall razor and blade

Case 4 • Gillette and the men’s wet-shaving market C-53

market and a 90 per cent share of the double-edge market, the only market in which it competed.

In 1948, Gillette began to diversity into new mar- kets through acquisition. The company purchased the Toni Company to extend its reach into the women’s grooming-aid market. In 1954, the company bought Paper Mate, a leading marker of writing instruments. In 1962, it acquired the Sterilon Corporation, which

manufactured disposable hospital supplies. As a result of these moves, a marketing survey found that the public associated Gillette with personal grooming as much as, or more than, with blades and razors.

In 1988, the Gillette Company was a leading pro- ducer of men’s and women’s grooming aids. Exhibit 1 lists the company’s major divisions. Exhibits 2 and 3 show the percentages and dollar volumes of net sales

Exhibit 1 Gillette product lines by company division, 1988

Blades and razors Stationery products Toiletries and cosmetics Oral B products Braun products

Trac II Atra Good News

Paper Mate Liquid Paper Flair Waterman Write Bros.

Adorn Toni Right Guard Silkience Soft and Dri Foamy Dry Look Dry Idea White Rain Lustrasilk

Oral B toothbrushes Electric razors Lady Elegance Clocks Coffee grinders and makers

Exhibit 2 Gillette’s sales and operating profits by product line, 1986–88 (US$mn)

1988 1987 1986

Product line Sales Profits Sales Profits Sales Profits

Blades and razors $1 147 $406 $1 031 $334 $903 $274

Toiletries and cosmetics 1 019 79 926 99 854 69 Stationery products 385 56 320 34 298 11 Braun products 824 85 703 72 657 63 Oral B 202 18 183 7 148 8 Other 5 (0.1) 4 2 48 (1) Totals $3 582 $643 $3 167 $548 $2 908 $424

Source: Gillette Company Annual Reports, 1985–88.

Exhibit 3 Gillette’s net sales and profit by business, 1984–88 (per cent)

Blades and razors

Toiletries and cosmetics

Stationery products

Braun products

Oral B products

Year Sales Profits Sales Profits Sales Profits Sales Profits Sales Profits 1988 32 61 28 14 11 9 23 13 6 3 1987 33 61 29 18 10 6 22 13 6 2 1986 32 64 30 16 11 3 20 15 5 2 1985 33 68 31 15 11 2 17 13 6 3 1984 34 69 30 15 12 3 17 12 3 2

Source: Gillette Company Annual Reports, 1985–88.

C-54 Case 4 • Gillette and the men’s wet-shaving market

and profits from operations for each of the company’s major business segments. Exhibits 4 and 5 present income statements and balance sheets for 1986–88.

Despite its diversification, Gillette continued to realise the importance of blade and razor sales to the company’s overall health. Gillette had a strong foot- hold in the razor and blade market, and it intended to use this dominance to help it achieve the compa- ny’s goal – ‘sustained profitable growth’. To reach this goal, Gillette’s mission statement indicated that the company should pursue ‘strong technical and market- ing efforts to assure vitality in major existing prod- uct lines; selective diversification, both internally and through acquisition; the elimination of product and business areas with low growth or limited profit potential; and strict control over product costs, over- head expenses, and working capital’.

Gillette introduced a number of innovative shav- ing systems in the 1970s and 1980s as part of its strategy to sustain growth. Gillette claimed that Trac II, the first twin-blade shaver, represented the most revolutionary shaving advance ever. The develop- ment of the twin-blade razor derived from shaving researchers’ discovery that shaving causes whiskers to be briefly lifted up out of the follicle during shaving, a process called ‘hysteresis’ by technicians. Gillette

invented the twin-blade system so that the first blade would cut the whisker and the second blade would cut it again before it receded. This system produced a closer shave than a traditional one-blade system. Gil- lette also developed a clog-free, dual-blade cartridge for the Trac II system.

Because consumer test data showed a 9-to-1 preference for Trac II over panellists’ current razors, Gillette raced to get the product to market. Gillette supported Trac II’s 1971 introduction, which was the largest new product introduction in shaving history, with a US$10 million advertising and promotion bud- get. Gillette cut its advertising budgets for its other brands drastically to support Trac II. The double- edge portion of the advertising budget decreased from 47 per cent in 1971 to 11 per cent in 1972. Gillette reasoned that growth must come at the expense of other brands. Thus, it concentrated its advertising and promotion on its newest shaving product and reduced support for its established lines.

Gillette launched Trac II during a World Series promotion and made it the most frequently advertised shaving system in America during its introductory period. Trac II users turned out to be predominantly young, college-educated men who lived in metropoli- tan and suburban areas and earned higher incomes.

Exhibit 4 Gillette income statements, 1986–88 (US$mn except for per share and stock price data)

1988 1987 1986

Net sales $3 581.2 $3 166.8 $2 818.3 Cost of sales 1 487.4 1 342.3 1 183.8 Other expenses 1 479.8 1 301.3 1 412.0 Operating income 614.0 523.2 222.5 Other income 37.2 30.9 38.2 Earnings before interest and tax 651.2 545.1 260.7 Interest expense 138.3 112.5 85.2 Non-operating expense 64.3 50.1 124.0 Earnings before tax 448.6 391.5 51.5 Tax 180.1 161.6 35.7 Earnings after tax 268.5 229.9 15.8 Earnings per share 2.45 2.00 0.12 Average common shares outstanding (000) 109 559 115 072 127 344 Dividends paid per share $0.86 $0.785 $0.68 Stock price range High Low

$49 $29 1/8

$45 7/8 $17 5/8

$34 1/2 $17 1/8

Source: Gillette Company Annual Reports, 1986–88.

Case 4 • Gillette and the men’s wet-shaving market C-55

As the fastest-growing shaving product on the market for five years, Trac II drove the switch to twin blades. The brand reached its peak in 1976 when consumers purchased 485 million blades and 7 million razors.

Late in 1976, Gillette, apparently in response to BIC’s pending entrance into the US market, launched Good News!, the first disposable razor for men sold in the United States. In 1975, BIC had introduced the first disposable shaver in Europe; and by 1976 BIC had begun to sell disposable razors in Canada. Gillette realised that BIC would move its disposable razor into the United States after its Canadian introduction, so it promptly brought out a new blue plastic disposable shaver with a twin-blade head. By year’s end, Gillette also made Good News! available in Austria, Canada, France, Italy, Switzerland, Belgium, Greece, Germany and Spain.

Unfortunately for Gillette, Good News! was real- ly bad news. The disposable shaver delivered lower profit margins than razor and blade systems, and it undercut sales of other Gillette products. Good News! sold for much less than the retail price of a Trac II cartridge. Gillette marketed Good News! on price and convenience, not performance; but the com- pany envisioned the product as a step-up item leading to its traditional high-quality shaving systems.

This contain-and-switch strategy did not succeed. Consumers liked the price and the convenience of dis- posable razors, and millions of Trac II razors began to gather dust in medicine chests across the country. Many Trac II users figured out that for as little as 25 cents, they could get the same cartridge mounted on a plastic handle that they had been buying for 56 cents to put on their Trac II handle. Further, dispos- able razors created an opening for competitors in a category that Gillette had long dominated.

Gillette felt sure, however, that disposable razors would never gain more than a 7 per cent share of the market. The disposable razor market share soon soared past 10 per cent, forcing Gillette into continu- al upward revisions of its estimates. In terms of units sold, disposable razors reached a 22 per cent market share by 1980 and a 50 per cent share by 1988.

BIC’s and Gillette’s successful introduction of the disposable razor represented a watershed event in ‘commoditisation’ – the process of converting well- differentiated products into commodities. Status, quality and perceived value had always played prima- ry roles in the marketing of personal care products. But consumers were now showing that they would forgo performance and prestige in a shaving product – about as close and personal as one can get.

Exhibit 5 Gillette balance sheets, 1986–88 (US$mn)

1988 1987 1986

Assets Cash $156.4 $119.1 $94.8

Receivables 729.1 680.1 608.8

Inventories 653.4 594.5 603.1

Other current assets 200.8 184.5 183.0

Total current assets 1 739.7 1 578.2 1 489.7

Fixed assets, net 683.1 664.4 637.3

Other assets 445.1 448.6 412.5

Total assets 2 867.9 2 731.2 2 539.5

Liabilities and equity Current liabilities* 965.4 960.5 900.7

Long-term debt 1 675.2 839.6 915.2

Other long-term liabilities 311.9 331.7 262.8

Equity† $ (84.6) $ 599.4 $ 460.8

* Includes current portion of long-term debt: 1988 = $9.6, 1987 = $41.0, 1986 = $7.6. Source: Gillette Company Annual Reports, 1986–88. † Includes retained earnings: 1988 = $1261.6, 1987 = $1 083.8, 1986 = $944.3.

C-56 Case 4 • Gillette and the men’s wet-shaving market

In 1977, Gillette introduced a new blade and razor system at the expense of Trac II. It launched Atra with a US$7 million advertising campaign and over 50 million US$2 rebate coupons. Atra (which stands for Automatic Tracking Razor Action) was the first twin-blade shaving cartridge with a pivoting head. Engineers had designed the head to follow a man’s facial contours for a closer shave. Researchers began developing the product in Gillette’s UK research and development lab in 1970. They had established a goal of improving the high-performance standards of twin- blade shaving and specifically enhancing the Trac II effect. The company’s scientists discovered that mov- ing the hand and face was not the most effective way to achieve the best blade–face shaving angle. The razor head itself produced a better shave if it pivoted so as to maintain the most effective shaving angle. Marketers selected the name ‘Atra’ after two years of extensive consumer testing.

Atra quickly achieved a 7 per cent share of the blade market and about one-third of the razor mar- ket. The company introduced Atra in Europe a year later under the brand name ‘Contour’. Although Atra increased Gillette’s share of the razor market, 40 per cent of Trac II users switched to Atra in the first year.

In the early 1980s, Gillette introduced most of the new disposable razors and product enhance- ments. Both Swivel (launched in 1980) and Good News! Pivot (1984) were disposable razors featur- ing movable heads. Gillette announced Atra Plus (the first razor with the patented Lubra-smooth lubricat- ing strip) in 1985 just as BIC began to move into the United States from Canada with the BIC shaver for sensitive skin. A few months later, Gillette ushered in Micro Trac – the first disposable razor with an ultra- slim head. Gillette priced the Micro Trac lower than any other Gillette disposable razor. The company claimed to have designed a state-of-the-art manufac- turing process for Micro Trac. The process required less plastic, thus minimising bulk and reducing man- ufacturing costs. Analysts claimed that Gillette was trying to bracket the market with Atra Plus (with a retail price of US$3.99 to US$4.95) and Micro Trac (US$0.99), and protect its market share with prod- ucts on both ends of the price and usage scale. Gillette also teased Wall Street with hints that, by the end

of 1986, it would be introducing yet another state- of-the-art shaving system that could revolutionise the shaving business.

Despite these product innovations and intro- ductions in the early 1980s, Gillette primarily focused its energies on its global markets and strategies. By 1985, it was marketing 800 products in more than 200 countries. The company felt a need at this time to coordinate its marketing efforts, first regionally and then globally.

Unfortunately for Gillette’s management team, others noticed its strong international capabilities. Ronald Perelman, chairman of the Revlon Group, attempted an unfriendly takeover in November 1986. To fend off the takeover, Gillette bought back 9.2 million shares of its stock from Perelman and sad- dled itself with additional long-term debt to finance the stock repurchase. Gillette’s payment to Perelman increased the company’s debt load from US$827 mil- lion to US$1.1 billion, and put its debt-to-equity ratio at 70 per cent. Gillette and Perelman signed an agree- ment preventing Perelman from attempting another takeover until 1996.

In 1988, just as Gillette returned its attention to new product development and global marketing, Coniston Partners, after obtaining 6 per cent of Gil- lette’s stock, engaged the company in a proxy bat- tle for four seats on its 12-person board. Coniston’s interest had been piqued by the Gillette–Perelman US$549 million stock buyback and its payment of US$9 million in expenses to Perelman. Coniston and some shareholders felt Gillette’s board and manage- ment had repeatedly taken actions that prohibited its shareholders from realising their shares’ full value. When the balloting concluded, Gillette’s management won by a narrow margin – 52 to 48 per cent. Coniston made US$13 million in the stock buyback program that Gillette offered to all shareholders, but Conis- ton agreed not to make another run at Gillette until 1991. This second takeover attempt forced Gillette to increase its debt load to US$2 billion and pushed its total equity negative to (US$84.6 million).

More importantly, both takeover battles forced Gillette to ‘wake up’. Gillette closed or sold its Jafra Cosmetics operations in 11 countries and jettisoned weak operations such as Misco, Inc. (a computer sup- plies business), and S.T. Dupont (a luxury lighter,

Case 4 • Gillette and the men’s wet-shaving market C-57

clock and watchmaker). The company also thinned its workforce in many divisions, such as its 15 per cent staff reduction at the Paper Mate pen unit. Despite this pruning, Gillette’s sales for 1988 grew 13 per cent to US$3.6 billion, and profits soared 17 per cent to US$268 million.

Despite Gillette’s concentration on fending off takeover attempts, it continued to enhance its razor and blade products. In 1986, it introduced the Con- tour Plus in its first pan-European razor launch. The company marketed Contour Plus with one identity and one strategy. In 1988, the company introduced Trac II Plus, Good News! Pivot Plus and Daisy Plus – versions of its existing products with the Lubra- smooth lubricating strip.

Schick Warner-Lambert’s Schick served as the second major competitor in the wet-shaving business. Warner-Lam- bert, incorporated in 1920 under the name William R. Warner & Company, manufactured chemicals and pharmaceuticals. Numerous mergers and acquisitions over 70 years resulted in Warner-Lambert’s involve- ment in developing, manufacturing and marketing a widely diversified line of beauty, health and well- being products. The company also became a major producer of mints and chewing gums, such as Den-

tyne, Sticklets and Trident. Exhibit 6 presents a list of Warner-Lambert’s products by division as of 1988.

Warner-Lambert entered the wet-shaving busi- ness through a merger with Eversharp in 1970. Ever- sharp, a long-time competitor in the wet-shave indus- try, owned the Schick trademark and had owned the Paper Mate Pen Company prior to selling it to Gillette in 1955. Schick’s razors and blades produced US$180 million in revenue in 1987, or 5.2 per cent of Warner- Lambert’s worldwide sales. (Refer to Exhibit 7 for operating results by division, and Exhibits 8 and 9 for income statement and balance sheet data.)

In 1989, Schick held approximately a 16.2 per cent US market share, down from its 1980 share of 23.8 per cent. Schick’s market share was broken down as follows: blade systems, 8.8 per cent; dispos- able razors, 4.1 per cent; and double-edged blades and injectors, 3.3 per cent.

Schick’s loss of market share in the 1980s occurred for two reasons. First, even though Schick pioneered the injector razor system (it controlled 80 per cent of this market by 1979), it did not market a disposable razor until mid-1984 – eight years after the first dis- posable razors appeared. Second, for years Warner- Lambert had been channelling Schick’s cash flow to its research and development in drugs.

In 1986, the company changed its philosophy: it allocated US$70 million to Schick for a three-year

Exhibit 6 Warner-Lambert product lines by company division, 1988

Ethical pharmaceuticals Gums and mints Non-prescription products Other products

Parke-Davis drugs Dentyne Sticklets Beemans Trident Freshen-up Bubblicious Chiclets Clorets Certs Dynamints Junior Mints Sugar Daddy Sugar Babies Charleston Chew Rascals

Benadryl Caladryl Rolaids Sinutab Listerex Lubraderm Anusol Tucks Halls Benylin Listerine Listermint Efferdent Effergrip

Schick razors Ultrex razors Personal Touch Tetra Aquarium

Source: Moody’s Industrial Manual.

C-58 Case 4 • Gillette and the men’s wet-shaving market

Exhibit 7 Warner-Lambert’s net sales and operating profit by division, 1985–88 (US$mn)

Net sales Operating profit/(loss) Division 1988 1987 1986 1985 1988 1987 1986 1985

Healthcare Ethical products $1 213 $1 093 $ 964 $ 880 $ 420 $ 351 $ 246 $ 224

Non-prescription products 1 296 1 195 1 077 992 305 256 176 177

Total healthcare 2 509 2 288 2 041 1 872 725 607 422 401

Gums and mints 918 777 678 626 187 173 122 138

Other products* 481 420 384 334 92 86 61 72

Divested businesses (464)

R&D (259) (232) (202) (208) Net sales and operating profit 3 908 3 485 3 103 3 200 745 634 599 (61)

* Other products include Schick razors, which accounted for US$180 million in revenue in 1987.

Source: Warner-Lambert Company Annual Report, 1987; Moody’s Industrial Manual.

Exhibit 8 Warner-Lambert income statements, 1986–88 (US$000)

1988 1987 1986

Net sales $3 908 400 $3 484 700 $3 102 918 Cost of sales 1 351 700 1 169 700 1 052 781 Other expenses 2 012 100 1 819 800 1 616 323 Operating income 544 600 495 200 433 814 Other income 61 900 58 500 69 611 Earnings before interest and tax 606 500 553 700 503 425 Interest expense 68 200 60 900 66 544 Earnings before tax 538 300 492 800 436 881 Tax 198 000 197 000 136 297 Non-recurring item – – 8 400 Earnings after tax 340 000 295 800 308 984 Retained earnings 1 577 400 1 384 100 1 023 218 Earnings per share 5.00 4.15 4.18 Average common shares outstanding (000) 68 035 71 355 73 985 Dividends paid per share 2.16 1.77 1.59 Stock price range High Low

$79 1/2 $59 7/8

$87 1/2 $48 1/4

$63 1/8 $45

Source: Moody’s Industrial Manual.

period and granted Schick its own sales force. In spite of Schick’s loss of market share, company execu- tives felt they had room to play catch-up, especially by exploiting new technologies. In late 1988, Schick revealed that it planned to conduct ‘guerrilla war- fare’ by throwing its marketing resources and efforts into new technological advances in disposable razors. As a result, Warner-Lambert planned to allocate the

bulk of its US$8 million razor advertising budget to marketing its narrow-headed disposable razor, Slim Twin, which it introduced in August 1988.

Schick believed that the US unit demand for dis- posable razors would increase to 55 per cent of the market by the early 1990s from its 50 per cent share in 1988. Schick executives based this belief on their feeling that men would rather pay 30 cents for a

Case 4 • Gillette and the men’s wet-shaving market C-59

disposable razor than 75 cents for a refill blade. In 1988, Schick held an estimated 9.9 per cent share of dollar sales in the disposable razor market.

Schick generated approximately 67 per cent of its revenues overseas. Also, it earned higher profit mar- gins on its non-domestic sales – 20 per cent versus its 15 per cent domestic margin. Europe and Japan represented the bulk of Schick’s international busi- ness, accounting for 38 per cent and 52 per cent, respectively, of 1988’s overseas sales. Schick’s Euro- pean business consisted of 70 per cent systems and 29 per cent disposable razors, but Gillette’s systems and disposable razor sales were 4.5 and 6 times larger, respectively.

However, Schick dominated in Japan. Warner- Lambert held over 60 per cent of Japan’s wet-shave market. Although Japan had typically been an electric shaver market (55 per cent of Japanese shavers use elec- tric razors), Schick achieved an excellent record and reputation in Japan. Both Schick and Gillette entered the Japanese market in 1962; and their vigorous com- petition eventually drove Japanese competitors from the industry, which by 1988 generated US$190 mil- lion in sales. Gillette’s attempt to crack the market flopped because it tried to sell razors using its own salespeople, a strategy that failed because Gillette did not have the distribution network available to Japanese companies. Schick, meanwhile, chose to

leave the distribution to Seiko Corporation. Seiko imported razors from the United States and then sold them to wholesalers nationwide. By 1988, Schick gen- erated roughly 40 per cent of its sales and 35 per cent of its profits in Japan. Disposable razors accounted for almost 80 per cent of those figures.

BIC Corporation The roots of the BIC Corporation, which was founded by Marcel Bich in the United States in 1958, were in France. In 1945, Bich, who had been the production manager for a French ink manufacturer, bought a factory outside Paris to produce parts for fountain pens and mechanical lead pencils. In his new busi- ness, Bich became one of the first manufacturers to purchase presses to work with plastics. With his knowledge of inks and experience with plastics and moulding machines, Bich set himself up to become the largest pen manufacturer in the world. In 1949, Bich introduced his version of the modern ballpoint pen, originally invented in 1939, which he called ‘BIC’, a shortened, easy-to-remember version of his own name. He supported the pen with memorable, effective advertising; and its sales surpassed even his own expectations.

Realising that a mass-produced disposable ballpoint pen had universal appeal, Bich turned his

Exhibit 9 Warner-Lambert balance sheets, 1986–88 (US$000)

1988 1987 1986

Assets Cash $176 000 $24 100 $26 791

Receivables 525 200 469 900 445 743

Inventories 381 400 379 000 317 212

Other current assets 181 300 379 600 720 322

Total current assets 1 264 500 1 252 600 1 510 068

Fixed assets, net 1 053 000 959 800 819 291

Other assets 385 300 263 500 186 564

Total assets 2 702 800 2 475 900 2 515 923

Liabilities and equity Current liabilities* 1 025 200 974 300 969 806 Current portion of long-term debt

7 100 4 200 143 259

Long-term debt 318 200 293 800 342 112

Equity $ 998 600 $ 874 400 $ 907 322

* Includes current portion of long-term debt. Source: Moody’s Industrial Manual.

C-60 Case 4 • Gillette and the men’s wet-shaving market

attention to the US market. In 1958, he purchased the Waterman Pen Company of Connecticut and then incorporated as Waterman-BIC Pen Corporation. The company changed its name to BIC Pen in 1971 and finally adopted the name BIC Corporation for the publicly owned corporation in 1982.

After establishing itself as the country’s largest pen maker, BIC attacked another market – the dispos- able lighter market. When BIC introduced its lighter in 1973, the total disposable lighter market stood at only 50 million units. By 1984, BIC had become so successful at manufacturing and marketing its dis- posable lighters that Gillette, its primary competitor, abandoned the lighter market. Gillette sold its Crick- et division to Swedish Match, Stockholm, the man- ufacturer of Wilkinson razors. By 1989, the dispos- able lighter market had grown to nearly 500 million units, and BIC lighters accounted for 60 per cent of the market.

Not content to compete just in the writing and lighting markets, BIC decided to enter the US shav- ing market in 1976. A year earlier, the company had launched the BIC Shaver in Europe and Canada. BIC’s entrance into the US razor market started an intense rivalry with Gillette. Admittedly, the compa- nies were not strangers to each other – for years they had competed for market share in the pen and lighter industries. Despite the fact that razors were Gillette’s primary business and an area where the company had no intention of relinquishing market share, BIC estab- lished a niche in the US disposable-razor market.

BIC, like Gillette, frequently introduced new razor products and product enhancements. In January 1985, following a successful Canadian test in 1984, BIC announced the BIC Shaver for Sensitive Skin. BIC claimed that 42 per cent of the men surveyed reported that they had sensitive skin, while 51 per cent of those who had heavy beards reported that they had sensi- tive skin. Thus, BIC felt there was a clear need for a shaver that addressed this special shaving problem. The US$10 million ad campaign for the BIC Shaver for Sensitive Skin featured John McEnroe, a highly ranked and well-known tennis professional, discuss- ing good and bad backhands and normal and sen- sitive skin. BIC repositioned the original BIC white shaver as the shaver men with normal skin should use,

while it promoted the new BIC Orange as the razor for sensitive skin.

BIC also tried its commodity strategy on sail- boards, car-top carriers and perfume. In 1982, BIC introduced a sailboard model at about half the price of existing products. The product generated nothing but red ink. In April 1989, the company launched BIC perfumes with US$15 million in advertising support. BIC’s foray into fragrances was as disappointing as its sailboard attempt. Throughout the year, Parfum BIC lost money, forcing management to concentrate its efforts on reformulating its selling theme, advertising, packaging and price points. Many retailers rejected the product, sticking BIC with expensive manufac- turing facilities in Europe. BIC found that consumers’ perceptions of commodities did not translate equally into every category. For example, many women cut corners elsewhere just to spend lavishly on their per- fume. The last thing they wanted to see was their favourite scent being hawked to the masses.

Despite these failures, BIC Corporation was the undisputed king of the commoditisers. BIC’s success with pens and razors demonstrated the upside poten- tial of commoditisation, while its failures with sail- boards and perfumes illustrated the limitations. BIC concentrated its efforts on designing, manufacturing and delivering the ‘best’ quality products at the lowest possible prices. And although the company produced large quantities of disposable products (for example, over 1 million pens a day), it claimed that each prod- uct was invested with the BIC philosophy: ‘maximum service, minimum price’.

One of BIC’s greatest assets was its retail distribu- tion strength. The high profile the company enjoyed at supermarkets and drugstores enabled it to win loca- tions in the aisles and display space at the checkout – the best positioning.

Even though BIC controlled only the number three spot in the wet-shaving market by 1989, it had exert- ed quite an influence since its razors first entered the US market in 1976. In 1988, BIC’s razors generated US$52 million in sales with a net income of US$9.4 million; BIC held a 22.4 per cent share of dollar sales in the disposable razor market. Exhibit 10 presents operating data by product line, and Exhibits 11 and 12 give income statement and balance sheet data.

Case 4 • Gillette and the men’s wet-shaving market C-61

The introduction of the disposable razor revo- lutionised the industry and cut into system razor profits. However, despite the low profit margins in disposable razors and the fact that the industry lead- er, Gillette, emphasised razor and blade systems, BIC remained bullish on the disposable razor market. In 1989, a spokesperson for BIC claimed that BIC ‘was going to stick to what consumers liked’. The com- pany planned to continue marketing only single-

blade, disposable shavers. BIC stated that it planned to maintain its strategy of underpricing competi- tors, but it would also introduce improvements such as the patented metal guard in its BIC Metal Shaver. Research revealed that the BIC Metal Shaver provided some incremental, rather than substitute, sales for its shaver product line. BIC executives believed that the BIC Metal Shaver would reach a 5–8 per cent market share by 1990.

Exhibit 10 BIC Corporation’s net sales and income before taxes, 1986–88 (US$mn)

1988 1987 1986

Net sales Writing instruments $118.5 $106.7 $91.7 Lighters 113.9 120.0 115.0 Shavers 51.9 47.1 49.6 Sport 10.6 16.8 11.3 Total 294.9 290.6 267.6

Profit/(loss) before taxes Writing instruments 16.7 17.5 15.0 Lighters 22.9 28.2 28.5 Shavers 9.4 8.5 8.0 Sport (4.7) (3.5) (3.6) Totals 44.3 50.7 47.9

Source: BIC Corporation, Annual Reports, 1986–88.

Exhibit 11 BIC Corporation consolidated income statements, 1986–88 (US$000)

1988 1987 1986

Net sales $294 878 $290 616 $267 624 Cost of sales 172 542 165 705 147 602 Other expenses 81 023 73 785 67 697 Operating income 41 313 51 126 52 325 Other income 4 119 1 836 7 534 Earnings before interest and tax 45 432 52 962 59 859 Interest expense 1 097 2 301 11 982 Earnings before tax 44 335 50 661 47 877 Tax 17 573 21 944 24 170 Extraordinary credit – – 2 486* Utilisation of operating loss carry forward 2 800 – – Earnings after tax 29 562 28 717 26 193 Retained earnings 159 942 142 501 121 784 Earnings per share 2.44 2.37 2.16 Average common shares outstanding (000) 12 121 12 121 12 121 Dividends paid per share 0.75 0.66 0.48 Stock price range High Low

$30 3/8 $24 3/8

$34 7/8 $16 1/2

$35 $23 1/4

* Gain from elimination of debt. Source: Moody’s Industrial Manual; BIC Annual Reports.

C-62 Case 4 • Gillette and the men’s wet-shaving market

Wilkinson Sword Swedish Match Holding Incorporated’s subsidiary, Wilkinson Sword, came in as the fourth player in the US market. Swedish Match Holding was a wholly owned subsidiary of Swedish Match AB, Stockholm, Sweden. The parent company owned subsidiaries in the United States that imported and sold doors, pro- duced resilient and wood flooring, and manufactured branded razors, blades, self-sharpening scissors and gourmet kitchen knives. (Exhibits 13 and 14 present income statement and balance sheet data on Swedish Match AB.)

A group of swordsmiths founded Wilkinson in 1772. Soldiers used Wilkinson swords at Waterloo, at the charge of the Light Brigade and in the Boer War. However, as the sword declined as a combat weapon, Wilkinson retreated to producing presen- tation and ceremonial swords. By 1890, Wilkinson’s cutlers had begun to produce straight razors, and by 1898 it was producing safety razors similar to King Gillette’s. When Gillette’s blades became popular in England, Wilkinson made stroppers to resharpen used blades. Wilkinson failed in the razor market, however, and dropped out during the Second World War.

By 1954, Wilkinson decided to look again at the shaving market. Manufacturers used carbon steel to

make most razor blades at that time, and such blades lost their serviceability rapidly due to mechanical and chemical damage. Gillette and other firms had experi- mented with stainless steel blades; but they had found that despite their longer-lasting nature, the blades did not sharpen well. But some men liked the durability; and a few small companies produced stainless steel blades.

Wilkinson purchased one small German compa- ny and put Wilkinson Sword blades on the market in 1956. Wilkinson developed a coating for the stainless blades (in the same fashion that Gillette had coated the Super Blue Blade) that masked their rough edges, allowing the blades to give a comfortable shave and to last two to five times longer than conventional blades. Wilkinson called the new blade the Super Sword- Edge. Wilkinson introduced the blades in England in 1961 and in the United States in 1962, and they became a phenomenon. Schick and American Safety Razor followed a year later with their own stainless steel blades, the Krona-Plus and Personna. Gillette finally responded in late 1963 with its own stainless steel blade; and by early 1964 Gillette’s blades were outselling Wilkinson, Schick and Personna combined. Wilkinson, however, had forever changed the nature of the razor blade.

Exhibit 12 BIC Corporation balance sheets, 1986–88 (US$000)

1988 1987 1986

Assets Cash $5 314 $4 673 $5 047 Certificates of deposit 3 117 803 6 401

Receivables, net 43 629 41 704 32 960

Inventories 70 930 59 779 50 058

Other current assets 37 603 47 385 34 898

Deferred income taxes 7 939 6 691 5 622

Total current assets 168 532 161 035 134 986

Fixed assets, net 74 973 62 797 58 385

Total assets 243 505 223 832 193 371

Liabilities and equity Current liabilities* 55 031 54 034 45 104 Current portion of long-term debt 157 247 287

Long-term debt 1 521 1 511 1 789

Equity $181 194 $164 068 $142 848

* Includes current portion of long-term debt. Source: Moody’s Industrial Manual.

Case 4 • Gillette and the men’s wet-shaving market C-63

In 1988, Wilkinson Sword claimed to have a 4 per cent share of the US wet-shave market; and it was predicting a 6 per cent share by mid-1990. Industry analysts, however, did not confirm even the 4 per cent share; they projected Wilkinson’s share to be closer to 1 per cent. Wilkinson introduced many new prod- ucts over the years, but they generally proved to be short-lived. The company never really developed its US franchise.

However, in late 1988, Wilkinson boasted that it was going to challenge the wet-shave category leader by introducing Ultra-Glide, its first lubricating shav- ing system. Wilkinson designed Ultra-Glide to go head-to-head with Gillette’s Atra Plus and Schick’s Super II Plus and Ultrex Plus. Wilkinson claimed that

Ultra-Glide represented a breakthrough in shaving technology because of an ingredient, hydromer, in its patented lubricating strip. According to Wilkinson, the Ultra-Glide strip left less residue on the face and provided a smoother, more comfortable shave by cre- ating a cushion of moisture between the razor and the skin.

Wilkinson introduced Ultra-Glide in March 1989 and supported it with a US$5 million advertising and promotional campaign (versus the Atra Plus US$80 million multimedia investment in the United States). Wilkinson priced Ultra-Glide 5–8 per cent less than Atra Plus. Wilkinson was undaunted by Gillette’s heavier advertising investment, and it expected to cash in on its rival’s strong marketing muscle. Wilkinson

Exhibit 13 Swedish Match AB income statements, 1986–88 (US$000)

1988 1987 1986

Net sales $2 814 662 $2 505 047 $1 529 704 Cost of sales N/A N/A N/A Operating expenses 2 541 128 2 291 023 1 387 360 Other expenses 108 206 95 420 48 711 Earnings before interest 165 328 118 604 93 633 Interest expense 5 386 19 084 21 618 Earnings before tax 159 942 99 520 72 015 Tax 57 612 29 996 39 165 Earnings after tax 102 330 69 554 32 850 Dividends paid per share 0.53 0.51 1.75 Stock price range High Low

22.53 $15.00

19.65 $11.06

66.75 $22.00

Source: Moody’s Industrial Manual.

Exhibit 14 Swedish Match AB balance sheets, 1986–88 (US$000)

1988 1987 1986

Assets Cash and securities $ 159 616 $ 117 027 $323 993 Receivables 611 372 561 479 297 321 Inventories 421 563 415 116 258 858 Total current assets 1 192 551 1 093 622 880 172 Fixed assets, net 707 664 671 409 397 411 Other assets 161 085 132 799 93 211 Total assets 2 061 300 1 897 830 370 794

Liabilities and equity Current liabilities 996 214 905 778 576 534 Current portion long-term debt Long-term debt 298 505 316 542 244 118 Equity

Source: Moody’s Industrial Manual.

C-64 Case 4 • Gillette and the men’s wet-shaving market

did not expect to overtake Gillette but felt its drive should help it capture a double-digit US market share within two to three years.

Many were sceptical about Wilkinson’s self- predicted market share growth. One industry analyst stated, ‘Gillette dominates this business. Some upstart won’t do anything.’ One Gillette official claimed his company was unfazed by Wilkinson. In fact, he was quoted as saying, in late 1988, ‘They [Wilkinson] don’t have a business in the US; they don’t exist.’

Nonetheless, Gillette became enraged and filed legal challenges when Wilkinson’s television ads for Ultra-Glide broke in May 1989. The ads stated that Ultra-Glide’s lubricating strip was six times smoother than Gillette’s strip and that men preferred it to the industry leader’s. All three major networks had reser- vations about continuing to air the comparison com- mercials. CBS and NBC stated that they were going to delay airing the company’s ads until Wilkinson responded to questions they had about its ad claims. In an 11th-hour counterattack, Wilkinson accused Gillette of false advertising and of trying to monopo- lise the wet-shave market.

GILLETTE’S SOUTH BOSTON PLANT

Robert Squires left his work station in the facilities engineering section of Gillette’s South Boston manu- facturing facility and headed for the shave test lab. He

entered the lab area and walked down a narrow hall. On his right were a series of small cubicles Gillette had designed to resemble the sink area of a typical bath- room. Robert opened the door of his assigned cubicle precisely at his scheduled 10 a.m. time. He removed his dress shirt and tie, hanging them on a hook beside the sink. Sliding the mirror up as one would a window, Robert looked into the lab area. Rose McCluskey, a lab assistant, greeted him.

‘Morning, Robert. See you’re right on time as usual. I’ve got your things all ready for you.’ Rose reached into a recessed area on her side of the cubicle’s wall and handed Robert his razor, shave cream, aftershave lotion and a clean towel.

‘Thanks, Rose. Hope you’re having a good day. Any- thing new you’ve got me trying today?’

‘You know I can’t tell you that. It might spoil your objectivity. Here’s your card.’ Rose handed Robert a shaving evaluation card (see Exhibit 15).

Robert Squires had been shaving at the South Boston Plant off and on for all of his 25 years with Gillette. He was one of 200 men who shaved every work day at the plant. Gillette used these shavers to compare its products’ effectiveness with competitors’ products. The shavers also conducted R&D testing of new products and quality control testing for manu- facturing. An additional seven to eight panels of 250

Exhibit 15 Gillette shaving evaluation card

NUMB. CODE STA TEST # NAME EMP. # DATE

IN-PLANT SHAVE TEST SCORECARD

INSTRUCTIONS: Please check one box in each column

Overall evaluation of shave

Freedom from nicks and cuts Caution Closeness Smoothness Comfort

❏ Excellent ❏ Very good ❏ Good ❏ Fair ❏ Poor

❏ Excellent ❏ Very good ❏ Good ❏ Fair ❏ Poor

❏ Exceptionally safe

❏ Unusually safe ❏ Average ❏ Slight caution

needed ❏ Excessive

caution needed

❏ Exceptionally close

❏ Very close ❏ Average ❏ Fair ❏ Poor

❏ Exceptionally smooth

❏ Very smooth ❏ Average ❏ Slight pull ❏ Excessive pull

❏ Exceptionally comfortable

❏ Very comfortable

❏ Average comfort smoothness

❏ Slight irritation ❏ Excessive

irritation

Source: The Gillette Company.

Case 4 • Gillette and the men’s wet-shaving market C-65

men each shaved every day in their homes around the country, primarily conducting R&D shave testing.

Like Robert, each shaver completed a shave eval- uation card following every shave. Lab assistants like Rose entered data from the evaluations to allow Gillette researchers to analyse the performance of each shaving device. If a product passed R&D hurdles, it became the responsibility of the marketing research staff to conduct consumer-use testing. Such consum- er testing employed 2000 to 3000 men who tested products in their homes.

From its research, Gillette had learned that the average man had 30 000 whiskers on his face that grew at the rate of half an inch (1.3 centimetres) per month. He shaved 5.8 times a week and spent three to four minutes shaving each time. A man with a life span of 70 years would shave more than 20 000 times, spending 3350 hours (130 days) removing 27.5 feet (8.4 metres) of facial hair. Yet, despite all the time and effort involved in shaving, surveys found that if a cream were available that would eliminate facial hair and shaving, most men would not use it.

Robert finished shaving and rinsed his face and shaver. He glanced at the shaving head. A pretty good shave, he thought. The cartridge had two blades, but it seemed different. Robert marked his evaluation card and slid it across the counter to Rose.

William Mazeroski, manager of the South Boston shave test lab, walked into the lab area carrying com- puter printouts with the statistical analysis of last week’s shave test data.

Noticing Robert, William stopped. ‘Morning, Robert. How was your shave?’

‘Pretty good. What am I using?’

‘Robert, you are always trying to get me to tell you what we’re testing! We have control groups and exper- imental groups. I can’t tell you which you are in, but I was just looking at last week’s results, and I can tell you that it looks like we are making progress. We’ve been testing versions of a new product since 1979, and I think we’re about to get it right. Of course, I don’t know if we’ll introduce it or even if we can make it in large quantities, but it looks good.’

‘Well, that’s interesting. At least I know I’m involved in progress. And, if we do decide to produce a new

shaver, we’ll have to design and build the machines to make it ourselves because there is nowhere to go to purchase blade-making machinery. Well, I’ve got to get back now; see you tomorrow.’

Thirty-seventh floor, The Prudential Center Paul Hankins leaned over the credenza in his 37th- floor office in Boston’s Prudential Center office build- ing and admired the beauty of the scene that spread before him. Paul felt as though he was watching an impressionistic painting in motion. Beyond the green treetops and red brick buildings of Boston’s fashion- able Back Bay area, the Charles River wound its way towards Boston Harbor. Paul could see the buildings on the campuses of Harvard, MIT and Boston Uni- versity scattered along both sides of the river. Soon the crew teams would be out practising. Paul loved to watch the precision with which the well-coordinated teams propelled the boats up and down the river. If only, he thought, we could be as coordinated as those crew teams.

Paul had returned to Boston in early 1988 when Gillette created the North Atlantic Group by com- bining what had been the North American and the European operations. Originally from Boston, he had attended Columbia University and earned an MBA at Dartmouth’s Tuck School. He had been with Gillette for 19 years. Prior to 1988, he had served as market- ing director for Gillette Europe from 1983 to 1984, as the country manager for Holland from 1985 to 1986, and finally as manager of Holland and the Scandina- vian countries.

During this 1983–87 period, Paul had worked for Jim Pear, vice president of Gillette Europe, to imple- ment a pan-European strategy. Prior to 1983, Gillette had organised and managed Europe as a classic decentralised market. To meet the perceived cultural nuances within each area, the company had treat- ed each country as a separate market. For example, Gillette offered the same products under a variety of sub-brand names. The company sold its Good News! disposable razors under the name ‘Blue II’ in the Unit- ed Kingdom, ‘Parat’ in Germany, ‘Gillette’ in France and Spain, ‘Radi e Getta’ (shave and throw) in Italy, and ‘Economy’ in other European markets.

C-66 Case 4 • Gillette and the men’s wet-shaving market

Jim Pear believed that in the future Gillette would have to organise across country lines, and he had developed the pan-European idea. He felt that shav- ing was a universal act and that Gillette’s razors were a perfect archetype for a ‘global’ product.

Gillette had launched Contour Plus, the European version of Atra Plus, in 1985/86 and had experienced greater success than the US launch which took place at the same time. The pan-European strategy seemed to be both more efficient and more effective. Colman Mockler, Gillette’s chairman, noticed the European success and asked Pear to come to Boston to head the new North Atlantic Group. Paul had come with him as vice president of marketing for the Shaving and Personal Care Group.

Paul turned from the window as he heard people approaching. Sarah Kale, vice president of marketing research; Brian Mullins, vice president of marketing, Shaving and Personal Care Group; and Scott Fried- man, business director, Blades and Razors, were at his door.

‘Ready for our meeting?’ Scott asked. ‘Sure, come on in. I was just admiring the view.’ ‘The purpose of this meeting,’ Paul began, ‘is to

begin formulating a new strategy for Gillette North Atlantic, specifically for our shaving products. I’m interested in your general thoughts and analysis. I want to begin to identify options and select a strategy to pursue. What have you found out?’

‘Well, here are the market share numbers you asked me to develop,’ Scott observed as he handed each person copies of tables he had produced (see Exhibits 16 and 17). Like Paul, Scott had earned an MBA from the Tuck School and had been with Gillette for 17 years.

‘These are our US share numbers through 1988. As you can see, Atra blades seem to have levelled off and Trac II blades are declining. Disposable razors now account for over 41 per cent of the market, in dollars, and for over 50 per cent of the market in terms of units. In fact, our projections indicate that disposable razors will approach 100 per cent of the market by the mid- to late 1990s given current trends. Although we have 56 per cent of the blade market and 58 per cent of the disposable razor market, our share of the disposable razor market has fallen. Fur- ther, you are aware that every 1 per cent switch from our system razors to our disposable razors represents a loss of US$10 million on the bottom line.’

‘I don’t think any of this should surprise us,’ Sarah Kale interjected. Sarah had joined Gillette after grad- uating from Simmons College in Boston and had been with the firm for 14 years. ‘If you look back over the 1980s, you’ll see that we helped cause this problem.’

‘What do you mean by that?’ asked Paul. ‘Well, as market leader, we never believed that the

use of disposable razors would grow as it has. We went along with the trend, but we kept prices low on our disposable razors, which made profitability worse for both us and our competition because they had to take our price into consideration in setting their prices. Then, to compensate for the impact on our profitability from the growth of the disposable razor market, we were raising the prices on our sys- tem razors. This made disposable razors even more attractive for price-sensitive users and further fuelled the growth of disposable razors. This has occurred despite the fact that our market research shows that men rate system shavers significantly better than dis- posable razors. We find that the weight and balance

Exhibit 16 Gillette market share of dollar sales, 1981–88 (per cent)

Product or category 1981 1982 1983 1984 1985 1986 1987 1988

Atra blades 15.4 17.3 19.4 18.7 20.2 20.9 20.0 20.5 Trac II blades 17.5 16.4 15.2 14.6 14.1 13.5 11.8 11.4 Gillette blades 47.3 48.9 52.1 54.2 55.8 57.1 54.1 56.0 Gillette disposables 14.3 15.4 17.4 20.0 21.1 22.7 22.2 24.0 All disposables 23.0 23.2 27.0 30.6 32.7 34.9 38.5 41.1 Gillette disposables as % of all disposables 67.9 66.9 64.7 65.7 64.6 64.2 57.6 58.4 Gillette razors 50.3 52.5 54.9 58.8 62.2 67.6 64.1 61.0

Source: Prudential-Bache Securities.

Case 4 • Gillette and the men’s wet-shaving market C-67

contributed by the permanent handle used with the cartridge contributes to a better shave.’

‘Yes, but every time I tell someone that,’ Paul add- ed, ‘they just look at me as if they wonder if I really believe that or if it is just Gillette’s party line.’

‘There’s one other thing we’ve done,’ Scott added. ‘Look at this graph of our advertising expenditures in the US over the 1980s [see Exhibit 18]. In fact, in constant 1987 dollars, our advertising spending has fallen from US$61 million in 1975 to about US$15 million in 1987. We seem to have just spent what was left over on advertising. We are now spending about one-half of our advertising on Atra and one-half on Good News!. Tentative plans call for us to increase the share going to Good News!. Our media budget for 1988 was about US$43 million. Further, we’ve tried three or four themes, but we haven’t stuck with any one for very long. We’re using the current theme, “The Essence of Shaving”, for both system and dispos- able products. Our advertising has been about 90 per cent product-based and 10 per cent image-based.’

‘Well, Scott’s right,’ Sarah noted, ‘but although share of voice is important, share of mind is what counts. Our most recent research shows a significant difference in how we are perceived by male consum- ers based on their age. Men over 40 still remember Gillette, despite our reduced advertising, from their

youth. They remember Gillette’s sponsorship of ath- letic events, like the Saturday Baseball Game of the Week and the Cavalcade of Sports. They remember “Look Sharp! Feel Sharp! Be Sharp” and Sharpie the Parrot. They remember their fathers loaning them their Gillette razors when they started shaving. There is still a strong connection between Gillette and the male image of shaving.’

‘How about with younger men?’ asked Brian. Brian had joined Gillette in 1975 after graduating from Washington and Lee University and earning a master’s degree in administration from George Wash- ington University.

‘Younger men’s views can be summed up simply – twin blade, blue and plastic,’ Sarah reported.

‘Just like our disposable razors!’ Paul exclaimed. ‘Precisely,’ Sarah answered. ‘As I say, we’ve done

this to ourselves. We have a “steel” man and “plas- tic” man. In fact, for males between 15 and 19, BIC is better known than Gillette with respect to shav- ing. Younger men in general – those under 30, these “plastic” men – feel all shavers are the same. Older men and system users feel there is a difference.’

‘Yes,’ Paul interjected, ‘and I’ve noticed something else interesting. Look at our logos. We use the Gillette brand name as our corporate name, and the brand name is done in thin, block letters. I’m not sure it has

Exhibit 17 Gillette system cartridges, 1971–88 (dollar share of US blade market)

Source: The Gillette Company; Prudential-Bache Securities.

0

5

71 72 73 74 75 76 77 78

Year

TRAC II

ATRA

79 80 81 82 83 84 85 86 87 88

15

20

25

30

P er

ce n t

sh ar

e

10

C-68 Case 4 • Gillette and the men’s wet-shaving market

the impact and masculine image we want. On top of that, look at these razor packages. We have become so product-focused and brand-manager-driven that we’ve lost focus on the brand name. Our brands look tired: there’s nothing special about our retail packag- ing and display.’

‘Speaking of the male image of shaving, Sarah, what does your research show about our image with women?’ asked Brian.

‘Well, we’ve always had a male focus and women identify the Gillette name with men and shaving, even those who use our products marketed to women. You know that there are more women wet-shavers than men in the US market, about 62 million versus 55 million. However, due to seasonability and lower fre- quency of women’s shaving, the unit volume used by women is only about one-third that of the volume used by men. Women use about eight to 12 blades a year versus 25 to 30 for men. It is still very consistent for us to focus on men.’

‘Well, we’ve got plenty of problems on the mar- keting side, but we also have to remember that we are part of a larger corporation with its own set of prob- lems,’ Brian suggested. ‘We’re only 30 per cent or so of sales but we are 60 per cent of profits. And, given the takeover battles, there is going to be increased pressure on the company to maintain and improve

profitability. That pressure has always been on us, but now it will be more intense. If we want to develop some bold, new strategy, we are going to have to fig- ure out where to get the money to finance it. I’m sure the rest of the corporation will continue to look to us to throw off cash to support diversification.’

‘This can get depressing,’ Paul muttered as he looked back at the window. ‘I can sense the low morale inside the company. People sense the inevita- bility of disposability. We see BIC as the enemy even though it is so much smaller than Gillette. We’ve got to come up with a new strategy. What do you think our options are, Scott?’

‘Well, I think we’re agreed that the “do-nothing” option is out. If we simply continue to do business as usual, we will see the erosion of the shaving mar- ket’s profitability as disposable razors take more and more share. We could accept the transition to dispos- able razors and begin to try to segment the dispos- able razor market based on performance. You might call this the “give up” strategy. We would be admit- ting that disposable razors are the wave of the future. There will obviously continue to be shavers who buy based on price only, but there will also be shavers who will pay more for disposable razors with additional benefits, such as lubricating strips or movable heads. In Italy, for example, we have done a lot of image

Exhibit 18 Blade and razor media spending, United States, 1975–87

75 76

61.4

15.1

(Constant 1987 media dollars)

77 78 79 80 81 82 83 84 85 86 87

Year

0

10

S M

M

20

30

40

50

60

70

Source: The Gillette Company.

Case 4 • Gillette and the men’s wet-shaving market C-69

building and focused on quality. Now, Italian men seem to perceive that our disposable razors have val- ue despite their price. In other words, we could try to protect the category’s profitability by segmenting the market and offering value to those segments willing to pay for it. We would de-emphasise system razors.

‘Or, we could try to turn the whole thing around. We could develop a strategy to slow the growth of disposable razors and to reinvigorate the system razor market.’

‘How does the new razor system fit into all this?’ Paul asked.

‘I’m pleased that we have continued to invest in R&D despite our problems and the takeover battles,’ Brian answered. ‘Reports from R&D indicate that the new shaver is doing well in tests. But it will be expen- sive to take to market and to support with advertising. Further, it doesn’t make any sense to launch it unless it fits in with the broader strategy. For example, if we decide to focus on disposable razors, it makes

no sense to launch a new system razor and devote resources to that.’

‘What’s the consumer testing indicating?’ asked Scott.

‘We’re still conducting tests,’ Sarah answered, ‘but so far the results are very positive. Men rate the shave superior to both Atra or Trac II and superior to our competition. In fact, I think we’ll see that con- sumers rate the new shaver as much as 25 per cent better on average. The independently spring-mount- ed twin blades deliver a better shave, but you know we’ve never introduced a product until it was clearly superior in consumer testing on every dimension.’

‘Okay. Here’s what I’d like to do,’ Paul concluded. ‘I’d like for each of us to devote some time to devel- oping a broad outline of a strategy to present at our next meeting. We’ll try to identify and shape a broad strategy then that we can begin to develop in detail over the next several months. Let’s get together in a week, same time. Thanks for your time.’

References Adams, R. B. Jr, 1978, King Gillette: The Man and His Wonderful Shaving

Device (Boston: Little, Brown). BIC Annual Report, 1989. Caminiti, S., 1989, ‘Gillette gets sharp’, Fortune, 8 May, p. 84. Dewhurst, P., 1981, ‘BICH = BIC’, Made in France International, Spring,

pp. 38–41. Dunkin, A., L. Baum and L. Therrein, 1986, ‘This takeover ar tist

wants to be a makeover artist, too’, Business Week, 1 December, pp. 106, 110.

Dun’s Million Dollar Directory, 1989. Fahey, A. and P. Sloan, 1988, ‘Gillette: $ 80M to rebuild image’,

Advertising Age, 31 October, pp. 1, 62. Fahey, A. and P. Sloan, 1988, ‘Wilkinson cuts in’, Advertising Age,

28 November, p. 48. Fahey, A. and P. Sloan, 1989, ‘Kiam gets some help: Grey sharpens

Remington ads’, Advertising Age, 13 November, p. 94. Gillette Annual Corporate Reports, 1985–88. Hammonds, K., 1987, ‘How Ron Perelman scared Gillette into shape’,

Business Week, 12 October, pp. 40–1. Hammonds, K., 1989, ‘At Gillette disposable is a dirty word’, Business

Week, 29 May, pp. 54–5. Jervey, G., 1984, ‘New blade weapons for Gillette-BIC war’, Advertising

Age, 5 November, pp. 1, 96. Jervey, G., 1985, ‘Gillette and BIC spots taking on sensitive subject’,

Advertising Age, 18 March, p. 53. Jer vey, G., 1985, ‘Gillette, Wilkinson heat up disposable duel’,

Advertising Age, 10 June, p. 12. Kiam V., 1987, ‘Remington’s marketing and manufacturing strategies’,

Management Review, February, pp. 43–5. Kiam V., 1989, ‘Growth strategies at Remington’, Journal of Business

Strategy, January/February, pp. 22–6.

Kummel, C. M. and Klompmaker, J. E., 1980, ‘The Gillette Company – Safety Razor Division’, in D. W. Cravens and C. W. Lamb (eds), Strategic Marketing: Cases and Applications (Homewood, Ill.: Irwin), pp. 324–45.

McGeehan, P., 1988, ‘Gillette sharpens its global strategy’, Advertising Age, 25 April, pp. 2, 93.

Newpor t, J. P., 1988, ‘The stalking of Gillette’, Fortune, 23 May, pp. 99–101.

North American Philips Corporation Annual Report, 1987. Pereira, J., 1988, ‘Gillette’s next-generation blade to seek new edge

in flat market’, The Wall Street Journal, 7 April, p. 34. Raissman, R., 1984, ‘Gillette pitches new throwaway’, Advertising Age,

9 July, p. 12. ‘Razors and blades’, 1989, Consumer Reports, May, pp. 300–4. Rothman, A., 1988, ‘Gillette, in a shift, to emphasize cartridge blades

over disposables’, The Wall Street Journal, 18 November, p. B6. Sacharow, S., 1982, Symbols of Trade (New York: Art Direction Book

Company). Shore, A., 1989, Gillette Report (New York: Shearson Lehman Hutton),

19 October. Shore, A., 1990, Gillette Company Update (New York: Prudential-

Bache Securities), May 18. Sloan, P., 1985, ‘Marschalk brains land Braun’, Advertising Age, 18 March,

p. 53. Sloan, P., 1988, ‘Remington gets the edge on Gillette’, Advertising Age,

16 May, pp. 3, 89. Sutor, R., 1988, ‘Household personal care products’, Financial World,

27 December. The Europa World Year Book 1990, vol. II. Trachtenberg, J. A., 1986, ‘Styling for the masses’, Forbes, 10 March,

pp. 152–3. Warner-Lambert Annual Corporate Report, 1987. Weiss, G., 1986, ‘Razor sharp: Gillette to snap back from a dull

stretch’, Barron’s, 25 August, pp. 15, 37.

C-70

Case 5

Gunns and the greens: Governance issues in Tasmania Dallas Hanson Colin Winkler University of Tasmania University of Tasmania

Introduction Gunns Limited is a listed Australian forestry com- pany that operates in the tourism-oriented island state of Tasmania, 40 degrees south of the equator. In a sluggish economy, Gunns has been a spectacu- lar performer for a decade. In 2001 the share price was $3.50 and in late 2003 it was $13. It is the first Tasmanian company to be worth $1 billion. Despite this success it remains controversial, a target for green activists and a common topic for critical discussion in Tasmanian homes. In September 2003, Gunns was forced by a section of its shareholding to hold an extraordinary general meeting (EGM) to discuss for- estry practices.

This case is about the company and the EGM. The key issues are these: is it possible for a compa- ny operating in a hostile social environment to pres- ent as a good corporate citizen? And, how does such a company best handle a mix of profit-oriented and green-oriented investors? Finally, are its practices sus- tainable? To make sense of these issues requires some background to be explained, and the first sections of the case thus provide a brief description of Tasmania and the ongoing forestry debate. This is followed by a history of Gunns. The EGM is then described and the issues discussed.

Tasmania, the island state, and the forestry debate Tasmania is the smallest Australian state, just 315 kilometres across its greatest width. The middle of the island is mountainous and features scattered lakes and alpine vegetation, while the west faces the Indian Ocean and is rainswept, with much of it covered in impenetrable ‘vertical scrub’. The east coast is much dryer and has golden beaches; the north-west coast has deep soils and a climate suited to vegetable grow- ing and dairying; and the south, and a plain next to the mountains (the midlands), is dry and a wool- growing area that achieves some of the highest prices for fine wool in the world. The government branch of Parks and Wildlife manages 354 reserves covering over one-third of the state, and the Forestry Commis- sion, a state government authority, controls still more. Almost 1.4 million hectares of this is World Heritage listed. In this small place the world traveller can find the equivalents of the burnished hills of southern California, the hills of the grape districts of the South of France, Wordsworthian English countrysides (both his Lake District feel and the mannered and pretty countryside of the green south of England), and the golden beaches that are stereotypically Australian. The variety of vegetation and unique wildlife are the lures that attract tourists.

Case 5 • Gunns and the greens C-71

This is a pleasant land with a temperate climate first settled by Europeans in 1802. The new settlers set about clearing the land for agriculture, displacing the indigenous inhabitants while setting up a wool/ wheat/cattle system modelled on England, complete with hawthorn, oaks, rabbits and much other exotic material. There was a thriving timber industry har- vesting an apparently inexhaustible resource, and successive Tasmania governments sought to attract foreign investment into it.

There were occasional outbursts from conservation-minded people, but the pattern of cutting/burning/clearing continued relatively quietly until 1972 when the post-war transition to hydro- electrification of industry via damming of major rivers collided with the nascent green movement. Damming policy was led by the Hydro Electric Corpo- ration (HEC), at the time a virtual government with- in the government; one long-time post-war premier was popularly known as ‘Electric Eric’. The focus of debate was the damming of the south-west’s Gordon River and flooding of Lake Pedder, a big remote lake with an unusual large, sandy beach. This led to the formation of the United Tasmania Group, the world’s first formal green party.1 In 1976 the debate heated up with another major dam proposal and the formation of the Tasmanian Wilderness Society. A major cam- paign resulted. This was a world event – ‘No dams’ was the cry in big street marches all over Australia, and all levels of government and the High Court of Australia were involved before the HEC was blocked and the Franklin saved. Green debate was by then a staple of café conversation.

Meanwhile, export woodchipping had begun, mainly sourced from ‘charismatic’ old-growth euca- lypts. Yehudi Menuhin, the great violinist and human- ist, said of this: ‘I can’t begin to tell you the beauty of those forests … the forest of Tasmania is yet unsul- lied and unpolluted by our kind of civilization. That we should have to defend them is something quite unbelievable …’2

His sentiments have been shared by a genera- tion of Tasmanians who continue to contribute to an ongoing forestry debate on radio, in newspapers and on the streets. The issue is in the faces of the people of the capital city because the main log-route to the chip- ping place is the highway that passes through the city

centre, past the Treasury building. Every day, scores of trucks go through with apparently excellent build- ing/furniture timber on board in the form of long, solid logs. In 2002, a government-sponsored survey that was part of a ‘Tasmania Together’ process led by the government found that a significant majority of Tasmanians wanted an end to old-growth logging: the opinion crosses conventional political lines.3 The green side of the debate is led by green parliamen- tarians, (there are four in the 25-seat lower house), the Wilderness Society, the Tasmanian Conservation Trust and the Australian Conservation Foundation. On the other side, the government is solidly pro- forestry (it is a conservative union-influenced Labor government), and the pro-forestry Forest Protection Society (and there is no evident intention of irony in the name) is a vocal pressure group.

Gunns: A company with connections The two brothers Gunn started a building business in northern Tasmania in 1877 and soon turned to mill- ing their own timber. They prospered and quickly became leading sawmillers. The industry was reli- ant on ‘crown-logs’, those cut off government land under licence, and Gunns had good access to this resource. The industry grew, as did Gunns, which, in the 1950s, initiated a policy of buying smaller saw- millers, private forests and rights to crown-logs. This process gathered pace after 1970 when it became evi- dent that the supply of crown-logs was limited. From 1982, led by John Gay, Gunns also sought to consoli- date its existing markets and expand into the growing export market for hardwood.

In 1986 the company was floated on the Australian Stock Exchange, with Gay as the CEO. The board at that time included as chairman Peter Wade, CEO of the mining and pulp and paper giant, North Bro- ken Hill; Edmund Rouse, the chair of a northern Tasmanian media firm; Mr Clements of the Tasma- nian firm Clements and Marshall; and two mem- bers from HMA, major investors in Gunns. (In later moves, Wade was replaced by David McQuestin, a Rouse connection, and still later, a former premier, Robin Gray, was appointed.)

C-72 Case 5 • Gunns and the greens

This was an era in which the external environ- ment of Gunns was also undergoing crucial changes, especially politically. Liberal premier Robin Gray called a state election in 1989 only to lose his major- ity. Labor and the Independents (as the greens had been identified) combined to become the Labor Green Accord (LGA) to prevent the Liberals remaining as a minority government. This upset the forest industry, which campaigned for a second election before the LGA could take power. The campaign collapsed when Edmund Rouse was imprisoned for attempting to bribe Labor MP Jim Cox to cross the floor to prevent the LGA from taking power. A Royal Commission also implicated McQuestin (another latter-day board member of Gunns), then managing director of Exam- iner National Television (ENT) of which Rouse was a substantial shareholder.4 McQuestin was cleared of being unlawfully involved as a principal offend- er in Rouse’s bribery charges, though the investiga- tion acknowledged that his acquiescence with Rouse’s direction was highly improper. During the investiga- tion into these bribery charges, it was revealed that the campaign for a second election actually stemmed from Gray’s office, although it was funded by the for- est industry.5

The Labor Green Accord eventually came to power and, in a (failed) endeavour to settle the forest industry–conservation debate, the Forest and Forest Industry Council (FFIC) was established. However, before long, the FFIC shifted ground to become more concerned with preserving the forest industry, and proposed Resource Security legislation that would give the forest industry guaranteed access to the for- ests. At the same time, the publicly owned Forestry Commission became a government business enter- prise, and was given exemption from freedom of information legislation. Labor’s attempt to pass the Resource Security legislation caused the downfall of the LGA coalition because it outraged the greens, and Labor was compelled to call an election in 1991 that returned the Liberals to power under Ray Groom’s premiership.

Meanwhile, Gunns had positioned itself in the early 1990s to undertake the bulk of the seasoned hardwood milling, moulding and veneers in the north and north-west of the state, leaving only a handful of significant, independent, locally-owned family businesses remaining in this sector of the forests

industry in that part of the state. In reaching this posi- tion, the company defended two High Court appeals against the issue of licences to cut timber.

This strategic positioning continued through the late 1990s and beyond, illustrated by Gunns’ buyout of Boral’s Tasmanian woodchipping interests and the acquisition (aided by the ANZ Bank) of North Forest Products – owners of major tree holdings, including a 120 000-hectare tree farm. This saw Gunns become Tasmania’s only woodchipping company, exporting 5.5 million tonnes of woodchips from the state each year. A significant proportion of this came from old-growth forests, including the Styx Valley of the Giants (as it is called by the Wilderness Society) – the location of the world’s tallest flowering eucalypts.

During this time, there was an additional pressure on Gunns and the government over tree plantations. The movement towards turning agricultural land into trees had grown over a decade, and the difficulties of other agricultural practices meant that a growing number of farmers were selling out to tree farmers – and Gunns is the biggest. This annoyed the near- by landowners because of the loss of sun, it annoyed the greens because the tree farms are usually quick- growing species that do not provide a habitat for wildlife, and it annoyed tourism operators because it presents an ugly face to the world with chemical clear- ing of sites before planting and clear felling. Gunns had a direct and highly public dispute over chemi- cal clearing in 2003 that further hindered its public image when an organic farmer near a new Gunns tree farm objected to the land clearing.6

Pressuring the institutional shareholders The opening years of the 21st century saw one of Gunns’ major shareholders, the Commonwealth Bank, targeted by the Wilderness Society, the soci- ety exhorting the bank’s shareholders to pressure its board to use the bank’s shareholding in Gunns (at the time, just over 17 per cent) to force the company to move out of the old-growth forests.

Other Australian banks came under pressure from various quarters, the ANZ Banking Group Ltd indicating that it did not hold a stake in Gunns but did have a banking relationship. Charles Goode, the

Case 5 • Gunns and the greens C-73

chairman of ANZ, said that the bank takes environ- mental issues seriously. ‘We are prepared to enter into dialogue with community groups such as the Wilder- ness Society,’ Mr Goode said. In 2003, the board had a half-day strategy meeting on environmental issues and, as forecast in The Examiner on 14 December 2002, the chairman and some executives visited the Gunns forestry sites in Tasmania in February 2003. Gunns’ managing director, John Gay, contended that the company had issued invitations to all the major banking institutions that had been targeted by the Wilderness Society with what he termed ‘misinfor- mation’.7

(At this point, an indication of the significance of these institutionals and some that follow is necessary: the ANZ, Westpac, Commonwealth and National Australia banks are Australia’s biggest banks, and the AMP and Perpetual Trustees are the major insurance companies in the nation, while Bankers Trust (BT) is a major investment firm.)

Corporate intransigence A group of 100 Gunns Ltd shareholders who opposed the firm’s logging practices took the step of request- ing an EGM of the company in February 2003. The group – coordinated by the Wilderness Society, but including shareholders from outside the society – relied upon the new Corporations Law governing cor- porate regulation in Australia which became effective on 15 July 2001. This scheme provides that the direc- tors of a company must call and arrange to hold a gen- eral meeting on the request of: • members with at least 5 per cent of the votes

that may be cast at the general meeting or • at least 100 members who are entitled to vote at

the general meeting. Gunns Ltd initially refused to hold the special

meeting. Executive chairman John Gay was report- ed as saying that the directors considered the Wilder- ness Society’s demand was not valid under existing regulations, and had decided that convening a special meeting to consider the issues raised by the society would be an inappropriate use of company funds.8 (The company maintained that the special meet- ing sought would cost tens of thousands of dollars.)

The Tasmanian president of the Directors Institute, Gerald Loughran (who had a business in the north of the state), said that legislation to change the 100- person rule to a 5 per cent rule was before the Senate and he hoped it would soon be resolved.9 However, Loughran seemingly ignored the fact that the 100- person rule did apply at the time the request for a meeting was made.

Gunns maintained that the requisition notic- es were invalid, and that the shareholders who had called for an EGM had ‘clearly not abided by the articles of association of the company’, although the company did not given the actual reason that the req- uisition was deemed to be invalid. Executive chair- man John Gay said that because of the Privacy Act he could not say exactly what was wrong with the requisition.10 He objected strongly and the Wilder- ness Society rethought its tactics.

The Wilderness Society then resubmitted a mod- ified resolution calling for an EGM of Gunns Ltd. Campaigner Leanne Minshull indicated that the soci- ety would take the issue to court if Gunns refused to call a meeting a second time. The meeting was duly called.

Extraordinary general meeting, 29 August 2003 In the lead-up to the August EGM at Gunns, helpful corporate professionals entered the fray on the green side: • Fund managers showed the Wilderness Society

how to draft better resolutions. • Lawyers gave pro bono advice on procedural

matters, secondary boycotts and defamation issues.

• Naomi Edwards (retired partner of Deloitte Touche Tohmatsu and former director of Trowbridge Consulting) crunched numbers for the Wilderness Society to back its claim that the company could refrain from logging old-growth forests without losing money.

• An international business strategist used by some of Australia’s biggest companies provided advice on the campaign in Japan. (Most of the Gunns woodchips are exported to Japan

C-74 Case 5 • Gunns and the greens

and China, where they are used in paper production.)

• A 1980s corporate raider gave tips on tactics for dealing with corporations and hosted private lunches in Sydney to put activists in touch with senior executives. Minshull did not ‘name names’, but she con-

firmed meetings with AMP, BT Financial Group, Commonwealth Bank, local and federal government superannuation schemes, National Australia Bank and Perpetual Trustees. Perpetual’s John Sevior said it was the first time he had experienced a campaign of this kind, and that it could be the first of many. ‘The world is getting more determined in a lot of ways,’ he said.11 One of the Sydney fund managers with whom Minshull had talks put up a proposal for a memorandum of understanding between Gunns, the Wilderness Society and institutional investors. Minshull believes that such cooperation is feasible, although the provisos she stipulated were uncompro- mising ‘… as long as the institutions tell Gunns to stop developing clear felling, selectively logging, or accepting product from certain forest areas’.12

The campaign seemed at the time to have had some effect. Westpac-owned BT Financial Group, which has a small undisclosed stake in Gunns, indi- cated its intention to abstain from voting, citing insuf- ficient information on which to make a decision. The financial house said it recognised the sensitive nature of environmental issues, and that it believed there was a lack of adequate data or information on the possible effects of adopting the resolution.13 There was an international dimension to this campaign: as reported in The Age, Minshull indicated that a loose coalition of activist organisations around the world, including Friends of the Earth International, Britain’s WWF (World Wide Fund for Nature), Greenpeace and the Rainforest Action Network, helped on the Gunns campaign by lobbying institutional sharehold- ers in Britain.14

In the end, no one really expected the Wilderness Society to get its way at the EGM. Gunns said that the shareholder activists controlled fewer than 250 000 shares, or about 0.3 per cent of the stock, and Mins- hull conceded that the resolution was unlikely to get anywhere near the 75 per cent needed. Gay accused the environmentalists of wasting shareholders’ money

on what amounted to a protest meeting. ‘That is dis- gusting,’ he said. ‘They conceded they haven’t got a hope in hell but they are taking this company through the pain.’ Gay indicated that there was no prospect of Gunns working with the activists, because the company operates within state laws and Tasmania is a signatory to the 1997 Regional Forest Agreement between the state and federal governments. ‘If I reject- ed (the opportunity) to take some logs, they would just issue them to someone else. They can keep coming but we don’t make the decisions. They are just damaging the shareholders of Gunns and the superannuation funds of Australia by harassing Gunns for a decision that Gunns doesn’t make. That’s how stupid it is.’15

FIAT (the Forest Industries Association of Tas- mania) weighed into the EGM issue by publishing half-page advertisements in all major newspapers, the text of which ran:

NOTICE TO GUNNS SHAREHOLDERS

THE GUNNS EXTRAORDINARY GENERAL MEETING THREATENS THE LIVELIHOOD OF

THOUSANDS OF TASMANIANS EMPLOYED IN OUR SAWMILL AND VENEER INDUSTRIES • Closing down more high-yielding forest will

take away the resource needed to supply our sawmill and veneer industries that add high value to out timber;

• 40% of our forests are already reserved – 4 times the international standard;

• mature timbers that supply our higher- value-adding industries are not available in regrowth or plantation forests;

• less than 1% of old-growth forest has been harvested in the last 5 years.

SUPPORT FOR THE WILDERNESS SOCIETY MOTION IS SUPPORT FOR A LOW-VALUE,

WOODCHIP-DRIVEN FUTURE FOR TASMANIA’S FOREST INDUSTRY

VOTE NO TO PROTECT THOUSANDS OF

TASMANIAN JOBS Forest Industries Association of Tasmania

Source: The Saturday Mercury, 23 August 2003, p. 21.

Case 5 • Gunns and the greens C-75

AMP Henderson indicated that it would vote against the Wilderness Society resolution at the EGM for Gunns to cease accessing logged old-growth forest timber from the so-called Tasmania Together region under Tasmania’s Regional Forest Agreement. AMP’s substantial shareholder notice in June 2003 stated that it owned 7.2 per cent of Gunns shares on issue. AMP Henderson’s chief investment officer, Merv Peacock, said that AMP had long discussions with a range of parties, including Gunns and Forestry Tasmania. He concluded that the resolution would have a material negative impact on the company’s profits and believed that the impact would be greater than that contained in analysis by actuary and Gunns shareholder, Naomi Edwards.16

Overall, a trend towards an ‘abstain’ or ‘against’ vote at the EGM emerged, as institutional sharehold- ers balanced the risk of a consumer backlash with their fiduciary obligation to investors. UniSuper, the univer- sity employees’ superannuation fund, announced that it would abstain, saying that a vote was ‘premature’,17 and the large Commonwealth government employee fund, PSS/CSS, decided to vote against the resolution. Perpetual Trustees and Colonial First State would not disclose their voting intentions, and the SIRIS Proxy Voting Service also declined to say how it advised its clients to vote at the meeting. No institutional share- holder went on record as supporting the Wilderness Society-led resolution. Dean Paatsch, director of SIRIS Governance Services Unit, said his consider- ations varied depending on whether the client had an environmental policy as part of its investment pro- cess. Paatsch said he believed that most institutions would abstain because of their concern for ‘reputa- tion risk’.

The lead-up to the EGM drew in crusading con- tributions from both sides of the debate, highlighted by the Wilderness Society’s own advertisements under the headline:

Tell Gunns to stop logging our oldgrowth forests

Join us outside the Gunns special meeting on oldgrowth

Source: The Examiner, 23 August 2003, p. 37.

The press also carried letters covering aspects of the situation. The following extracts from The Examiner on 24 August are representative of the range of the debate:

Woodchips on a platter Those who see Paul Lennon as a hard man should have a look at his Forest Practices Amendment Bill 2003, currently before Parliament.

For the third time since 1998, the Forest Practices Board is being given an amnesty for any previous violations of planning regulations and its own rules regarding them.

As in FPA Amendment 48 of 1998, there is a bonus on top of forgiveness … the FPB has been empowered to overrule the state’s premier appel- late planning body, the Resource Management and Planning Appeals Tribunal, when that body has found forestry to be inappropriate.

Forest system is world class Tasmania’s Regional Forest Agreement is fast approaching its sixth anniversary.

This 20-year vision for our forests established a comprehensive, adequate and representative reserve system … it is a pity that green activists, who are a small group, refuse to accept (the) massive conservation gains from this landmark agreement.

The campaign also included Timber Communi- ties Australia’s half-page advertisements in major newspapers on 27 August under the banner:

We are all proud members of Tasmania’s forest

industry family. Our forest industry supports

one in every 20 Tasmanian jobs

C-76 Case 5 • Gunns and the greens

These advertisements, such as that in The Exam- iner on 27 August 2003, bore testimonials from a variety of ‘typical Tasmanians’ whose jobs in some way depended on the forest industry. On the day of the EGM itself, a large ‘open letter’ on behalf of 3000 employees and contractors of Gunns was published in The Examiner calling on Gunns’ board to reject out- right the motion requiring the company ‘to ban pro- cessing of timber from a significant portion of Tasma- nia’s multiple use forests’.

The day before the EGM, Gunns released the com- pany’s financial results, announcing its record $74 million after-tax profit for 2002/03. The 39 per cent profit increase was a result of strong demand across each of the company’s key markets. Total group turn- over rose by 17 per cent to $610 million, with oper- ating cash flow also up 17 per cent to $104 million.

The meeting: Green fizzer and fountain of commercial rationality? The EGM was held at 10 a.m. on 29 August at 110 Lindsay Street in Launceston, a city of about 60 000 people. More than 200 pro- and anti-logging dem- onstrators gathered outside Gunns’ offices, and log trucks lined the street in a show of strength for the industry. The resolution called on Gunns not to source any timber from the ‘Tasmania Together’ forests, which include the Styx, Tarkine, Great Western Tiers, Southern Forests, Tasman Peninsula, North-East Highlands, Eastern Tiers and proposed extensions to the Ben Lomond National Park.18 The Wilderness Society had encouraged shareholders to attend the EGM and vote for the resolution, had sought proxy voting rights, and, in the lead-up to the EGM, had run stalls outside many Commonwealth Banks pro- viding information and pro forma letters for people to send to the bank.

Some 20 speakers addressed the 90-minute meet- ing, and shareholders voted overwhelmingly against

the resolution calling for Gunns to withdraw from 240 000 hectares of old-growth forest, the resolution being lost by 54.8 million to 248 000 votes. Institutions representing some 1.5 million votes abstained.19 Gay said the vote demonstrated clear support for the board. ‘This whole action was nothing more than a publicity stunt by the Wilderness Society, staged for political purposes in a futile attempt to attack a well- performing and legitimate Tasmanian business.’20 The resolution was easily defeated with 98 per cent of votes against. But most disappointing for green groups and activists was that only 2.6 per cent of voters abstained – the usual form of protest for insti- tutional investors. So, Perpetual with 10.17 per cent, the Commonwealth Bank with 8.6 per cent, and AMP with 7.21 per cent were effectively saying they were in favour of logging old-growth forests – a stance that could cause them some grief at their coming annual meetings given the high level of activism on the issue. Despite always having the numbers, John Gay didn’t want too much debate from the floor. At one point he told the Wilderness Society’s Leanne Minshull to ‘sit down, young lady’.21

What does the future hold for Gunns? There are some recurring themes in Tasmanian pol- itics, the latest one of significance being that of a world-class pulp mill to value add the woodchip resource. There was a strong sense of déjà vu about the revelation in June 2003 that Gay and then Deputy Premier (now Premier) Lennon (the chief government supporter of forestry industry) discussed the possi- bility of a pulp mill. Lennon maintained that there was no pulp mill proposal before the government and that such a mill was only one of several downstream processing options discussed with Gay, who him- self said that while he would like to see a pulp mill established in Tasmania, it would require a financial investment of an order of magnitude possibly beyond Gunns’ resources.

Case 5 • Gunns and the greens C-77

The company is still beset by campaigners. It does not seem to be able to appear as a good corporate citizen despite its financial success and despite the failure of the greens at the EGM. The paper of record on 14 November 2003 displays the problem: sharing the front page were Lennon putting forward a pulp mill and guaranteeing Gunns ‘front running’, and ‘Hector the Protector’, a forest activist who has decid- ed to go to gaol for 51 days rather than pay a $5000 fine for perching in a tree for 12 days in protest at log- ging. Hector (his standard name is Smith) was accom- panied at court by a noisy band of placard-holding protesters. Perhaps Gunns must face the reality that a forestry firm, despite being law-abiding and popular

with the institutional shareholders and government, cannot please the majority of the people. It is well protected by legislation that guarantees access to the critical wood resource and has a dedicated workforce, but it would be nice to be well regarded. And will the institutional investors continue to support it? The next phase of activism will not be targeted at Gunns but at its investors. How much heat will a bank take for the sake of what is, for it, a minor investment? Is a concession to green thinking required? But, is that enough? The green agenda is not about compromise but full achievement of goals; compromise is for poli- ticians and corporations. Sustainability of forests in Tasmania is a hot issue without clear winners so far.

References Australian Society of Archivists, 2003, ‘North Broken Hill Ltd (1912–

1988)’, Guide to Australian Business Records, www.archivists.org. Burbury, S. C., 1945, ‘Investigation into alleged irregularities in the

Forestry Depar tment, in Tasmania, 1944–1945, Journals and Printed Papers of the Parliament of Tasmania, 133(20).

Gee, H., 2001, For the Forests (Hobart: The Wilderness Society). Graeme-Evans, A., 1995, Against the Odds: Risbys – Tasmanian Timber

Pioneers 1826-1995 (Hobart: Tasbook Publishers). Kessell, S. L., 1944, ‘Preliminary repor t on the forests and forestry

administration of Tasmania, in Tasmania, 1944–1945’, Journals and Printed Papers of the Parliament of Tasmania, 131(45).

Kessell, S. L., 1945, ‘Report on the forests and forestry administration of Tasmania, in Tasmania, 1944–1945’, Journals and Printed Papers of the Parliament of Tasmania, 132(42).

Lyons, B., 1998, All Gunns Blazing: J. & T. Gunn and the Development of Launceston, 1871–1997 (Launceston: self-published). (The background material in this case study owes much to this source, quite apart from the attributions in specific references.)

Perrin, G. S., 1898, ‘Forests of Tasmania: Their conservation and future management’, PP 48/1898. (An earlier report by Perrin on ‘The systematic conservation of the woods and forests of Tasmania’ is known to draw attention to the need for more positive forestry activity; however the whereabouts of this report are unknown.)

Pritchett, S., 2001, ‘Environmentalism, politicians, Gunns and money’, 1 September, www.aushomepage.com.au.

Rodway, L., 1898–99; ‘Forestry for Tasmania’, in Papers and Proceedings of the Royal Society of Tasmania.

Steane, S. W., 1947, ‘The evolution of state forest policy and administration up to 1947’ (a study by a former Conservator of Forests, in the official records of Forestry Tasmania, File No. 9633).

Tasmania, 1945–46, ‘Report (Parts I and II) of the Royal Commissioner on Forestry Administration’, Journals and Printed Papers of the Parliament of Tasmania, 133(39).

Tasmania, 1946, ‘Repor t (Par ts III, IV, V, and VI) of the Royal Commissioner on Forestry Administration’, Journals and Printed Papers of the Parliament of Tasmania, 135(1).

Tasmania Together, 2002 (Hobart: Tasmanian Government Printer). Walsh, M., 2003, ‘AMP to vote no at Gunns EGM’, 27 August, www.

ethicalinvestor.com.au. Wettenhall, R. L., 1968, A Guide to Tasmanian Government Administration

(Hobart: Platypus Press).

Media reference sources ABC Online Australian Financial Review The Advocate The Age The Examiner The Mercury The Saturday Mercury The Sunday Examiner

Notes 1 H. Gee, 2001, For the Forests (Hobar t: The Wilderness

Society). 2 Ibid. 3 Tasmania Together, 2002 (Hobar t: Tasmanian Government

Printer). 4 S. Pritchett, 2001, ‘Environmentalism, politicians, Gunns and

money’, 1 September 2003, www.aushomepage.com.au. 5 Ibid.

C-78 Case 5 • Gunns and the greens

6 www.wilderness.org.au. 7 The Sunday Examiner, 15 December 2002. 8 The Examiner, 19 March 2003. 9 The Advocate, 25 February 2003. 10 The Mercury, 20 March 2003. 11 The Age, 23 August 2003, ‘Business’, p. 1. 12 Ibid. 13 Ibid.

14 Ibid. 15 Ibid. 16 www.ethicalinvestor.com.au. 17 www.investordaily.com. 18 The Age, 30 August 2003, ‘Business’, p. 2. 19 Ibid. 20 The Saturday Mercury, 30 August 2003, p. 9. 21 The Australian Financial Review, 1 September 2003, p. 44.

C-79

Case 6

Growth at Hubbard’s Foods?* Jodyanne Kirkwood Diane Ruwhiu University of Otago University of Otago

Dick Hubbard paused for a minute from the notes he was writing for his company newsletter to reflect on the recent changes he had initiated in the com- pany. He thought back to the early days of the busi- ness, when he did everything in the company single- handedly, including making the breakfast cereals. He looked out into the company car park and saw that it was almost full. He suddenly realised he was respon- sible for the livelihoods of many people other than himself. Should he take the next step and expand the company further? Dick contemplated the various scenarios and considered what they would mean for his business …

Background Hubbard’s produces a range of 23 breakfast cereals that are targeted towards the mid–high price ranges in the cereal market. A recent extension to the prod- uct range was an organic muesli that is in the very high price range. Hubbard’s cereals are distinctive due to their use of New Zealand and tropical fruits and using fruit flavouring to bake the cereals in. Exhibit 1 provides a schematic that represents the elements that influence its operation. For a full description of

manufacturing processes and the supply chain, see the appendix.

Products Hubbard’s products are aimed at both the high price range and low end of the cereal market. The high- end products have such innovative names as ‘Berry Berry Nice’ and ‘Yours Fruitfully’ (refer to Exhibit 2 for ingredient lists). While the main output from the operation is high-quality cereals under the Hubbard’s brand, the company also manufactures some product lines for a range of supermarket private labels. These private labels are typically at the lower end of the price range for cereal, such as rice puffs and cornflakes.

Demand for breakfast cereal products has a slight seasonal variation. In summer months, consumption is approximately 10 per cent higher than in win- ter months. The breakfast cereal industry has been undergoing rapid change in the past two or three years, including an increase in the muesli-style cereals that Hubbard’s popularised, an increase in supermar- ket own brands, as well as the huge growth in cereal bars and muesli bars (which Hubbard’s does not produce). Exact growth figures are not available as

* An earlier version of this case was presented at the North American Case Research Association conference in Banff, Canada, 3–5 October 2002. This case is part of a series of cases on Hubbard’s Foods. Refer to the reference list for full details of published cases in the series.

C-80 Case 6 • Growth at Hubbard’s Foods?

the cereal industry is highly competitive. In 2000/01, Hubbard’s exported 14.4 per cent of its production, mainly to Australia, but a small amount was exported to the United Kingdom, Singapore and Hong Kong. Financial information for the company is shown in Exhibit 3.

Competitors Hubbard’s has an 18.5 per cent share of the cereal market in New Zealand, which makes them the third- largest player in the market. (Exact market share for the competitors is not known.) There are three strong direct competitors to Hubbard’s in the New Zealand market: Sanitarium, Uncle Tobys and Kellogg’s.

Sanitarium is a New Zealand-owned company that is located in a nearby suburb of Auckland. If either Sanatarium or Hubbard’s runs out of an ingre- dient, the other will supply it if they have it available. A Seventh Day Adventist baker, whose philosophies were strong on healthy living and vegetarianism, started Sanitarium Health Foods over 100 years ago. Sanitarium continues to market their cereals using these philosophies, and has quite a strong focus on sponsoring events and charities, as well as promot- ing healthy living. Sanitarium’s main breakfast cereal products are Weetbix and Cornflakes, and they have entered the cereal bar market as well as the breakfast- in-a-drink market.

Uncle Tobys is part of the Goodman Fielder chain, which is Australasia’s largest food manufacturer, employing around 16 000 people. Goodman Fielder produces such food items as bread, potato crisps,

sauces and baking products. The Uncle Tobys brand specialises in breakfast cereals and has a strong pres- ence in the cereal bar market. Cereal products include Weeties and Fruit Feast.

Kellogg’s is an international brand that was estab- lished in Australia in the 1920s. Products were export- ed from the Australian factory to New Zealand, and Kellogg’s has a strong influence in the New Zealand market with brands such as Coco Pops, Nutri-Grain and Special K. Kellogg’s employs around 485 people in Australia and New Zealand, and also has a pres- ence in the cereal bar market.

There is also an increasing trend in New Zealand for individual supermarkets to have their own ‘no frills’ or ‘budget’ brands which are also in competi- tion with Hubbard’s. However, the Hubbard’s brand generally does not compete with this sector of the market, although it has recently launched a cornflake product under the Hubbard’s brand name. The mid- range segment of the market is not an area the com- pany has chosen to target.

Business start-up From humble beginnings, Dick has created a success- ful business. After being turned down for a scholar- ship to Massey University, he self-financed his degree. Dick then worked as a food technologist for many years, gaining valuable experience managing a tropi- cal fruit factory in Niue for three years. On his return to New Zealand, he was appointed general manager of a local food manufacturer. He also went on a team- work and confidence building course called Outward

Exhibit 1 New Zealand business environment

Economy

LocationTechnology Political/regulatory

Suppliers

Cereal industry Customers

Inputs: ingredients, equipment, staff, office equipment

Manufacturing processes, research and development

Outputs: cereal products

Hubbard's Foods Ltd

Case 6 • Growth at Hubbard’s Foods? C-81

Bound, which Dick attributes with having assisted him immensely, and he lists the completion of the course as one of his life successes.

After several years of contemplating what to do with his life, Dick decided to start his own business. The company was started in 1988 with the grand total of four employees, under the name Winner Foods, changing its name to Hubbard’s two years later. During the early years of start-up and growth the company

experienced tough times and at one stage was within three weeks of going into receivership. Dick had to take the drastic action of asking his employees to go home on an extended holiday because he could not afford to pay them. He also made changes in his own life – for example, on occasion he walked to work to save petrol.

Those early days of hardship have not been for- gotten and Hubbard’s is managed under principles of

Exhibit 2 Examples of Hubbard’s products

Product name Description of product Ingredients

‘Berry Berry Nice’ ‘This toasted muesli is full of berry flavour – because the oats and other muesli ingredients are all soaked in berry juice before they are baked. Freeze-dried strawberries and blackberries, as well as yoghurt coated raisins complete the distinctly Hubbard’s finishing touch.’

rolled oats, raspberry juice, honey, brown sugar, vegetable oil, yoghurt raisins (yoghurt powder, raisins), freeze dried strawberry pieces, freeze dried blackberries, sesame seed, coconut, salt, natural berryfruit flavour.

‘Yours Fruitfully’ ‘This natural muesli combines the grains, nuts and seeds you would expect with some distinctly New Zealand fruits – the kiwi and the apricot. YCR’s, hazelnuts and oatbran “sticks” give Yours Fruitfully a distinctly different taste, that has certainly won favour.’

rolled oats, flaked wheat, raisins, apricot nuggets, brown sugar, oatbran, honey, wheatgerm, yoghurt coated raisins (raisins, vegetable fat, yoghurt powder, sugar, milk powder, lecithin), coconut, sunflower seeds, hazelnuts, skim milk powder, sesame seeds, soya oil, freeze dried kiwifruit.

Source: www.hubbards.co.nz.

Exhibit 3 Financial information, 1998–2001

April 1998 – March 1999

April 1999 – March 2000

April 2000 – March 2001

Sales $21 297 245 $22 686 163 $24 321 789 Sales increase on previous year 23.05% 6.5% 7.2% Export sales as % of total sales 7.7% 9.6% 14.4% Net profit before tax $608 829 $1 029 210 $978 052 Return on shareholders’ funds – after tax 10.26% 20.32% 17.12% Staff profit share paid N/A N/A $94 172 Company tax paid $240 114 $316 021 $249 373 Hubbard’s Foods market share 17.4% 18.1% 18.5%

Source: Triple Bottom Line (TBL) report, 2000/01.

C-82 Case 6 • Growth at Hubbard’s Foods?

minimum waste and minimum fuss; there is very little excess at Hubbard’s, with no expensive furniture or company car fleets to be seen. Dick firmly believes the early sacrifices made by him and his employees helped the company to get established.

The business did falter for some time as Dick diversified into roasting nuts and making items for bulk bins in supermarkets. The decision to diversi- fy further into a broader product range was made in order to generate some cash flow. An oat bran muesli was launched as an in-house supermarket brand and was very successful. Dick used this foundation, as well as the extensive knowledge gained of the cereal markets, to launch his own brand.

Business growth By 1993, the business was growing quickly and Dick realised he had to make changes to the way he man- aged the company. Until this time, he had managed it by himself, including tasks such as human resources management, purchasing, marketing and quality management. To address the changing situation and to alleviate some of the day-to-day administrative decision making required by him, he employed an assistant and additional office staff to help him man- age the business.

As a direct result of the strong growth in demand, decisions were made about the original factory, as it became too small. A new factory in Mangere, Auck- land was purpose built for Hubbard’s. Mangere is on the outskirts of Auckland in a low-income, high- unemployment area where the population is largely made up of Maori and Pacific Islanders. This larger

factory operates 24 hours a day, five days a week, and in busy times it operates seven days a week. Now the factory is working to almost 100 per cent capacity and is again becoming too small for the growing company.

Since Dick established the company, it has grown steadily in staff numbers. The company is now out- growing the definition of a small–medium enterprise (SME), which in New Zealand is a company that employs fewer than 100 employees. Hubbard’s now employs approximately 120 staff at any one time.

In response to the positive growth of the company, Dick and his wife Diana, who were the company’s owners, appointed a new formal board of directors in 2001. A primary reason behind this move was to ensure that all stakeholder interests were being con- sidered in the company’s growth and the recognition of the increasing number of stakeholders’ livelihoods involved.

This has been a total shift for Hubbard’s, from Dick operating in an owner/CEO role, to a new struc- ture which gives some of the decision-making respon- sibility and strategy development to a high-level board of directors. Dick will remain as CEO of Hubbard’s. The board consists of six members, and to help main- tain an objective and effective influence, a profes- sional company director chairs the board. Exhibit 4 shows the membership of the board.

Company philosophies and vision Dick believes there are a number of key stakeholders who have an interest in the business, including

Exhibit 4 Hubbard’s board of directors

Source: TBL report, 2000/01.

Dick Hubbard CEO

Diana Hubbard Wife of CEO

Hubbard’s operations manager

Hubbard’s marketing manager

Former CEO of Watties Ltd

Professional director

Case 6 • Growth at Hubbard’s Foods? C-83

shareholders (Dick and Diana), employees, custom- ers, suppliers and the community. He has a strong vision for the business that bears his name and uses a food metaphor to outline their aim in the Triple Bot- tom Line (TBL)1 report, which is to ‘provide suste- nance for the “mind, body and soul”’ of everyone who has contact with the company (TBL report, 2000/01). This simple statement exemplifies Hubbard’s commit- ment to being a socially responsible organisation.

Dick has a distinctive and simple no-nonsense style of management. Before entering the premises, you notice a large sign in front of the main doors. It states:

‘This is a “no nonsense” management zone. No management excesses, corporate ego trips, committee decisions, inter-company memos, buck passing, back stabbing, or any other dubious management decisions allowed on these premises.’

An illustration of Dick’s no-nonsense approach to managing staff has become folklore at Hubbard’s. The story is told of how one employee told Dick she was intimidated by him wearing a tie. Dick immediately took off the tie and cut it up. The tie is now framed in the offices at Hubbard’s and is a strong visual state- ment of Dick’s commitment to his philosophy of man- agement.

Dick makes an effort to ensure that he provides a family culture at the factory. This works well for the business as the majority of staff at Hubbard’s are Pacific Islanders, and a significant aspect of many Pacific Island cultures is based around the importance of the family. Therefore, Dick’s management style offers an extension of a family atmosphere into the workplace. Along similar lines, there is no documented manage-

ment structure at Hubbard’s, illustrating his philoso- phy of a non-hierarchical business.

Many of the manufacturing processes at Hub- bard’s are manual, such as mixing of cereals. In con- trast, a number of the larger competitors manufac- ture cereal in a more equipment-intensive manner than Hubbard’s and therefore tend to have a much lower staffing ratio. However, Dick believes in cre- ating employment and will not replace people with machinery unless absolutely necessary.

Key stakeholders

Employees Staff are a vital stakeholder in the business. Dick sums up his philosophy to staff as being ‘based around the concept of “a group of people”. As such, our people within the company are to be treated with respect, dignity and an over-riding acknowledgement that, first and foremost, they are people’ (TBL report, 2000/01). Exhibit 5 outlines figures regarding staff and remuneration.

Dick fosters an atmosphere of camaraderie among employees and management. He encourages open communication and allows for all staff (including himself) to be on a first-name basis with each other. A particularly informal approach to communication allows Dick to practise a hands-on approach to man- agement by meeting with employees once every three months. Ten employees at a time visit his office for a lunch of takeaways to discuss what is happening in the factory. Also, all managers are expected to be in the factory on a regular basis, and every six months spend an entire shift on the factory floor.

Exhibit 5 Employee information

April 2000 – March 2001

Number of souls on board (employees) 116 Remuneration $3 969 603 Average remuneration $31 820 Profit share paid out $94 172 Staff employed from WINZ (Work and Income New Zealand) or employment courses 17 of the 30 new employees

(57% of new employees) Production personnel 4.65 staff/$million turnover

Source: TBL report, 2000/01.

C-84 Case 6 • Growth at Hubbard’s Foods?

The company experiences very little absentee- ism and staff turnover is low. This may be indicative of the way employees embrace and show commit- ment to Dick’s management philosophy. He strong- ly believes this approach to running his business is going to become more popular as employees look beyond pay rates. Increasingly, potential employees are taking into account the culture of the company in their employment decision.

Dick believes in sharing his company’s suc- cess with his employees and achieves this by taking employees on trips. Dick is well known for taking all 100 Hubbard’s staff to Samoa, in the South Pacific, for a long weekend in 1998. At a total cost of approxi- mately $170 000, Dick chartered a plane to celebrate Hubbard’s 10-year anniversary. The trip was a trib- ute to the Pacific Island workforce’s culture and heri- tage. This added to the family culture at Hubbard’s, as many of the employees had not been back to their homeland for years. In subsequent years, other trips have occurred within New Zealand. In 2000, Dick and the entire staff met the prime minister, Helen Clark, to celebrate 10 years of the Hubbard’s brand being in business. Exhibit 6 shows the trips taken by staff over the past few years.

Recently the company has implemented a profit- sharing scheme for employees. The scheme distributes 10 per cent of Hubbard’s pre-tax profit as a ‘dividend’ to employees every six months. This profit-sharing scheme works according to a formula that is based entirely on length of service. There is absolutely no

recognition made of seniority or existing salary/wage rates.

One staff member’s story is illustrated below:

I came to Hubbard’s as a storeman starting rate $9

an hour – I thought, pardon not another one! As I

was picking orders I came across orders saying NO

CHARGE. This surprised me because I have been

a storeman a long time and never come across NO

CHARGE – always money wanted.

One day Dick was in the storeroom so I

approached Dick and I said, ‘Some of the orders

say NO CHARGE.’

He says, ‘Yes.’

‘How do you make money?’ I said.

He said ‘Son’ and touched my arm and told

me he believed that a company needs to make a

profit but he also believes in giving some – you

will reap plenty. He really believes in giving and

sharing. It really touched me. All my life as a

worker I just came to make money. That point was

a turning point. Before Dick talked to me I felt

cheated because I felt I should earn more. Now I

am motivated to work hard. I learned to succeed

you have to go the extra mile.

Now I am deputy supervisor.

Staff at Hubbard’s are paid a relatively mid- range rate of pay, and this is almost entirely due to Dick’s desire to be socially responsible. Dick prefers to hire the long-term unemployed and works with the Work and Income New Zealand offices to create

Exhibit 6 Staff trips taken by Hubbard’s

1997: Day trip to Rotorua

1998: Long weekend to Samoa

1999: Day trip to Rotorua

2000: Day trip to Waingaro Hot Springs

Source: TBL report, 2000/01.

Case 6 • Growth at Hubbard’s Foods? C-85

employment. The staff survey results show employees’ levels of satisfaction with a range of issues regarding their employment. Exhibit 7 reports on two of these issues.

Dick has consistently built a culture around caring for others, creating employment and being socially responsible, in addition to the more usual financial results. However, his philosophy on creating employ- ment has created some problems. In 2000, an indus- trial dispute arose that led to a picket over wage and meal allowances. This dispute was partially due to pay rates. This industrial issue was resolved quick- ly by increasing pay and allowances, and through increased communication between management, the union and employees.

Shareholders Although focusing on being a socially responsible company, financial success is vital to Hubbard’s con- tinuing success. Dick realises that in order to main- tain employment levels and achieve his broader social goals, the company must be financially viable. The company is founded on Dick’s vision, combined with commitment and loyalty from employees. There is great importance placed on running the company in a fiscally appropriate and responsible manner. The success and growth of the company has required

financial discipline and sound profitability. Dick believes this to be important and puts considerable emphasis on appropriate management practices to ensure positive growth for the company. Decision making at Hubbard’s combines both a human- centred and economic approach to ensure an appro- priate degree of profitability is maintained to allow for all stakeholder interests to be looked after.

Community Dick also believes in sharing his financial success with those outside the company. For over 10 years, Hub- bard’s has supported Outward Bound, the outdoor pursuits organisation. A donation of 50 cents from every packet of the ‘Outward Bound’ cereal sold is made to Outward Bound. This results in a donation of in excess of $100 000 per year, and stems from Dick’s personal experience of going on an Outward Bound course. Other sponsorships include World Vision’s Kids for Kids concert, which is a children’s charity that benefited by $21 000 from Hubbard’s in 2001. Other local community projects with schools include support for local high schools of cash scholar- ships and motivational prizes ($5000). A donation of $5000 was also made to the New Zealand Businesses for Social Responsibility, and $1500 was provided for a student scholarship.

Exhibit 7 Staff satisfaction survey results

Source: TBL report, 2000/01, as at March 2001.

% o

f r es

p o

n d en

ts

Very badly

Badly Okay

How Hubbard's rates

(a) Remuneration

Good Very good

0

10

20

30

40

50

% o

f r es

p o

n d en

ts

Very badly

Badly Okay

How Hubbard's rates

(b) Job training

Good Very good

0

5

10

15

20

25

30

35

C-86 Case 6 • Growth at Hubbard’s Foods?

In addition to sharing his financial success, Dick is very open to sharing his story with others. His back- ground shows hardship, and New Zealanders enjoy hearing about his rise from being a micro-business into one of the most famous companies and business- men in New Zealand. Dick was also invited by the government to help direct New Zealand businesses towards the future. He is an inspiration to people starting their own business and is undoubtedly a role model for many people.

Hubbard’s has also reported on another fac- tor in their Triple Bottom Line report: ‘influencing’. Hubbard’s does this by producing the Clipboard newsletter (refer to Exhibit 8). In order to promote social responsibility by businesses, Dick founded the New Zealand Business for Social Responsibility (NZBSR) in 1998, and membership has now risen to 180 members.

The company is a member of the New Zea- land Business Council for Sustainable Development (NZBCSD) and Dick is on its executive board. The NZBCSD is a branch of the World Business Council for Sustainable Development, and exists to promote the concept of sustainable development within New

Zealand. Hubbard’s follows a campaign of reduc- ing or eliminating waste, informing and educating customers, and producing innovative products that conform to the precepts of sustainable development. Hubbard’s currently recycles paper and cardboard, plastic shrink wrap which comes on inward pallet, aluminium and plastic containers, raw material con- tainers and toner cartridges.

Customers Traditionally, Hubbard’s has not utilised any forms of advertising, other than the newsletter, which is included in each cereal box. Dick is realistic and does not try to pretend that the business is 100 per cent trouble-free, and wrote about the past labour dispute. The Clipboard enables customers to feel they know Dick, his family and even his dog.

Hubbard’s has never believed in heavy adver- tising for brand or products. This was not merely a cost-saving measure, but evidence of Dick’s personal philosophy regarding the social ‘pollution’ caused by too much advertising. He preferred to create goodwill and public knowledge of his products through word- of-mouth and his many ‘good deeds’ of corporate

Exhibit 8

Case 6 • Growth at Hubbard’s Foods? C-87

responsibility that appeared regularly in national headlines. This exposure is extremely valuable to the company and the vast majority of the articles show the company in a very positive light.

In recent times, however, Dick has released lim- ited advertising, which uses the following guidelines that have been presented in the Triple Bottom Line report.

Our advertising will be aimed to inform and not to create unrealistic or irrelevant images.

Our advertising will not play on anyone’s con- science, fear, weakness or worries.

We will not advertise directly to children and we will not invoke ‘pester-power’.

Our advertising will not use ‘continual repetition’, or ‘irritation’ as a technique.

Our advertising will not promote the concept of ‘instant gratification’ or ‘instant fix’.

Our advertising will not denigrate our opposition and we will not undertake ‘comparative advertising’ as seen in the USA and now in Australia.

Our advertising will respect your values and we recognise that they could be different to ours.

We will spend consumers’ money wisely and responsibly.

Source: TBL report.

By keeping customers informed (via the Clipboard) and doing what they say they will do, Hubbard’s has developed and maintained a good relationship with customers. The company is not afraid to publish complaints from customers, and operates as an honest and socially responsible company with regard to customers.

The future? Until now, Hubbard’s has grown with Dick as a hands- on owner and CEO, while maintaining his strong desire to operate his company in a socially responsible way. The result of this socially responsible stance is a company that is highly respected in New Zealand as

well as being profitable. The question Dick now faces is whether he should expand the business further and capture some of the untapped markets he is sure are out there. Dick now has to weigh up the positives and negatives associated with growing his business.

Note 1 Triple bottom line reporting aims to extend traditional company

repor ting, which focused on financial information, to a more inclusive reporting system, which adds people and the environment to the report.

Appendix: Manufacturing processes Many of the manufacturing processes are manual, with mixing of cereals with fruit being done by hand. Dick acknowledges the company is falling behind on the information technology front and will be invest- ing a substantial amount of money into this in the near future. The production process has become more complicated, because of the large number of products and various packaging requirements. One generic product may need to be packaged in six different ways for each customer.

Work flow The factory has expanded as new technology has been implemented. A production line approach was not working, so machines have been separated and redesigned. One product may require to work on Machines A, D, G and H, and another product may require D, F, J and S. This means there is no standard flow through the factory and can mean that work in process backs up behind machinery while waiting for spare capacity. This also causes problems for the pro- duction planner and scheduler.

Schedules Schedules are based on sales reports from which trends are able to be gauged. Twelve monthly sales analyses are viewed, and seasonal patterns are taken into account. Some areas such as Invercargill (situ- ated in the lower South Island) experience a much

C-88 Case 6 • Growth at Hubbard’s Foods?

greater drop in sales in winter (up to 50 per cent) than Auckland does, so the market is very much depen- dent on climate. However, a seasonal pattern also emerges because of the Christmas shutdown of many companies in New Zealand. Therefore, many of Hub- bard’s customers purchase large volumes of product in December, resulting in low January sales.

Purchasing Purchasing is the responsibility of one staff member and is integrated with production planning, so all pro- cesses are operating with the same information and targets. It is considered to be a strategic activity and a recent analysis was conducted to ensure that the com- pany is providing adequate resources and support to purchasing. The purchasing decision is facilitated by regular stocktakes and visual observation, which is common practice for a business of this size. Approxi- mately six weeks’ supply of raw materials is stored in the on-site warehouse, totalling almost NZ$3 million in value.

The types of orders range from bulk to small- sized orders. The bulk orders are for common ingre- dients, such as sugar or oats where the average order equates to 1000 tonnes. Bulk orders also tend to have long lead times, in some cases two to three months, because they come from overseas suppliers. A domes- tic supplier usually supplies smaller orders, such as a few litres of flavouring. Some are delivered on a just- in-time (JIT) basis, where an order is placed in the morning, and will be delivered by that afternoon.

Hubbard’s purchases approximately 400 lines of raw materials, many of which are imported, either direct from the supplier or through a New Zealand agent. Purchases are made based on quality as oppos- ed to cost, because in this industry cheaper sup- pliers usually mean lower quality. Hubbard’s can- not afford to purchase inferior raw materials because it is renowned for being a high-quality producer. Suppliers are evaluated under Hubbard’s HACCP (Hazard Analysis Critical Control Point) program. This requires specifications and inward checks on raw materials and packaging. A fairly recent activity encourages key suppliers to evaluate Hubbard’s per- formance, giving suppliers the opportunity to provide input into areas for improvement.

Suppliers Suplliers are important to Hubbard’s and essential in maintaining the company’s drive for high qual- ity standards. The nature of the product makes the quality of raw materials vital and therefore long-term relationships with key suppliers are viewed as being essential to success and are actively sought. Packag- ing is an input into Hubbard’s operation that adds a great deal of value to the products, as the packaging adds to the innovative nature of the product. Dick maintains a collaborative relationship with the main packaging supplier, as Hubbard’s accounts for 60 per cent of the total sales of the packaging company. This supplier visits Hubbard’s regularly to discuss specifi- cations and any new innovations.

C-89

Case 7

Incat Tasmania’s race for international success: Blue-riband strategies Mark Wickham Dallas Hanson University of Tasmania University of Tasmania

In 1999, Robert Clifford (aged 56) entered the Busi- ness Review Weekly’s ‘Richest 200 Australians’ for the first time, qualifying for the elite group with an estimated net worth of some $150 million.1 Clifford is the founder and chairman of Incat Tasmania, a highly successful catamaran manufacturer in Hobart. His far-sightedness as a shipbuilder, alongside his ability to manage innovation, enabled his small boat-build- ing business (and river-ferry operation) to become a world force in the high-speed catamaran market, exporting to Europe, Asia and the Americas. So suc- cessful has the Incat operation been, that in 2000, it directly employed over 1000 people, generated $250 million in revenue, and accounted for approximately 23 per cent of Tasmania’s total export earnings.2

Clifford and Clifford Incorporated: Don’t pay the ferrymen ... Despite the worldwide success of their aluminium catamaran range, the family business did not origi- nally set out to build state-of-the-art vessels for the international passenger ferry market. Instead, the

Clifford family business sought to reintroduce a trans-Derwent ferry service in the early 1970s, one that would predominantly serve Tasmania’s tourist population.3 The application to undertake the ferry operation was granted by the state government of the day, and in late 1972 the newly formed Sullivan’s Cove Ferry Company launched the first of its ‘bush- ranger’ fleet, the Matthew Brady. Business proved to be good in the early stages, with both tourists and locals taking advantage of the novel Derwent River ferry service.

The Clifford family’s decision to begin a ferry ser- vice across the Derwent River appeared to be rather fortuitous, given the tragic chance event that occurred early in 1975. On 5 January, at 9.27 p.m., the bulk ore carrier Lake Illawarra crashed into the 19th pier of the Tasman Bridge, claiming 12 lives, and severing the Eastern Shore’s link with Hobart by knocking out an 80-metre section of the bridge.4 Many tens of thousands of motorists and cyclists were now unable to travel easily to their required destinations, be it for work or pleasure. Bob Clifford found himself in the enviable position of being in the right place at the right time.

C-90 Case 7 • Incat Tasmania’s race for international success

... ’til they get you to the other side – Transportation returns to Van Diemen’s Land Due to the increase in demand for the ferry service, the Sullivan’s Cove Ferry Service increased its bushranger fleet to four with the James McCabe, Martin Cash and Lawrence Kavanagh. These vessels were built in near record time, and given the lessons learned from pre- vious efforts, they were more advanced, being built ‘as the plans were being drawn up’.5 The four bush- rangers were to serve as the west–east link for some three years while repairs to the Tasman Bridge were under way. In this time, Clifford’s ferries transported in excess of nine million paying passengers.

Despite the successful launch of the additional bushranger vessels, demand for the ferry service still outweighed Clifford’s supply. In order to improve customer service and increase the business’s rev- enues, Clifford hired a new British-built ‘fast ferry’, the Michael Howe. The Howe was twice as fast and twice as comfortable as the bushranger fleet owned by Clifford, and was an instant success with the public. Unfortunately, the Michael Howe was also a maintenance-intensive investment, with 75 per cent of all company maintenance expenditure spent on the new ‘hired hand’. Clifford was understandably unimpressed with the boat’s design and maintenance requirements, despite the public’s obvious delight with the faster service. The flaws that Clifford observed in the boat’s design and structure (the mechanics were far too complicated and labour-intensive to be viable in the long term) once again reignited his innovative flair. ‘If the English can sell 34 heaps of rubbish like this [around the world], how many properly engi- neered fast ships could we sell from Tasmania?6 And with this marketing opportunity well in his grasp, the Clifford business began its initial foray into the inter- national fast-ferry industry.

Clifford, Bob Clifford: Licensed to keel During the following 20-year period, Bob Clifford utilised his entrepreneurial flair, and the help of some of his close shipbuilding friends, to design and build a succession of innovative catamarans. Of utmost con- cern for Clifford was the need to lighten the weight of his new catamaran designs, which had tradition- ally been built using either steel or iron. A revela- tion occurred in 1979, when Clifford decided to try something that no one else had been able to achieve throughout the history of shipbuilding – the use of aluminium in the construction of the ship’s hull. Alu- minium welding had not hitherto been considered a viable option for ship construction, as the metal is prone to bursting into flame at the high temperatures associated with the welding process. After a consider- able amount of trial-and-error experimentation with his network of shipbuilding friends, Clifford per- fected the aluminium welding techniques that were to propel his brand of fast ferry into the highly lucra- tive international markets.

Incat Tasmania: Eighty metres and beyond By 1995, the world market for high-speed ferries had grown to generate sales revenues of just under $1.6 billion annually.7 Not surprisingly, a significant num- ber of businesses had entered the international cat- amaran industry to gain a share of this substantial revenue opportunity. By 1995, Clifford was faced with direct, and intensifying, competition, both from domestic firms (such as Austal Limited, Sea Wind, Venturer, Commercial Catamarans and Aussie Cat) and UK- and US-based firms (such as the ‘US Cat- amaran’ Company and Prout Catamarans). Each of the domestic firms, and Austal Limited in particu- lar, had also perfected the aluminium welding tech- nologies, and were similarly able to compete in the same markets as Incat. Over the next five years, for instance, Austal Limited would mirror Incat’s foray

Case 7 • Incat Tasmania’s race for international success C-91

into passenger and cargo vessels, luxury passenger vessels, and craft suitable for military operations. The international competitors, however, were not able to mirror the Australian success with the aluminium welding technologies, and still based their vessels on the traditional steel-based hulls.

Of greatest concern to Incat was the fact that each of these competitors was also a newly ‘internation- alising firm’, with access to similar resources (that is, revenues from international markets, raw materi- als and trained staff), and had likewise based their growth on the manufacture of innovative high-speed vessels. A number of Incat’s competitors had also tar- geted the potentially lucrative Chinese market for fast ferries, somewhat threatening Clifford’s most imme- diate and highly prioritised ‘internationalising strat- egy’. It would appear that Incat Tasmania no longer had a monopoly in the world’s high-speed catamaran market, nor the innovation and expertise required for success therein.

Clifford was well aware of the need to maintain Incat’s revenue growth, and protect its market share, in the face of this increasingly competitive industry. As had been the case in the past, Clifford once again returned to the drawing board to design a ‘new and improved catamaran’ for the world’s markets. The result was Incat’s (and, indeed, the world’s) first 80- metre-plus catamaran, the Condor 12. The innova- tive changes introduced by Clifford this time around would focus on passenger and crew safety, an impor- tant point of differentiation, given the spate of ferry disasters occurring in Europe at the time.8

The Condor 12 was equipped with four of the world’s most advanced safety systems (known as the Marine Evacuation System [MES]). The MES ensures that the entire passenger population of the Condor 12 (some 700 people) can be evacuated in an emergency in less than 12 minutes, a time significantly less than that required by the peak international marine safe- ty body (the International Maritime Organisation). In addition to the MES, the Condor 12 was also fit- ted with an advanced and lightweight fire protec- tion. Also installed upon the vessel were single-leafed hinged fire doors, single and double sliding fire doors,

engine room fire-dampers, fire hatches and smoke baffles. These new features, combined with structural fire protection, formed the best fire protection sys- tem available for a high-speed aluminium craft. The safety features were well received by the new owners of the boat, which in 1996 was to serve as a major transport vessel for passengers crossing the English Channel.

The success of the Condor 12 was once again evi- dent to those in the market that provide a fast ferry service. In the period 1996 to 1998, Incat was to pro- duce a number of 80-metre-plus catamarans for the European market. As was the Incat tradition, the new catamarans became larger, with greater levels of comfort and safety, and saw the adoption of new and innovative technologies. The completed catamarans during this period are as follows:

Stena Lynx 3 81 metres, English Channel ferry

Holyman Express 81 metres, England–Belgium run

Condor Express 86 metres, UK, 800-passenger, 200-car capacity

Sicilia Jet 86 metres, Mediterranean Sea vessel

Condor Vitesse 86 metres, UK, summer season ferry carrier

Incat 045 86 metres, Bass Strait carrier Cat-Link V 91 metres, Scandinavia Catalonia 91 metres, Spain

During this period, Incat averaged the construc- tion and launch of one catamaran every 10 weeks. The most notable boat of the latest generation was the Catalonia, a 91-metre wave-piercing catama- ran destined for Spain. Although the Catalonia was completed over-schedule (due to the inability of the company to physically perform the tasks required given the workload), it remained very much the lat- est ‘showpiece’ of the Incat Empire. Unlike previous efforts, the Catalonia was fitted out with a duty-free shop, and a number of extra luxurious features (stair- cases, plush carpeting, and so on). The more luxuri- ous fit-out meant that it was noticeably heavier than

C-92 Case 7 • Incat Tasmania’s race for international success

other similarly sized catamarans. However, the Cata- lonia remained capable of travelling at a respectable 48 knots as a lightship, and at 43 knots fully load- ed. Despite the Catalonia’s size and weight, Clifford was confident that the craft was faster than the Hover Speed Great Britain, with which he had won the Hales Trophy (a ‘Blue Riband’ award) in 1990. (The ‘Blue Riband’ Hales Trophy is awarded to the commer- cial vessel that undertakes the fastest crossing of the Atlantic Ocean, a record that in 1990 was held by the liner the SS United States before Clifford won the trophy and the attention of the world’s media.) With this thought in mind, as well as the implications for marketing and sales growth, Clifford decided to use the Catalonia to secure a second ‘Blue Riband vessel’ for the company.

During the same time, Incat’s major competitor, Austal Limited, diversified away from its reliance on luxury aluminium-hulled passenger vessels, in favour of a multi-domestic-based business focusing on yachts, pleasure craft and cargo vessels. The company, unlike Incat, decided to list on the stock exchange and form alliances with other firms internationally in order to form an Austal group of companies based in the United States, Europe and Asia. By 1998, the Austral group of companies included Austral Limited (based in Australia), Austal USA (a joint venture partner- ship with leading US shipbuilder Bender Shipbuilding & Repair), Oceanfast (a yacht manufacturer), Image Marine (a pleasure craft manufacturer) and Austal Service (a maintenance company).9

Incat’s Hales Trophy Defence: Catalonia and the Atlantic Ocean crossing In mid-May of 1998, the Catalonia left Hobart, bound for New York from where the latest record attempt would begin. On Saturday, 6 June 6, the Cat- alonia hauled its anchor and set sail for the UK in an attempt to set a new record for the Hales Trophy, as well as a new record for the greatest distance trav- elled by a ship in a given 24-hour period. Once again, the mass media were on hand to witness the great feats undertaken by Clifford and his Incat team. Once again the media, and the rest of the interested world,

were treated to a triumph. The Catalonia had, in only its second international voyage, managed to become the first boat in history to cover in excess of 1000 nau- tical miles in a 24-hour period. She had also crossed the Atlantic faster than any commercial vessel before her, establishing a new world record for Clifford and Incat.

While this journey was under way, the Incat man- ufacturing plant was putting the finishing touches on a new 91-metre catamaran named the Cat-Link V. Built for the Scandinavian company Scandlines, the boat was also to undertake a record-breaking attempt for the Atlantic Ocean crossing. Within weeks of the Catalonia’s efforts, the Cat-Link V successfully rewrote the record books and claimed the Hales Tro- phy and ‘Blue Riband’ certification. What was most important for Clifford was the fact that now three Incat vessels had managed to break the speed records once held by a US vessel for 50 years, and do it in absolute comfort.

Strong demand for Incat’s wave-piercing catama- rans resulted in the development of an important joint venture agreement with Afai Ships of Hong Kong. The joint venture was important, as it provided Incat with an initial foray into the high-potential Chinese market, as well as helped the company to keep up with the huge global demand for its vessels. The Chi- nese yard started work on its first vessel early in 1998, under the supervision of Graeme Freeman, an Incat manager. Most of the materials for the ships were supplied through the Tasmanian yard, and a constant team of Incat personnel and sub-contractors travelled to Hong Kong to supervise each stage of construc- tion.10 The joint venture proved successful, with the first ship completed by May of 1988, with a second ship’s construction already under way. As with any licensing agreement, a major risk for Incat lies in the potential theft of its intellectual property, and there- fore potentially the company’s core competency of innovative catamaran design. Perhaps indications of the innovative drive within the company, Incat man- agement said of such a concern that: ‘We haven’t real- ly worried too much about the theft of our intellec- tual property. We work on the theory that whatever our licensees are stealing, they are stealing yesterday’s work anyway.’11

Case 7 • Incat Tasmania’s race for international success C-93

Growth into the future: Incat and the continued internationalisation of a Tasmanian icon The main issue facing Bob Clifford and his team at Incat mid-decade is ensuring the continued growth of the company through innovation, diversification and globalisation in the face of increasing competition and ‘tough global economic times’. The history of success- ful marketing exercises, the constant flow of innova- tion throughout the organisation, and the ability of Incat to foster international relationships have, at least to date, seen the company rise from obscurity to a global leader in boating excellence. While there seems to be little change to the strength of global demand for high-speed vessels, cash flow problems did arise in early 2001 when a number of ships built by the com- pany remained unsold for an extended period. The amount of money tied up in the idle ships equated to a substantial cutting back in employee overtime and other ‘non-essential company expenditure’.

This cutback in ‘non-essential’ expenditure, unfor- tunately for Incat’s workforce, apparently extended to include a 15 per cent pay-rise claim by the two main unions operating in the shipyard (the Australian Man- ufacturing Workers Union and the Construction, For- estry, Mining and Energy Union). Clifford’s response to the pay claim was to dismiss it entirely, stating that pay increases at Incat will only result from an increase in catamaran sales. Given the state of the company’s sales at the time (having completed, but as yet unsold vessels on the books), the pay claim appeared to be doomed to failure. In response to Clifford’s statement that it would be easier for the union to ‘get blood from a stone’ than a pay rise based merely upon a ‘cost-of- living’ adjustment, industrial action was undertaken by some 650 workers in the form of a 24-hour strike. Clifford was forewarned of this imminent industrial action, and acted immediately to release a statement to this sector of his workforce that branded some as ‘donkeys with not enough brains to make their heads ache’.12 He continued to suggest that ‘as “intelligent leaders” in tough economic times, Incat has no choice but to “cull the donkey population” for the good of

the majority, and in doing so get rid of “the weakest links”.’13

Unfortunately, the culling of employees was to no avail, with the firm’s financer, the National Australia Bank (NAB), appointing a receiver management team to the company in mid-2001. The receiver managers were appointed largely to control the firm’s perceived expenditure issues, and to enforce the cessation of the continued construction of otherwise unwanted ves- sels. It was stated by representatives of the NAB that it had no wish to dismantle the company, but rather protect its loans to the firm by taking closer control of its financial management. Again, a tragic event heralded a new period of growth for the company. On 11 September 2001, the financial centre of the US economy, the Twin Towers of the World Trade Cen- ter, suffered a horrific terrorist attack that destroyed the capitalist symbols and killed approximately 3000 people. Although the economic damage resulted in a major share price slump in the short term, it also sparked a major increase in defence spending around the globe, spending that would directly benefit the struggling Incat Tasmania. It was lauded that the US government had a potential A$20 billion to spend on new ‘tactical response’ vehicles, vehicles the ser- vice lacked for quick response to situations of armed conflict. Incat, rather fortuitously, had provided the Australian defence force with use of a catamaran (the HMAS Jervis Bay) for such duties in the East Timor peacekeeping mission, and was therefore well posi- tioned to bid for the US contract.

The US government’s response to the ‘9/11’ terror- ist attacks, the so-called War on Terror in Afghanistan and Iraq, freed up substantial monetary resources for the invasion of these countries. During 2002, Incat managed to win a major US contract that resulted in the NAB removing its receiver management team. The contract allowed the company to again innovate its designs (both in terms of vessels and financial man- agement strategies) to accommodate the specific needs of the US military, as well as once again to license out its manufacturing processes to an overseas construc- tion company.14

The business of building fast ferries remains a relatively new one and, as such, there is consider- able scope for still further market development (con- tinued catamaran-based construction) and market

C-94 Case 7 • Incat Tasmania’s race for international success

diversification (that is, new product lines). As Clif- ford himself states:

There are always problems to be solved that will require the design of both new and innovative products. It is coming up with ideas that is essential, and for that you need people with their brains in gear. Likewise, new markets will emerge to be served, and our team is constantly working

to ‘improve the breed’. If there is one thing that I’m proud of, it is [Incat’s] ability to solve problems and expand our horizons.15

Although this ability seems to have always existed at Incat under Clifford’s leadership, the question aris- es as to whether it will provide a continued source of competitive advantage into the future.

Notes 1 T. Thomas, 1999, ‘ “Dunce” leaves the rest in his wake’, Business

Review Weekly, 28 May. 2 T. Skotnicki, 2000, ‘Exports: Full throttle’, Business Review Weekly,

18 August. 3 R . Clifford, 1998, Incat – The First 40 Years (Victoria: Baird

Publications); Thomas, ‘ “Dunce” leaves the rest in his wake’. 4 Clarence City Home Page, 2001, ‘The Tasman Bridge disaster’,

16 March, www.ccc.tas.gov.au. 5 Clifford, Incat. 6 Ibid., p. 22. 7 Austal Limited information memorandum, 2000. 8 Clifford, Incat.

9 Austal Home Page, 2003, ‘Company overview’, 20 August www. austal.com.

10 S. L. McCaughey, P. W. Liesch and D. Poulson, 2000, ‘An unconven- tional approach to intellectual proper ty protection: The case of an Australian firm transferring shipbuilding technologies to China’, Journal of World Business, 35(1), pp. 1–22.

11 Ibid. 12 M. Haley, 2001, ‘Incat’s “cull” star ts with strike’, The Mercur y,

4 April 13 R. Clifford, 2001, ‘The intelligent worker’: An address to staff at

Incat Tasmania, 3 April. 14 Clifford, Incat. 15 Ibid.

C-95

Case 8

The Golden Arches in India: A case of strategic adaptation Nitin Pangarkar Saroja Subrahmanyan National University of Singapore St Mary’s College

Background In March 2003, the McDonald’s Corporation’s Indian operation was at a critical juncture in its evo- lution. Between 1995 (the year its joint ventures were formed) and December 2002, the company and its joint venture partners had opened 46 restaurants. According to the earlier plans (June 2000), the com- pany was aiming to have 80 outlets in India by the end of the year.1 Since the investment to open each out- let amounted to Rs 20 to 30 million (approximately, US$417 000 to US$626 000 based on a 1 January 2003 exchange rate of Rs 47.92 = US$1)2 excluding real-estate costs,3 the rapid expansion would mean more than doubling of its investments, which (accord- ing to some estimates) stood at a level of Rs 3.5 bil- lion in June 2000.4 Some recent reports, however, had hinted that, due to the recent lacklustre financial performance of the parent corporation, McDonald’s might scale back its number of planned outlets by as much as 20 per cent to 64. The scaling back would be part of a wider decision to restructure operations in emerging markets, including closure of 250 outlets.5

Though the management of McDonald’s India had denied these reports, the pace of expansion seemed to have slowed down over the past year.6 Since the com- pany was not required to release its financial figures, it was not clear whether it was on track to achieve its original objective of breakeven by the year 2003.7 In fact, reducing the number of planned outlets would postpone the date for achieving breakeven since con- siderable fixed costs had been incurred in developing a supply chain, creating brand name recognition and inducing trial among potential customers.

McDonald’s: The global fast-food powerhouse McDonald’s was, by far, the world’s biggest marketer of fast food. In 2003, it operated more than 31 000 restaurants and served 46 million customers each day in 118 countries. For the financial year 2002, the company had attained US$41.5 billion in system-wide sales (out of which US$25.7 billion was accounted for by franchised restaurants), US$2.1 billion in operat- ing profits and US$893 million in net profits. It also

C-96 Case 8 • The Golden Arches in India

had US$24.0 billion in assets. (See Exhibit 1 for a geographic analysis of McDonald’s operations.) It was also, routinely, cited by the business press as being a savvy marketer. In June 1999, with a value of US$26.231 billion, the McDonald’s brand was rated as being the eighth most valuable brand in the world, ahead of well-known brands such as Sony, Nokia and Toyota.8

McDonald’s had a long history in Asia. It entered the Japanese market in 1971, which was followed by entry into other newly industrialising economies (such as Singapore and Hong Kong, among others) in Asia. Entry into China occurred only in 1990. McDonald’s entered India in 1996. (See Exhibit 2 for McDonald’s start-up dates in East Asian and South Asian countries.) The late entry could be attributed to several factors, such as the fact that a significant percentage of India’s population was vegetarian, the limited purchasing power of the population and the closed nature of the economy.

The Indian market India was a vast subcontinent with an area one-fourth that of the United States, and a population almost four times that large, at about 1 billion. The per cap- ita GDP was quite low at US$400 (approximate). However, after adjusting for purchasing power parity, India’s economy exhibited a per capita GDP (2002) of US$2540 and an aggregate GDP of US$2.66 trillion. On this basis, it was ranked the fifth-largest econ- omy in the world (ranking above France, Italy, the UK and Russia) with the third-largest GDP in Asia behind Japan and China. (See Exhibit 3 for income distribution in India.9) Among emerging economies, India was often considered second only to China. Despite the low per capita income levels, the sheer size of the ‘eating out’ market in India was substan- tial. According to one estimate, India’s food expen- diture amounted to US$77 billion in 2000, out of a total world food spending of US$4000 billion.10 The Indian food market was, however, highly fragmented,

Exhibit 1 Geographic analysis of McDonald’s operations and performance (financial year 2002)

Overall

Geographic breakdown

US Europe Asia-

Pacific Latin

America Canada

Middle East & Africa

Partner corporate

brands

Revenues (US$mn) 15 405.7 5 422.7 5 136.0 1 236.7 813.9 633.6 1 294 N/A

Operating income (US$mn) 2 112.9 1 673.3 1 021.8 64.3 (133.4) 125.4 (66.8) (571.7)

Total assets (US$mn) 23 970.5 8 687.4 8 310.6 3 332.0 1 425.3 703.2 780.4 731.6

Capital expenditures (US$mn) 2 003.8 752.7 579.4 230.4 119.9 111.6 190.4 19.4

Depreciation & amortisation (US$mn) 1 050.8 383.4 334.9 141.7 59.6 35.6 40.3 55.3

Average annual sales per restaurant (US$000) N/A 1 628 1 821 1 091 931 1395 N/A N/A

Margins in company- operated restaurants (%) 14.4 16.0 15.9 11.3 9.4 13.7 N/A

Margins in franchised restaurants (%) 78.5 79.1 76.7 85.8 66.9 79.2 N/A N/A

Source: www.mcdonalds.com.

Case 8 • The Golden Arches in India C-97

with millions of roadside stalls collectively account- ing for a large share of the market.

India’s economic diversity was matched by its social diversity. There were more than 20 major spo- ken languages and over 200 dialects. The Indian cur- rency (Rupee) had its denomination spelt out not only in English and Hindi (the national language), but also in three other languages. About 50 per cent of the population was considered to be illiterate, and adver- tising reached them via billboards and audio-visual means. For national launches, at least eight languages were used. In addition, the country faced poor infra- structure with frequent power outages even in New Delhi (the capital city) and Bangalore (India’s Silicon Valley).

In terms of political system, India was a democ- racy. Since independence from the British in 1947, the economic system had historically been modelled on the socialist style. Under this system, the government strictly controlled entry and exit of domestic as well as multinational corporations (MNCs) into different sectors. Multinational firms also faced a variety of other restrictions. Since 1991, India had started deregulating the economy. However, the socialist mind-set could not be erased overnight. A member of the parliament had the following comment regarding the influx of multinational firms in consumer sectors

such as packaged food: ‘We want computer chips and not potato chips.’

The country also had a few anti-Western factions, which opposed the entry of MNCs, in general. The mistrust of MNCs could be at least partially attribut- ed to the fact that the British rule of India was rooted in the entry of the British East India Company (for trading purposes) into the country. There were sev- eral small but vocal groups of health activists and environmentalists that were opposed specifically to the entry of fast-food giants such as McDonald’s and KFC. When KFC opened its restaurant in Bangalore in 1995, local officials found that KFC had excessive levels of monosodium glutamate (MSG) in its food and closed the outlet. The outlet soon reopened, how- ever. Vandana Shiva, a vocal exponent of environ- mental and animal welfare issues, made the following comment in an audio interview with McSpotlight:

The McDonald’s experience, which is really the experience of eating junk while thinking you are in heaven, because of the golden arches, which is supposed I guess to suggest that you enter heaven, and the clown Ronald McDonald, are experiences that the majority of the Indian population would reject – I think our people are too earthy. First, of all, it would be too expensive for the ordinary Indian – for the peasant, or the person in the slums

Exhibit 2 Dates of McDonald’s entry into East and South Asian markets

Year of opening Country Restaurants in 2002 Restaurants in 1997

1971 Japan 3 891 2 437 1975 Hong Kong 216 140 1979 Singapore 130 105 1980 Philippines 236 157 1981 Malaysia 149 110 1984 Taiwan 350 233 1985 Thailand 100 61 1988 South Korea 357 114 1990 China (Shenzhen, Special Economic Zone) – – 1991 Indonesia 105 103 1992 China (Beijing) 546 184 1996 India 46 9 1998 Pakistan 20 0 1998 Sri Lanka 2 0

Sources: For start-up dates: James L. Watson (ed.), 1997, Golden Arches East (Stanford, CA: Stanford University Press), Table 2. For number of restaurants: McDonald’s Corporation 2002 Annual Report, from www.mcdonalds.com.

C-98 Case 8 • The Golden Arches in India

– it’s an experience that a very tiny elite would

engage in, and most of that elite which knows

what good food is all about – would not fall for it.

McDonald’s is doing no good to people’s health,

and in a country like India where first of all, we

are not a meat culture, and therefore our systems

are ill-adapted to meat in the first place, and where

people are poorer – shifting to a diet like this will

have an enormous impact.11

Since 1991, when the Indian economy began open- ing up to foreign investments, many multinationals had rushed in – lured by the attraction of serving a large middle class, estimated at 300 million. Howev- er, even some of the well-known global brands failed with their initial strategies and were forced to repo- sition, including, in some cases, drastic reduction of prices. Some multinationals (for example, Peugeot) even had to close shop. Kellogg’s, which entered with high-priced cereals (several orders of magnitude more expensive than the traditional Indian breakfast), faced a lack of demand. KFC initially failed to realise that Indians were repulsed by chicken skin, which was vital for the Colonel’s secret batter to stick. Thus, apart from a lack of understanding about the local tastes, a combination of circumstances, including overestima- tion of the demand potential, rosy assumptions about the dismantling of bureaucratic hurdles to doing busi- ness, infrastructural inadequacies and, finally, inap- propriate firm strategies (for example, pricing), led to many failures and disappointments.

McDonald’s entry strategy in India McDonald’s India was incorporated as a wholly owned subsidiary – McDonald’s India Pvt Ltd, or MIPL, in 1993.12 In April 1995, the wholly owned subsidiary entered into two 50:50 joint ventures: with Connaught Plaza Restaurants (Mr Vikram Bakshi) to own and operate the Delhi restaurants, and Hardcas- tle Restaurants (Mr Amit Jatia) to own and operate the Mumbai outlets.

Though McDonald’s had done product adapta- tion to suit local tastes and cultures in several previ- ous ventures, such as the McPork Burgers served with Thai Basil in Thailand, the Teriyaki Burger in Japan, rice dishes in Indonesia, McSpaghetti with Filipino ham in the Philippines, McTempeh Burgers (ferment- ed soyabean) in Indonesia and McLox Salmon sand- wiches in Norway, the degree of adaptation required in India was significantly greater.13 McDonald’s replaced its core product, Big Mac, with the Maharaja Mac. The latter had a mutton patty (instead of the beef patty in the Big Mac), to avoid offending the sensi- bilities of Hindus (80 per cent of the population), who consider killing the cow as sacrilegious, and Muslims (12 per cent of the population), for whom pork was taboo. In addition, since 40 per cent of the market was estimated to be vegetarian, the menu includ- ed the McAloo Burger (based on potato), a special salad sandwich for vegetarians and the McChicken kebab sandwich. It also offered spicier sauces such as

Exhibit 3 Income distribution in India

Classification Number of people (mn) Households (mn) Income in US$

The Deprived 763 131 <600 The Aspirants 120 20 1000–3000 The Climbers 45 8 3000–6000 The Strivers 25 5 6000–12 500 The Rich (total) 2.18 0.3545 >12 500 The Near Rich 1.55 0.25 12 500–25 000 The Clear Rich 0.444 0.074 25 000–50 000 The Sheer Rich 0.144 0.024 50 000–125 000 The Super Rich 0.039 0.0065 >125 000

Income figures are approximate and based on the following two sources: Chaterjee Adite, 1998, ‘Marketing to the superrich’, Business Today, Living Media India Ltd, 22 April; Warren Berryman and Jenni McManus, 1998, ‘India: Turning the Elephant Economy’, Independent Business Weekly, 24 June.

Case 8 • The Golden Arches in India C-99

McMasala and McImli (made from tamarind). Other elements of the menu, such as chicken nuggets, fillet of fish sandwiches, fries, sodas and milk shakes, were common with the rest of McDonald’s system.

In 1998, McDonald’s India set up a menu develop- ment team to collect consumer feedback. The results of the team’s research revealed that while Indian cus- tomers didn’t want the company to entirely localise its menu, they wanted a wider product range, more hot food and lower entry-level prices for products.14 The company subsequently introduced several new prod- ucts, such as the Veg Pizza McPuff, that were priced

attractively and became top sellers in the menu. By 2001, almost 75 per cent of the menu in India was localised versus 33 per cent for a typical Asian coun- try. (See Exhibit 4 for the complete menu offered in March 2003.15)

The adaptation of the strategy went well beyond the menu, encompassing many aspects of the restau- rant management system. Two different menu boards were displayed in each restaurant – green for vegetar- ian products and purple for non-vegetarian products. Behind the counter, restaurant kitchens had separate, dedicated preparation areas for the meat and non-meat

Exhibit 4 McDonald’s menu in India

Menu item Price (Rs) Menu item Price (Rs)

Burgers Happy Meals (burger with regular drink and a toy)

Salad Sandwich 54.00 McAloo Tikki Burger 64.00

Salad Sandwich 18.00 Veg Pizza McPuff 54.00 Veg Pizza McPuff 17.00 McAloo Tikki Burger 28.00 Value Meals (burger with potato wedges/regular fries McVeggie Burger 34.00 and regular drink) Veg Surprise 18.00 McAloo Tikki Burger 49.00 Chicken McGrill 24.00 Salad Sandwich 39.00 McChicken Burger 46.00 Veg Surprise 44.00 Filet-O-Fish 46.00 Chicken McGrill 49.00 Chicken Maharaja Mac 55.00 Paneer Salsa Wrap 40.00 Meal combos Chicken Mexican Wrap 49.00 (burger with medium fries and medium drink) Fries Extra Cheese 6.50 Regular 20.00 Upsize to Burger with large fries and a large drink 10.00 Medium 26.00 McVeggie Combo 75.00 Large 33.00 McChicken Combo 89.00 Potato Wedges 20.00 Filet-O-Fish Combo 89.00 Beverages Paneer Salsa Wrap Combo 82.00 Regular Coke/Fanta/Sprite 17.00 Chicken Mexican Wrap Combo 92.00 Medium Coke/Fanta/Sprite 21.00 Chicken Maharaja Mac Combo 94.00 Large Coke/Fanta/Sprite 25.00 Cappuccino 17.00 Desserts Café Mocha 17.00 Soft serve: Pineapple/Hot Fudge Topping/ Vanilla 19.00 Espresso Black 12.00 Soft Serve: Cone 8.00 Elaichi Tea 17.00 Soft Serve: McSwirl 12.00 Tea 12.00 McShakes: Chocolate/Strawberry/Vanilla 30.00 Mineral Water (500 ml) 14.00 McShakes Regular: Chocolate/Strawberry/Vanilla 25.00 Quick bites McShakes Medium: Chocolate/Strawberry/Vanilla 35.00 Cappuccino + Wedges 25.00 McShakes Large: Chocolate/Strawberry/Vanilla 45.00 Cappuccino + Puff 29.00 Apple Pie 24.00

Source: www.mcdonaldsindia.com.

C-100 Case 8 • The Golden Arches in India

products. The kitchen crew (in charge of cooking) had different uniforms to distinguish their roles and they did not work at the vegetarian and non-vegetarian stations on the same day, thus ensuring clear segrega- tion.16 The wrapping of vegetarian and non-vegetarian food took place separately. These extra steps were tak- en to assure Indian customers of the wholesomeness of both products and their preparation. To convince Indian customers that the company would not serve beef, and respect the culinary habits of its clientele, McDonald’s printed brochures explaining all these steps and took customers for kitchen tours.

McDonald’s positioned itself as a family restaur- ant. The average price of a meal combo, which includ- ed burger, medium fries and medium drink, varied from Rs 75 for a vegetarian meal to Rs 94 for a Maha- raja Mac meal. This could be compared with KFC meal prices at Rs 59 (Crispy Burger, Regular Fries and Large Pepsi) and Rs 79 (KFC Chicken, Colonel Burger and Regular Pepsi). McDonald’s Happy Meal, which included a complimentary toy, was priced between Rs 54 and Rs 64. The prices in India were lower than in Sri Lanka or Pakistan, and even the price of the Maharaja Mac was 50 per cent less than an equiva- lent product in the United States.17 To fight its premi- um image among the public, the company undertook selective price cutting and also ran some periodic promotions. In March 2003, the company was offer- ing value meals for as low as Rs 39 and Quick Bites for as low as Rs 25. The company’s ice-cream offer- ings were priced extremely attractively – starting at Rs 8 for a soft serve cone. Apparently, even these low prices afforded McDonald’s a healthy margin (40 per cent for cones). As Vikram Bakshi, explained: ‘I will never become unaffordable, as I will not then be able to build up volumes.’18 The lower price could be attri- buted to two key factors. First, pricing strategies of MNC rivals as well as by mid-range local restaurants influenced McDonald’s pricing strategies as well as special promotions. For instance, in February 1999, several competitors were running special promo- tions, with KFC offering a meal inclusive of chicken, rice and gravy for Rs 39. For Rs 350, Pizza Hut was offering a whole family meal including two medium pizzas, bread and Pepsi. Wimpy’s was offering mega meals at Rs 35.19 Some analysts, however, were scep- tical of McDonald’s loss-leaders (or price cutting on

selective items) strategy since they believed that cus- tomers attracted purely by these low prices would not pay repeat visits. The development of a local low- cost supply chain was a second key enabling factor in McDonald’s pricing strategy.

Advertising and promotion Some elements of the McDonald’s promotional strat- egy remained the same as in other parts of the world – especially its emphasis on attracting children. A Happy Meal film had been consistently shown on the Cartoon Network and Zee (a popular local channel) Disney Hour. McDonald’s had also teamed up with Delhi Traffic Police and Delhi Fire service to highlight safety issues, again trying to create goodwill among schoolchildren.20 In late 2002, McDonald’s held a children’s painting competition across all its outlets in Delhi. As many as 5000 children participated in the competition and a selection of 12 paintings (screened by some of India’s noted artists) were printed and sold as greeting cards. The proceeds from the sale of greet- ing cards would go towards restoring vision, through corrective surgeries, for needy children.21 The com- pany embarked on its first nationwide promotional campaign in June 2000. The campaign, budgeted at Rs 100 million, was expected to highlight (in phased order) the brand (the experience: There is something special about McDonald’s), food quality and variety.22 The company also ran special promotions during fes- tivals and vegetarian days, and was even developing garlic-free sauces to bring in ‘hard-core’ vegetarian traffic.23

In November 2000, McDonald’s launched a mas- sive Get Lucky promotional scheme in collaboration with MTV, Sony Music, Coca-Cola, Hungama.com and General Motors. Under the scheme, customers buying a large meal combo, priced at between Rs 69 and Rs 89, would receive a scratch card. Customers could win giveaways such as caps, T-shirts, audiotapes and CDs, Internet browsing cards, and free tickets to a concert by Lucky Ali (a popular local singer). Pur- chase of a second meal combo within the same month would make customers eligible for lucky draws whose prizes included a trip to New Zealand and an Opel Corsa car. This was the first high-profile program launched by the company for adults – specifically,

Case 8 • The Golden Arches in India C-101

young parents. In May, the company had launched a promotional program for children coinciding with summer vacations.24 The Get Lucky campaign devel- oped some snags a few months later, since many of the promised giveaways – such as trips to New Zealand, Opel Corsa cars and even the Lucky Ali concert – had not materialised.25

In March 2001, McDonald’s India increased its advertising expenditure from Rs 150 million to Rs 200 million. In June 2002, having induced trial from a number of potential customers, McDonald’s was aiming to generate repeat visits from customers. It changed its advertising slogan to Let’s have McDon- ald’s today (in Hindi: To Aaj McDonald’s ho jaaye) versus the earlier theme of There is something special about McDonald’s (in Hindi: McDonald’s main hain kuch baat) launched in mid-2000. The objective of the new campaign was to position McDonald’s as a com- fort zone for young families. The company’s adver- tising and promotional budget for 2002 was fixed at Rs 180 million.26

Community involvement and citizenship behaviour McDonald’s was involved in a variety of community welfare projects, including the following: • It maintained public parks in Delhi and had

taken up the responsibility for the maintenance and upkeep of two traffic triangles at a busy traffic junction in Mumbai.

• It was also helping in maintaining heritage structures of historic importance.

• It was the first fast-food restaurant chain in Delhi to withdraw the use of polythene bags in restaurants, replacing them with recyclable paper bags.

• It was playing a leading role in a campaign to detoxify one of India’s major rivers by installing grease traps to separate oil from water before discharging into the drainage system.

• It treated all effluent material before disposal. It also segregated plastic, paper and liquid wastes into recycling versus discharge.

• It had participated in the Pulse Polio Awareness rally by sponsoring food and drinks for the

volunteers. In 2001, it went a step further and set up a vaccination booth outside its restaurant in Pune.

Targeting markets In terms of selection of cities, McDonald’s followed the same strategy in India as in the rest of the world. Its initial focus on Mumbai and Delhi was driven by the following factors: these were the two largest cities in India, their citizens enjoyed relatively high income levels compared to the rest of the country, and they were exposed to foreign food and culture. After estab- lishing a presence in leading cities, it then moved to smaller satellite towns, near the metropolitan cities (for example, from Delhi to Gurgaon and Noida, both suburbs of Delhi, and from Mumbai to Pune). McDonald’s often found that there were positive spillover effects, in terms of its reputation, from the metropolitan cities to the satellite towns. In Jaipur, the company was hoping to attract foreign tourists. (See Exhibit 5 for a brief profile of the key cities on McDonald’s radar screen.)

Developing the supply chain Even before it opened the first restaurant, McDonald’s spent as much as Rs 500 million (US$12.8 million) to set up a supply network, distribution centres and logistics support. By mid-2000, some estimates placed the total investment in the supply chain at almost Rs 3 billion.27 Local suppliers, distributors and joint venture partners and employees had to match the res- taurant chain’s quality and hygiene standards before they became part of its system. McDonald’s experi- ence in identifying and cultivating the supplier of let- tuce provided an excellent illustration of the difficul- ties involved. In 1991, hardly any iceberg lettuce was grown in India, except for a small quantity grown around Delhi during the winter months. McDonald’s identified a lettuce supplier (Mr Mangesh Kumar from Ootacamund in Tamilnadu, a southern state) and helped him in a broad range of activities from seed selection to advice on farming practices. For sev- eral other suppliers, such as Cremica Industries which supplied the sesame seed buns, McDonald’s helped them to gain access to foreign technology. In another instance, it encouraged Dynamix, the supplier for

C-102 Case 8 • The Golden Arches in India

cheese, to establish a program for milk procurement by investing in bulk milk collection and chilling cen- tres. This, in turn, led to higher milk yields and over- all collections, as well as an improvement in milk quality. McDonald’s ended up with a geographically diverse sourcing network with buns coming from North India, chicken and cheese coming from West- ern India, and lettuce and pickles coming from south- ern India. By 1999, it was sourcing 98 per cent of the ingredients and paper products from India. The only exception was French fries, which were imported from Indonesia.28 There were as many as 40 suppliers in the company’s supply chain.29

A dedicated distribution system was established to match the suppliers’ production and delivery sched- ules with the restaurants’ needs. The first two cen- tralised distribution centres were set up near Mumbai

and at Cochin (in the southernmost part of India) in joint ventures with two local retailers, both of whom had to learn from international distributors of McDonald’s products how the restaurant chain han- dled distribution worldwide and particularly how to enhance the quality of storage operations. The com- pany estimated that each distribution centre could service about 25 outlets.

McDonald’s strove to keep the storage volumes of products high in order to exploit all possible econ- omies of scale. The distribution centres were also expected to maintain inventory records and interact with suppliers and the logistics firm to make sure that their freezers were well stocked. McDonald’s Qual- ity Inspection Programme (QIP) carried out quality checks at over 20 different points at various stages in the movement of goods from farms to restaurants. It

Exhibit 5 Profile of the Indian cities targeted by McDonald’s

Place

Population

Remarks State

Annual per capita income in Rs (1997/98)1

Annual per capita income in Rs (1997/98)21991 2001

Agra 892 1 076 Tourist attraction; home to the Taj Mahal

Uttar Pradesh 7 263 5 890

Jaipur 1 459 1 893 Major tourist attraction Rajasthan 9 356 7 694

Chandigarh 504 790 Capital city of two northern states, Punjab and Haryana

Punjab and Haryana

19 500 14 457

Ahmedabad 2 955 3 823 Major business centre in western India

Gujarat 16 251 13 709

Vadodara/ Baroda

1 031 1 454 Business centre Gujarat 16 251 13 709

Mumbai 9 926 12 903 Commercial capital of India Maharashtra 18 365 16 217

Pune 1 567 2 004 Satellite town of Mumbai; manufacturing centre

Maharashtra 18 365 16 217

Ludhiana 1 043 1 482 Textile manufacturing centre in North India

Punjab 19 500 14 457

Delhi 9 119 13 661 Capital city; seat of the central government

Delhi 22 687 19 091

Bangalore 2 660 3 637 India’s Silicon Valley Karnataka 11 693 11 153

Notes: 1 Income data from Per Capita Income (State-wise) – Maps of India. The figures refer to the whole state and not the particular cities. Income levels for cities are likely to be somewhat higher than the figures for the whole states.

2 Income data from The Associated Chambers of Commerce and Industry of India http://203.122.1.245/assocham/prels/04181.asp. The figures refer to the whole state and not the particular cities. Income levels for cities are likely to be somewhat higher than the figures for the whole states.

Source: Population data from www.world-gazetteer.com/fr/fr_in.htm.

Case 8 • The Golden Arches in India C-103

had adopted Hazard Analysis Critical Control Point (HACCP) – a systematic approach to food safety that emphasised prevention within suppliers’ facilities and restaurants rather than detection through inspection of illness or presence of microbiological data. Mr Amit Jatia had the following comment:

The most important part of our operations was

developing a cold chain (the process of procure-

ment, warehousing, transportation and retailing

of food products under controlled temperatures).

There is practically no need of knife in any rest-

aurant. All the chopping and food processing is

done in the plants. Only the actual cooking takes

place in the restaurants.30

Even with the suppliers and distribution system in place, McDonald’s needed a distribution link to move raw materials to its restaurants. Logistics management was contracted out to AFL Logistics – itself a 50:50 joint venture between Air Freight (a Mumbai-based firm) and FX Coughlin of the United States, McDonald’s international logistics provider. AFL logistics was responsible for the temperature- controlled movement of all products (by rail, road or air, as appropriate) from individual suppliers to regional distribution centres. McDonald’s had to work extremely hard at inculcating a service orien- tation in its employees, especially those involved in physical logistics, since the freshness of the food was at stake. The truck operators had to be explicitly and clearly instructed not to switch off the trucks’ refrigeration system to save on fuel or electricity. The corporation went to the extent of installing tracking devices, which would show the temperature chart through the entire journey.31

Since 1999, McDonald’s had started using India as an export base for cheese, lettuce and other prod- ucts that went into its burgers. Exports had already begun to Sri Lanka where it had opened in October 1998, and trial shipments had commenced to Hong Kong and the Middle East. The company was also trying to export its products to Europe, Russia and Southeast Asia. 32 Amit Jatia had the following com- ment: ‘Things are becoming global in nature. Once you set up a supply chain in a strategic location it can service other countries as well.’33

Past performance and planned strategies During its first 12 months of operations, McDonald’s opened seven outlets (four in Delhi and three in Mum- bai), had 6 million customer visits and had served up 350 000 Maharaja Macs. By the end of 1998, the number of outlets had increased to 14, and, by mid- 2000, to 25 outlets, with an outlet in Pune and Jai- pur in addition to 13 in Delhi and 10 in Mumbai. By December 2000, it had opened another 21 outlets to bring the total to 46.

McDonald’s success was especially notable in view of the fact that KFC, which had entered the Indi- an market at about the same time, had pulled out dur- ing the year.34

According to one estimate, in June 2002, McDon- ald’s 38 restaurants (operating at the time) averaged about 4000 customer visits per day.35 Over the previ- ous four years, the number of transactions had grown at a 15 per cent annual rate.36 The spending per cus- tomer visit at McDonald’s was estimated at around Rs 45. One gratifying aspect of McDonald’s success was the fact that, by mid-2000, it derived as much as 50 per cent of its revenues from vegetable food items, thus disproving its critics – especially those who were sceptical of its ability to serve food that suited Indi- an palates. In 1997, McDonald’s food was classi- fied by consumers as being bland. Within three short years, however, McDonald’s was being sought for its unique taste.37 The vegetarian pizza McPuffs, which combined pizza ingredients with samosas (an Indian snack), and Chicken McGrill seasoned with mayon- naise and extra-tangy Indian spices, had proved to be particularly popular.38 It had also attracted some loyal customers with its value pricing and localised menu. One such customer said:

A normal kebab with all the trimmings, at a regular

restaurant would cost more than Rs 25 and if the

new McGrill is giving us a similar satisfaction with

its mint chutney (sauce), then we’d rather eat in a

lively McDonald’s outlet than sitting in a cramped

car on the road.

To exploit the opportunities created due to its better brand awareness and customer acceptance,

C-104 Case 8 • The Golden Arches in India

McDonald’s was following several different strategies. First, it was increasing the seating capacity in several of its restaurants by adding birthday party areas as well as expanding general seating areas. Initially, four restaurants in Delhi had been expanded and more would follow, depending on the results obtained.

The company was also trying to enter new cities where there might be demand for McDonald’s fast food. One outlet each had been opened in cities such as Ludhiana (north India), Ahmedabad and Baroda (western India). The secondary cities, typically, had lower per capita income levels as well as population density than Mumbai or Delhi, and residents were also likely to be less open to Western food.

In addition to the traditional outlets in busy loca- tions within key cities, McDonald’s was also trying to open outlets in new locations including the follow- ing: • at the inter-state bus terminal in New Delhi (one

outlet) • at airports and railway stations (for example, in

Mumbai and Jaipur) • on busy highways and in petrol stations • in malls, multiplexes and cinema halls.

One advantage of these outlets was that they required lower investment per outlet versus a tradi-

tional format. A key concern, however, was wheth- er the customer profile would be appropriate. For example, the highway travellers in India tended to be mostly truck drivers and bus passengers, who were not likely to go for the McDonald’s type of food. For several other types of locations (for example, railways stations), analysts were wondering whether McDon- ald’s outlets would generate enough traffic. The wide variety of formats and the dispersed network of out- lets would accentuate the problems in maintaining quality and hygiene standards, as well as the infra- structural inadequacies. As Clair Babrowski, presi- dent of McDonald’s Asia-Pacific operations, who was very upbeat about the growth prospects in the Indian market, had said: ‘Part of opening a store is figuring out who’s going to fix the equipment and how the deliveries will get there.’39

Analysts were also wondering whether the com- pany was hasty in trying to expand too fast before achieving breakeven. On the other hand, having suc- ceeded in developing the supply chain and creating a satisfied customer base, it seemed to be an opportune time for the company to expand. In summary, the pace and degree of expansion posed difficult dilem- mas and would most likely impact the company’s per- formance over the next several years.

Notes 1 ‘McDonald’s India to invest Rs 7.5 billion’, http://biz.indiainfo.

com. 2 Approximate exchange rates on 31 December of each year

were as follows: 1997: US$1 = Rs 39.246 1998: US$1 = Rs 42.481 1999: US$1 = Rs 43.516 2000 : US$1 = Rs 46.664 2001: US$1 = Rs 48.170 2002: US$1 = Rs 47.870 3 ‘Big Mac at a fast clip’, Business Line, 27 June 2002. 4 ‘McDonald’s plans major investments in India’, http://news.

sawaal.com. 5 ‘McDonald’s expansion plans under review’, Business Line,

2 August 2001. 6 For instance, in June 2002, McDonald’s was predicting that it

would have 54 outlets by the end of 2002. The company ended the year with 46 outlets.

7 ‘Ronald McDonald to relive Indian dream’, Business Line, 9 March 2001.

8 Wall Street Journal, Europe, June 1999; reproduced at www. branding-kaeuffer.com.

9 www.odci.gov/cia/publications/factbook/geos/in.html#Econ. 10 ‘Long way for India to go on the retail front’, Business Line,

6 December 2000. 11 ‘Vandana Shiva on McDonald’s exploitation and the global

economy’, www.mcspotlight.org. 12 ‘McDonald’s expansion plans under review.’ 13 ‘Look who’s going native’, Far Eastern Economic Review, 1 February

2001. 14 ‘McDonald’s shifts to product-focused ads’, Business Line,

8 September 2000. 15 ‘Look who’s going native.’ 16 ‘Happy birthday, Maharaja Mac! One year later: McDonald’s in

India’, www.media.mcdonalds.com. 17 ‘Of PPPs, Big Macs and exchange rates’, Business Line, 8 May

1999. 18 ‘McDonald’s reworks its menu’, www.india-today.com. 19 ‘Dinner on discount’, Business Line, 25 February 1999. 20 ‘McDonald’s readies expansion model – restaurants to come up

in Pune, Jaipur and Bangalore’, www.hindubusinessonline.com. 21 ‘Bestowing vision’, Business Line, 18 November 2002. 22 ‘McDonald’s goes for media splash’, Business Line, 3 April 2000.

Case 8 • The Golden Arches in India C-105

23 ‘McDonald’s readies expansion model.’ 24 ‘McDonald’s to dish out mega promotions’, Business Line,

2 November 2000. 25 ‘India: Bic Mac: not a lucky promo’, Business Line, 20 March 2001. 26 ‘Big Mac at a fast clip.’ 27 ‘McDonald’s readies expansion model.’ 28 ‘McJatia tickles Bombay’s tastebuds, builds an empire, all in two

years, The Rediff Business Special’, www.rediff.com. 29 ‘Big Mac sets eyes on south’, Business Line, 24 February 2001. 30 ‘McJatia tickles Bombay’s tastebuds.’ 31 ‘Jatia forayed into McDonald’s foodbiz by chance, The Rediff

Business Special’, www.rediff.com. 32 ‘McDonald’s to head south’, Business Line, 21 April 2002.

33 ‘India to be McDonald’s expor t base’, www.indianexpress. com.

34 ‘Look who’s going native.’ 35 Since each restaurant was designed with a seating capacity of

150, this meant a turnover of about 26 times during the course of the day. ‘Big Mac at a fast clip.’

36 ‘Big Mac at a fast clip.’ 37 ‘McDonald’s shifts to product-focused ads.’ 38 ‘Look who’s going native’; ‘McDonald’s readies expansion

model.’ 39 ‘Risk y business’, Chain Leader, 7(11) , November 20 02,

pp. 63–7.

C-106

Case 9

Monsanto*: Better living through genetic engineering? Seth Brooks Melissa Schilling John Scrofani

Early in the year 2000, Monsanto Company merged with Pharmacia & Upjohn, forming Pharmacia Cor- poration, and making Monsanto part of the third- largest pharmaceutical company in the world. Later that year, Monsanto raised cash through a partial (15 per cent) initial public offering. As of March 2001, Monsanto employed 14 700 people, and at the helm was the president and chief executive officer, Hendrik Verfaillie.

Verfaillie faced a number of interesting challenges. Monsanto was a company that had, over the last decade, dramatically reinvented itself. Throughout the 20th century, Monsanto had acquired many com- panies, expanding into a diverse range of business- es. However, when Bob Shapiro had stepped into the office of CEO in 1993, he restructured the company to be more focused on ‘life sciences’ – or the combi- nation of science and technology to find solutions for growing global needs. Explosive innovation in bio- technology had unleased a vast range of new potential products and offered the allure of tapping new, fast- growing markets. As of 2001, Monsanto had a new

capital structure, and a new portfolio focused entirely on applying biotechnology to agriculture.

Though the company had pared down its corporate portfolio in order to have more strategic direction, Monsanto’s move towards life sciences was not without its problems. One of the most successful applications of biotechnology to Monsanto’s business had been Roundup® – a popular agricultural herbi- cide that worked in conjunction with genetically mod- ified crop seeds. The combination of a powerful her- bicide and crop seeds that are genetically modified to resist the herbicide had been a profound innovation, and had dramatically increased crop yields. By 1996, Roundup® accounted for 17 per cent of Monsanto’s total annual sales.1 However, Monsanto’s patents on Roundup® had begun to expire in several countries in 1991, and expired in the United States in Septem- ber 2000. To make matters worse, strong negative consumer perceptions of genetically modified (GM) foods began to surface towards the end of the decade, severely retarding the company’s sales in Europe and beginning to threaten Monsanto’s American markets as well.

* This case has been prepared as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Case 9 • Monsanto C-107

The science of life Monsanto is an industry leader in the bioengineer- ing of foods. ‘The term “biotechnology” refers to the use of living organisms or their products to modify human health and the human environment,’ accord- ing to the National Health Museum’s website.2

For thousands of years, from the time human communities began to settle in one place, cultivate crops and farm the land, humans have manipulated the genetic nature of the crops and animals they raise. Crops have been bred to improve yields, enhance taste and extend the growing season. Each of the 15 major crop plants, which provide 90 percent of the globe’s food and energy intake, has been extensively manipulated, hybridized, inter- bred and modified over the millennia by countless generations of farmers intent on producing crops in the most effective and efficient ways possible.3

Many scientists argue that genetic engineering is simply a ‘… refinement of the kinds of genetic modi- fication that have long been used to enhance plants … for food’.4 The science of genetics and the understand- ing of why physical traits are passed from parent to child began over a century ago. German scien- tist Gregor Mendel conducted the first experiments aimed at understanding the science behind genetic inheritance. Mendel used artificial hybridisation, the fertilisation of the flower of one species by the pollen of another species, on thousands of plants, record- ing the traits of the successive generations. In 1865 he published a paper about his work, ‘Versuche über Pflanzen-Hybriden’ (Experiments in Plant Hybri- disation).5 The idea that physical traits are passed through generations of organisms created the new field of science focused on genetics.

In 1953, James Watson, a US biologist, and Fran- cis Crick, an English biophysicist, discovered the structure of DNA (deoxyribonucleic acid).6 DNA works like a blueprint to define all characteristics, or traits, of an organism. A DNA molecule has a double- helix shape, like a twisting stepladder. DNA strands are quite similar to a written language. The ‘letters’ of this genetic language are formed by the DNA nucleo- tides, which are the ‘steps’ in the DNA stepladder.

The ‘words’ in the genetic language are formed of codons, each codon consisting of three nucleotides. The ‘sentences’ in the genetic language are genes, which are made up of many codons. A ‘book’ in the genetic language is an entire string of DNA, which defines all the characteristics of an organism.

Modern understanding of the chemical properties of DNA allows scientists to ‘cut’ the DNA strand at a certain point in the stepladder using enzymes that are produced naturally by some bacteria. With this enzyme technology, scientists can ‘cut’ away a desir- able gene from one organism, then ‘paste’ that gene into another organism, forming what is called a recom- binant DNA strand (see Exhibit 1). It is through this cutting and pasting of genes that scientists can give organisms traits that they previously did not have, without the use of the longer and more ambiguous process of cross-fertilisation.

Genetically engineered crops and herbicide

Without efficient crop protection products, world-

wide yields would fall by an average of 30 to 60

per cent. They would also fluctuate wildly.7

Farmers across the world can either choose to spray their crops with some form of herbicide, or they can till their land on a daily basis, drastically decreasing

Exhibit 1 Cutting and pasting DNA

Source: Modified from http://esg-www.mit.edu:8001/bio/rdna/cloning.html.

C-108 Case 9 • Monsanto

their productivity. If they do choose herbicide, they can go the path of buying very effective and expen- sive proprietary products such as Roundup®, or they can buy the cheaper alternative generic brands such as Squadron, Storm or Post Plus. A 1997 study indicated that Roundup® clearly outperformed these generic brands. The results showed that Roundup® led to a net income per acre of US$235 compared to the oth- ers, which produced US$209 per acre (see Exhibit 2). Roundup® cost about US$34 per gallon compared to generic brands that cost US$15–$20 per gallon.8 In 1998, Monsanto lowered the cost of Roundup® by US$6 to US$10 per gallon in order to increase sales volume and to better compete with generic compa- nies. Generic products were popular in developing countries where it was difficult for farmers to afford proprietary products.9 Furthermore, competing with generic brands had become particularly important as Roundup’s patents began to expire.

Roundup® herbicide technology Roundup® is a wide-spectrum herbicide, meaning that it is toxic to any plants it comes in contact with. As noted in the Mother Jones environmental journal, ‘… its main ingredient, glyphosate, breaks down quickly in soil, so that little or no toxic byproduct accumu- lates in plant or animal tissue – a detail that Mon- santo highlights when describing itself as an envi- ronmentally friendly company.’10 As of March 2001, Roundup® had been used commercially for more than 20 years and was used in over 100 countries. It was

estimated that in 1998, worldwide use of glyphos- phate exceeded 112 000 tons, and that 71 per cent of all genetically engineered crops planted that year were designed to be resistant to herbicides such as Monsanto’s Roundup®.11

Roundup Ready® crops Monsanto markets several agricultural products that have been genetically modified to tolerate Roundup® herbicide. These crops, including Roundup Ready® soybeans, Roundup Ready® canola and Roundup Ready® cotton, are sold to farmers. Roundup Ready® soybeans, the first of Monsanto’s Roundup Ready® genetically modified crops, was approved for com- mercialisation in 1995.

Roundup® herbicide is a broad-spectrum herbi- cide which controls a wide range of broadleaf and grass weeds. Most herbicides used in crops are selec- tive, and only control certain types of weeds. Farm- ers using Roundup Ready® soybean seeds can use Roundup® herbicide to control weeds in their crop. If Roundup® herbicide were applied over the top of a conventional soy crop, it would kill the crop as well as the weeds. Apart from the ability to toler- ate Roundup®, the crop is klike any other soy crop. Farmers can still use all the traditional herbicides they would with a conventional crop, and the composition of the soybeans produced is equivalent to a conven- tional soabean crop.

Monsanto enters into agreements with farmers who grow Roundup Ready® crops. These agreements

Exhibit 2 Roundup® versus generic glyphosate brands

Herbicide treatment SOG Yield BU/A Net income/Acre

Squadron 3 pts PRE 33.6 US$209.20 Storm 1.5 pts + Poast Plus 24 oz 21 DAP + 7 Later 33.6 US$204.70 Roundup Ultra 32 oz 28 DAP 36.8 US$235.80

The Roundup vs. best conventional herbicide alternative study was designed to evaluate the economics of the Roundup Ready seed/herbicide system versus conventional herbicide programs. Each herbicide program was applied at labelled rates. Net income is figured by multiplying the yield (Bu/A) by US$7 minus herbicide costs, minus a US$4 fee per herbicide application, and the US$5 tech fee for Roundup Ready soybeans figured at a bag per acre.

In the systems study herbicide applications were made based on labelled recommendations and no other weed control was allowed. The systems studies are designed to measure the effectiveness of the herbicide management practices and input costs. Based on the 1996 trial at Marian AR, the Roundup Ready seed/herbicide system was superior economically to the other two conventional herbicide programs. These differences can be attributed to advantages in weed control and the removal of crop stress typically associated with conventional herbicide programs.

Source: www.asgrow.com/gknowled/CRMar96RR5.html, 23 March 1999.

Case 9 • Monsanto C-109

have two main purposes. First, they ensure that grow- ers are aware of all their regulatory obligations, and second, they help Monsanto protect their intellectual property and the investment they have made in Round- up Ready® technology. Monsanto provides support to farmers to ensure that they meet their requirements to be compliant with the law.

Terminal technology

On March 3 1998 the company Delta and Pine Land Co. (Mississippi, USA) and the U.S. Department of Agriculture (USDA) announced that they received US Patent No. 5,723,765 on a new genetic technology designed to prevent unauthorized seed saving by farmers.12

The technology enabled the environment to influence the characteristics a plant exhibits, even if the parents of the plant do not have those characteristics. With this technology it was possible to create genetic char- acteristics in plants that only emerge if they have the proper external stimulus. For example, two geneti- cally altered parent plants can thrive in a moist region and exhibit characteristics of tropical plants, and their offspring can be moved to a desert region and exhibit characteristics of a desert plant, even though neither parent exhibited these desert characteristics. Monsanto hoped to capitalise on this technology by using it to prevent farmers from saving their seeds from year to year (and thus forgoing purchasing them from Monsanto). Monsanto would have utilised this technology by altering the plant’s reproductive sys- tem so that, unless a patented chemical was applied to the seeds at a certain time during their development, the seeds would be unable to germinate. This tech- nology would have further strengthened Monsanto’s ability to enforce its contracts with farmers, by mak- ing the farmers unable to use seeds harvested from the plants they grew using Monsanto’s seeds in the next season.

Monsanto announced its intention to merge with Delta and Pine Land Co. in the spring of 1998, in hopes of acquiring this technology. However, in response to consumer and farmer outrage, Robert Shapiro wrote an open letter dated 4 October 1999, stating that Monsanto was making the public a ‘… commitment not to commercialize sterile seed tech-

nologies, such as the one dubbed “Terminator”. We are doing this based on input from … a wide range of other experts and stakeholders, including our very important grower constituency.’13 Additionally, Sha- piro wrote: ‘… though we do not yet own any sterile seed technology, we think it is important to respond to those concerns at this time by making clear our commitment not to commercialize gene protection systems that render seed sterile.’14 Monsanto with- drew its Department of Justice filing for a merger with Delta and Pine Land Co. on 20 December 1999.

History of Monsanto

Monsanto’s germination Monsanto was founded in 1901 by John Francis Queeny, a 30-year veteran of the Meyer Brothers Drug Company, with the goal of producing prod- ucts for the food and pharmaceutical industries. The company was named after the founder’s wife, whose maiden name was Olga Mendez Monsanto. In 1902 the St Louis based company began producing saccha- rin. For several years after, the entire saccharin out- put was shipped to Georgia-based Coca-Cola Co. The company soon began producing caffeine and vanilla as well. In 1917, Monsanto entered the pharmaceu- ticals business when it became the first company to produce Aspirin.

As a result of financial crisis and wartime debt in the late 1920s, shares were offered to the public in 1927, one year before Edgar Queeny, the son of John Queeny, succeeded his father as president of the com- pany. He announced his vision of an era of expansion into new businesses that would take Monsanto into the 1930s. This expansion would include immedi- ate acquisitions that expanded the company into the rubber, chemicals, textile, paper, leather, soap and detergents industries. Monsanto also moved into the plastics and resin industries, the result of which gave it ownership of the first man-made plastic, celluloid.

During the Second World War years, Monsanto became involved in uranium research for the Man- hattan Project. This was done in the Mound Plant in Dayton, Ohio, which was used as a nuclear facility for the government for the next 40 years. In the 1950s, Monsanto began to expand its chemical business.

C-110 Case 9 • Monsanto

Through licensing technology from DuPont, the com- pany began to produce acrylic fibre and nylon. Mon- santo also entered into the fertiliser industry, as well as the plastic bottle industry. During this decade, Monsanto built a plant to produce ultra-pure sili- cone, which was used as raw material in the electron- ics industry.

In the 1960s, Monsanto created a new company division focused exclusively on agriculture. It intro- duced Lasso® herbicide, and Roundup® followed a few years later. In the late 1960s, almost a decade after establishing the agriculture division, Monsan- to moved into the seed and hybrid swine business through an acquisition. The 1972 appointment of John W. Hanley marked the beginning of an era of heavy investment in biotechnology research.

The 1980s began with a new president being named: Richard J. Mahoney. Immediately after assuming the position, Mahoney sold off the com- modity chemicals portion of Monsanto’s busi- ness to DuPont. Monsanto used the money for new research and development, and created new technolo- gies, including the artificial sweetener ‘Nutrasweet’ (aspartame). At the beginning of the 1980s, Mon- santo declared biotechnology as its strategic research focus. One year after this announcement, scientists at Monsanto were the first to successfully genetically modify a plant cell. This led to success in growing plants with genetically engineered traits. Two years after this success, a major restructuring of the com- pany took place. Monsanto divested its non-strategic businesses to consolidate around its core competency, high-value-added proprietary products.

The 1990s served as a decade of expanding medi- cine production for Monsanto. Using new techniques in bioengineering, it was able to create new medi- cines at a faster pace than ever before. In the early 1990s, it sold its first Ambien®, an insomnia treat- ment, and Daypro®, an arthritis treatment. In 1993, Robert B. Shapiro was named the new CEO of Mon- santo. He announced that the company would refocus its strategy and become a life sciences company. In the mid-1990s, Monsanto’s first genetically modi- fied crops were approved for commercial sale, includ- ing Roundup Ready® glyphosate-tolerant soybeans. Monsanto formed the Solaris Unit, which produced

Ortho®, Greensweep® and Roundup® lawn and gar- den products.

As part of his effort to restyle Monsanto into an exclusively life sciences company, in 1997, Shapiro urged the company to spin off all the chemical parts of the business into a company called Solutia. Shapiro saw this as a good way for his company to increase its profitability by focusing on a key competitive advan- tage. (See Exhibit 3 for a complete corporate diversi- fication timeline.)

Monsanto’s evolved form On 19 December 1999, Monsanto and pharmaceuti- cal giant Pharmacia & Upjohn, Co. announced their intention to merge. The merger was approved by shar- eowners on 23 March 1999, creating a new entity called Pharmacia Corporation. Monsanto’s phar- maceutical business was merged with Pharmacia & Upjohn’s. According to information provided on the Pharmacia website at the time of the merger,

Monsanto Company is the wholly owned agricultural subsidiary of Pharmacia Corporation. Monsanto is committed to finding solutions to the growing global needs for food and health by sharing common forms of science and technology among agriculture, nutrition and health.15

(See Exhibits 4 and 5 for Monsanto’s financial information valid at time of merger.)

Monsanto’s suppliers In its move to become a company oriented around life sciences, Monsanto had spun off its chemical busi- nesses that made the chemicals necessary to produce Roundup®. Though in general it was not dependent on any single supplier for a significant amount of its raw materials or fuel requirements, certain raw mate- rials were obtained from a few major suppliers. For example, Monsanto purchased its North American supply of elemental phosphorus, a key raw material for the production of Roundup® herbicide, from P4 Production, LLC, a joint venture between Monsanto and Solutia Inc.16

On the crop side of the business, Monsanto had engaged in a spree of mergers and acquisitions,

Case 9 • Monsanto C-111

Exhibit 3 Monsanto’s corporate diversification timeline

1901 John F. Queeny founds the original Monsanto. His wife was Olga Monsanto Queeny. The first product of that company was saccharine.

1945 The original Monsanto produces and markets agricultural chemicals, including 2,4D.

1960 The Agricultural Division is established.

1964 Ramrod herbicide is introduced, beginning the use of Western theme names for the original Monsanto’s brands of herbicides.

1968 Commercialization of Lasso herbicide in the U.S. begins the trend toward reduced-tillage farming.

1975 A cell biology research progam is established in the Agricultural Division.

1976 Roundup herbicide is commercialised in the U.S.

1981 A molecular biology group has been set up and biotechnology is firmly established as Monsanto’s strategic research focus.

1982 Scientists working for the original Monsanto are the first to genetically modify a plant cell.

1982 The original Monsanto acquires the Jacob Hartz Seed Co., known for its soybean seed.

1984 The Life Sciences Research Center opens in Chesterfield.

1987 The original Monsanto conducts the first U.S. field trials of plants with biotechnology traits.

1994 The original Monsanto’s first biotechnology product to win regulatory approval, Polilac, bovine somatotropin (Bst) for dairy cows, goes on sale in the U.S.

1996 The original Monsanto acquires the plant biotechnology assets of Agracetus and purchases an interest in Calgene, another biotech research company. (The Calgene acquisition was completed the following year.)

1996 The original Monsanto’s first plant biotechnology product, Roundup Ready soybeans and canola and Bollgard cotton, are planted commercially.

1997 YieldGard corn, with protection against the European corn borer, is commercialized. Asgrow agronomics seed business is purchased by the original Monsanto.

1997 The original Monsanto spins off its industrial chemical and fibers business as Solutia Inc.

1998 The original Monsanto completes its purchase of DeKalb Genetics Corp.

1998 Roundup Ready corn is introduced.

2000 The original Monsanto enters into a merger and changes its name to Pharmacia Corporation.

A new Monsanto Company

2000 A new Monsanto company, based on the previous agriculatural division of Pharmacia, is incorporated as a stand-alone subsidiary of the pharmaceutical company. (Pharmacia itself eventually becomes a subsidiary of Pfizer, in 2003.)

2002 YieldGard Rootworm and YieldGard Plus corn get U.S. approval.

2002 The new Monsanto company is spun off from Pharmacia and is now a separate company.

2003 More than 300 seed companies in the United States have licenses for Monsanto biotechnology traits.

2004 The majority of cotton and soybean seeds planted in the U.S. have at least one biotechnology trait.

Source: www.monsanto.com, 17 August 2004.

expanding its business to incorporate companies that had previously supplied many of the raw materi- als that Monsanto used to develop Roundup Ready® crops. Monsanto acquired or formed long-term relationships with six seed companies between 1995 and 1997 (see Exhibit 3).

Research and development Monsanto prides itself on being a company that develops breakthrough proprietary technology. The

development of Roundup® herbicide in the 1960s had put Monsanto’s agricultural division into the fore- front, and scientists in this division were working hard to develop the next generation of herbicide and seed systems. In the early 1990s, Bruce Bickner, co-president of Monsanto’s agribusiness, spent $0.14 per revenue dollar on R&D compared to the industry average of $0.09 per revenue dollar.17 However, some felt that Monsanto’s focus on R&D-based proprietary products might cause it to miss out on the large global market for

C-112 Case 9 • Monsanto

crop protection. It was estimated that by 2001, 53 per cent of the world agrochemical market would consist of generic chemicals (rather than proprietary chemicals).18 In most countires Monsanto’s sales growth was weaker than sales growth in the United States (see Exhibits 6 and 7).

Human resources Monsanto placed considerable emphasis on the value of its employees. It was often reinforced that excel- lent management of people was crucial to retain Mon- santo’s foothold in the market. HR managers were required to have a master’s degree and at least five years of HR management experience ‘… to ensure proper staffing skills, change management, coaching and counseling, project management and organiza- tional design’.19 The senior staff at Monsanto went to great effort to place people into the positions that fit them best, believing that a failure to properly allocate employees would result in a forfeiture of the compa- ny’s competitive position.

Marketing Monsanto targeted professional farmers by advertis- ing Roundup® in magazines such as Farm & Country, Farm Journal and High Plains Journal.20 The pri- mary marketing message for Roundup® was that it was a safe product to use. The productivity increase enabled by Roundup® was already clear to farmers – at least those in the United States. As noted in The Economist,

Americans in general have a positive perception of

technology and are willing to accept the biological

version of it. They are willing to overlook the

fact that they are growing and eating genetically

modified foods in return for increased yields and

reduced costs.21

Ron Thompson, a corn farmer in Illinois, noted: ‘If there is a farm that grows corn, canola, soy, or wheat, then its farmer probably buys Roundup®. It is in his best interest.’22

Exhibit 4 Monsanto’s statement of consolidated income (loss) (US$mn)

2000 1999 1998

Net sales 5 493 5 248 4 448 Cost of goods sold 2 770 2 556 2 149 Gross profit 2 723 2 692 2 299 Operating expenses:

Selling, general and administrative expenses 1 253 1 237 1 135 Research and development expenses 588 695 536 Acquired in-process research and development 402 Amortisation and adjustment of goodwill 212 128 77 Restructuring – net 103 22 94

Total operating expenses 2 156 2 082 2 244 Income from operations 567 610 55 Interest expense (net of interest income of $30, $26 and $27 in 2000, 1999 and 1998, respectively) (184) (243) (94) Other expense (income) – net (49) (104) (21)

Income (loss) before income taxes and cumulative effect of accounting change 334 263 (60) Income tax provision (159) (113) (65)

Income (loss) before cumulative effect of accounting change 175 150 (125) Cumulative effect of a change in accounting principle, net of tax benefit of US$16 million (26)

Net income (loss) 149 150 (125)

Source: Data from Monsanto Annual Report 2000.

Case 9 • Monsanto C-113

Exhibit 5 Monsanto’s statement of consolidated financial position (US$mn)

Assets 2000 1999

Current Assets: Cash and cash equivalents 131 26 Trade receivables, net of allowances of $171 in 2000 and $151 in 1999 2 515 2 028 Miscellaneous receivables 283 350 Related party loan receivable 205 Related party receivable 261 Deferred tax assets 225 130 Inventories 1 253 1 440 Other Current Assets 100 53 Total Current Assets 4 973 4 027 Property, Plant and Equipment Land 69 82 Buildings 766 708 Machinery and equipment 2 688 2 187 Computer software 190 155 Construction in progress 746 726 Total property, plant and equipment 4 459 3 858 Less accumulated depreciation 1 800 1 639 Net Property, Plant and Equipment 2 659 2 219 Goodwill (net of accumulated amortisation of $290 in 2000 and $183 in 1999) 2 827 3 081 Other Intangible Assets (net of accumulated amortisation of $506 in 2000 and $362 in 1999)

779 935

Other Assets 488 839 Total Assets 11 726 11 101

Liabilities and Shareowner’s Equity Current Liabilities: Short-term debt 158 Related party short-term loan payable 635 Short-term debt of parent attributable to Monsanto 89 Accounts payable 525 466 Related party payable 162 Accrued compensation and benefits 172 147 Restructuring reserves 38 26 Accrued marketing programs 181 256 Miscellaneous short-term accruals 886 720 Total Current Liabilities 2 757 1 704 Long-term debt 962 Long-term debt of parent attributable to Monsanto 4 278 Postretirement Liabilities 367 Other Liabilities 299 474 Shareowners’ Equity Common stock (authorised: 1 500 000 000 shares, par value $0.01 Issued: 258 043 000 shares in 2000 3 Additional contributed capital 7 853 Parent company’s net investment 4 926 Retained earnings 2 Accumulated other comprehensive loss (479) (281) Reserve for ESOP debt retirement – attributable to Monsanto (38)

Total Shareowners’ Equity 7 341 4 645 Total Liabilities and Shareowners’ Equity 11 726 11 101

Source: Data from Monsanto Annual Report 2000.

C-114 Case 9 • Monsanto

Distribution On 12 July 1999, Monsanto signed an agreement making Scott’s Company the sole marketing and dis- tribution agent of Roundup® in the United States. Scott’s was the most recognised agent of garden products in the US.23 Prior to this, Monsanto dis- tributed Roundup® through the Central Garden and Pet Company, which sold Roundup® to retailers and sometimes directly to farmers. Global opportunities had also caught Monsanto’s attention. ‘The interna- tional potential for our existing biotechnology traits is roughly double the acreage potential within North

America,’ noted Verfaillie. In July 1998, Monsanto purchased Cargill Seed Business, an already estab- lished worldwide seed company with operations and distribution in 51 countries in Central and South America, Europe, Asia and Africa, in order to gain quicker access to these markets.24

As part of its strategy to lessen its reliance on US sales and increase the acceptance of biotechnology internationally, Monsanto’s near-term plans includ- ed: (1) working with the Brazilian government and other stakeholders to obtain approval for planting Roundup Ready® soybeans in Brazil; (2) accelerating

Exhibit 6 Monsanto’s sales by region (US$mn)

Year

S a le

s (U

S $ m

n )

0 1995 1996 1997 1998 1999

1

2

3

4

5

6

United States

Europe – Africa

Latin America

Asia – Pacific

Canada

Exhibit 7 Monsanto’s trade receivables by region (US$mn)

Year

U S

$ m

n

0 1996 1997 1998 1999

100

200

300

400

500

600

700

800

900 US agricultural product distributors

Customers in Latin American Southern Cone Counties

European agricultural product distributors

Pharmaceutical distributors worldwide

Customers in the former Soviet Union

Customers in South-East Asia

Case 9 • Monsanto C-115

the commercialisation of Roundup Ready® corn by securing a licence to import grain grown from Roundup Ready® seeds into Europe; and (3) expand- ing its markets in Asia by securing the approval of Bollgard insect-protected cotton in India.25

Levelling the field Monsanto faced several large competitors. One giant in the market was American Home Products (AHP), whose agricultural subsidiary, Cynamid Corpora- tion, competed directly with Monsanto through a heavy focus on R&D and marketing.26 It had intro- duced alternative products that had the same chemi- cal base as Roundup® and thus could be used with it. DuPont Corporation and Novartis Corporation also competed with Monsanto and its parent company, Pharmacia, primarily in the areas of pharmaceuticals, chemicals and consumer home products. The patent expiration of glyphosate had further opened opportu- nities for companies to enter the agribusiness, an area that had long been dominated by Monsanto.

Patent expiration Roundup® herbicide was registered for use in 1974. By 1991 patents protecting it had expired in several countries, including Australia. Patent protection for the active ingredient in the herbicide expired in the United States in September 2000.27 Having had patent protection on the production and sale of Roundup® herbicide, Monsanto now stood on the threshold of competing with other chemical firms that made glyphosate-based herbicides. Monsanto began lowering prices on Roundup® in markets where pat- ent expiration was most likely to impact sales. Mon- santo hoped to recoup in volume what it would lose in profit margins.

On 19 January 1999, Dow Chemical Company subsidiary Dow AgroSciences LLC and Monsanto announced a multi-year manufacturing agreement that also licensed the rights to Monsanto’s patent data for glyphosate herbicide.

The agreement will allow Dow AgroSciences to register its own brand of glyphosate herbicide for sale globally. However, Dow AgroSciences will not be able to reference Monsanto data when registering

its products for use in Japan. Additionally, the

agreement allows Dow AgroSciences to use its

own brand of glyphosate herbicide over the top

of Roundup Ready® soybeans and cotton in the

year 2000 in the United States, and beginning in

2001, over the top of Roundup Ready® corn in the

United States.28

DuPont DuPont was an extremely large company with US$28 billion in sales in 1999.29 Its business was split fairly evenly between three divisions: Chemicals (which DuPont is most widely known for), pharmaceuticals and life sciences. From 1998 to 2000, its herbicide share in the soybean market had slipped from 30 per cent to 12 per cent due to inroads by Roundup®, and the company was forced to slash 800 jobs in the agri- cultural division.30 However, in 2000, the company began producing herbicides similar to Roundup® under a licensing arrangement from Monsanto.

Novartis Novartis competed in the areas of consumer health, healthcare and agribusiness with US$25 billion in sales in 1999.31 The company was founded in 1758 under the name Ciba Geigy, and began by producing chemicals, dyes and drugs of all kinds. At the time of Monsanto’s inception in 1901, Ciba was a market leader in artificial sweeteners. Like Monsanto and AHP, it competed worldwide, offering herbicides, insecticides, plant activators and seed treatment. While Novartis had not developed any breakthrough agricultural products in recent years, it did have the highest capital-spending budget for R&D in crop protection technologies.32 It also licensed glyphosate from Monsanto for use in its herbicide products.

American Home Products As mentioned previously, American Home Products (AHP) posed a significant threat to Monsanto. Its acquisition of Cynamid Corporation in 1994 signif- icantly strengthened the company on a global basis, placing AHP among the top-tier in sales of agricul- tural sciences.33 AHP’s sales jumped from US$8.9 billion in 1994 to US$13.3 billion in 1995, due to the acquisition of Cynamid.34 However, AHP showed a

C-116 Case 9 • Monsanto

net loss of US$1.2 million in 1999, due to the mass restructuring of the organisation to accommodate the new agricultural company. In addition, it conducted a nationwide inventory buyback program of soy- bean seeds in order to prepare for Cynamid’s future herbicide products. This reduced 1999 net sales by US$175 million.35

AHP’s focus on market research and R&D result- ed in the development of an improved alternative to Roundup® products, EXTREMETM herbicide and PURSUIT residual. EXTREMETM used glyphosate, the same main ingredient used in Roundup®, and com- bined it with a residual agent PURSUIT, which pre- vented new weeds from growing up to six days after application.36 The customer could not get this ben- efit from using Roundup® alone. When AHP asked customers how to improve Roundup®, 85 per cent of them responded, ‘Give it residual control.’37 The two companies, Cynamid (AHP) and Monsanto, signed a multi-year agreement in July 1999 in which Cynamid (AHP) would be allowed to purchase the glyphosate for use in EXTREMETM.38 Since the product could be used in conjunction with the glyphosate-immune seeds sold by Monsanto, AHP was able to benefit by Monsanto’s large installed base of existing customers (see Exhibit 8).

Growing concerns The genetically modified food industry had long faced opposition in Europe, and was facing increasing criticism in the United States. In addition, Monsanto

in particular was facing charges of misleading adver- tising, and that Roundup®’s primary active ingre- dient, glyphosate, had been linked to illnesses that included a form of cancer known as non-Hodgkin’s lymphoma.

Patenting life Although in the year 2000 the controversy over bio- engineered foods was only beginning in the United States, other countries had advocated against the sale of GM food for years. The use of biotechnology to create genetically modified food ‘… has set off a fire- storm among European consumers’.39 In the Euro- pean Union, a legal and political battle had ensued over whether or not to allow companies to patent ‘life’ (that is, gene sequences which they have either discov- ered or engineered).

In 1988, the European Commission first proposed

a patent directive (law) which would have allowed

such patents. Seven years later, in 1995, the

European Parliament (EP) rejected this legislative

proposal because it deemed the patenting of life-

forms unethical. But in 1998, the Parliament

succumbed to pressure from the biotech industry

and adopted the ‘Life Patents Directive’. However,

the Directive is now being challenged before the

European Court of Justice and it is still not certain

whether the industry will get what it wants. In

addition, matters are made even more complicated

by the existence of a parallel patenting system, the

much older European Patent Convention (EPC),

Exhibit 8 Global herbicide sales of American Home Products/Monsanto (US$mn)

1997 1998E 1999E 2000P 2001P 2002P 97–02 ‘CGR

Roundup $2 188 $2 450 $2 650 $2 850 $2 850 $2 850 5% Pursuit 540 570 600 625 650 675 5% Prowl/Stomp 314 325 340 360 380 400 5% Scepter 117 135 165 195 225 250 16% Lasso/Harness 390 360 360 360 360 360 –2% BST 160 190 210 230 250 270 11% Squadron 68 80 95 110 125 140 16% Other Herbicides 448 490 550 610 660 700 9% Total Herbicides $4 225 $4 600 $4 970 $5 340 $5 500 $5 645 6% % Change 15% 9% 8% 7% 3% 3%

Note: E = Estimated, P = Predicted. Source: Pharmaceutical Industry Pulse Part 6, SG Cowen Securities Corporation, 1 October 1998.

Case 9 • Monsanto C-117

Exhibit 9 Greenpeace’s labelling guidelines

Policy Concerning the Labelling and Declaration of Genetically Engineered Food Products

Greenpeace International, November 1997 Greenpeace is opposed to the release of genetically modified organisms (GMOs) into the environment. We also believe that stream-lining of crops (sometimes referred to as segregation) is essential for the right of consumers to be provided with the choice of non-genetically manipulated food. For products that do contain or are produced by GMOs all products, seeds, animal feed, and food products and their components must be very clearly labelled.

Greenpeace has provided an example of how a label for such products could look. We are calling on the EU Commission to implement a comprehensive and immediate labelling program for its citizens that allows for the choice of non-genetically modified food for consumers.

Greenpeace Policy on Labelling in the European Union All food products that have been produced, processed, grown or cultivated under one of the following preconditions have to be marked with a clear and easily visible label (see Annex 1), to inform consumers about the production process and to allow an informed choice between genetically engineered and conventional food products.

The label has to be used as a non-removable sticker or as a direct imprint on the product itself or its packaging (whatever is displayed to the customer). The labelling policy should come into effect immediately as stickers can be used as a phase in for the interim period when direct imprints should be obligatory.

For the labelling process, the complete chain of production and all components of the final product must be taken into consideration. All ingredients and components of the final product must be listed. The technical capability to detect GMOs is not a criteria for labelling.

Additional information on the product must clearly state if the product contains proteins from plants, animals or microorganisms known to initiate allergies.

A central register of all products on the market in the European Union should be maintained. Information should be collected and results published for the public by the EU Scientific Food Committee controlling program on the short and long term effects of genetic engineering in food.

Liability for any health effects caused from food or products derived from GMOs should be the responsibility of the food processing company or company involved.

(A) Labelled ‘Genetically Manipulated’ Food products must be marked with the label ‘Genetically manipulated’ if one or more of the following preconditions applies to either the finished product or one or more of its components: 1. Food products and/or their components that consist of or contain genetically modified organisms (according to the

definition set out in the EU-directive 90/220/EEC). This regulation applies both for finished products and their components, regardless whether the genetical modification can be detected by currently available scientific standards or not.

2. Food products and/or their components that are produced or derived from genetically modified organisms. This regulation applies both for finished products and their components, regardless of whether the genetical modification can be detected by currently available scientific standards or not.

3. Food products, if their additives are produced or derived from genetically modified plants or animals. 4. Food products obtained or derived from animals raised and fed with genetically modified animal fodder. 5. Animal fodder must be labelled as genetically manipulated: if the fodder or its components consist of or contain genetically modified organisms or their parts; if the fodder or its

essential components are produced or derived from genetically modified organisms. 6. Animals that are genetically engineered and sold for food or animal fodder (such as fish meal).

(B) Labelled ‘Produced with Genetic Engineering’ Food products have to be marked ‘Produced with genetic engineering’ (without a label; in written form, placed within the list of ingredients), if one or more of the following preconditions applies to either the finished product or one or more of its components: 1. Food products that are produced with the help of production processes that operate with genetically modified organisms or

their derivatives. 2. Food products that contain or are produced with the help of additives (vitamins, enzymes, flavoured substances

(flavourants)) that are produced or derived from genetically modified organisms.

Source: Information taken from www.greenpeace.org/~geneng/.

C-118 Case 9 • Monsanto

which does not allow patents on plants but is

undecided on patents on animals and genes.40

Patents on gene sequences were first allowed in the United States. If laws banning the patenting of gene sequences were upheld, Monsanto would be unable to protect itself from other companies copying and reselling the technology in which it had invested so heavily.

The regulation of genetically modified foods In the United States, the Food and Drug Administra- tion (FDA) is responsible for regulating the biotech industry.

Under FDA policy developers of bioengineered

foods are expected to consult with the agency

before marketing, to ensure that all safety and

regulatory questions have been fully addressed.

FDA’s policy also requires special labeling for

bioengineered foods under certain circumstances.

For example, a bioengineered food would need

to be called by a different or modified name if

its composition were significantly different from

its conventionally grown counterpart, or if its

nutritive value has been significantly altered.

Special labeling would be required if consumers

need to be informed about a safety issue, such as

the possible presence of an allergen that would not

normally be found in the conventionally-grown

product.41

As the FDA policy existed in 2000, most products that contained genetically modified components did not need to state this fact on their labels. This raised heavy criticism from consumer advocacy groups, which lobbied to have food containing GM prod- ucts labelled as such. One advocacy group, Green- peace, released a guideline for labelling GM foods (see Exhibit 9).

Consumer advocates also criticised the FDA’s policy that unless a genetically modified food is sig- nificantly different from its ‘natural’ counterpart, the agency would not test that food product for safety. The FDA asserted that GM food is ‘… exempt from

testing because it is “generally recognized as safe” (GRAS)’.42 However, many scientists, including sci- entists working for the FDA, insisted that the agency should test all genetically modified products on the market.

Herbicide risks Many of those who were opposed to the use of genet- ically modified food were also concerned because companies developing herbicide-resistant crops had begun requesting permits allowing higher residues of chemicals in genetically engineered food. For exam- ple, Monsanto had already received permits enabling a threefold increase in herbicide residues on geneti- cally engineered soybeans in Europe and the United States (up from six parts per million (PPM) to 20 PPM).43 This was particularly alarming because a study by Swedish oncologists Dr Lennart Hardell and Dr Mikael Eriksson, published in the 15 March 1999 Journal of American Cancer Society, indicated a link between glyphosate and non-Hodgkin’s lymphoma (NHL). The researchers maintained that exposure to glyphosate increased the risk of contracting this form of cancer.44

Sadhbh O’Neill, of the European organisation Genetic Concern, stated that this study reinforces concerns by environmentalists and health profession- als that:

… far from reducing herbicide use, glyphosate resistant crops may result in increased residues to which we as consumers will be exposed in our food. Increased residues of glyphosate and its metabolites are already on sale via genetically engineered soya, common in processed foods. However no studies of the effects of GE soya sprayed with Roundup on health have been carried out either on animals or humans to date.45

The United States Department of Agriculture (USDA) statistics from 1997 show that expanded plantings of Roundup Ready® soybeans (i.e. soybeans genetically engineered to be tolerant to the herbicide) resulted in a 72 percent increase in the use of glyphosate. According to the Pesticides Action Network, scientists estimate that plants genetically engineered to be herbicide resistant

Case 9 • Monsanto C-119

will actually triple the amount of herbicides used.

Farmers, knowing that their crop can tolerate or

resist being killed off by the herbicides, will tend

to use them more liberally.46

Misleading advertising Though Monsanto marketed Roundup® as ‘biode- gradable’ and ‘environmentally’ friendly, test results had shown that the main ingredient in Roundup®, gly- sophate, was the number one cause of illness among farm workers.47 This brought them under close scru- tiny by the US Attorney General’s office. As a result, Monsanto was forced to pay fines up to US$100 000 to compensate the government for the money spent in the investigation.

To counter the European aversion to genetically modified foods, Monsanto launched a US$1.6 million campaign to ease Europeans’ hard feelings about genetically modified seeds and pesticides. It promised citizens that genetically modified foods were harm- less to the environment and to people who eat them. It also declared that GM potatoes and tomatoes had been approved for sale in the UK (when in fact the UK had not yet approved these vegetables for sale). The European public showed a less-than-welcoming response to this campaign, complaining on 13 sep-

arate occasions to the UK Advertising Standards Authority that these ads were false and consumers were hurt as a result.48

Positioning for the future The technological innovation embodied in Roundup® and Roundup Ready® seeds had given Monsanto a dominant and profitable position in the agricul- tural market. This product line had come to repre- sent a significant portion of Monsanto’s revenues and profits. However, with the impending patent expi- ration, increasing pressure from groups opposed to genetically modified foods, and other possi- ble health concerns, the future of Roundup® – and, indeed, Monsanto – had become quite murky. Ver- faillie needed to position his company for the future, but to do this required addressing some very diffi- cult questions. Could Monsanto defend its position in Roundup®? If not, could it develop new markets that leveraged its biotechnology resources? Would geneti- cally modified foods gain acceptance, or face increas- ing opposition and regulation? Was promoting genet- ically modified foods ethical? How could Monsanto increase its competitiveness internationally? In sum, how would Monsanto evolve to face the future?

Notes The website sources given below were correct at the time of the merger but may no longer be vlaid. 1 www.monsanto.com/Monsanto/mediacenter/background/

96sep24_Herbicide.html. 2 www.accessexcellence.org/AB/BC/what_is_biotechnology.

html. The National Health Museum is a 501(c)(3) non-profit corporation, based in Washington DC.

3 www.biotechknowledge.com/primer/primer.html. 4 Henry Miller, MD, Fellow at Stanford University’s Hoover

Institution, 17 June 1999. 5 http://netspace.students.brown.edu/MendelWeb/home.html. 6 http://library.thinkquest.org/10551/web1Eng/biotech2.htm. 7 www.cp.vovartis.com/dframe.htm. 8 Kerri Walsh. 1998, Chemical Week, 9 September. 9 Alice Naude, 1998, Chemical Market Reporter, 253(10), 9 March,

p. FR8. 1 0 Information taken from MOJO Wire, www.mojones.com/

mother_jones/ JF97/brokaw.html. 1 1 www.safe2use.com/pesticidenews/roundup.htm.. 1 2 www.greenpeace.org/~geneng/highlights/pat/98_09_20.htm.

1 3 www.monsanto.com/monsanto/gurt/default.htm. 1 4 Ibid. 1 5 www.pharmacia.com/facts_monsanto.html. 1 6 Monsanto’s 1999 10K. 1 7 Anonymous; 1999, ‘Agri marketing’, Skokie, 37(6), June, p. H. 1 8 Naude, Chemical Market Reporter. 19 www.monsanto.com/monsanto/about/careers/default.htm. 20 http://dir.yahoo.com/Science/Agriculture/News_and_Media/

Magazines/Trade_Magazines/. 2 1 Anonymous, 1999, The Economist, 19 June. 2 2 www.farmsource.com/Product_Info/. 23 Scott’s Company news release, Marysville, Ohio, 12 July 1999. 24 Andrew Wood, 1998, Chemical Week, 1 July. 25 Hendrik Verfaille, CEO of Monsanto, Letter to Shareowners,

1 March 2001. 26 www.cynamid.com. 27 www.sec.gov/Archives/edgar/data/67686/0000067686-99-

000050-index.html. 28 www.monsanto.com/monsanto/mediacenter/99/99jan19_dow.

html. 29 www.hoovers.Dupont.htm. 30 Robert Westervelt, 2000, Chemical Week, 19 January.

C-120 Case 9 • Monsanto

31 www.hoovers.novartis.htm. 32 www.cp.novartis.com/d_frame.htm. 33 www.ahp.com/overview.htm. 34 www.ahp.com/netsales.htm. 35 www.hoovers.com. 36 www.extremecontrol.com. 37 Ibid. 38 S. Thompson, Public Affairs, www.cynamid.pressrelease.com. 39 Lucette Lagnado, 2000, ‘Chefs at the biotech barricades’, The

Wall Street Journal, 9 March, p. B1. 40 www.greenpeace.org/~geneng/.

41 www.fda.gov/oc/biotech/default.htm. 42 www.netlink.de/gen/Zeitung/1999/990624b.htm. 43 www.safe2use.com/pesticidenews/roundup.htm. 44 Wendy Prisnitz, 1999, ‘New studies link Monsanto’s Roundup

to cancer’, Natural Life, 68, July, Toronoto, Canada, www.life. ca/nl/68/cancer.html.

45 Ibid. 46 Ibid. 47 http://jinx.sistm.unsw.edu.au/~greenlft/1997/262/262p13c.

htm. 48 Anonymous, The Economist.

C-121

Case 10

Nucor Corporation and the US steel industry Brian K. Boyd Steve Gove Arizona State University Arizona State University

Darlington, South Carolina, 1969. Making steel is a technically demanding, complex and dangerous pro- cess. Nucor Corp.’s initial foray into steel production was the latter. Instead of staffing the plant with sea- soned steel veterans, Nucor hired farmers, mechan- ics and other intelligent, motivated workers. Those employees along with company executives and digni- taries in attendance at Nucor’s mill opening fled the plant as the inaugural pour resulted in molten steel pouring on to the mill floor and spreading towards the crowd. Onlookers and employees alike were left wondering if Nucor would ever successfully produce steel.1

The steel industry, a classic example of a market in the late stages of maturity, traces its roots to colonial- era blacksmiths who forged basic farm and house- hold equipment. The industry grew (and consolidat- ed) rapidly in the first half of the 20th century, with worldwide demand growing throughout the 1960s. However, a series of shifts in market dynamics led to dramatic industry-wide declines in growth and prof- itability. The dominant players faced the same prob- lems as leaders of other mature industries – Ford and General Motors, for example: obsolete production facilities, bureaucratic management systems, heavily unionised workers and hungry foreign competitors. Due to its centrality in the economy, the decline of the

steel industry was cited by some observers as evidence of the decline of the overall US economic system.

While foreign competition played a significant role in changing the US steel industry, an even larger factor emerged during the 1970s: minimill technol- ogy. Traditional ‘integrated mills’ rely on large-scale vertical integration including integrated coke and ore production. ‘Minimills’ used a new technology to recycle scrap steel and quickly stole most of the commodity steel market away from integrated pro- ducers. This enabled minimills to enter a geographic market with a distinct cost advantage: they typically require a capital investment of US$300 to US$500 million, or 5–10 per cent of that required for an inte- grated mill. The minimill revolution has resulted in a dramatic dispersion of the steel manufacturers from the ‘rust belt’ to the primary population and growth areas of the United States. The impact of minimills on the industry is best demonstrated by looking at the former industry leader US Steel (now USX Corp.). In 1966, US Steel controlled 55 per cent of the American steel market; in 1986 it controlled only 17 per cent.

Despite its inauspicious foray into steel, Nucor Corp. has become the benchmark for both the US steel industry and US industry in general. Nucor is one of the fastest growing and most efficient steel producers in the world. Despite declining demand for steel, Nucor’s growth has been phenomenal. Since

C-122 Case 10 • Nucor Corporation and the US steel industry

pouring its first batch of steel in the 1960s to support in-house operations, the company has become one of the top five producers of steel in the United States. Without an R&D department, Nucor has repeated- ly achieved technological feats other steel producers thought impossible. Their hourly pay is among the lowest in the industry, yet they have the highest pro- ductivity per worker of any steel producer in the US and near zero employee turnover. How has Nucor achieved such phenomenal success? Can it continue to do so?

US steel industry history Steel has been a part of the domestic economic system since the colonial era, when iron (the parent of steel) was smelted and forged. The early 19th century, with the advent of steam engines, cotton gins and farming combines, advanced iron as a commodity of progress. The addition of carbon to iron yielded a material with additional strength, elasticity, toughness and malle- ability at elevated temperatures. The Civil War pro- vided the impetus for the industry to organise, con- solidate, expand and modernise to supply the vast quantities of steel required for warfare.

Following the Civil War, the construction of new transportation systems, public works projects,

automobiles, bridges, ships and large buildings all fuelled a torrid expansion of the industry lasting through the turn of the century. Domestic econom- ic expansion and two world wars maintained an unquenchable appetite for steel both in the United States and around the world in the first half of the 20th century. In the aftermath of the Second World War, America’s steel industry prospered as it sup- plied an ever-expanding domestic economy and the rebuilding of war-ravaged infrastructures. This wind- fall for the domestic industry was in actuality one of the root causes for its eventual decline. US plants, left idle by the end of the war, were reactivated to sup- port the Marshall Plan and MacArthur’s rebuilding of Japan. The war-torn nations of the world, however, rebuilt their industrial facilities from the ground up, incorporating the latest production technology. Con- versely, domestic producers were content with older, formerly inactivated facilities.

Global demand for steel expanded continuously throughout the 1960s; domestic producers elected not to meet this demand, choosing only to match domestic consumption requirements. This present- ed an opportunity for up-start foreign producers to rejuvenate and strengthen themselves without direct- ly competing against US producers. Throughout this expansion, the relationship between management and

Exhibit 1 Comparative trends: GDP, steel industry output and Nucor output, 1980–96

Note: Information is overall trends; it is not to scale for comparison. GDP is scaled on right axis in trillions of 1992$. Industry is scaled on left axis in million tons. Nucor is scaled on left axis in million tons, but shown at 10×.

Steel industry GDPNucor

19 80

0

20

40

60

80

100

120

140

$0

$1

$2

$3

$4

$5

$6

$7

$8

19 82

19 84

19 86

19 88

19 90

19 92

19 94

19 96

Case 10 • Nucor Corporation and the US steel industry C-123

labour soured. In 1892, Henry Clay Frick’s Pinker- ton guards attacked striking workers, setting the stage for a contentious relationship between manage- ment and labour. Labour, represented by the United Steel Workers of America (USWA), and management began negotiating three-year collective bargaining agreements beginning in 1947. These negotiations frequently collapsed, and strikes following the third year of a contract became commonplace. Firms depen- dent on steel soon initiated a pattern of accumulating 30-day ‘strike hedge’ inventories to feed operations during strike shutdowns. In 1959, the USWA walked out for 116 days. In 1964, another strike required presidential intervention. The impact of these strikes reverberated throughout the economy. Major cus- tomers began to look for stable supplies of steel from foreign producers who, in 1959, met only 3 per cent of domestic demand. Fuelled by excess capacity and strike-induced demand, foreign producers were pro- viding 18 per cent of domestic demand by the time a long-term labour accord was reached in the early 1970s. Foreign producers currently supply 20–25 per cent of the steel used in the United States.

The slowdowns and closures of the 1970s set the stage for the steel industry’s ‘dark ages’ – the period from 1980 to 1986 when steel output declined from 115 to 80 million tons despite an increase in real GDP. The energy crisis led to demand for smaller, lighter cars which require less steel, also resulting in less required tonnage. R&D in the steel industry led to

stronger blends of steel. New materials, such as petro- leum-based materials (plastics), organics (wood/pulp) and synthetic materials (fibreglass, epoxies) became significant threats in several applications customar- ily met by steel. Overall employment in steel fell from 535 000 in 1979 to 249 000 in 1986.

Despite this decline, this was also a period of shakeout and dynamic activity in the industry. Slow- ly, and with the help of the federal government (pri- marily in tax and regulatory relief and enforcement of Uruguay Trade Agreements / Voluntary Restrain- ing Agreements), some firms were able to revitalise their operations by streamlining production, select- ing better markets, focusing production (minimills), improving facilities, stabilising labour contracts, and reducing labour content through plant modernisation, dollar devaluation and a reprieve from the onslaught of substitute materials. This gave the surviving firms an opportunity to recover and prosper.

Historically, demand for steel fluctuates in both the US and international markets due to its close ties to durable and capital goods, markets which suffer more acutely during austerity and are more prosperous dur- ing economic expansions. Economic swings notwith- standing, there has been little appreciable growth in steel demand between the 1950s and the 1990s. Cur- rent domestic production is approximately 100 mil- lion tons per year, far less than the 120 million tons of 1981. Decline in demand has led to substantial excess capacity. In 1980, for example, domestic producers

Exhibit 2 World capacity, production and idle capacity, 1970–90

0

200

400

600

800

Capacity

19 70

19 75

19 80

19 85

19 90

Year % idle 1970 20 1972 22 1974 13 1976 25 1978 24 1980 29 1982 39 1984 29 1986 31 1988 23 1990 23

Production

M il li o

n s

o f

to n

s

C-124 Case 10 • Nucor Corporation and the US steel industry

had 25 per cent idle capacity. While the industry now operates at 90 per cent of capacity, this has come as a result of reduced capacity, not increased output; total domestic capacity declined by 30 per cent between 1980 and 1994. Capacity reduction in the steel indus- try is expensive, particularly for integrated producers. USX Corp., for example, eliminated 16 per cent of its capacity in 1983 at a cost of US$1.2 billion. Still, by 1987, USX had 40 per cent idle capacity.

While large-scale, integrated producers such as USX were shedding excess capacity, a new type of competitor, ‘minimills’, was entering the market. Minimills utilise recycled steel (in the form of junk cars, scrap, etc.) as a primary ingredient. Unlike the integrated producers, minimills are less capital- intensive, smaller and have historically focused on pro- ducing low-technology, entry-level products. Unlike integrated mills, which have seen production decline, minimills have seen explosive growth, with numerous plants opening in the late 1980s and 1990s.

Overall, the steel industry has all of the char- acteristics of a highly competitive market: stagnant demand, excess capacity and numerous global com- petitors. The ability of the largest firm to use its power to set prices is gone. Above-average industry margins are quickly targeted by other firms. These factors are compounded by a largely commodity-like product that minimises switching costs and customer loyalty. Not surprisingly, the profit performance of the industry has been weak; the industry as a whole lost money during much of the 1980s. In 1987, the first (albeit small) industry-wide profit in eight years was posted. With the exception of the 1990–91 reces-

sion, domestic producers have gradually improved the return on assets to a value of 6.1 per cent in 1994. A flurry of exits and Chapter 11 reorganisations led to an improved profit potential for remaining firms by the mid-1990s. The success is more pronounced in the minimill sector, although the integrated pro- ducers are presently healthy and now represent a new threat to the minimills.

Emerging industry trend While in many ways the industry appears to have stabilised, a number of emerging trends threaten to cause further disruption within the industry to both integrateds and minimills.

Minimill over-capacity Starting in 1989, only one company, Nucor, was capable of producing flat-rolled steel using minimill technology. However, competing firms have started using similar technology and there were expected to be 10 new flat-roll minimills on-line by 1997, adding 13 million tons of production capacity – about 10 per cent of 1996 production – to the industry. This new capacity should become available just as steel con- sumption is expected to decline.

Scrap prices Due to growing demand for scrap metal, its cost has become increasingly volatile in the 1990s. In 1994, for example, prices climbed as much as US$50/ton to US$165–170/ton, while 10 million tons of Amer- ican scrap were exported to offshore customers. In

Exhibit 3 US production, 1974 and 1994

P ro

d u

ct io

n in

m ill

io n

s o

ft o

n s

160 140 120 100

80 60 40 20

0

1974

Integrated mills Minimills Other scrap mills Speciality firms

1994

Case 10 • Nucor Corporation and the US steel industry C-125

1996, prices reached US$200/ton, and were expected to climb, but instead declined to US$170–180/ton by the end of 1997.

Euro production While growth has improved in recent years, demand for steel is still weak in much of Europe, particularly in Eastern European nations. Western Europe alone had 20 million tons of excess capacity in 1994, and Rus- sian mills were operating at 65 per cent of capacity. Additionally, many European mills are state-owned and subsidised. Faced with weak performance and idle capacity, many of these mills are aggressively pursing export opportunities in China and other parts of Asia. Russian steel exports approached US$4 billion in 1993, double their 1992 level.

Antidumping rulings US integrated steel producers filed 72 charges of dumping against foreign competitors – primarily the Germans and Japanese. In 1993, the International Trade Commission concluded that there was some justification for these charges, but not for others, and ruled that foreign steel caused no harm in 40 of the 72 cases. Stock prices for US producers (in aggregate) declined US$1.1 billion in the 90 minutes following the announcement of the ruling.

Industry economic structure The domestic steel industry, until recent technological changes, was essentially composed of two vertically integrated sectors. The first was the raw steel produc- tion sector which encompassed steel-making opera- tions from the unearthing of ores and coke to the basic ore reduction and smelting. The outcome or product of this sector was ingots, billets and slabs which are standard steel shapes. These products were then sent to finishing mills (the second sector) which conducted various heat treating and shaping processes to produce finished steel products such as bars, tubes, castings, forgings, plates, sheets and structural shapes. These two sectors were typically housed under a single facil- ity but as two distinct operations in what was termed the ‘integrated’ producer. Traditionally, steel manu- facturers used batch processing, which involved heat- ing a furnace of steel and pouring the entire furnace full of molten steel into billets, ingots and slabs. These intermediate products were then processed and the process was repeated. The onset of continuous cast- ing technology (a process in which ores are reduced and poured into final shapes without the intermediate production of slabs and ingots) in the late 1970s has blurred the classical two-sector demarcation. Most producers today use the continuous casting process

Exhibit 4 Domestic capacity and production, 1980–96

0

50

100

150

200

M il li o

n s

o f

to n

s

19 80

19 83

19 86

19 89

19 92

19 95

Capacity Production

C-126 Case 10 • Nucor Corporation and the US steel industry

for producing isometric shapes, but raw steel must still be shipped to finishing mills for manufacture of more complex products.

The suppliers to the steel industry can be broadly assigned to three major classes: ore, energy and trans- portation. Since a preponderance of the final produc- tion cost is tied up in these input items, many producers have vertically integrated backwards by acquiring ore and coal/coke mining firms and transportation net- works (rail and barge). The supply factors of produc- tion (transformation factors) are labour to operate plants, capital facilities and land. Recent moderni- sation has significantly substituted technology for labour in steel production.

Minimills are a significant force of change in the industry, as their supplier and customer requirements differ from the integrated mills. First, ore supplies are, to differing degrees, replaced by a need for access to large quantities of scrap steel. Second, minimills, while still large consumers of electricity, consume far less power than their integrated mill counter- parts. This, along with the lower output capacity of each plant, allows for placement of the mills closer to the third factor: the changing customer base. This has resulted in a radical shift in steel production in recent years from western Pennsylvania and Ohio to a much broader dispersion of steel mills throughout the United States. By one estimate, steel mills can now be found in over half of the US states.

The principal markets and customers for steel are the classical markets. Some sectors are on the decline, while others are fairly stable. The automotive sector was historically the largest consumer of steel in peace- time. Construction materials is now the largest sector, followed by the automobile and container industries, energy equipment, industrial machinery, farming equipment, car/rail production and various military applications. The reduced demand by the automo- bile industry is the result of the lower steel content in a modern automobiIe, a trend steel producers are aggressively trying to counter by banding together to form the Steel Alliance which is running a US$100 million advertising campaign targeted at consumers and touting the advantages of steel for automobile design (and house construction).

Service centres are playing an increased role in the industry, acting as major distributors and whole- salers for finished steel products to steel consumers (construction firms, shipbuilders, machine fabrica- tors, etc.). With the exception of the automobile and automobile part manufacturers (who contract direct- ly with producers), most finished steel is delivered to end users via the steel service centre, moving some of the inventory management burden to the service cen- tres for a marginal mark-up to the end user. This pres- ents a forecasting complication to planners and strat- egists, as all demand for steel is a derived demand. The forecaster must be able to look into the macro forces affecting an economy and project steel’s role in

Exhibit 5 Steel demand by market sector, 1972 and 1998

0

5

10

15

20

25

30 1972

A ut

o m

o ti ve

P er

ce n

t o

fd em

an d

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Case 10 • Nucor Corporation and the US steel industry C-127

the broader economic system from which a consumer demand pattern could be ascertained.

Steel production technology Any attempt to consolidate steel and steel production technology into a few paragraphs would be doing the topic a disservice. However, two major issues deserve additional attention: production factors and substi- tutes. Automation has improved the competitive posi- tion of the industry by reducing its exposure to vol- atile labour markets and labour costs. It has also increased the flexibility of producers to shift product output and incorporate the continuous casting pro- cess. Closely related is the elimination of the old open- hearth furnace in favour of the blast-oxygen furnace and electric arc furnaces, which are far more efficient, more easily automated and require less manpower. These furnaces also reduce stack emissions, a critical environmental requirement (and a concern that many foreign producers do not face). While technology has been a driver of change, labour agreements and rela- tions have not always made it possible to fully exploit the benefits of technological improvements.

The proliferation of substitute materials is an important issue. It is important to note, however, that while substitutes have made significant inroads into steel markets over the last 30 years, they will likely never replace steel as the commodity of choice for many applications. Steel will not be displaced (with very minor exceptions) as a material in strength applications: plastic is not strong enough; graphite- reinforced plastics and epoxies lack steel’s thermal resistance properties; wood is not as strong or envi- ronmentally resistant as steel; and titanium remains a rare, expensive, strategically controlled material. Furthermore, steel comes in many different compo- sitions (stainless, tool, high-strength, galvanised). The industry’s R&D efforts have continued to evolve steel to meet the demands of customers. In short, steel remains – and is likely to remain – the material of choice in most applications.

Nucor Corporation Nucor Corp. began life as the Nuclear Corporation of America. The latter was a highly diversified and marginally profitable company; its products included instruments, semiconductors, rare earths and con- struction. One of its potential acquisitions was Coast Metals, a family-owned producer of speciality met- als. When the acquisition fell through, Nuclear hired one of Coast’s top engineers as a consultant to recom- mend other acquisition targets. The engineer – Ken Iverson – had strong technical skills (including a grad- uate degree in metallurgy from Purdue University) and general management experience. Based on Iver- son’s recommendation, Nuclear acquired a steel joist company in South Carolina. Subsequently, Iverson joined Nuclear as a vice president in 1962. Nuclear built a second joist plant in Nebraska the following year. Iverson was responsible for supervising the joist operations as well as the research, chemical and con- struction segments. By 1965, the diversified company had experienced another string of losses, although the joist operations were profitable, and Iverson was pro- moted to president.

Recognising that its most valuable skills lay in its joist operations, Nuclear became Nucor Corp. and divested non-joist operations. New joist plants soon followed, including one in Alabama in 1967 and another in Texas in 1968. As a joist company, Nucor was dependent on American and foreign steel produ- cers for its key input. Iverson decided to integrate backwards into steel making in the hopes of stabilising supply and lowering input costs for the joist business. So, Nucor began construction of its own steel mill in Darlington, South Carolina – a location close to an existing joist operation. The Darlington plant used the then new minimill technology. When the plant opened on 12 October 1969, the pouring of the first batch of steel resulted in molten steel cascading out of the mould and across the floor of the plant. Despite the mishap, Nucor quickly became adept at mini- mill technology. In addition to supplying its own joist operations, it began competing with integrateds and other minimills in the commodity steel business. Iver- son and Nucor soon became recognised as the ‘South- west Airlines’ of steel: a simple, no-frills organisation,

C-128 Case 10 • Nucor Corporation and the US steel industry

with a unique culture, highly motivated workers and the lowest cost structure of the industry. Some indica- tors of Nucor’s success include: • It is the only major player in the industry that

can boast of 22 years of uninterrupted quarterly dividends (Nucor began paying quarterly dividends in 1973) and 30 years of continuous quarterly profits, despite numerous slumps and downturns in the industry (see Exhibits 6–14).

• Between 1980 and 1990, Nucor doubled in size. In comparison, the six main integrated producers reduced their steel-making capacity from 108 to 58 million tons during this period.

• In 1990, Nucor had six steel plants and a total annual capacity of 3 million tons. By 1995, it had added a seventh plant, and its overall capacity neared 8 million tons.

• In 1994, Nucor generated US$1.50 in sales for every dollar in property, plant and equipment. The industry average was US$0.95 before depreciation expenses. After depreciation, these ratios are US$2.18 and US$1.83, respectively.

• Nucor continues to be the industry leader in cost efficiency. In 1990, it produced 980 tons of steel per employee each year, at a net cost of US$60/ ton, compared to the industry average of 420 tons per employee at a cost of US$135/ton. In 1994, Nucor’s conversion cost was US$170/ton, roughly US$50–75 less than its competitors. Nucor has primary mills located in Arkansas,

Nebraska, Utah, South Carolina, Texas and Indiana. Additional operating facilities located in Fort Payne, Alabama; Conway, Arkansas; Saint Joe and Water- loo, Indiana; Wilson, North Carolina; and Swansea, South Carolina are all engaged in the manufacture of steel products. During 1997, the average utilisa- tion rate of all operating facilities was more than 85 per cent of production capacity. Nucor competes in a number of distinct product segments, and the empha- sis on these segments has changed substantially in recent years. Historically, the largest segment was the Nucor Steel division, which produces bar and light structural steel products. In 1991, this was its largest segment (measured by product volume). However, by 1995, sheet steel, once considered to be an exclusive product of integrated producers, accounted for the

largest production volume. Heavy structural beams from a joint venture with Yamato Steel of Japan were the third-largest segment, followed by the Vulcraft joist division. Remaining products – including grind- ing balls, fasteners, ball bearings and prefabricated steel buildings – each account for relatively small pro- portions of total output.

While Nucor’s first experience with steel was the result of backward integration by the Vulcraft joist division, the manufacture of steel has become the cen- tral focus of the firm. That focus has broadened to include sheet steel (1989) and heavy structural beams (1988). The company has also extended its focus to several downstream products, including fasteners and ball bearings (both in 1986) and prefabricated metal buildings (1988). With the exception of the ball bearings mill, which was acquired, new business segments are developed internally. Roughly 15 per cent of steel output is used internally for downstream operations. More recently, Nucor has chosen to inte- grate backwards from steel with a plant in Trinidad. This backward integration is aimed at lowering pro- duction costs; the plant produces iron carbide, which is expected to become an alternative to scrap in the minimill process.

Nucor’s strategy Nucor has chosen to avoid the formalised planning processes that are typically found in Fortune 500 firms. This lack of formalisation also extends to the company’s mission statement, which is non-existent but known to all employees. The company does not have a formal mission statement, as management believes that most mission statements are developed in isolation, never seen or conveyed to employees, and have little in common with what the firm really does and how it operates. Nonetheless, all Nucor employ- ees can tell you what their job entails and what the objective of the organisation is: the production of high volumes of quality, low-cost steel.2 Nucor and its employees recognise that all the steel produced must meet industry standards for quality. In fact, Nucor frequently exceeds quality standards. High levels of production per man-hour result in low costs and, sub- sequently, prices among the lowest in the industry.

Case 10 • Nucor Corporation and the US steel industry C-129

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C-130 Case 10 • Nucor Corporation and the US steel industry

Exhibit 7 Annual balance sheets, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Assets Cash & equivalents 104.40 201.80 101.93 27.26 25.55 38.30 51.65 32.55 26.38 72.78 128.74 185.14 112.71 79.06 44.89 8.71 21.75 36.65 27.42 7.10 Net receivables 292.64 283.21 258.13 202.18 132.14 109.46 126.75 106.95 97.43 80.08 61.27 70.87 66.87 58.17 38.34 48.70 43.52 40.21 31.90 23.39 Inventories 385.80 306.77 243.03 215.02 206.41 186.08 136.64 139.45 123.22 81.50 105.60 78.64 73.80 56.56 48.83 73.00 49.60 40.01 41.55 30.41 Prepaid expenses 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other current assets 45.54 38.97 35.61 23.79 0.52 0.47 0.09 1.08 0.74 0.36 0.14 0.11 0.08 0.11 0.48 0.98 0.49 0.50 0.25 0.26 Total current assets 828.38 830.74 638.70 468.23 364.62 334.29 315.13 280.03 247.76 234.72 295.74 334.77 253.45 193.89 132.54 131.38 115.37 117.36 101.11 61.16 Gross plant property & equipment 2 698.75 2 212.89 1 977.58 1 820.99 1 574.10 1 261.53 1 086.37 1 048.01 942.27 618.54 452.26 376.23 359.97 338.66 322.85 318.86 219.10 160.46 115.25 86.67 Accumulated depreciation 907.60 747.49 614.36 459.95 448.34 414.25 363.12 294.22 240.37 199.16 181.43 150.95 131.87 107.36 83.78 66.25 46.02 35.88 26.72 20.73 Net plant property & equipment 1 791.15 1 465.40 1 363.22 1 361.04 1 125.77 847.28 723.25 753.80 701.90 419.37 270.83 225.28 228.10 231.31 239.07 252.62 173.07 124.58 88.53 65.94 Investments at equity 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other investments 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Intangibles 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Deferred charges 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other assets 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 5.04 0.27 0.63 0.37 0.02 0.78 2.78 1.17 3.81 0.92 Total assets 2 619.53 2 296.14 2 001.92 1 829.27 1 490.38 1 181.58 1 038.38 1 033.83 949.66 654.09 571.61 560.31 482.19 425.57 371.63 384.78 291.22 243.11 193.46 128.01

Liabilities Long-term debt due in one year 0.75 0.15 0.25 0.20 0.20 2.00 2.21 2.27 2.21 2.21 3.05 2.40 2.40 2.40 1.60 1.66 1.70 1.25 0.46 0.44 Notes payable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Accounts payable 224.37 214.56 182.85 165.74 119.30 93.76 78.72 89.75 93.17 68.46 53.17 35.47 32.69 37.14 22.95 32.24 36.64 26.42 24.15 12.08 Taxes payable 10.29 11.30 15.51 14.27 10.46 11.07 10.65 13.20 35.80 24.34 14.31 27.60 23.71 14.81 12.54 10.73 4.36 15.91 15.64 4.44 Accrued expenses Other current liabilities 230.25 221.12 183.86 170.29 142.02 122.34 134.00 88.34 84.92 52.46 47.91 55.78 41.74 34.14 29.02 28.41 23.79 19.96 15.54 13.35

Total current liabilities 465.65 447.14 382.47 350.49 271.97 229.17 225.58 193.56 216.11 147.47 118.44 121.26 100.53 88.49 66.10 73.03 66.49 63.54 55.79 30.30 Long-term debt 152.60 106.85 173.00 352.25 246.75 72.78 28.78 155.98 113.25 35.46 42.15 40.23 43.23 45.73 48.23 83.75 39.61 41.40 41.47 28.13 Deferred taxes 50.00 51.00 63.00 53.00 18.82 21.10 25.82 18.82 15.32 19.32 27.32 41.32 38.82 33.22 25.02 15.62 7.52 4.92 4.02 2.62 Investment tax credit 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Minority interest 265.71 220.66 175.99 143.09 140.50 124.05 105.44 81.02 72.71 23.83 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other liabilities 76.28 88.38 84.86 28.27 28.11 22.87 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.04 0.66 Total liabilities 1 010.24 914.03 879.31 927.10 706.15 469.97 385.62 449.39 417.38 226.08 187.91 202.81 182.59 167.44 139.35 172.41 113.62 109.85 101.33 61.72

Equity Preferred stock – redeemable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Preferred stock – non-redeemable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Total preferred stock 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Common stock 35.95 35.90 35.80 35.70 17.78 8.86 8.82 8.78 8.74 8.70 8.67 5.73 5.67 5.64 2.80 2.79 2.74 2.70 1.78 1.25 Capital surplus 55.05 48.67 39.27 29.91 39.41 42.81 37.67 34.23 30.54 27.38 25.19 24.30 18.99 17.02 17.70 16.24 12.91 10.67 10.41 9.55 Retained earnings 1 535.95 1 315.85 1 065.80 854.86 745.26 678.16 624.66 559.90 511.46 410.51 367.58 327.82 275.04 235.57 211.92 193.36 161.95 119.89 79.94 55.50 Less: treasury stock 17.66 18.30 18.26 18.31 18.23 18.23 18.39 18.46 18.46 18.58 17.73 0.35 0.09 0.10 0.14 Common equity 1 609.29 1 382.11 1 122.61 902.17 784.23 711.61 652.76 584.45 532.28 428.01 383.70 357.50 299.60 258.13 232.28 212.38 177.60 133.26 92.13 66.30

Total equity 1 609.29 1 382.11 1 122.61 902.17 784.23 711.61 652.76 584.45 532.28 428.01 383.70 357.50 299.60 258.13 232.28 212.38 177.60 133.26 92.13 66.30

Total liabilities & equity 2 619.53 2 296.14 2 001.92 1 829.27 1 490.38 1 181.58 1 038.38 1 033.83 949.66 654.09 571.61 560.31 482.19 425.57 371.63 384.78 291.22 243.11 193.46 128.01

Common shares outstanding 87.80 87.60 87.33 87.07 86.74 86.42 85.95 85.60 85.15 84.78 84.52 85.89 84.97 84.54 83.95 83.57 82.20 81.05 80.26 78.80

Note: All US$mn. Source: Compustat.

Case 10 • Nucor Corporation and the US steel industry C-131

Exhibit 7 Annual balance sheets, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Assets Cash & equivalents 104.40 201.80 101.93 27.26 25.55 38.30 51.65 32.55 26.38 72.78 128.74 185.14 112.71 79.06 44.89 8.71 21.75 36.65 27.42 7.10 Net receivables 292.64 283.21 258.13 202.18 132.14 109.46 126.75 106.95 97.43 80.08 61.27 70.87 66.87 58.17 38.34 48.70 43.52 40.21 31.90 23.39 Inventories 385.80 306.77 243.03 215.02 206.41 186.08 136.64 139.45 123.22 81.50 105.60 78.64 73.80 56.56 48.83 73.00 49.60 40.01 41.55 30.41 Prepaid expenses 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other current assets 45.54 38.97 35.61 23.79 0.52 0.47 0.09 1.08 0.74 0.36 0.14 0.11 0.08 0.11 0.48 0.98 0.49 0.50 0.25 0.26 Total current assets 828.38 830.74 638.70 468.23 364.62 334.29 315.13 280.03 247.76 234.72 295.74 334.77 253.45 193.89 132.54 131.38 115.37 117.36 101.11 61.16 Gross plant property & equipment 2 698.75 2 212.89 1 977.58 1 820.99 1 574.10 1 261.53 1 086.37 1 048.01 942.27 618.54 452.26 376.23 359.97 338.66 322.85 318.86 219.10 160.46 115.25 86.67 Accumulated depreciation 907.60 747.49 614.36 459.95 448.34 414.25 363.12 294.22 240.37 199.16 181.43 150.95 131.87 107.36 83.78 66.25 46.02 35.88 26.72 20.73 Net plant property & equipment 1 791.15 1 465.40 1 363.22 1 361.04 1 125.77 847.28 723.25 753.80 701.90 419.37 270.83 225.28 228.10 231.31 239.07 252.62 173.07 124.58 88.53 65.94 Investments at equity 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other investments 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Intangibles 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Deferred charges 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other assets 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 5.04 0.27 0.63 0.37 0.02 0.78 2.78 1.17 3.81 0.92 Total assets 2 619.53 2 296.14 2 001.92 1 829.27 1 490.38 1 181.58 1 038.38 1 033.83 949.66 654.09 571.61 560.31 482.19 425.57 371.63 384.78 291.22 243.11 193.46 128.01

Liabilities Long-term debt due in one year 0.75 0.15 0.25 0.20 0.20 2.00 2.21 2.27 2.21 2.21 3.05 2.40 2.40 2.40 1.60 1.66 1.70 1.25 0.46 0.44 Notes payable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Accounts payable 224.37 214.56 182.85 165.74 119.30 93.76 78.72 89.75 93.17 68.46 53.17 35.47 32.69 37.14 22.95 32.24 36.64 26.42 24.15 12.08 Taxes payable 10.29 11.30 15.51 14.27 10.46 11.07 10.65 13.20 35.80 24.34 14.31 27.60 23.71 14.81 12.54 10.73 4.36 15.91 15.64 4.44 Accrued expenses Other current liabilities 230.25 221.12 183.86 170.29 142.02 122.34 134.00 88.34 84.92 52.46 47.91 55.78 41.74 34.14 29.02 28.41 23.79 19.96 15.54 13.35

Total current liabilities 465.65 447.14 382.47 350.49 271.97 229.17 225.58 193.56 216.11 147.47 118.44 121.26 100.53 88.49 66.10 73.03 66.49 63.54 55.79 30.30 Long-term debt 152.60 106.85 173.00 352.25 246.75 72.78 28.78 155.98 113.25 35.46 42.15 40.23 43.23 45.73 48.23 83.75 39.61 41.40 41.47 28.13 Deferred taxes 50.00 51.00 63.00 53.00 18.82 21.10 25.82 18.82 15.32 19.32 27.32 41.32 38.82 33.22 25.02 15.62 7.52 4.92 4.02 2.62 Investment tax credit 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Minority interest 265.71 220.66 175.99 143.09 140.50 124.05 105.44 81.02 72.71 23.83 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Other liabilities 76.28 88.38 84.86 28.27 28.11 22.87 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.04 0.66 Total liabilities 1 010.24 914.03 879.31 927.10 706.15 469.97 385.62 449.39 417.38 226.08 187.91 202.81 182.59 167.44 139.35 172.41 113.62 109.85 101.33 61.72

Equity Preferred stock – redeemable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Preferred stock – non-redeemable 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Total preferred stock 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Common stock 35.95 35.90 35.80 35.70 17.78 8.86 8.82 8.78 8.74 8.70 8.67 5.73 5.67 5.64 2.80 2.79 2.74 2.70 1.78 1.25 Capital surplus 55.05 48.67 39.27 29.91 39.41 42.81 37.67 34.23 30.54 27.38 25.19 24.30 18.99 17.02 17.70 16.24 12.91 10.67 10.41 9.55 Retained earnings 1 535.95 1 315.85 1 065.80 854.86 745.26 678.16 624.66 559.90 511.46 410.51 367.58 327.82 275.04 235.57 211.92 193.36 161.95 119.89 79.94 55.50 Less: treasury stock 17.66 18.30 18.26 18.31 18.23 18.23 18.39 18.46 18.46 18.58 17.73 0.35 0.09 0.10 0.14 Common equity 1 609.29 1 382.11 1 122.61 902.17 784.23 711.61 652.76 584.45 532.28 428.01 383.70 357.50 299.60 258.13 232.28 212.38 177.60 133.26 92.13 66.30

Total equity 1 609.29 1 382.11 1 122.61 902.17 784.23 711.61 652.76 584.45 532.28 428.01 383.70 357.50 299.60 258.13 232.28 212.38 177.60 133.26 92.13 66.30

Total liabilities & equity 2 619.53 2 296.14 2 001.92 1 829.27 1 490.38 1 181.58 1 038.38 1 033.83 949.66 654.09 571.61 560.31 482.19 425.57 371.63 384.78 291.22 243.11 193.46 128.01

Common shares outstanding 87.80 87.60 87.33 87.07 86.74 86.42 85.95 85.60 85.15 84.78 84.52 85.89 84.97 84.54 83.95 83.57 82.20 81.05 80.26 78.80

Note: All US$mn. Source: Compustat.

C-132 Case 10 • Nucor Corporation and the US steel industry

Exhibit 8 Annual cash flow statement, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Indirect operating activities Income before extraordinary items 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Depreciation and amortization 182.23 173.89 157.65 122.27 97.78 93.58 84.96 76.57 56.27 41.79 34.93 31.11 28.90 27.11 26.29 21.60 13.30 9.71 7.46 5.93 Extraordinary items and disc. operations 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Deferred taxes (8.00) (15.00) (2.00) 1.00 (3.00) (4.00) 7.00 3.50 (4.00) (8.00) (14.00) 2.50 5.60 8.20 9.40 8.10 2.60 0.90 1.40 0.80 Equity in net loss (earnings) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Sale of property, plant, and equipment and sale of investments – loss (gain) 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA

Funds from operations – other 82.57 48.18 17.67 9.75 23.17 26.11 29.71 8.32 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Receivables – decrease (increase) (9.43) (25.07) (55.96) (70.03) (22.69) 14.80 (19.80) (9.52) (18.93) NA NA NA NA NA NA NA NA NA NA NA Inventory – decrease (increase) (79.03) (63.75) (28.01) (8.61) (20.33) (49.43) 2.81 (16.24) (44.65) NA NA NA NA NA NA NA NA NA NA NA Accounts payable and accrued liabs – inc (Dec) 9.81 31.72 17.11 46.44 25.53 11.54 (11.03) (3.43) 25.36 NA NA NA NA NA NA NA NA NA NA NA Income taxes – accrued – increase (decrease) (1.01) (4.21) 1.24 3.81 (0.61) 0.42 (2.55) (22.60) (8.54) NA NA NA NA NA NA NA NA NA NA NA Other assets and liabilities – net change 25.30 26.87 90.60 43.67 26.32 15.66 48.16 3.56 71.33 NA NA NA NA NA NA NA NA NA NA NA Operating activities – net cash flow 450.61 447.16 424.95 271.79 205.41 173.40 214.33 98.00 147.71 NA NA NA NA NA NA NA NA NA NA NA

Investing activities Investments – increase 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Sale of investments 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Short-term investments – change 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Capital expenditures 537.44 263.42 185.32 364.16 379.12 217.72 56.75 130.20 345.63 188.99 81.43 29.07 26.08 19.62 14.79 101.52 62.44 45.99 31.59 15.95 Sale of property, plant, and equipment 1.59 0.92 5.22 1.30 2.12 0.55 0.83 1.26 0.40 3.69 0.94 0.79 0.38 0.27 2.05 0.38 0.65 0.23 1.54 0.02 Acquisitions 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Investing activities – other 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 78.50 NA NA NA NA NA NA NA NA NA NA NA Investing activities – net cash flow (535.84) (262.50) (180.11) (362.86) (377.00) (217.17) (55.92) (128.95) (266.73) NA NA NA NA NA NA NA NA NA NA NA

Financing activities Sale of common and preferred stock 7.07 9.67 9.50 8.51 5.60 5.35 3.59 3.86 3.33 2.34 3.96 5.39 2.01 2.20 1.46 3.37 2.29 1.33 1.52 1.02 Purchase of common and preferred stock 0.00 0.22 0.00 0.17 0.08 0.00 0.04 0.14 0.0 0.96 17.52 0.27 0.00 0.00 0.12 0.00 0.00 0.16 0.13 0.22 Cash dividends 28.06 24.49 15.69 13.91 12.13 11.22 10.30 9.40 8.49 7.60 6.68 5.70 5.08 4.22 3.63 3.33 3.00 2.31 1.41 1.04 Long-term debt – issuance 46.50 24.00 0.00 105.70 183.90 46.00 0.00 45.00 80.00 0.00 4.91 0.00 0.00 0.00 7.50 46.40 0.00 1.14 13.90 0.00 Long-term debt – reduction 0.15 90.25 179.20 0.20 11.73 2.20 127.27 2.21 2.21 6.69 3.00 3.00 2.50 2.50 43.02 2.25 1.79 1.21 0.56 3.54 Current debt – changes 0.00 0.84 (0.65) 0.00 NA NA NA NA NA NA NA NA

Financing activities – other (37.52) (3.51) 15.22 (7.16) (6.73) (7.51) (5.29) 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Financing activities – net cash flow (12.16) (84.79) (170.17) 92.77 158.84 30.42 (139.31) 37.11 72.62 NA NA NA NA NA NA NA NA NA NA NA Exchange rate effect 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Cash and equivalents – change (97.40) 99.87 74.68 1.71 (12.75) (13.35) 19.10 6.17 (46.40) (55.96) (56.41) 72.43 33.66 CF CF CF CF CF CF CF

Direct operating activities Interest paid – net 6.95 9.21 16.06 10.74 9.14 3.42 8.58 16.03 3.65 NA NA NA NA NA NA NA NA NA NA NA Income taxes – paid 152.90 176.50 124.37 57.52 40.82 34.68 31.70 46.90 49.24 NA NA NA NA NA NA NA NA NA NA NA

Note: All US$mn. Source: Compustat.

CF – combined figure. NA – not available. NC – not calculable.

Case 10 • Nucor Corporation and the US steel industry C-133

Exhibit 8 Annual cash flow statement, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Indirect operating activities Income before extraordinary items 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Depreciation and amortization 182.23 173.89 157.65 122.27 97.78 93.58 84.96 76.57 56.27 41.79 34.93 31.11 28.90 27.11 26.29 21.60 13.30 9.71 7.46 5.93 Extraordinary items and disc. operations 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Deferred taxes (8.00) (15.00) (2.00) 1.00 (3.00) (4.00) 7.00 3.50 (4.00) (8.00) (14.00) 2.50 5.60 8.20 9.40 8.10 2.60 0.90 1.40 0.80 Equity in net loss (earnings) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Sale of property, plant, and equipment and sale of investments – loss (gain) 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA

Funds from operations – other 82.57 48.18 17.67 9.75 23.17 26.11 29.71 8.32 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Receivables – decrease (increase) (9.43) (25.07) (55.96) (70.03) (22.69) 14.80 (19.80) (9.52) (18.93) NA NA NA NA NA NA NA NA NA NA NA Inventory – decrease (increase) (79.03) (63.75) (28.01) (8.61) (20.33) (49.43) 2.81 (16.24) (44.65) NA NA NA NA NA NA NA NA NA NA NA Accounts payable and accrued liabs – inc (Dec) 9.81 31.72 17.11 46.44 25.53 11.54 (11.03) (3.43) 25.36 NA NA NA NA NA NA NA NA NA NA NA Income taxes – accrued – increase (decrease) (1.01) (4.21) 1.24 3.81 (0.61) 0.42 (2.55) (22.60) (8.54) NA NA NA NA NA NA NA NA NA NA NA Other assets and liabilities – net change 25.30 26.87 90.60 43.67 26.32 15.66 48.16 3.56 71.33 NA NA NA NA NA NA NA NA NA NA NA Operating activities – net cash flow 450.61 447.16 424.95 271.79 205.41 173.40 214.33 98.00 147.71 NA NA NA NA NA NA NA NA NA NA NA

Investing activities Investments – increase 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Sale of investments 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Short-term investments – change 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Capital expenditures 537.44 263.42 185.32 364.16 379.12 217.72 56.75 130.20 345.63 188.99 81.43 29.07 26.08 19.62 14.79 101.52 62.44 45.99 31.59 15.95 Sale of property, plant, and equipment 1.59 0.92 5.22 1.30 2.12 0.55 0.83 1.26 0.40 3.69 0.94 0.79 0.38 0.27 2.05 0.38 0.65 0.23 1.54 0.02 Acquisitions 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Investing activities – other 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 78.50 NA NA NA NA NA NA NA NA NA NA NA Investing activities – net cash flow (535.84) (262.50) (180.11) (362.86) (377.00) (217.17) (55.92) (128.95) (266.73) NA NA NA NA NA NA NA NA NA NA NA

Financing activities Sale of common and preferred stock 7.07 9.67 9.50 8.51 5.60 5.35 3.59 3.86 3.33 2.34 3.96 5.39 2.01 2.20 1.46 3.37 2.29 1.33 1.52 1.02 Purchase of common and preferred stock 0.00 0.22 0.00 0.17 0.08 0.00 0.04 0.14 0.0 0.96 17.52 0.27 0.00 0.00 0.12 0.00 0.00 0.16 0.13 0.22 Cash dividends 28.06 24.49 15.69 13.91 12.13 11.22 10.30 9.40 8.49 7.60 6.68 5.70 5.08 4.22 3.63 3.33 3.00 2.31 1.41 1.04 Long-term debt – issuance 46.50 24.00 0.00 105.70 183.90 46.00 0.00 45.00 80.00 0.00 4.91 0.00 0.00 0.00 7.50 46.40 0.00 1.14 13.90 0.00 Long-term debt – reduction 0.15 90.25 179.20 0.20 11.73 2.20 127.27 2.21 2.21 6.69 3.00 3.00 2.50 2.50 43.02 2.25 1.79 1.21 0.56 3.54 Current debt – changes 0.00 0.84 (0.65) 0.00 NA NA NA NA NA NA NA NA

Financing activities – other (37.52) (3.51) 15.22 (7.16) (6.73) (7.51) (5.29) 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Financing activities – net cash flow (12.16) (84.79) (170.17) 92.77 158.84 30.42 (139.31) 37.11 72.62 NA NA NA NA NA NA NA NA NA NA NA Exchange rate effect 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 NA NA NA NA NA NA NA NA NA NA NA Cash and equivalents – change (97.40) 99.87 74.68 1.71 (12.75) (13.35) 19.10 6.17 (46.40) (55.96) (56.41) 72.43 33.66 CF CF CF CF CF CF CF

Direct operating activities Interest paid – net 6.95 9.21 16.06 10.74 9.14 3.42 8.58 16.03 3.65 NA NA NA NA NA NA NA NA NA NA NA Income taxes – paid 152.90 176.50 124.37 57.52 40.82 34.68 31.70 46.90 49.24 NA NA NA NA NA NA NA NA NA NA NA

Note: All US$mn. Source: Compustat.

CF – combined figure. NA – not available. NC – not calculable.

C-134 Case 10 • Nucor Corporation and the US steel industry

Exhibit 9 Annual income statement, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Sales 3 647.03 3 462.05 2 975.60 2 253.74 1 619.24 1 465.46 1 481.63 1 269.01 1 061.36 851.02 755.23 758.50 660.26 542.53 486.02 544.82 482.42 428.68 306.94 212.95 Cost of goods sold 2 956.93 2 726.28 2 334.11 1 843.58 1 319.60 1 209.17 1 208.12 1 028.68 832.88 671.55 575.45 569.69 510.83 434.62 382.32 434.61 356.12 305.98 220.50 162.32 Gross profit 690.11 735.77 641.49 410.16 299.64 256.29 273.51 240.33 228.49 179.47 179.78 188.80 149.43 107.91 103.70 110.21 126.30 122.71 86.44 50.63 Selling general & administrative expense 120.39 130.68 113.39 87.58 76.80 66.99 70.46 66.99 62.08 55.41 65.90 59.08 45.94 33.99 31.72 33.53 38.16 36.72 28.66 19.73 Operating income before deprec. 569.72 605.09 528.10 322.57 222.84 189.30 203.05 173.34 166.40 124.06 113.88 129.72 103.49 73.93 71.98 76.69 88.14 85.98 57.78 30.90 Depreciation depletion & amortization 182.23 173.89 156.65 122.27 97.78 93.58 84.96 76.57 56.27 41.79 34.93 31.11 28.90 27.11 26.29 21.60 13.30 9.71 7.46 5.93 Operating profit 387.49 431.20 370.45 200.31 125.06 95.73 118.09 96.77 110.14 82.27 78.95 98.62 74.59 46.82 45.69 55.09 74.84 76.27 50.33 24.98 Interest expense 7.55 9.28 14.59 14.32 9.03 2.60 8.10 16.88 9.18 3.94 5.32 4.36 4.62 4.80 8.41 10.67 3.53 4.30 2.87 2.82 Non-operating income/expense 7.84 10.41 1.08 1.12 1.30 2.69 1.23 5.74 6.63 4.91 10.61 11.92 8.58 5.55 0.52 0.42 4.75 2.79 1.00 0.10 Special items 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Pretax income 387.77 432.34 356.93 187.11 117.33 95.82 111.22 85.64 107.58 83.23 84.24 106.18 78.55 47.56 37.79 44.83 76.06 74.77 48.45 22.25 Total income taxes 139.60 157.80 130.30 63.60 38.10 31.10 36.15 27.80 36.70 32.70 37.80 47.70 34.00 19.70 15.60 10.10 31.00 32.50 22.60 9.80 Minority interest

Income before extraordinary items & discontinued operations

248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45

Preferred dividends 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Available for common 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Savings due to common stock equivalents 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Adjusted available for common 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Extraordinary items 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Discontinued operations 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 38.56 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Adjusted net income 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45

Earnings per share (primary) – excluding extra items & disc op

2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 0.83 0.60 0.54 0.69 0.53 0.33 0.27 0.42 0.55 0.52 0.33 0.16

Earnings per share (primary) – including extra items & disc op

2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 1.29 0.60 0.54 0.69 0.53 0.33 0.27 0.42 0.55 0.52 0.33 0.16

Earnings per share (fully diluted) excluding extra items & disc op

2.83 3.13 2.59 1.41 0.91 0.75 0.87 0.68 0.83 0.60 0.54 0.68 0.53 0.33 0.27 0.42 0.54 0.52 0.32 0.16

Earnings per share (fully diluted) including extra items & disc op

2.83 3.13 2.59 1.41 0.91 0.75 0.87 0.68 1.28 0.60 0.54 0.68 0.53 0.33 0.27 0.42 0.54 0.52 0.32 0.16

EP from operations 2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 0.83 Dividends per share 0.32 0.28 0.18 0.16 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.04 0.04 0.03 0.02 0.01

Note: All US$mn.

Case 10 • Nucor Corporation and the US steel industry C-135

Exhibit 9 Annual income statement, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Sales 3 647.03 3 462.05 2 975.60 2 253.74 1 619.24 1 465.46 1 481.63 1 269.01 1 061.36 851.02 755.23 758.50 660.26 542.53 486.02 544.82 482.42 428.68 306.94 212.95 Cost of goods sold 2 956.93 2 726.28 2 334.11 1 843.58 1 319.60 1 209.17 1 208.12 1 028.68 832.88 671.55 575.45 569.69 510.83 434.62 382.32 434.61 356.12 305.98 220.50 162.32 Gross profit 690.11 735.77 641.49 410.16 299.64 256.29 273.51 240.33 228.49 179.47 179.78 188.80 149.43 107.91 103.70 110.21 126.30 122.71 86.44 50.63 Selling general & administrative expense 120.39 130.68 113.39 87.58 76.80 66.99 70.46 66.99 62.08 55.41 65.90 59.08 45.94 33.99 31.72 33.53 38.16 36.72 28.66 19.73 Operating income before deprec. 569.72 605.09 528.10 322.57 222.84 189.30 203.05 173.34 166.40 124.06 113.88 129.72 103.49 73.93 71.98 76.69 88.14 85.98 57.78 30.90 Depreciation depletion & amortization 182.23 173.89 156.65 122.27 97.78 93.58 84.96 76.57 56.27 41.79 34.93 31.11 28.90 27.11 26.29 21.60 13.30 9.71 7.46 5.93 Operating profit 387.49 431.20 370.45 200.31 125.06 95.73 118.09 96.77 110.14 82.27 78.95 98.62 74.59 46.82 45.69 55.09 74.84 76.27 50.33 24.98 Interest expense 7.55 9.28 14.59 14.32 9.03 2.60 8.10 16.88 9.18 3.94 5.32 4.36 4.62 4.80 8.41 10.67 3.53 4.30 2.87 2.82 Non-operating income/expense 7.84 10.41 1.08 1.12 1.30 2.69 1.23 5.74 6.63 4.91 10.61 11.92 8.58 5.55 0.52 0.42 4.75 2.79 1.00 0.10 Special items 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Pretax income 387.77 432.34 356.93 187.11 117.33 95.82 111.22 85.64 107.58 83.23 84.24 106.18 78.55 47.56 37.79 44.83 76.06 74.77 48.45 22.25 Total income taxes 139.60 157.80 130.30 63.60 38.10 31.10 36.15 27.80 36.70 32.70 37.80 47.70 34.00 19.70 15.60 10.10 31.00 32.50 22.60 9.80 Minority interest

Income before extraordinary items & discontinued operations

248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45

Preferred dividends 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Available for common 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Savings due to common stock equivalents 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Adjusted available for common 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45 Extraordinary items 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Discontinued operations 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 38.56 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Adjusted net income 248.17 274.54 226.63 123.51 79.23 64.72 75.07 57.84 70.88 50.53 46.44 58.48 44.55 27.86 22.19 34.73 45.06 42.27 25.85 12.45

Earnings per share (primary) – excluding extra items & disc op

2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 0.83 0.60 0.54 0.69 0.53 0.33 0.27 0.42 0.55 0.52 0.33 0.16

Earnings per share (primary) – including extra items & disc op

2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 1.29 0.60 0.54 0.69 0.53 0.33 0.27 0.42 0.55 0.52 0.33 0.16

Earnings per share (fully diluted) excluding extra items & disc op

2.83 3.13 2.59 1.41 0.91 0.75 0.87 0.68 0.83 0.60 0.54 0.68 0.53 0.33 0.27 0.42 0.54 0.52 0.32 0.16

Earnings per share (fully diluted) including extra items & disc op

2.83 3.13 2.59 1.41 0.91 0.75 0.87 0.68 1.28 0.60 0.54 0.68 0.53 0.33 0.27 0.42 0.54 0.52 0.32 0.16

EP from operations 2.83 3.14 2.60 1.42 0.92 0.75 0.88 0.68 0.83 Dividends per share 0.32 0.28 0.18 0.16 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.04 0.04 0.03 0.02 0.01

Note: All US$mn.

C-136 Case 10 • Nucor Corporation and the US steel industry

Exhibit 10 Annual ratios, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Liquidity Current ratio 1.78 1.86 1.67 1.34 1.34 1.46 1.40 1.45 1.15 1.59 2.50 2.76 2.52 2.19 2.01 1.80 1.74 1.85 1.81 2.02 Quick ratio 0.85 1.08 0.94 0.65 0.58 0.64 0.79 0.72 0.57 1.04 1.60 2.11 1.79 1.55 1.26 0.79 0.98 1.21 1.06 1.01 Working capital per share 4.13 4.38 2.93 1.35 1.07 1.22 1.04 1.01 0.37 1.03 2.10 2.49 1.80 1.25 0.79 0.70 0.59 0.66 0.56 0.39 Cash flow per share 4.90 5.12 4.40 2.82 2.04 1.83 1.86 1.57 1.49 1.09 0.96 1.04 0.86 0.65 0.58 0.67 0.71 0.64 0.41 0.23

Activity Inventory turnover 8.54 9.92 10.19 8.75 6.72 7.49 8.75 7.83 8.14 7.18 6.25 7.47 7.84 8.25 6.28 7.09 7.95 7.50 6.13 NC Receivables turnover 12.67 12.79 12.93 13.48 13.40 12.41 12.68 12.42 11.96 12.04 11.43 11.01 10.56 11.24 11.17 11.81 11.52 11.89 11.10 NC Total asset turnover 1.48 1.61 1.55 1.36 1.21 1.32 1.43 1.28 1.32 1.39 1.33 1.46 1.45 1.36 1.29 1.61 1.81 1.96 1.91 NC Average collection period (days) 28.00 28.00 28.00 27.00 27.00 29.00 28.00 29.00 30.00 30.00 31.00 33.00 34.00 32.00 32.00 30.00 31.00 30.00 32.00 NC Days to sell inventory 42.00 36.00 35.00 41.00 54.00 48.00 41.00 46.00 44.00 50.00 58.00 48.00 46.00 44.00 57.00 51.00 45.00 48.00 59.00 NC Operating cycle (days) 71.00 64.00 63.00 68.00 80.00 77.00 70.00 75.00 74.00 80.00 89.00 81.00 80.00 76.00 90.00 81.00 77.00 78.00 91.00 NC Performance Sales/net property, plant & equip 2.04 2.36 2.18 1.66 1.44 1.73 2.05 1.68 1.51 2.03 2.79 3.37 2.89 2.35 2.03 2.16 2.79 3.44 3.47 3.23 Sales/stockholder equity 2.27 2.50 2.65 2.50 2.06 2.06 2.27 2.17 1.99 1.99 1.97 2.12 2.20 2.10 2.09 2.57 2.72 3.22 3.33 3.21

Profitability Operating margin before depr (%) 15.62 17.48 17.75 14.31 13.76 12.92 13.70 13.66 15.68 14.58 15.08 17.10 15.67 13.63 14.81 14.08 18.27 20.06 18.83 14.51 Operating margin after depr (%) 10.62 12.46 12.45 8.89 7.72 6.53 7.97 7.63 10.38 9.67 10.45 13.00 11.30 8.63 9.40 10.11 15.51 17.79 16.40 11.73 Pretax profit margin (%) 10.63 12.49 12.00 8.30 7.25 6.54 7.51 6.75 10.14 9.78 11.15 14.00 11.90 8.77 7.78 8.23 15.77 17.44 15.78 10.45 Net profit margin (%) 6.80 7.93 7.62 5.48 4.89 4.42 5.07 4.56 6.68 5.94 6.15 7.71 6.75 5.14 4.57 6.37 9.34 9.86 8.42 5.85 Return on assets (%) 9.47 11.96 11.32 6.75 5.32 5.48 7.23 5.59 7.46 7.73 8.12 10.44 9.24 6.55 5.97 9.03 15.47 17.38 13.36 9.73 Return on equity (%) 15.42 19.86 20.19 13.69 10.10 9.09 11.50 9.90 13.32 11.81 12.10 16.36 14.87 10.79 9.55 16.35 25.37 31.72 28.06 18.78 Return on investment (%) 12.24 16.06 15.40 8.84 6.76 7.12 9.54 7.04 9.87 10.37 10.91 14.70 12.99 9.17 7.91 11.73 20.74 24.20 19.35 13.19 Return on average assets (%) 10.10 12.77 11.83 7.44 5.93 5.83 7.24 5.83 8.84 8.25 8.21 11.22 9.81 6.99 5.87 10.27 16.87 19.36 16.08 NC Return on average equity (%) 16.59 21.92 22.39 14.65 10.59 9.49 12.13 10.36 14.76 12.45 12.53 17.80 15.97 11.36 9.98 17.81 28.99 37.50 32.63 NC Return on average investment (%) 13.28 17.26 15.80 9.62 7.62 7.63 9.33 7.51 11.76 11.07 11.28 15.79 13.78 9.54 7.70 13.53 23.00 27.42 22.67 NC

Leverage Interest coverage before tax 52.35 47.60 25.46 14.07 13.99 37.85 14.73 6.07 12.72 22.11 16.83 25.35 18.00 10.91 5.49 5.20 22.55 18.40 17.86 8.88 Interest coverage after tax 33.87 30.59 16.53 9.63 9.77 25.89 10.27 4.43 8.72 13.82 9.73 14.41 10.64 6.81 3.64 4.25 13.77 10.84 9.99 5.41 Long-term debt/common equity (%) 9.48 7.73 15.41 39.04 31.46 10.23 4.41 26.69 21.28 8.29 10.98 11.25 14.43 17.72 20.76 39.44 22.30 31.07 45.02 42.44 Long-term debt/shrhldr equity (%) 9.48 7.73 15.41 39.04 31.46 10.23 4.41 26.69 21.28 8.29 10.98 11.25 14.43 17.72 20.76 39.44 22.30 31.07 45.02 42.44 Total debt/invested capital (%) 7.56 6.26 11.77 25.22 21.08 8.23 3.94 19.26 16.08 7.73 10.61 10.72 13.31 15.84 17.77 28.84 19.01 24.42 31.39 30.26 Total debt/total assets (%) 5.85 4.66 8.65 19.27 16.57 6.33 2.98 15.31 12.16 5.76 7.91 7.61 9.46 11.31 13.41 22.20 14.18 17.54 21.68 22.32 Total assets/common equity 1.63 1.66 1.78 2.03 1.90 1.66 1.59 1.77 1.78 1.53 1.49 1.57 1.61 1.65 1.60 1.81 1.64 1.82 2.10 1.93

Dividends Dividend payout (%) 11.31 8.92 6.92 11.26 15.31 17.34 13.72 16.25 11.98 15.04 14.38 9.74 11.41 15.13 16.34 9.58 6.66 5.46 5.46 8.38 Dividend yield (%) 0.63 0.49 0.33 0.30 0.36 0.58 0.77 0.73 0.84 0.91 1.03 0.74 1.12 0.70 0.83 0.80 0.63 0.86 1.03 1.30

Note: All ratios.

NC – not calculable.

Case 10 • Nucor Corporation and the US steel industry C-137

Exhibit 10 Annual ratios, 1977–96

Dec-96 Dec-95 Dec-94 Dec-93 Dec-92 Dec-91 Dec-90 Dec-89 Dec-88 Dec-87 Dec-86 Dec-85 Dec-84 Dec-83 Dec-82 Dec-81 Dec-80 Dec-79 Dec-78 Dec-77

Liquidity Current ratio 1.78 1.86 1.67 1.34 1.34 1.46 1.40 1.45 1.15 1.59 2.50 2.76 2.52 2.19 2.01 1.80 1.74 1.85 1.81 2.02 Quick ratio 0.85 1.08 0.94 0.65 0.58 0.64 0.79 0.72 0.57 1.04 1.60 2.11 1.79 1.55 1.26 0.79 0.98 1.21 1.06 1.01 Working capital per share 4.13 4.38 2.93 1.35 1.07 1.22 1.04 1.01 0.37 1.03 2.10 2.49 1.80 1.25 0.79 0.70 0.59 0.66 0.56 0.39 Cash flow per share 4.90 5.12 4.40 2.82 2.04 1.83 1.86 1.57 1.49 1.09 0.96 1.04 0.86 0.65 0.58 0.67 0.71 0.64 0.41 0.23

Activity Inventory turnover 8.54 9.92 10.19 8.75 6.72 7.49 8.75 7.83 8.14 7.18 6.25 7.47 7.84 8.25 6.28 7.09 7.95 7.50 6.13 NC Receivables turnover 12.67 12.79 12.93 13.48 13.40 12.41 12.68 12.42 11.96 12.04 11.43 11.01 10.56 11.24 11.17 11.81 11.52 11.89 11.10 NC Total asset turnover 1.48 1.61 1.55 1.36 1.21 1.32 1.43 1.28 1.32 1.39 1.33 1.46 1.45 1.36 1.29 1.61 1.81 1.96 1.91 NC Average collection period (days) 28.00 28.00 28.00 27.00 27.00 29.00 28.00 29.00 30.00 30.00 31.00 33.00 34.00 32.00 32.00 30.00 31.00 30.00 32.00 NC Days to sell inventory 42.00 36.00 35.00 41.00 54.00 48.00 41.00 46.00 44.00 50.00 58.00 48.00 46.00 44.00 57.00 51.00 45.00 48.00 59.00 NC Operating cycle (days) 71.00 64.00 63.00 68.00 80.00 77.00 70.00 75.00 74.00 80.00 89.00 81.00 80.00 76.00 90.00 81.00 77.00 78.00 91.00 NC Performance Sales/net property, plant & equip 2.04 2.36 2.18 1.66 1.44 1.73 2.05 1.68 1.51 2.03 2.79 3.37 2.89 2.35 2.03 2.16 2.79 3.44 3.47 3.23 Sales/stockholder equity 2.27 2.50 2.65 2.50 2.06 2.06 2.27 2.17 1.99 1.99 1.97 2.12 2.20 2.10 2.09 2.57 2.72 3.22 3.33 3.21

Profitability Operating margin before depr (%) 15.62 17.48 17.75 14.31 13.76 12.92 13.70 13.66 15.68 14.58 15.08 17.10 15.67 13.63 14.81 14.08 18.27 20.06 18.83 14.51 Operating margin after depr (%) 10.62 12.46 12.45 8.89 7.72 6.53 7.97 7.63 10.38 9.67 10.45 13.00 11.30 8.63 9.40 10.11 15.51 17.79 16.40 11.73 Pretax profit margin (%) 10.63 12.49 12.00 8.30 7.25 6.54 7.51 6.75 10.14 9.78 11.15 14.00 11.90 8.77 7.78 8.23 15.77 17.44 15.78 10.45 Net profit margin (%) 6.80 7.93 7.62 5.48 4.89 4.42 5.07 4.56 6.68 5.94 6.15 7.71 6.75 5.14 4.57 6.37 9.34 9.86 8.42 5.85 Return on assets (%) 9.47 11.96 11.32 6.75 5.32 5.48 7.23 5.59 7.46 7.73 8.12 10.44 9.24 6.55 5.97 9.03 15.47 17.38 13.36 9.73 Return on equity (%) 15.42 19.86 20.19 13.69 10.10 9.09 11.50 9.90 13.32 11.81 12.10 16.36 14.87 10.79 9.55 16.35 25.37 31.72 28.06 18.78 Return on investment (%) 12.24 16.06 15.40 8.84 6.76 7.12 9.54 7.04 9.87 10.37 10.91 14.70 12.99 9.17 7.91 11.73 20.74 24.20 19.35 13.19 Return on average assets (%) 10.10 12.77 11.83 7.44 5.93 5.83 7.24 5.83 8.84 8.25 8.21 11.22 9.81 6.99 5.87 10.27 16.87 19.36 16.08 NC Return on average equity (%) 16.59 21.92 22.39 14.65 10.59 9.49 12.13 10.36 14.76 12.45 12.53 17.80 15.97 11.36 9.98 17.81 28.99 37.50 32.63 NC Return on average investment (%) 13.28 17.26 15.80 9.62 7.62 7.63 9.33 7.51 11.76 11.07 11.28 15.79 13.78 9.54 7.70 13.53 23.00 27.42 22.67 NC

Leverage Interest coverage before tax 52.35 47.60 25.46 14.07 13.99 37.85 14.73 6.07 12.72 22.11 16.83 25.35 18.00 10.91 5.49 5.20 22.55 18.40 17.86 8.88 Interest coverage after tax 33.87 30.59 16.53 9.63 9.77 25.89 10.27 4.43 8.72 13.82 9.73 14.41 10.64 6.81 3.64 4.25 13.77 10.84 9.99 5.41 Long-term debt/common equity (%) 9.48 7.73 15.41 39.04 31.46 10.23 4.41 26.69 21.28 8.29 10.98 11.25 14.43 17.72 20.76 39.44 22.30 31.07 45.02 42.44 Long-term debt/shrhldr equity (%) 9.48 7.73 15.41 39.04 31.46 10.23 4.41 26.69 21.28 8.29 10.98 11.25 14.43 17.72 20.76 39.44 22.30 31.07 45.02 42.44 Total debt/invested capital (%) 7.56 6.26 11.77 25.22 21.08 8.23 3.94 19.26 16.08 7.73 10.61 10.72 13.31 15.84 17.77 28.84 19.01 24.42 31.39 30.26 Total debt/total assets (%) 5.85 4.66 8.65 19.27 16.57 6.33 2.98 15.31 12.16 5.76 7.91 7.61 9.46 11.31 13.41 22.20 14.18 17.54 21.68 22.32 Total assets/common equity 1.63 1.66 1.78 2.03 1.90 1.66 1.59 1.77 1.78 1.53 1.49 1.57 1.61 1.65 1.60 1.81 1.64 1.82 2.10 1.93

Dividends Dividend payout (%) 11.31 8.92 6.92 11.26 15.31 17.34 13.72 16.25 11.98 15.04 14.38 9.74 11.41 15.13 16.34 9.58 6.66 5.46 5.46 8.38 Dividend yield (%) 0.63 0.49 0.33 0.30 0.36 0.58 0.77 0.73 0.84 0.91 1.03 0.74 1.12 0.70 0.83 0.80 0.63 0.86 1.03 1.30

Note: All ratios.

NC – not calculable.

C-138 Case 10 • Nucor Corporation and the US steel industry

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C-140 Case 10 • Nucor Corporation and the US steel industry E

x h

ib it

1 3

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Case 10 • Nucor Corporation and the US steel industry C-141

E x h

ib it

1 3

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Exhibit 14 Steel companies (SIC 3312) sorted by sales

Company name SIC 1996 Sales 1996 Assets

Broken Hill Proprietary – ADR 3312 $15 260.90 $28 113.50 British Steel PLC – ADR 3312 $11 882.00 $12 939.60 Pohang Iron & Steel Co – ADR 3312 $11 140.60 $18 967.60 USX-US Steel Group 3312 $6 547.00 $6 580.00 Bethlehem Steel Corp 3312 $4 679.00 $5 109.90 LTV Corp 3312 $4 134.50 $5 410.50 Allegheny Teledyne Inc 3312 $3 815.60 $2 606.40 Nucor Corp 3312 $3 647.03 $2 619.53 National Steel Corp – CL B 3312 $2 954.03 $2 547.06 Inland Steel Co 3312 $2 397.30 $2 342.80 AK Steel Holding Corp 3312 $2 301.80 $2 650.80 Armco Inc 3312 $1 724.00 $1 867.80 Weirton Steel Corp 3312 $1 383.30 $1 300.62 Rouge Steel Co – CL A 3312 $1 307.40 $681.95 WHX Corp 3312 $1 232.70 $1 718.78 Texas Industries Inc 3312 $985.67 $847.92 Lukens Inc 3312 $970.32 $888.75 Grupo IMSA SA DE CV – ADS 3312 $953.00 $1 404.00 Algoma Steel Inc 3312 $896.47 $983.47 Quanex Corp 3312 $895.71 $718.21 Carpenter Technology 3312 $865.32 $911.97 Birmingham Steel Corp 3312 $832.49 $927.99 Oregon Steel Mills Inc 3312 $772.82 $913.36 Republic Engnrd Steels Inc 3312 $746.17 $640.58 Geneva Stl Co – CL A 3312 $712.66 $657.39 Highvld Stl & Vanadium – ADR 3312 $695.36 $957.28 Northwestern Stl & Wire 3312 $661.07 $442.52 Tubos de Acero de Mex – ADR 3312 $645.16 $1 027.85 Titan International Inc 3312 $634.55 $558.59 Florida Steel Corp 3312 $628.40 $554.90 J & L Specialty Steel 3312 $628.02 $771.93 Chaparral Steel Company 3312 $607.66 $475.34 Ipsco Inc 3312 $587.66 $1 025.00 Talley Industries Inc 3312 $502.70 $280.39 NS Group Inc 3312 $409.38 $300.03 Laclede Steel Co 3312 $335.38 $331.11 Keystone Cons Industries Inc 3312 $331.18 $302.37 Huntco Inc – CL A 3312 $264.09 $222.44 Steel Dynamics Inc 3312 $252.62 $522.29 Roanoke Electric Steel Corp 3312 $246.29 $167.02 Grupo Simec-Spon ADR 3312 $214.64 $509.72 Bayou Steel Corp – CL A 3312 $204.43 $199.27 New Jersey Steel Corp 3312 $145.21 $151.37 China Pacific Inc 3312 $123.50 $114.33 Kentucky Electric Steel Inc 3312 $98.32 $78.43 Steel of West Virginia 3312 $95.33 $79.30 UNVL Stainless & Alloy Prods 3312 $60.26 $42.10 Consolidated Stainless Inc 3312 $50.82 $51.25 Stelax Industries Ltd 3312 $0.73 $16.76

C-142 Case 10 • Nucor Corporation and the US steel industry

Nucor’s strategic intent is clearly known by employees, customers and its competitors. Each year, the business review of the annual report gives this succinct description of its scope of operations: ‘Nucor Corporation’s business is the manufacture of steel products.’ The annual letter to shareholders gives this picture of the company:

Your management believes that Nucor is among

the nation’s lowest cost steel producers. Nucor

has operated profitably for every quarter since

1966. Nucor’s steel products are competitive with

those of foreign imports. Nucor has a strong sense

of loyalty and responsibility to its employees.

Nucor has not closed a single facility, and has

maintained stability in its work force for many

years ... Productivity is high and labor relations

are good.3

As with the mission, goals at Nucor are equally streamlined. Iverson has noted that in some compa- nies planning systems are as much ritual as reality, resulting in plans and budgets that are inappropri- ate and unrealistic.4 Nucor has both long- and short- range goals. However, they are handled differently than at many firms. Short-term plans focus on bud- get and production for the current and next fiscal year. The plans are zero-based – created from actu- al needs and estimates for specific projects – not an updated copy of a prior year’s budget. Long-range plans are a combination of the plans of different divi- sions and plant – a bottom-up approach to planning. The long-range plans are seen as guides – not gos-

pel. The plans incorporate relative goals instead of specific milestones that the firm expects managers to achieve. Division and plant managers set their target goals knowing that they will be rewarded for meet- ing them, but not punished if for unexpected reasons they are not met.

Similarly, even plans for specific projects are min- imalist. For example, the company handles new mill construction largely internally. Many aspects of the plant design are done ‘on the fly’ to save time. The company does not create finely detailed construction plans for new plants. Instead, it uses this experience as a guide for starting construction. It then fills in the details as construction proceeds.5 This approach allows Nucor to construct plants both faster and at less cost than their competitors. The Hickman, Arkan- sas mill was completed six months ahead of schedule, going from groundbreaking to first commercial ship- ment in a mere 16 months.

By 1995, Nucor had become the fourth-largest domestic steel producer. CEO John Correnti targets annual growth at between 15 and 18 per cent – sub- stantially above the 1–2 per cent rate of growth for the industry. Given Nucor’s size and the industry’s maturity, growth for Nucor requires taking mar- ket share away from the integrated producers. Most experts agree that Nucor is well positioned to achieve such growth and sustain profitability, given its indus- try-leading cost structure. Steel industry analysts attribute Nucor’s ability to grow in a constricting market to the firm’s aggressive style of management, its innovative and revolutionary technologies, and a

Exhibit 15 Nucor annual sales, 1986–97

0

19 86

19 88

19 90

19 92

19 94

19 96

19 97

1 000

2 000

3 000

4 000

5 000

M ill

io n

s o

fd o

lla rs

Case 10 • Nucor Corporation and the US steel industry C-143

solid understanding of the dynamics and cost-drivers of the steel industry.

Nucor can trace its low-cost position to a com- bination of three factors: technological innovation, continuous process refinement and a strong corporate culture. Investments in any of the three alone is insuf- ficient; the three elements must work together for the firm to be productive and successful.

Technological innovation at Nucor Historically, the main distinction between minimills and integrated producers has been the range of prod- ucts offered. While minimill technology is less capital- intensive, the production process is also limited to commodity steel products: bars, angles and structural steel beams. Integrated producers largely retreated from these commodity products and concentrated on sheet steel, which was presumably safe from encroach- ment by the minis. Strategically, though, Nucor more closely resembles the integrated producers versus other minimills in terms of product offerings. Innovative use of technology is key to this strategy.

A prime example of Nucor’s innovation was its foray into sheet steel. By the mid-1980s, Iverson had anticipated the coming shake-out among minimills; the lure of easy pickings from dinosaurs like Beth- lehem Steel had drawn many firms into the minimill business, resulting in over-supply. Integrated mills pro- duce steel sheet by starting with 10-inch-thick slabs of steel and repeatedly processing the slab through roll- ers to reduce thickness and increase width. Multiple rolling machines result in a production line hundreds of metres long. Conventional wisdom said that it was impossible to produce the 10-inch-thick steel slabs needed to roll sheet steel in a minimill; their small electric arc furnaces simply did not have the same capability as the blast furnace used by an integrat- ed mill. Nucor carefully researched emerging tech- nology. Rather than develop a proprietary system, they licensed and modified a new German caster and began a US$270 million experiment. This new plant – in Crawfordsville, Indiana – started up in 1987. The process was very different from making sheet steel in an integrated plant. Nucor’s system involves the high- ly controlled continuous pouring of molten steel into a narrow mould and on to a conveyor belt to form a continuous two-inch-thick ribbon of semi-solid steel

– pouring steel much in the same manner as frost- ing an endless cake using a pastry tube. The process requires sophisticated computer technology and mon- itoring to ensure constant quality and to avert costly and dangerous spills. This precisely sized ribbon of steel is then rolled to the specific thickness using a few smaller-sized rolling machines. This results in a much smaller and less expensive plant than a tradi- tional mill for the production of sheet steel.

The technical challenges of producing steel using this method are the basic requirements of entry into the minimill market. Profitability, however, is achieved through efficiency. Labour costs constitute a large portion of the cost of steel. Integrated producers can take up to four to five man-hours per ton to pro- duce sheet steel, with three hours/ton on a productiv- ity benchmark. In comparison, Nucor’s Crawfords- ville plant took only 45 man-minutes per ton. Such efficiency gave Nucor a US$50–75 cost advantage per ton, a savings of nearly 25 per cent compared to their competitors. By 1996, Nucor had production time down to 36 minutes per ton with additional savings expected. A second sheet plant was added in 1992, and capacity was expanded at both plants in 1994. Production capacity was 1 million tons in 1989, and 3.8 million tons in 1995.

Not content with the sheet steel market, Nucor chose to enter a new strategic segment in 1995: spe- ciality steel. The Crawfordsville plant was modified to produce thin slab stainless steel – another ‘impossible’ feat for a minimill. Through experimentation, it was able to produce two-inch-thick stainless steel slabs. It shipped 16 000 tons in 1995, 50 000 tons in 1996, and expects to hit a production capacity of 200 000 tons annually. Coincidentally, perhaps, its projected capacity mirrors the volume of stainless sheet import- ed to the United States – about 10 per cent of stainless steel demand in the United States.

Another example of technological innovation was Nucor’s entry into the fastener steel segment. Fasten- ers include hardware such as hex and structural bolts and socket cap screws, which are used extensively in an array of applications, including construction, machine tools, farm implements and military applica- tions. Dozens of American fastener plants shuttered their doors in the 1980s, and foreign firms captured virtually all of this business segment. After a year of

C-144 Case 10 • Nucor Corporation and the US steel industry

studying the fastener market and available technolo- gy, Nucor built a new fastener plant in Saint Joe, Indi- ana. Productivity was substantially higher than that at comparable US plants, and a second fastener plant came on-line in 1995. The fastener plants receive most of their steel from the Nucor Steel division. With a production capacity of 115 000 tons – up substantial- ly from 50 000 tons in 1991 – Nucor has the capacity to supply nearly 20 per cent of this market.

A final example of technological innovation con- cerns upstream diversification. Scrap steel is a critical input for minimills. Quality differences in scrap types coupled with insufficient supply have led to large fluctuations in scrap costs. Frank Stephens, a min- ing engineer, had developed a technology to improve the efficiency of steel making through the use of iron carbide. Stephens had tried – unsuccessfully – to sell this process to US Steel, National Steel and Armco, among others.6 In comparison, to Nucor, iron carbide appeared to be an opportunity to reduce its reliance on the increasingly volatile scrap steel market. After speaking with the inventor of the process and touring an iron carbide pilot plant in Australia, Nucor made preliminary plans to construct an iron carbide pilot plant.7 The location selected – Trinidad – would pro- vide the large quantities of low-cost natural gas need- ed for iron carbide production. Nucor estimated that establishing the pilot plant would require US$60 mil- lion. However, as the process was unproven, Nucor would, in essence, be making a gamble that would yield an industry-revolutionising process or be invest- ing US$60 million in a plant that would be virtual- ly worthless. To Nucor, the investment constituted a measured risk; while the investment to determine the feasibility was significant, if the process failed it would not cripple the firm. In 1994, Nucor opened

the iron carbide pilot plant at a cost of US$100 mil- lion – almost double expectations. At the end of 1995, the plant was operating at only 60 per cent of capacity. Still, Nucor was betting big on this oppor- tunity. Nucor estimates that the use of iron carbide would allow them to reduce their steel-making costs by US$50 per ton – a 20 per cent reduction. Addi- tionally, Nucor is working on a joint venture with US Steel to manufacture steel directly from iron carbide, which could revolutionise the steel industry.

Process refinement at Nucor Much of the business press focuses on the high-profile quantum advances made at Nucor, such as the creation of flat-rolled steel in an electric arc furnace and the use of iron carbide as a substitute for scrap. However, an emphasis on continuous innovation is felt through- out the organisation and is equally important. A man- ager from Nucor’s Crawfordsville mill observed that most of the innovation comes not from management, but from equipment operators and line supervisors. The job of management, says the manager, is to make sure the innovations can be implemented.8 For exam- ple, workers discovered that they could fine-tune sur- face characteristics of their galvanised steel (a benefit valued by many customers) simply by making small adjustments to the air pressure of a coating process. Changes such as these do not require management review or approval. Instead, equipment operators and line supervisors are authorised to innovate and imple- ment processes that improve production. Such inno- vation is routine enough at Nucor that management does not track individual improvements. Rather, Nucor tracks innovation by looking at the end result – reductions in the amount of labour required to pro- duce each ton of steel.

Exhibit 16 Nucor’s principal manufacturing locations, 1997

Location Size (ft2) Products

Blytheville–Hickman, Arkansas 2 880 000 Steel shapes, flat-rolled steel Norfolk–Stanton, Nebraska 2 28 000 Steel shapes, joists, deck Brigham City–Plymouth, Utah 1 760 000 Steel shapes, joists Darlington–Florence, South Carolina 1 610 000 Steel shapes, joists, deck Grapeland–Jewett, Texas 1 500 000 Steel shapes, joists, deck Crawfordsville, Indiana 1 410 000 Flat-rolled steel Berkeley, South Carolina 1 300 000 Flat-rolled steel

Case 10 • Nucor Corporation and the US steel industry C-145

Employee innovation is driven by two factors. First, the company’s bonus system means that any substantial improvements to efficiency will contribute to both the plant’s performance and individual pay cheques. Second, the corporate culture emphasises how experiments – even failed ones – keep Nucor as the perennial benchmark for industry productivity. Experiments are conducted both at the time of mill start-up and on an ongoing basis. Typical of most mill start-ups, the start-up of Nucor’s Hickman plant was fraught with problems. The high rate of the produc- tion line resulted in ‘breakouts’ – bad pours – of the ‘ribbon’ of steel for thin-slap casting. Though initial- ly occurring at the rate of several per day, breakouts have been declining since the plant became operation- al. The high rates of production still result in two to five breakouts per week and Nucor continues to make modifications to the equipment to reduce this level.

Focusing on clean-steel practices, the melt-shop people are developing mould powders that can han- dle the high-speed, thin-slab casting. Mould powders insulate, lubricate, aid uniform heat transfer, and absorb inclusions, all of which makes for cleaner steel. Unfortunately, no existing mould powders can handle hot steel at the rate Nucor could potentially produce it: 200 inches a minute. To reduce inclusions (impuri- ties in the steel), Nucor is working to standardise all operating practices in the two furnaces and two ladle furnaces.

The Nucor philosophy towards innovation is that attempts at improvement will be accompanied by failures. Tony Kurley, a Nucor plant manager, recalls

Nucor chairman Ken Iverson’s expectation that suc- cess is making the correct decision 60 per cent of the time. What’s important isn’t the mistakes that are made, says Iverson, but the ability to learn from the 20 per cent that are truly mistakes and the 20 per cent that are sub-optimal decisions.9

This willingness to modify on the fly and ‘shoot from the hip’, as one melt-shop supervisor puts it, makes Nucor an exciting place to work. The lean, flexible workforce is continually trying new things, doing different jobs. Employees continue to engage in risk taking because the company rewards success and does not punish for failures. The result is that employ- ees, from top managers to hourly personnel, are will- ing to take risks to achieve innovation and take own- ership in their jobs.

At Nucor, the tolerance levels for failure are apparently high. In the 1970s, a Nucor plant man- ager was considering the replacement of the electric arc furnace in the plant with an induction furnace. At Nucor, the plant manager has the authority to select the type of furnaces used in his plant. There was no clearly right or wrong answer. A discussion yielded strong arguments in favour of the switch from some plant managers and equally enthusiastic arguments against the switch from others. The plant manager elected to make the switch at a cost to Nucor of US$10 million. From the start, the new furnaces failed to live up to expectations and resulted in repeated shut- downs. Discussion shifted to the pluses and minuses of removing the furnace and within a year the furnace was removed. When the manager told Iverson of his

Exhibit 17 Nucor annual worker productivity, 1990–97

0

200

400

600

800

1000

1 200

1400

1600

19 90

19 91

19 92

19 93

19 94

19 95

19 96

19 97

T o

n s/

em p

lo ye

e/ ye

ar

C-146 Case 10 • Nucor Corporation and the US steel industry

decision, Iverson supported him, saying he had made the right decision – there was no sense in leaving the reminder of a bad decision laying around.10

Despite the price tag on this particular learn- ing experience, management was unfazed. Iverson’s comment on this failure was that the true problem is people not taking risks. Nucor has a saying: ‘Don’t study an idea to death in a dozen committee meetings; try it out and make it work.’

Through incremental advances, employees are continually able to streamline and refine the steel- making process. The data suggests that Nucor employ- ees have not come close to exhausting these enhance- ments. Productivity, as measured in tons produced per employee, doubled from 1990 to 1995 (626 tons/ worker and 1269 tons/worker, respectively) and con- tinues to climb. In 1997, productivity exceeded 1400 tons/worker. How is Nucor able to realise such pro- ductivity gains in this mature industry? The following examples highlight incremental innovations.

Preventive maintenance Preventive maintenance is a crucial but time- consuming task at a minimill. At Nucor-Yamato, a joint venture between Nucor and Yamato Kogyo, a Japanese steel producer, the plant had week-long shutdowns three times a year. During these periods, outside contractors would strip, service and replace worn machinery. The outages could involve as many as 800 contractor personnel – a difficult task to man- age. Further exacerbating the situation was the level of skill and low level of productivity of some contrac- tor personnel. Aside from the challenges of hunting down missing contractors, the plant (and employees) suffered from the three weeks without production. The company addressed both of these concerns by eliminating the week-long shutdowns, instead tack- ling specific areas of the mill in focused, 24-hour shutdowns. This new process has several advan- tages, including spreading the maintenance costs over a wider window and being able to use a smaller in- house staff that operates continually. Some mainte- nance jobs are large enough to still require multiple- day shutdowns, but the number of outside contractors has been reduced from 800 to 150. Through this pro- gram, downtime at the plant has fallen from 10 per cent to near 1 per cent. Some improvements are less

dramatic, but significant nonetheless. A young engi- neer at a Nucor plant was concerned that too much was being spent to lubricate and maintain a series of supporting screws under a rolling line. He had a bet- ter idea. The screws, part of the original manufactur- er’s design, were replaced with metal shims, achiev- ing an annual savings of over US$1 million.

Reduced melt times At the Crawfordsville plant, workers made a series of small changes, such as replacing an exhaust pipe and tinkering with the chemistry of the melt. By doing so, they reduced the melt time from 72 minutes to 65 minutes. While this may seem a small improvement, it meant that an additional 25 tons of steel could be poured in a single shift.

Revitalisation of outdated equipment When Nucor bought a casting line from a German supplier, an obsolete reversing mill, which is used to reduce the thickness of steel, was thrown in as an afterthought to sweeten the deal. The capacity of the reducing mill was rated as 325 000 tons a year by the supplier. Nucor employees immediately began fiddling with the mill; the following are among the improvements and results: • Changing the way the steel was fed into the

machine increased capacity from 360 to 1960 feet per minute.

• Changes reduced the time to thread the machine from five minutes to 20 seconds.

• Nucor changed the type and grade of lubricating oil and installed a bigger motor. With these changes, Nucor processed 650 000

tons of steel during the first year the equipment was in operation – twice the machine’s capacity as rated by its manufacturer. Nucor anticipates that an addi- tional 10 per cent increase can be achieved.11

New galvanising line At one point, Nucor decided to install a galvanising line that coats finished steel to enhance its durability. Engineers from US$17.8-billion USX Corp. visited the plant before the foundation for the line had even been poured, and Nucor engineers told them they would have the line running by year’s end. The USX visitors laughed because they had started building a similar line a year earlier and it still wasn’t operational. The

Case 10 • Nucor Corporation and the US steel industry C-147

day after Christmas, USX ran its first coil through its new galvanising line. Twelve hours later, Nucor’s US$25 million galvanising line was operational. No other firm had constructed such a line for less than US$48 million.12

Continuous production In most minimills, the conversion of scrap to a fin- ished product is a discontinuous process. Scrap is con- verted to ingots, for instance, which are then stock- piled for further conversion. When building their new Hickman plant in the early 1990s, Nucor tried an experiment: continuous production. All steps of the steel-making process are coordinated, from picking up the raw scrap, to melting it, forming it and laying down a finished coil. Continuous production is both faster (three to four hours from inputs to finished product) and more efficient. The downside? This just- in-time approach eliminates all slack or buffers in the process; problems at any point in the production line shut the entire operation down. How well has this new process worked? As with other Nucor plants, virtually none of the employees had ever worked in a steel mill before. Still, plant performance within one year of start-up was competitive with more estab- lished mills: 0.66 man-hours per ton, and a 91 per cent yield (percentage of scrap converted to finished product, a measure of efficiency). In late July 1993, the Hickman plant shipped 8804 tons, setting a new Nucor record for the most tons shipped from a single plant in a day.13

Culture at Nucor A key ingredient in any effective corporate culture is people. It is not surprising that many organisations, especially manufacturing firms, have dysfunctional cultures given the fear and distrust experienced by many workers, frequent layoffs and an ‘us versus them’ mentality. Executives of Bethlehem Steel, for example, constructed a golf course using corporate funds, then built a second and third course for mid- dle managers and employees, respectively. Ken Iver- son questioned how a company with a culture so dysfunctional as to require the construction of three golf courses to maintain the hierarchical distinction between executives, managers and line employees could ever expect to improve its operations.14

Nucor differs dramatically from its competitors. At Nucor, ‘us versus them’ clearly implies manage- ment and workers united against competitors. One melt-shop supervisor described a sense of personal responsibility not only for his own job but also for the firm. He described his position at Nucor as being much like running his own company – a typical com- ment given the entrepreneurial environment Nucor has created. Decentralised authority and a sense of individual responsibility are a key part of that struc- ture. John Correnti explains that he does not want to micro-manage the firm’s operations. Doing so, he feels, would result in employees placing blame when things go wrong instead of taking responsibility and finding solutions. This, Correnti feels, results in line personnel having a realistic ability to control their own job environment, increase productivity and increase their pay.15

Still, Nucor is anything but a ‘workers’ paradise’. The standards for employee productivity are extreme- ly high, and there are a number of painful remind- ers of this emphasis. For example, the steelworker who is 15 minutes late loses his production bonus for the day – as much as half of the day’s pay. Thirty minutes late and the bonus for the entire week is for- feited. Workers are not paid for sicknesses less than three days, or for production downtime due to bro- ken machinery. However, by most measures, Nucor is the employer of choice. There is extreme competition for new positions. The Darlington plant has routinely received 1000 applications from a single job posting in the newspaper. Similarly, the new plant in Jewett, Texas (population 435), received 2000 applications. Employee turnover rates are among the lowest in the industry. For example, the Crawfordsville, Indiana, plant lost a total of four employees between 1988 and 1994: two for drug use and two for poor perfor- mance. Nucor is a non-union shop with much of the opposition to unions coming from Nucor employees who feel that union rules would hurt productivity and subsequently their pay cheques. According to company folklore, there has been one labour dispute outside the mill gates, and plant supervisors had to protect union pamphleteers from angry employees!

How does Nucor achieve such levels of motiva- tion and dedication? Iverson suggests that corporate America has confused the ideas of motivation and

C-148 Case 10 • Nucor Corporation and the US steel industry

manipulation. Manipulation stipulates a one-sided relationship wherein management convinces employ- ees to do things in the interest of management. Moti- vation involves getting employees to do things that are in the best interest of both parties. In the long term, Iverson says, motivation yields a strong company whereas manipulation destroys a company. With this in mind, Nucor has identified the following elements as critical to effective employee motivation: 1 Everyone must know what is expected of them,

and goals should not be set too low. 2 Everyone must understand the rewards, which

must be clearly delineated and not subjective. 3 Everyone must know where to go to get help.

The company must have a system that clearly tells the employee who to talk to when confused or upset.

4 Employees must have real voices. They must participate in defining the goals, determining the working conditions and establishing production processes.

5 The company must provide a feedback system so that employees always know how they, their group and the company are doing.16

The approach appears to work. A long-time Nucor employee recalls when the Darlington, South Carolina, plant could produce 30 tons of steel a day. The same plant now produces 100 tons of steel an hour. The worker says that, given the can-do attitude of employees and the focus on constant improvement, the ‘sky is the limit’ for additional improvements.17

While Nucor is a merit-oriented company, it also makes it clear that there are no ‘classes’ of employ- ees. Top managers receive the same benefits as steel- makers on everything from vacation time to health insurance. There are no preferred parking spaces, and the ‘executive dining room’ is the delicatessen across the street. Incidentally, the corporate headquarters is located in a dowdy strip mall in Charlotte, North Carolina. Not surprisingly, there is no corporate jet or executive retreat in the Caymans. Officers travel in coach class on business trips, and the organisa- tion is rife with legends of corporate austerity – such as Iverson travelling via subway when on business in New York City (true, incidentally). This emphasis on egalitarianism is an integral part of the Nucor cul- ture. Iverson, wanting to eliminate even the smallest

distinctions between personnel, ordered everyone to wear the same colour hardhat. In many plants, the colour of your hardhat is a highly visible signal of your level in the company hierarchy. Even at Nucor, some managers thought that their authority rested not in their expertise and management ability, but in the colour of their hat. This goal of egalitarianism has not been completely without problems. When it was brought to Iverson’s attention that workers need- ed to be able to quickly identify maintenance person- nel, Iverson admitted his mistake and at Nucor plants everyone wears green hardhats except maintenance personnel who wear yellow so that they can be eas- ily spotted.18

This approach appears transferable and the moti- vational effects are contagious. Iverson recalls when Nucor purchased a plant and immediately sold the limousine and eliminated executive parking spaces in favour of a first-come, first-served system. Iverson greeted employees on their way into the plant and recalls one employee who parked in what was the boss’s reserved spot and commented that the simple changes in the parking system made him feel much better about the company.19

Compensation and bonus system Leadership by example can only induce so much behaviour; one of the more visible aspects of Nucor’s culture is its compensation system, particularly the prominent bonus system. ‘Gonna make some money today?’ is a common greeting on the plant floor, and discussion of company financials is as common in the lunchroom as basketball scores. The bonus sys- tem is highly structured, consisting of no special or discretionary bonuses. The company is divided based on production teams of 25–50 individuals who are responsible for a complete task (such as a cold rolled steel fabrication line). The group includes everyone on that line, from scrap handlers to furnace operators, mould and roller operators, and even finish packag- ers. Managers get together and, based on the equip- ment being used, set a standard for production. This standard is known to everyone in advance and doesn’t change unless the company makes a significant invest- ment in capital equipment. With the standard in mind, employees make whatever changes they see fit to increase production. A bonus is paid for all produc-

Case 10 • Nucor Corporation and the US steel industry C-149

tion over the standard and there is no limit as to how much bonus can be paid. The only qualifier is that the production must be good – that is, of sufficient qual- ity for sale. No bonus is paid for bad production. At the end of the week, all employees on a particular line get the same production bonus, which is issued along with their weekly cheques.20

With bonuses, Nucor employees typically earn as much as their unionised counterparts in the integrat- ed plants. Weekly bonuses have, in recent years, aver- aged 100–200 per cent of base wages. Typical pro- duction workers earn US$8 to US$9 in base pay plus an additional US$16 per hour in production bonuses and averaged US$60 000 in 1996, making them the highest-paid employees in the industry. Since Nucor locates its plants in rural locations, employee salaries are well above the norm for any specific area, making Nucor jobs highly desirable.

Nucor also offers several other benefits to help motivate and retain employees. In the 1980s, it shift- ed to a workweek of four 12-hour days. Workers take four days off and then resume another intensive shift – a practice borrowed from the oil industry. While this practice results in a lot of expensive overtime – Crawfordsville alone paid out an extra half a mil- lion dollars in 1995 due to the compressed workweek – management feels that the ensuing morale and pro- ductivity gains pay for themselves. The company has also disbursed special US$500 bonuses (four times in the last 20 years) in exceptionally good years. They also provide four years worth of college tuition sup-

port (up to US$2000/year) for each child of each employee – excluding only the children of corporate officers.

Job security Listening to Nucor managers, it is difficult to deter- mine which fact they are most proud of: 30 years of uninterrupted quarterly profits or 20 years since they have last had to lay off an employee. Nucor locates in rural areas and there are often few other employ- ment opportunities, let alone other jobs at similar pay scales, so Nucor feels a strong responsibility for keep- ing workers employed, even during economic down- turns.

Popular impressions aside, Iverson is clear to note that Nucor does not have a no-layoff policy. He cau- tions that Nucor will lay off employees as a last resort if the survival of the company is at stake.21 But dur- ing prior downturns, the company has chosen to ride out slowdowns with its ‘Share the Pain’ program, which involves reduced workweeks and plant slow- downs instead of layoffs. What is most unusual with the program is that the brunt of poor performance is felt most heavily at upper parts of the organisa- tion, particularly as long-term compensation is an integral part of the executive pay system. During a period of reduced demand for steel, the plants reduce their operations. For line personnel and foremen, this reduces their income by about 20 per cent. For depart- ment heads, who are covered by a bonus plan based on the profitability of their plant, slowdowns result in

Exhibit 18 Nucor profitability vs industry, 1981–95

–6%

–4%

–2%

0%

2%

4%

6%

8%

19 81

19 83

19 85

19 87

19 89

19 91

19 93

19 95

Nucor Industry

C-150 Case 10 • Nucor Corporation and the US steel industry

a reduction of about one-third of their pay. Nucor’s top managers have their pay based largely on return on shareholders’ equity – the measure most impor- tant to shareholders. This is hit the hardest and top managers see their pay decline the most – as much as two-thirds or three-quarters of their income is lost.22 This structure serves a number of purposes. First, the line personnel don’t feel that they are bearing the brunt of a downturn. Second, there is a great deal of motivation to further reduce the cost per ton so that Nucor can underprice any other producer and keep its mills active even during an economic downturn. Lastly, while the shareholders may not be happy with a reduced ROI, they at least know that management has an incentive to improve company performance. As an example, Iverson notes that in 1961 – a good year – he made US$460 000 including bonuses. In 1982, though, Nucor fell shy of its 8 per cent return on equity and Iverson earned only US$108 000.23

Summary How important is the corporate culture to Nucor’s success? Management is free to point out that their advantage does not stem from proprietary technol- ogy. After all, most of their innovations – including thin-slab casting and the use of iron carbide – are based on technology developed by other firms. While they pioneered the modifications to make thin-slab casting possible, numerous other minimills are hot on their heels in this product segment. Nucor’s plants are open to firms seeking to benchmark their oper- ations, including other steel producers. When other

firms tour a plant, they may see the same equipment as in their plant. Many comment on the culture of the plant. One visitor from an integrated producer com- mented that at his plant the culture is adversarial, management versus employee, with no trust between the parties. ‘Us versus them’ refers to workers versus management and production. In contrast, at Nucor, workers are seen striving together as a team, help- ing each other and working towards a common goal: the production of a high volume of low-cost, quality steel.24

Iverson explains Nucor’s success as being based on a combination of the technology used and the cul- ture of the organisation. He is unsure if technology is 20, or 30, or even 40 per cent – but he’s sure it is less than half of the formula for Nucor’s achievements. The culture that Nucor instills is focused primar- ily on the long-term health of the organisation. For example, debt is avoided, start-up costs are not capi- talised but rather are expensed in the current peri- od, and depreciation and write-offs lean towards the detriment of short-term earnings. Iverson is adamant about not bowing to short-term pressures to manage earnings or spread dividends evenly over a quarterly basis. He refuses to do it. He compares companies that try endlessly to meet short-term projections at the expense of a long-term approach to dogs on a leash – trying to perform a trick to satisfy the stock mar- ket. He admonishes short-term share speculators to stay away from the company. He compares Nucor to an eagle and invites long-term investors to soar with the company.25

Notes 1 J. L. McCar thy, 1996, ‘Passing the torch at big steel’, Chief

Executive, 111, p. 22. 2 K. Iverson, 1993, ‘Changing the rules of the game’, Planning

Review, 21(5), pp. 9–12. 3 Nucor Corp. Annual Report 1996. 4 K. Iverson, 1993, ‘Effective leaders stay competitive’, Executive

Excellence, 10(4), pp. 18–19. 5 G. McManus, 1992, ‘Scheduling a successful star tup’, Iron Age

New Steel, 8(7), pp. 14–18. 6 S. Carey and E. Nor ton, 1995, ‘Blast from the past: Once

scorned, a man with an idea is wooed by the steel industry’, Wall Street Journal, 29 December, p. A1.

7 R . S. Ahlbrandt, R . J. Fruehan and F. Giarratani, 1996, The Renaissance of American Steel (New York: Oxford University Press).

8 T. Kuster, 1995, ‘How Nucor Crawfordsville works’, Iron Age New Steel, 11(12), pp. 36–52.

9 B. Berry, 1993, ‘Hot band at 0.66 manhours per ton’, Iron Age New Steel, 1(1), pp. 20–6.

10 K. Iverson, 1998, Plain Talk: Lessons from a Business Maverick (New York: John Wiley & Sons).

11 E. O. Welles, 1994, ‘Bootstrapping for billions’, Inc., 16(9), pp. 78–86.

12 Ibid. 13 Berry, ‘Hot band at 0.66 manhours per ton’. 14 Iverson, Plain Talk.

Case 10 • Nucor Corporation and the US steel industry C-151

15 Ahlbrandt, Fruehan and Giarratani, The Renaissance of American Steel.

1 6 Iverson, ‘Changing the rules of the game’. 17 Ibid. 18 J. Isenberg, 1992, ‘Hot steel and good common sense’,

Management Review, 81(8), pp. 25–7. 19 Iverson, Plain Talk.

20 Iverson, ‘Changing the rules of the game’. 21 Iverson, Plain Talk. 22 Isenberg, ‘Hot steel and good common sense’. 23 Iverson, ‘Changing the rules of the game’. 24 B. Berry, 1996, ‘The importance of Nucor’, Iron Age New Steel,

12(7), p. 2. 25 Iverson, Plain Talk.

C-152

Case 11

Philip Condit and the Boeing 777*: From design and development to production and sales Isaac Cohen San Jose State University

* This case was presented in the October 2000 meeting of the North American Case Research Association at San Antonio, Texas. © Isaac Cohen, 2000. The author is grateful to the San Jose State University College of Business for its support.

Following his promotion to Boeing CEO in 1988, Frank Shrontz looked for ways to stretch and upgrade the Boeing 767 – an eight-year-old wide-body twin jet – in order to meet Airbus competition. Airbus had just launched two new 300-seat wide-body models, the two-engine A330 and the four-engine A340. Boe- ing had no 300-seat jetliner in service, nor did the company plan to develop such a jet.

To find out whether Boeing’s customers were interested in a double-decker 767, Philip Condit, Boe- ing executive vice president and future CEO (1996), met with United Airlines vice president Jim Guyette. Guyette rejected the idea outright, claiming that an upgraded 767 was no match for Airbus’s new-model transports. Instead, Guyette urged Boeing to develop a brand-new commercial jet, the most advanced air- plane of its generation. Shrontz had heard similar sug- gestions from other airline carriers. He reconsidered Boeing’s options, and decided to abandon the 767

idea in favour of a new aircraft program. In Decem- ber 1989, accordingly, he announced the 777 project and put Philip Condit in charge of its management. Boeing had launched the 777 in 1990, delivered the first jet in 1995, and by February 2001, 325 B-777s were flying in the services of the major international and US airlines.1

Condit faced a significant challenge in managing the 777 project. He wanted to create an airplane that was preferred by the airlines at a price that was truly competitive. He sought to attract airline custom- ers as well as cut production costs, and he did so by introducing several innovations – both technological and managerial – in aircraft design, manufacturing and assembly. He looked for ways to revitalise Boe- ing’s outmoded engineering production system, and to update Boeing’s manufacturing strategies. And to achieve these goals, Condit made continual efforts to spread the 777 program-innovations company wide.

Case 11 • Philip Condit and the Boeing 777 C-153

Looking back at the 777 program, this case focus- es on Condit’s efforts. Was the 777 project success- ful and was it cost-effective? Would the development of the 777 allow Boeing to diffuse the innovations in airplane design and production beyond the 777 program? Would the development of the 777 permit Boeing to revamp and modernise its aircraft manu- facturing system? Would the making and selling of the 777 enhance Boeing competitive position relative to Airbus, its only remaining rival?

The aircraft industry Commercial aircraft manufacturing was an industry of enormous risks where failure was the norm, not the exception. The number of large commercial jet mak- ers had been reduced from four in the early 1980s – Boeing, McDonnell Douglas, Airbus and Lockheed – to two in late 1990s, turning the industry into a duopoly, and pitting the two survivors – Boeing and Airbus – one against the other. One reason why air- craft manufacturers so often failed was the huge cost of product development.

Developing a new jetliner required an up-front investment of up to US$15 billion (2001 dollars), a lead time of five to six years from launch to first deliv- ery, and the ability to sustain a negative cash flow throughout the development phase. Typically, to break even on an entirely new jetliner, aircraft manufactur- ers needed to sell a minimum of 300 to 400 planes and at least 50 planes per year. Only a few commer- cial airplane programs had ever made money.2

The price of an aircraft reflected its high devel- opment costs. New-model prices were based on the average cost of producing 300 to 400 planes, not a single plane. Aircraft pricing embodied the principle of learning by doing, the so-called learning curve3 workers steadily improved their skills during the assembly process, and as a result, labour cost fell as the number of planes produced rose.

The high and increasing cost of product develop- ment prompted aircraft manufacturers to utilise sub- contracting as a risk-sharing strategy. For the 747, the 767 and the 777, the Boeing Company required subcontractors to share a substantial part of the air- plane’s development costs. Airbus did the same with its own latest models. Risk-sharing subcontractors

performed detailed design work and assembled major subsections of the new plane while airframe integra- tors (that is, aircraft manufacturers) designed the air- craft, integrated its systems and equipment, assembled the entire plane, marketed it, and provided customer support for 20 to 30 years. Both the airframe integra- tors and their subcontractors were supplied by thou- sands of domestic and foreign aircraft components manufacturers.4

Neither Boeing, nor Airbus, nor any other post- war commercial aircraft manufacturer produced jet engines. A risky and costly venture, engine building had become a highly specialised business. Aircraft manufacturers worked closely with engine makers – General Electric, Pratt and Whitney, and Rolls-Royce – to set engine performance standards. In most cases, new airplanes were offered with a choice of engines. Over time, the technology of engine building had become so complex and demanding that it took lon- ger to develop an engine than an aircraft. During the life of a jetliner, the price of the engines and their replacement parts was equal to the entire price of the airplane.5

A new-model aircraft was normally designed around an engine, not the other way around. As engine performance improved, airframes were rede- signed to exploit the engine’s new capabilities. The most practical way to do so was to stretch the fuselage and add more seats in the cabin. Aircraft manufactur- ers deliberately designed flexibility into the airplane so that future engine improvements could facilitate later stretching. Hence the importance of the ‘family concept’ in aircraft design, and hence the reason why aircraft manufacturers introduced families of planes made up of derivative jetliners built around a basic model, not single, standardised models.6

The commercial aircraft industry, finally, gained from technological innovations in two other indus- tries. More than any other manufacturing indus- try, aircraft construction benefited from advances in material applications and electronics. The develop- ment of metallic and non-metallic composite materi- als played a key role in improving airframe and engine performance. On the one hand, composite materials that combined light weight and great strength were utilised by aircraft manufacturers; on the other, heat- resisting alloys that could tolerate temperatures of up

C-154 Case 11 • Philip Condit and the Boeing 777

to 3000 degrees were used by engine makers. Simi- larly, advances in electronics revolutionised avionics. The increasing use of semiconductors by aircraft man- ufacturers facilitated the miniaturisation of cockpit instruments, and more important, it enhanced the use of computers for aircraft communication, navigation, instrumentation and testing.7 The use of computers contributed, in addition, to the design, manufacture and assembly of new-model aircraft.

The Boeing Company The history of the Boeing Company may be divided into two distinct periods: the piston era and the jet age. Throughout the piston era, Boeing was essen- tially a military contractor producing fighter aircraft in the 1920s and 1930s, and bombers during the Sec- ond World War. During the jet age, beginning in the 1950s, Boeing had become the world’s largest manu- facturer of commercial aircraft, deriving most of its revenues from selling jetliners.

Boeing’s first jet was the 707. The introduction of the 707 in 1958 represented a major breakthrough in the history of commercial aviation; it allowed Boeing to gain a critical technological lead over the Douglas Aircraft Company, its closer competitor. To benefit from government assistance in developing the 707, Boeing produced the first jet in two versions: a mili- tary tanker for the Air Force (k-135) and a commer- cial aircraft for the airlines (707-120). The compa- ny, however, did not recoup its own investment until 1964, six years after it delivered the first 707, and 12 years after it had launched the program. In the end, the 707 was quite profitable, selling 25 per cent above its average cost.8 Boeing retained the essential design of the 707 for all its subsequent narrow-body single-aisle models (the 727, 737 and 757), introduc- ing incremental design improvements, one at a time.9 One reason why Boeing used shared design for future models was the constant pressure experienced by the company to move down the learning curve and reduce overall development costs.

Boeing introduced the 747 in 1970. The develop- ment of the 747 represented another breakthrough; the 747 wide-body design was one of a kind; it had no real competition anywhere in the industry. Boeing bet

the entire company on the success of the 747, spend- ing on the project almost as much as the company’s total net worth in 1965, the year the project started.10 In the short run, the outcome was disastrous. As Boe- ing began delivering its 747s, the company was strug- gling to avoid bankruptcy. Cutbacks in orders as a result of a deep recession, coupled with production inefficiencies and escalating costs, created a severe cash shortage that pushed the company to the brink. As sales dropped, the 747’s breakeven point moved further and further into the future.

Yet, in the long run, the 747 program was a tri- umph. The Jumbo Jet had become Boeing’s most profitable aircraft and the industry’s most efficient jetliner. The new plane helped Boeing to solidify its position as the industry leader for years to come, leav- ing McDonnell Douglas far behind, and forcing the Lockheed Corporation to exit the market. The new plane, furthermore, contributed to Boeing’s manufac- turing strategy in two ways. First, as Boeing increased its reliance on outsourcing, six major subcontractors fabricated 70 per cent of the value of the 747 air- plane,11 thereby helping Boeing to reduce the proj- ect’s risks. Second, for the first time, Boeing applied the family concept in aircraft design to a wide-body jet, building the 747 with wings large enough to sup- port a stretched fuselage with bigger engines, and offering a variety of other modifications in the 747’s basic design. The 747-400 (1989) is a case in point. In 1997, Boeing sold the stretched and upgraded 747- 400 in three versions, a standard jet, a freighter, and a ‘combi’ (a jetliner whose main cabin was divided between passenger and cargo compartments).12

Boeing developed other successful models. In 1969, it introduced the 737, the company’s narrow- body flagship, and in 1982 it put into service two additional jetliners, the 757 (narrow-body) and the 767 (wide-body). By the early 1990s, the 737, 757 and 767 were all selling profitably. Following the introduction of the 777 in 1995, Boeing’s families of planes included the 737 for short-range travel, the 757 and 767 for medium-range travel, and the 747 and 777 for medium- to long-range travel (Exhibit 1).

In addition to building jetliners, Boeing also expanded its defence, space and information busi- nesses. In 1997, the Boeing Company took a strategic

Case 11 • Philip Condit and the Boeing 777 C-155

gamble, buying the McDonnell Douglas Company in a US$14 billion stock deal. As a result of the merger, Boeing had become the world’s largest manufactur- er of military aircraft, NASA’s largest supplier, and the Pentagon’s second-largest contractor (after Lock- heed). Nevertheless, despite the growth in its defence and space businesses, Boeing still derived most of its revenues from selling jetliners. Commercial aircraft revenues accounted for 59 per cent of Boeing’s US$49 billion sales in 1997 and 63 per cent of its US$56 bil- lion sales in 1998.13

Following its merger with McDonnell, Boeing had one remaining rival: Airbus Industrie.14 In 1997, Airbus booked 45 per cent of the worldwide orders

for commercial jetliners15 and delivered close to one- third of the worldwide industry output. In 2000, Air- bus shipped nearly two-fifths of the worldwide indus- try output (Exhibit 2).

Airbus’s success was based on a strategy that combined cost leadership with technological leader- ship. First, Airbus distinguished itself from Boeing by incorporating the most advanced technologies into its planes. Second, Airbus managed to cut costs by utilis- ing a flexible, lean production manufacturing system that stood in a stark contrast to Boeing’s mass pro- duction system.16

As Airbus prospered, the Boeing Company was struggling with rising costs, declining productivity, delays in deliveries and production inefficiencies. Boe- ing Commercial Aircraft Group lost US$1.8 billion in 1997 and barely generated any profits in 1998.17 All through the 1990s, the company looked for ways to revitalise its outdated production manufacturing sys- tem, on the one hand, and to introduce leading-edge technologies into its jetliners, on the other. The devel- opment and production of the 777, first conceived of in 1989, was an early step undertaken by Boeing managers to address both problems.

The 777 program The 777 program was Boeing’s single largest project since the completion of the 747. The total develop- ment cost of the 777 was estimated at US$6.3 bil- lion and the total number of employees assigned to the project peaked at nearly 10 000. The 777’s twin- engines were the largest and most powerful ever built (the diameter of the 777’s engine equalled the 737’s fuselage), the 777’s construction required 132 000 uniquely engineered parts (compared to 70 000 for

Exhibit 2 Market share of shipments of commercial aircraft: Boeing, McDonnell Douglas and Airbus, 1992–2000 (%)

1992 1993 1994 1995 1996 1997 1998 1999 2000

Boeing 61 61 63 54 55 67 71 68 61 McDonnell Douglas 17 14 9 13 13 Airbus 22 25 28 33 32 33 29 32 39

Sources: Aerospace Facts and Figures, 1997–98, p. 34; Wall Street Journal, 3 December 1998 and 12 January 1999; The Boeing Company Annual Report 1997, p. 19; Data supplied by Mark Luginbill, Airbus Communication Director, 16 November 1998, 1 February 2000 and 20 March 2001.

Exhibit 1 Total number of commercial jetliners delivered by the Boeing Company, 1958–2001

Model No. delivered First delivery

B-707 1 010 (retired) 1958

B-727 1 831 (retired) 1963

B-737 3 901 1967

B-747 1 264 1970

B-757 953 1982

B-767 825 1982

B-777 325 1995

B-717 49 2000

Total: 10 159

* McDonnell Douglas commercial jetliners (the MD-11, MD-80 and MD-90) are excluded.

Sources: Boeing Commercial Airplane Group, Announced Orders and Deliveries as of 12/31/97; The Boeing Company Annual Report 1998, p. 35; ‘Commercial airplanes: Order and delivery summary’, www.Boeing.com,

20 March 2001.

C-156 Case 11 • Philip Condit and the Boeing 777

the 767), the 777’s seat capacity was identical to that of the first 747 that had gone into service in 1970, and its manufactured empty weight was 57 per cent greater than the 767’s. Building the 777 alongside the 747 and 767 at its Everett plant near Seattle, Wash- ington, Boeing enlarged the plant to cover an area of 76 football fields.18

Boeing’s financial position in 1990 was unusually strong. With a 21 per cent rate of return on share- holder equity, a long-term debt of just 15 per cent of capitalisation and a cash surplus of US$3.6 billion, Boeing could gamble comfortably.19 There was no need to bet the company on the new project, as had been the case with the 747, or to borrow heavily, as had been the case with the 767. Still, the decision to develop the 777 was definitely risky; a failure of the new jet might have triggered an irreversible decline of the Boeing Company and threatened its future sur- vival.

The decision to develop the 777 was based on market assessment – the estimated future needs of the airlines. During the 14-year period from 1991 to 2005, Boeing market analysts forecasted a 100 per cent increase in the number of passenger miles trav- elled worldwide and a need for about 9000 new com- mercial jets. Of the total value of the jetliners needed in 1991–2005, Boeing analysts forecasted a US$260 billion market for wide-body jets smaller than the 747. An increasing number of these wide-body jets were expected to be larger than the 767.20

A consumer-driven product To manage the risk of developing a new jetliner, air- craft manufacturers had first sought to obtain a min- imum number of firm orders from interested carri- ers, and only then to commit to the project. Boeing CEO Frank Shrontz had expected to obtain 100 ini- tial orders of the 777 before asking the Boeing board to launch the project, but as a result of Boeing’s financial strength, on the one hand, and the increas- ing competitiveness of Airbus, on the other, Schrontz decided to seek the board’s approval earlier. He did so after securing only one customer: United Airlines. On 12 October 1990, United had placed an order for 34 of the 777s and an option for an additional 34 air- craft, and two weeks later, Boeing’s board of direc- tors approved the project.21

Negotiating the sale, Boeing and United drafted a handwritten agreement (signed by Philip Condit and Richard Albrecht, Boeing’s executive vice presidents, and Jim Guyette, United’s executive vice president) that granted United a larger role in designing the 777 than the role played by any airline before. The two companies pledged to cooperate closely in develop- ing an aircraft with the ‘best dispatch reliability in the industry’ and the ‘greatest customer appeal in the industry’. ‘We will endeavor to do it right the first time with the highest degree of professionalism’ and with ‘candor, honesty, and respect’ [the agreement read]. Asked to comment on the agreement, Philip Condit said: ‘We are going to listen to our customers and understand what they want. Everybody on the program has that attitude.’22 Gordon McKinzie, Unit- ed’s 777 program director, agreed: ‘In the past we’d get brochures on a new airplane and its options … wait four years for delivery, and hope we’d get what we ordered. This time Boeing really listened to us.’23

Condit invited other airline carriers to partici- pate in the design and development phase of the 777. Altogether, eight carriers from around the world (United, Delta, America, British Airways, Qantas, Japan Airlines, All Nippon Airways and Japan Air System) sent full-time representatives to Seattle; British Airways alone assigned 75 people at one time. To facilitate interaction between its design engineers and representatives of the eight carriers, Boeing intro- duced an initiative called ‘Working Together’. ‘If we have a problem,’ a British Airways production man- ager explained, ‘we go to the source – design engineers on the IPT [Integrated Product Teams], not service engineer(s). One of the frustrations on the 747 was that we rarely got to talk to the engineers who were doing the work.’24

‘We have definitely influenced the design of the aircraft,’ a United 777 manager said, mentioning changes in the design of the wing panels that made it easier for airline mechanics to access the slats (slats, like flaps, increased lift on takeoffs and landings), and new features in the cabin that made the plane more attractive to passengers.25 Of the 1500 design features examined by representatives of the airlines, Boeing engineers modified 300. Among changes made by Boeing was a redesigned overhead bin that left more stand-up headroom for passengers (allowing a

Case 11 • Philip Condit and the Boeing 777 C-157

six-foot-three tall passenger to walk from aisle to aisle), ‘flattened’ side walls which provided the occu- pant of the window seat with more room, overhead bin doors which opened down and made it possible for shorter passengers to lift baggage into the over- head compartment, a redesigned reading lamp that enabled flight attendants to replace light bulbs, a task formerly performed by mechanics, and a com- puterised flight deck management system that adjust- ed cabin temperature, controlled the volume of the public address system, and monitored food and drink inventories.26

More important were changes in the interior con- figuration (layout plan) of the aircraft. To be able to reconfigure the plane quickly for different markets of varying travel ranges and passenger loads, Boeing’s customers sought a flexible plan of the interior. On a standard commercial jet, kitchen galleys, closets, lavatories and bars were all removable in the past but were limited to fixed positions where the interi- or floor structure was reinforced to accommodate the ‘wet’ load. On the 777, by contrast, such components as galleys and lavatories could be positioned any- where within several ‘flexible zones’ designed into the cabin by the joint efforts of Boeing engineers and rep- resentatives of the eight airlines. Similarly, the flex- ible design of the 777’s seat tracks made it possible for carriers to increase the number of seat combina- tions as well as reconfigure the seating arrangement quickly. Flexible configurations resulted, in turn, in significant cost savings; airlines no longer needed to take the aircraft out of service for an extended period of time in order to reconfigure the interior.27

The airline carriers also influenced the way in which Boeing designed the 777 cockpit. During the program definition phase, representatives of United Airlines, British Airways and Qantas – three of Boeing’s clients whose fleets included a large number of 747-400s – asked Boeing engineers to model the 777 cockpit on the 747-400’s. In response to these requests, Boeing introduced a shared 747/777 cock- pit design that enabled its airline customers to use a single pool of pilots for both aircraft types at a sig- nificant cost savings.28

Additionally, the airline carriers urged Boeing to increase its use of avionics for in-flight entertain- ment. The 777, as a consequence, was equipped with

a fully computerised cabin. Facing each seat on the 777, and placed on the back of the seat in front, was a combined computer and video monitor that featured movies, video programs and interactive computer games. Passengers were also provided with a digital sound system comparable to the most advanced home stereo available, and a telephone. About 40 per cent of the 777’s total computer capacity was reserved for passengers in the cabin.29

The 777 was Boeing’s first fly by wire (FBW) air- craft, an aircraft controlled by a pilot transmitting commands to the movable surfaces (rudder, flaps, etc.) electrically, not mechanically. Boeing installed a state-of-the-art FBW system on the 777 partly to sat- isfy its airline customers, and partly to challenge Air- bus’s leadership in flight control technology, a posi- tion Airbus had held since it introduced the world’s first FBW aircraft, the A-320, in 1988.

Lastly, Boeing customers were invited to contrib- ute to the design of the 777’s engine. Both United Airlines and All Nippon Airlines assigned service engineers to work with representatives of Pratt and Whitney (P&W) on problems associated with engine maintenance. P&W held three specially scheduled ‘airline conferences’. At each conference, some 40 airline representatives clustered around a full-scale mock-up of the 777 engine and showed Pratt and Whitney engineers gaps in the design, hard-to-reach points, visible but inaccessible parts, and accessible but invisible components. At the initial conference, Pratt and Whitney picked up 150 airline sugges- tions, at the second, 50, and at the third, 10 more suggestions.30

A globally manufactured product Twelve international companies located in 10 countries, and 18 more US companies located in 12 states, were contracted by Boeing to help manufacture the 777. Together, they supplied structural components as well as systems and equipment. Among the foreign suppliers were companies based in Japan, Britain, Australia, Italy, Korea, Brazil, Singapore and Ireland; among the major US subcontractors were the Grumman Corporation, Rockwell (later merged with Boeing), Honeywell, United Technologies, Bendix and the Sunstrand Corporation. Of all foreign participants, the Japanese played the largest role. A consortium

C-158 Case 11 • Philip Condit and the Boeing 777

made up of Fuji Heavy Industries, Kawasaki Heavy Industries and Mitsubishi Heavy Industries had worked with Boeing on its wide-body models since the early days of the 747. Together, the three Japanese subcontractors produced 20 per cent of the value of the 777’s airframe (up from 15 per cent of the 767’s). A group of 250 Japanese engineers had spent a year in Seattle working on the 777 alongside Boeing engineers before most of its members went back home to begin production. The fuselage was built in sections in Japan and then shipped to Boeing’s huge plant at Everett, Washington for assembly.31

Boeing used global subcontracting as a market- ing tool as well. Sharing design work and production with overseas firms, Boeing required overseas carri- ers to buy the new aircraft. Again, Japan is a case in point. In return for the contract signed with the Mitsubishi, Fuji and Kawasaki consortium – which was heavily subsidised by the Japanese government – Boeing sold 46 of the 777 jetliners to three Japanese air carriers: All Nippon Airways, Japan Airlines and Japan Air System.32

A family of planes From the outset, the design of the 777 was flexible enough to accommodate derivative jetliners. Because all derivatives of a given model shared maintenance, training and operating procedures, as well as replace- ment parts and components, and because such deriv- atives enabled carriers to serve different markets at lower costs, Boeing’s clients were seeking a family of planes built around a basic model, not a single 777. Condit and his management team, accordingly, urged Boeing’s engineers to incorporate the maximum flex- ibility into the design of the 777.

The 777’s design flexibility helped Boeing to man- age the project’s risks. Offering a family of planes based on a single design to accommodate future changes in customers’ preferences, Boeing spread the 777 project’s risks among a number of models all belonging to the same family.

The key to the 777’s design efficiency was the wing. The 777 wings, exceptionally long and thin, were strong enough to support vastly enlarged mod- els. The first model to go into service, the 777-200, had a 209-foot-long fuselage, was designed to carry

305 passengers in three class configurations, and had a travel range of 5900 miles in its original version (1995), and up to 8900 miles in its extended version (1997). The second model to be introduced (1998), the 777-300, had a stretched fuselage of 242 feet (10 feet longer than the 747) was configured for 379 pas- sengers (three classes), and flew to destinations of up to 6800 miles away. In the all-tourist class configura- tion, the stretched 777-300 could carry as many as 550 passengers.33

Digital design The 777 was the first Boeing jetliner designed entirely by computers. Historically, Boeing had designed new planes in two ways: paper drawings and full-size models called mock-ups. Paper drawings were two- dimensional and therefore insufficient to account for the complex construction of the three-dimensional airplane. Full-scale mock-ups served as a backup to drawings.

Boeing engineers used three classes of mock-ups. Made up of plywood or foam, class 1 mock-ups were used to construct the plane’s large components in three dimensions, refine the design of these compo- nents by carving into the wood or foam, and feed the results back into the drawings. Made partly of metal, class 2 mock-ups addressed more complex problems such as the wiring and tubing of the airframe, and the design of the machine tools necessary to cut and shape the large components. Class 3 mock-ups gave the engineers one final opportunity to refine the mod- el and thereby reduce the need to keep on changing the design during the actual assembly process or after delivery.34

Despite the engineers’ efforts, many parts and components did not fit together on the final assembly line but rather ‘interfered’ with each other – that is, they overlapped in space. The problem was both per- vasive and costly; Boeing engineers needed to rework and realign all overlapping parts in order to join them together.

A partial solution to the problem was provided by the computer. In the last quarter of the 20th century, computer-aided design was used successfully in car manufacture, building construction, machine production and several other industries; its application

Case 11 • Philip Condit and the Boeing 777 C-159

to commercial aircraft manufacturing came later, both in the United States and in Europe. Speaking of the 777, Dick Johnson, Boeing chief engineer for digital design, noted the ‘tremendous advantage’ of computer application:

With mock-ups, the … engineer had three

opportunities at three levels of detail to check

his parts, and nothing in between. With Catia

[Computer aided three dimensional, interactive

application] he can do it day in and day out over

the whole development of the airplane.35

Catia was a sophisticated computer program that Boeing bought from Dassault Aviation, a French fighter plane builder. IBM enhanced the program to improve image manipulation, supplied Boeing with eight of its largest mainframe computers, and con- nected the mainframes to 2200 computer terminals that Boeing distributed among its 777 design teams. The software program showed on a screen exactly how parts and components fit together before the actual manufacturing process took place.36

A digital design system, Catia had five distinctive advantages. First, it provided the engineers with 100 per cent visualisation, allowing them to rotate, zoom and ‘interrogate’ parts geometrically in order to spot- light interferences. Second, Catia assigned a numeri- cal value to each drawing on the screen and thereby helped engineers to locate related drawings of parts and components, merge them together, and check for incompatibilities. Third, to help Boeing’s customers service the 777, the digital design system created a computer-simulated human – a Catia figure playing the role of the service mechanic – who climbed into the three-dimensional images and showed the engi- neers whether parts were serviceable and entry acces- sible. Fourth, the use of Catia by all 777 design teams in the US, Japan, Europe and elsewhere facilitated instantaneous communication between Boeing and its subcontractors and ensured the frequent updat- ing of the design. And fifth, Catia provided the 777 assembly line workers with graphics that enhanced the narrative work instructions they received, show- ing explicitly on a screen how a given task should be performed.37

Design-build teams (DBT) Teaming was another feature of the 777 program. About 30 integrated-level teams at the top and more than 230 design-build teams at the bottom worked together on the 777.38 All team members were con- nected by Catia. The integrated-level teams were organised around large sections of the aircraft; the DBTs around small parts and components. In both cases, teams were cross-functional, as Philip Condit observed:

If you go back … to earlier planes that Boeing built, the factory was on the bottom floor, and Engineering was on the upper floor. Both Manufacturing and Engineering went back and forth. When there was a problem in the factory, the engineer went down and looked at it. …

With ten thousand people [working on the 777], that turns out to be really hard. So you start devising other tools to allow you to achieve that – the design-build team. You break the airplane down and bring Manufacturing, Tooling, Planning, Engineering, Finance, and Materials all together [in small teams].39

Under the design-build approach, many of the design decisions were driven by manufacturing con- cerns. As manufacturing specialists worked alongside engineers, engineers were less likely to design parts that were difficult to produce and needed to be rede- signed. Similarly, under the design-build approach, customers’ expectations as well as safety and weight considerations were all incorporated into the design of the aircraft; engineers no longer needed to ‘chain saw’40 structural components and systems in order to replace parts that did not meet customers’ expecta- tions, were unsafe, or were too heavy.

The design of the 777’s wing provides an exam- ple. The wing was divided into two integration-lev- el teams, the ‘leading edge’ (the forward part of the wing) and the ‘trailing edge’ (the back of the wing) team. Next, the trailing edge team was further divid- ed into 10 design-build teams, each named after a piece of the wing’s trailing edge (Exhibit 3). Mem- bership in these DBTs extended to two groups of out- siders: representatives of the customer airlines and

C-160 Case 11 • Philip Condit and the Boeing 777

engineers employed by the foreign subcontractors. Made up of up to 20 members, each DBT decided its own mix of insiders and outsiders, and each was led by a team leader. Each DBT included represen- tatives from six functional disciplines: engineering, manufacturing, material, customer support, finance, and quality assurance. The DBTs met twice a week for two hours to hear reports from team members, discuss immediate goals and plans, divide responsibil- ities, set time lines, and take specific notes of all deci- sions taken.41 Described by a Boeing official as ‘little companies’, the DBTs enjoyed a high degree of auton- omy from management supervision; team members designed their own tools, developed their own manu- facturing plans, and wrote their own contracts with the program management, specifying deliverables, resources and schedules. John Monroe, a Boeing 777 senior project manager, remarked:

The team is totally responsible. We give them a

lump of money to go and do th[eir] job. They decide

whether to hire a lot of inexpensive people or to

trade numbers for resources. It’s unprecedented.

We have some $100 million plus activities led by

non-managers.42

Exhibit 3 The 10 DBTs (‘little companies’) responsible for the wing’s trailing edge

Flap Supports Team Inboard Flap Team Outboard Flap Team Outboard Fixed Wing Team Flaperon* Team Aileron* Team Inboard Fixed Wing and Gear Support Team Main Landing Gear Doors Team Spoilers** Team Fairings*** Team

The Flaperon and Aileron were movable hinged sections of the trailing edge that

helped the plane roll in flight. The Flaperon was used at high speed, the Aileron at

low speed.

** The spoilers were the flat surfaces that lay on top of the trailing edge and

extended during landing to slow down the plane.

*** The fairings were the smooth parts attached to the outline of the wing’s

trailing edge. They helped reduce drag.

Source: Karl Sabbagh, 21st Century Jet: The Making and Marketing of the

Boeing 777 (New York: Scribner, 1996), p. 73.

Employees’ empowerment and culture An additional aspect of the 777 program was the empowering of assembly line workers. Boeing man- agers encouraged factory workers at all levels to speak up, offer suggestions and participate in deci- sion making. Boeing managers also paid attention to a variety of ‘human relations’ problems faced by workers, problems ranging from childcare and park- ing to occupational hazards and safety concerns.43

All employees entering the 777 program – man- agers, engineers, assembly line workers and others – were expected to attend a special orientation session devoted to the themes of teamwork and quality con- trol. Once a quarter, the entire ‘777 team’ of up to 10 000 employees met off-site to hear briefings on the aircraft status. Dressed casually, the employees were urged to raise questions, voice complaints and pro- pose improvements. Under the 777 program, man- agers met frequently to discuss ways to promote com- munication with workers. Managers, for example, ‘fire fought’ problems by bringing workers together and empowering them to offer solutions. In a typi- cal ‘fire-fight’ session, Boeing 777 project managers learned from assembly line workers how to improve the process of wiring and tubing the airframe’s inte- rior: ‘staffing’ fuselage sections with wires, ducts, tubes and insulation materials before joining the sec- tions together was easier than installing the interior parts all at once in a pre-assembled fuselage.44

Under the 777 program, in addition, Boeing assembly line workers were empowered to appeal management decisions. In a case involving middle managers, a group of Boeing machinists sought to replace a non-retractable jig (a large device used to hold parts) with a retractable one in order to ease and simplify their jobs. Otherwise they had to carry heavy equipment loads up and down stairs. Again and again, their supervisors refused to implement the change. When the machinists eventually approached a factory manager, he inspected the jig personally and immediately ordered the change.45

Under the 777 program, work on the shop floor was ruled by the ‘Bar Chart’. A large display panel placed at different work areas, the Bar Chart listed the name of each worker, his or her daily job descrip-

Case 11 • Philip Condit and the Boeing 777 C-161

tion, and the time available to complete specific tasks. Boeing had utilised the Bar Chart system as a ‘man- agement visibility system’ in the past, but only under the 777 program was the system fully computerised. The chart showed whether assembly line workers were meeting or missing their production goals. Boe- ing industrial engineers estimated the time it took to complete a given task and fed the information back to the system’s computer. Workers ran a scanner across their ID badges and supplied the computer with the data necessary to log their job progress. Each employ- ee ‘sold’ his/her completed job to an inspector, and no job was declared acceptable unless ‘bought’ by an inspector.46

Leadership and management style The team in charge of the 777 program was led by a group of five vice presidents, headed by Philip Con- dit, a gifted engineer who was described by one Wall Street analyst as ‘a cross between a grizzly bear and a teddy bear. Good people skills, but furious in the marketplace.’47 Each of the five vice presidents rose through the ranks, and each had 25–30 years’ experi- ence with Boeing. All were men.48

During the 777 design phase, the five VPs met regularly every Tuesday morning in a small confer- ence room at Boeing’s headquarters in Seattle in what was called the ‘Muffin Meeting’. There were no agendas drafted, no minutes drawn, no overhead projectors used and no votes taken. The home-made muffins, served during the meeting, symbolised the informal tone of the forum. Few people outside the circle of five had ever attended these weekly sessions. Acting as an informal chair, Condit led a freewheel- ing discussion of the 777 project, asking each VP to say anything he had on his mind.49

The weekly session reflected Boeing’s sweeping new approach to management. Traditionally, Boeing had been a highly structured company governed by engineers. Its culture was secretive, formal and stiff. Managers seldom interacted, sharing was rare, divisions kept to themselves, and engineers competed with each other. Under the 777 program, Boeing made serious efforts to abandon its secretive manage- ment style. Condit firmly believed that open com- munication among top executives, middle managers and assembly line workers was indispensable for

improving morale and raising productivity. He urged employees to talk to each other and share informa- tion, and he used a variety of management tools to do so: information sheets, orientation sessions, question and answer sessions, leadership meetings, regular man- agers’ meetings and ‘all team’ meetings. To empower shop floor workers as well as middle managers, Condit introduced a three-way performance review procedure whereby managers were evaluated by their supervisors, their peers and their subordinates.50 Most important, Condit made teamwork the hallmark of the 777 pro- ject. In an address entitled ‘Working Together: The 777 Story’ and delivered in December 1992 to mem- bers of the Royal Aeronautics Society in London,51 Condit summed up his team approach:

[T]eam building is … very difficult to do well but when it works the results are dramatic. Teaming fosters the excitement of a shared endeavor and creates an atmosphere that stimulates creativity and problem solving.

But building team[s] … is hard work. It doesn’t come naturally. Most of us are taught from an early age to compete and excel as individuals. Performance in school and performance on the job are usually measured by individual achievement. Sharing your ideas with others, or helping others to enhance their performance, is often viewed as contrary to one’s self interest.

This individualistic mentality has its place, but … it is no longer the most useful attitude for a workplace to possess in today’s world. To create a high performance organization, you need employees who can work together in a way that promotes continual learning and the free flow of ideas and information.

The results of the 777 project The 777 entered revenue service in June 1995. Since many of the features incorporated into the 777’s design reflected suggestions made by the airline carriers, the pilots, mechanics and flight attendants were quite enthusiastic about the new jet. Three achievements of the program – in airplane interior, aircraft design and aircraft manufacturing – stood out.

C-162 Case 11 • Philip Condit and the Boeing 777

Configuration flexibility The 777 offered carriers enhanced configuration flex- ibility. A typical configuration change took only 72 hours on the 777 compared to three weeks in com- peting aircraft. In 1992, the Industrial Design Society of America granted Boeing its Excellence Award for building the 777 passenger cabin, honouring an air- plane interior for the first time.52

Digital design The original goal of the program was to reduce ‘change, error, and rework’ by 50 per cent, but engi- neers building the first three 777s managed to reduce such modification by 60 per cent to 90 per cent. Catia helped engineers to identify more than 10 000 inter- ferences that would have otherwise remained unde- tected until assembly, or until after delivery. The first 777 was only 0.023 inch short of perfect alignment, compared to as much as 0.5 inch on previous pro- grams.53 Assembly line workers confirmed the ben- eficial effects of the digital design system. ‘The parts snap together like Lego blocks,’ said one mechanic.54 Reducing the need for reengineering, replanning, retooling and retrofitting, Boeing’s innovative efforts were recognised yet again. In 1993, the Smithsonian Institution honoured the Boeing 777 division with its Annual Computerworld Award for the manufactur- ing category.55

Empowerment Boeing 777 assembly line workers expressed a high level of job satisfaction under the new program. ‘It’s a whole new world,’ a 14-year Boeing veteran mechanic said. ‘I even like going to work. It’s bubbly. It’s clean. Everyone has confidence.’56 ‘We never used to speak up,’ said another employee, ‘didn’t dare. Now fac- tory workers are treated better and are encouraged to offer ideas.’57 Although the Bar Chart system required Boeing 777 mechanics to work harder and faster as they moved down the learning curve, their principal union organisation, the International Association of Machinists, was pleased with Boeing’s new approach to labour–management relations. A union spokesman reported that under the 777 program, managers were more likely to treat problems as opportunities from which to learn, rather than as mistakes for which to

lay blame. Under the 777 program, the union rep- resentative added, managers were more respectful of workers’ rights under the collective bargaining agreement.58

Unresolved problems and lessons learned Notwithstanding Boeing’s success with the 777 pro- ject, the cost of the program was very high. Boeing did not publish figures pertaining to the total cost of Catia. But a company official reported that under the 777 program, the 3D digital design process required 60 per cent more engineering resources than the older, 2D drawing-based design process. One reason for the high cost of using digital design was slow computing tools: Catia’s response time often lasted minutes. Another was the need to update the design software repeatedly. Boeing revised Catia’s design software four times between 1990 and 1996, making the system easier to learn and use. Still, Catia continued to experience frequent software problems. Moreover, several of Boeing’s outside suppliers were unable to utilise Catia’s digital data in their manufacturing process.59

Boeing faced training problems as well. One challenging problem, according to Ron Ostrowski, director of 777 engineering, was ‘to convert people’s thinking from 2D to 3D. It took more time than we thought it would. I came from a paper world and now I am managing a digital program.’60 Converting people’s thinking required what another manager called an ‘unending communication’ coupled with training and retraining. Under the 777 program, Ostrowski recalled, ‘engineers had to learn to interact. Some couldn’t, and they left. The young ones caught on’ and stayed.61

Learning to work together was a challenge to managers, too. Some managers were reluctant to embrace Condit’s open management style, fearing a decline in their authority. Others were reluctant to share their mistakes with their superiors, fearing reprisals. Some other managers, realising that the new approach would end many managerial jobs, resisted change when they could, and did not pursue it whole- heartedly when they could not. Even top executives were sometimes uncomfortable with Boeing’s open management style, believing that sharing information

Case 11 • Philip Condit and the Boeing 777 C-163

with employees was likely to help Boeing’s competi- tors obtain confidential 777 data.62

Teamwork was another problem area. Working under pressure, some team members did not function well within teams and had to be moved. Others took advantage of their new-born freedom to offer sug- gestions, but were disillusioned and frustrated when management either ignored these suggestions or did not act upon them. Managers experienced different team-related problems. In several cases, managers kept on meeting with their team members repeatedly until they arrived at a solution desired by their bosses. They were unwilling to challenge senior executives, nor did they trust Boeing’s new approach to team- ing. In other cases, managers distrusted the new digi- tal technology. One engineering manager instructed his team members to draft paper drawings alongside Catia’s digital designs. When Catia experienced a problem, he followed the drawing, ignoring the com- puterised design, and causing unnecessary and costly delays in his team’s part of the project.63

Extending the 777 revolution Boeing’s learning pains played a key role in the com- pany’s decision not to implement the 777 program company wide. Boeing officials recognised the impor- tance of teamwork and Catia in reducing change, error and rework, but they also realised that teaming required frequent training, continuous reinforcement and ongoing monitoring, and that the use of Catia was still too expensive, though its cost was going down. (In 1997, Catia’s ‘penalty’ was down to 10 per cent.) Three of Boeing’s derivative programs – the 737 Next Generation, the 757-300 and the 767-400 – had the option of implementing the 777’s program innova- tions, and only one, the 737, did so, adopting a modi- fied version of the 777’s cross-functional teams.64

Yet the 777’s culture was spreading in other ways. Senior executives took broader roles as the 777 entered service, and their impact was felt through the company. Larry Olson, director of information systems for the 747/767/777 division, was a former 777 manager who believed that Boeing 777 employees ‘won’t tolerate going back to the old ways’. He expected to fill new positions on Boeing’s next program – the 747X – with former 777 employees in their forties.65 Philip Condit, Boeing CEO, implemented several of his own 777 innovations, intensifying the use of meetings among Boeing’s managers, and promoting the free flow of ideas throughout the company. Under Condit’s leadership, all mid-level managers assigned to Boeing Commercial Airplane Group, about 60 people, met once a week to discuss costs, revenues and production schedules, product by product. By the end of the meeting – which sometimes ran into the evening – each manager had to draft a detailed plan of action dealing with problems in his/her department.66 Under Condit’s leadership, more importantly, Boeing developed a new ‘vision’ that grew out of the 777 project. Articulating the company’s vision for the next two decades (1996–2016), Condit singled out ‘Customer satisfaction’, ‘Team leadership’ and ‘A participatory workplace’ as Boeing’s core corporate values.67

Conclusion: Boeing, Airbus and the 777 Looking back at the 777 program 11 years after the launch and six years after first delivery, it is now (2001) clear that Boeing produced the most success- ful commercial jetliner of its kind. Airbus launched the A330 and A340 in 1987, and McDonnell Douglas

Exhibit 4 Total number of MD11, A330, A340 and 777 airplanes delivered during 1996–2000

1996 1997 1998 1999 2000

McDonnell Douglas/Boeing MD11 15 12 12 8 4

Airbus A330 10 14 23 44 43

Airbus A340 28 33 34 20 19

Boeing 777 32 59 74 83 55

Sources: For Airbus, Mark Luginbill, Airbus Communication Director, 1 February 2000 and 20 March 2001. For Boeing, The Boeing Company Annual Report 1997, p. 35, 1998, p. 35; ‘Commercial airplanes: Order and delivery summary’, www.Boeing.com, 2 February 2000 and 2 February 2001.

C-164 Case 11 • Philip Condit and the Boeing 777

launched a new 300-seat wide-body jet in the mid- 1980s, the three-engine MD11. Coming late to mar- ket, the Boeing 777 soon outsold both models. The 777 had entered service in 1995, and within a year Boeing delivered more than twice as many 777s as the number of MD11s delivered by McDonnell Doug- las. In 1997, 1998 and 1999, Boeing delivered a larger number of 777s than the combined number of A330s and A340s delivered by Airbus, and in 2000 the 777 outsold each of its two Airbus competitors (Exhibit 4). A survey of nearly 6000 European airline passen- gers who had flown both the 777 and the A330/A340 found that the 777 was preferred by more than three out of four passengers.68 In the end, a key element in the 777’s triumph was its popularity with the travel- ling public.

Appendix A: Selected features of the 777 Aerodynamic efficiency Aircraft operating efficiency depended, in part, on aerodynamics: the smoother the surface of the plane and the more aerodynamic the shape of the plane, the less power was needed to overcome drag during flight. To reduce aerodynamic drag, Boeing engineers sought to discover the optimal shape of the plane’s major components – namely, the wings, fuselage, nose, tails and nacelles (engine-protective contain- ers). Speaking of the 777’s ‘airfoil’, the shape of the wing, Alan Mulally, the 777’s director of engineering (he later succeeded Condit as the project manager), explained:

The 777 airfoil is a significant advance in airfoil

design over … past airplanes … We arrived at

this shape by extensive analysis in wind tunnel …

[W]e learned new things by testing the airfoil at

… near flight conditions as far as temperature …

pressures, and air distribution are concerned. And

… we’ve ended up with an airfoil that is a new

standard at maximizing lift versus drag.69

The 777’s advanced wing enhanced its ability to climb quickly and cruise at high altitudes. It also enabled the airplane to carry full passenger payloads out of many high-elevation airfields served by Boeing customers. Boeing engineers estimated that the design of the 777 lowered its aerodynamic drag by 5–10 per cent compared to other advanced jetliners.70

A service-ready aircraft A two-engine plane needed special permission from the Federal Aviation Administration (FAA) to fly long over-water routes. Ordinarily, the FAA first certified a twin-jet for one hour of flight away from an airport, then two hours, and only after two years in service, three hours across water anywhere in the world. For the 767, Boeing attained the three hours certification, known as ETOPS (extended range twin-engine oper- ations) approval, after two years in service. For the 777, Boeing customers sought to obtain an ETOPS approval right away, from day one of revenue oper- ations. Boeing 777 customers also expected the new jet to deliver a high level of schedule reliability from the start. (Boeing 767 customers experienced frequent mechanical and computer problems as the 767 entered service in 1982.71)

To receive an early ETOPS approval, as well as minimise service disruptions, Boeing engineers made special efforts to produce a ‘service-ready’ plane. Using advanced computer technology, Boeing tested the 777 twice as much as the 767, improved and streamlined the testing procedure, and checked all systems under simulated flight conditions in a new US$370 million high-tech lab called Integrated Aircraft System Laboratory. The Boeing Company, in addition, conducted flight tests for an extended period of time, using United pilots as test pilots. Following a long validation process that included taking off, flying and landing on one engine, the FAA certified the 777 in May 1995.72

The 777 proved highly reliable. During the first three months of its revenue service, United Airlines experienced a schedule reliability of 98 per cent, a level the 767 took 18 months to reach. British Air- ways’ first 777 was in service five days after delivery, a company record for a new aircraft. The next three 777s to join British Airways fleet went into service a day after they arrived at Heathrow.73

Case 11 • Philip Condit and the Boeing 777 C-165

The use of composite materials Advanced composite materials accounted for 9 per cent of the 777’s total weight; the comparable figure for Boeing’s other jetliners was 3 per cent. Improved Alcoa aluminum alloys that saved weight and reduced corrosion and fatigue were used for the con- struction of the 777’s upper wing skin; other non- metallic composites were used for the 777’s rudder, fines and the tails. To help reduce corrosion around the lavatories and galleys, Boeing pioneered the use of composite materials for the construction of the floor beam structure. Boeing made a larger use of titanium alloys on the 777 than on any previous air- craft. Substituting steel with titanium cut weight by half, and space by one quarter; titanium was also 40 per cent less dense than steel, yet of equal strength. The use of heat-resisting titanium in the 777’s engine nacelle saved Boeing 180 pounds per engine, or 360 pounds per plane; the use of titanium rather than steel for building the 777’s landing gear saved Boeing 600 pounds per plane. Although titanium was more expensive than steel or aluminum, the choice of its application was driven by economics: for each pound of empty weight Boeing engineers squeezed out of the 777, Boeing airline customers saved hundreds of dol- lars worth of fuel during the lifetime of the plane.74

Appendix B: The 777’s choice of engines Pratt and Whitney (P&W), General Electric (GE) and Rolls-Royce (RR) had all developed the 777 jet engine, each offering its own make. Boeing required an engine that was more powerful, more efficient

and quieter than any jet engine in existence; the 777 engine was designed to generate close to 80 000 pounds of thrust (the forward force produced by the gases escaping backward from the engine) or 40 per cent more power than the 767’s.75

All three engine makers had been selected by Boeing airline customers (Exhibit 5). United Airlines chose the Pratt & Whitney engine. Partly because P&W supplied engines to United 747 and 767 fleets, and also because the design of the 777 engine was an extension of the 747’s and 767’s design, United management sought to retain P&W as its primary engine supplier.76 British Airways, on the other hand, selected the GE engine. A major consideration in Brit- ish Airways’ choice was aircraft efficiency: fuel con- sumption of the GE engine was 5 per cent lower than that of the two competing engines. Other carriers selected the RR engine for their reasons pertaining to their own needs and interests.

Exhibit 5 The choice of engines: Boeing 777’s largest customers

Air France GE All Nippon Airways P&W American Airlines RR British Airways GE Cathay Pacific Airways RR Continental Airlines GE Delta Airlines RR International Lease Finance Corp. GE Japan Air System P&W Japan Airlines P&W Korea Airlines P&W Malaysia Airlines RR Saudi Airlines GE Singapore Airlines RR Thai Airways International RR United Airlines P&W

Source: Boeing Commercial Airplane Group, 777 Announced Order and

Delivery Summary … as of 9/30/99.

Notes 1 Eugene Rodgers, 1991, Flying High: The Story of Boeing (New York:

Atlantic Monthly Press, 1996), pp. 423–15; Michael Dornheim, ‘777 twinjet will grow to replace 747-200’, Aviation Week and Space Technology, 3 June, p. 43.

2 ‘Commercial airplanes: Order and delivery, summary’, 2 February 2000, www.Boeing.com/commercial/ orders/index.html.

3 J. P. Donlon, 1994, ‘Boeing’s big bet’ (an interview with CEO Frank Shrontz), Chief Executive, November/December, p. 42; Michael Der touzos, Richard Lester and Rober t Solow, 1990, Made in America: Regaining the Productive Edge (New York: Harper Perennial), p. 203.

4 John Newhouse, 1982, The Sporty Game (New York: Alfred Knopf ), p. 21, but see also pp. 10–20.

5 David C. Mowery and Nathan Rosenberg, 1982, ‘The commercial aircraft industr y’, in Richard R . Nelson (ed.), Government

C-166 Case 11 • Philip Condit and the Boeing 777

and Technological Progress: A Cross Industry Analysis (New York: Pergamon Press), p. 116 ; Der touzos et. al, Made in America, p. 200.

6 Dertouzos, et. al, Made in America, p. 203. 7 Newhouse, Sporty Game, p. 188; Mowery and Rosenberg, ‘The

commercial aircraft industry’, pp. 124–5. 8 Mowery and Rosenberg, ‘The commercial aircraft industry’,

pp. 102–3, 126–8. 9 John B. Rae, 1968, Climb to Greatness: The American Aircraft Industry,

1920–1960 (Cambridge, MA: MIT Press), pp. 206–7; Rodgers, Flying High, pp. 197–8.

10 Frank Spadaro, 1992, ‘A transatlantic perspective’, Design Quarterly, Winter, p. 23.

11 Rodgers, Flying High, p. 279; Newhouse, Sporty Game, Ch. 7. 12 M. S. Hochmuth, 1974, ‘Aerospace’, in Raymond Vernon (ed.),

Big Business and the State (Cambridge: Harvard University Press), p. 149.

13 Boeing Commercial Airplane Group, Announced Orders and Deliveries as of 12/31/97, Section A1.

14 The Boeing Company Annual Report 1998, p. 76. 15 Formed in 1970 by several European aerospace firms, the

Airbus Consortium had received generous assistance from the French, British, German and Spanish governments for a period of over two decades. In 1992, Airbus had signed an agreement with Boeing that limited the amount of government funds each aircraft manufacturer could receive, and in 1995, at long last, Airbus had become profitable. ‘Airbus 25 years old’, 1997, Le Figaro, October (reprinted in English by Airbus Industrie); Rodgers, Flying High, Ch. 12; Business Week, 30 December 1996, p. 40.

16 Charles Goldsmith, 1998, ‘Re-engineering, after trailing Boeing for years, Airbus aims for 50 percent of the market’, Wall Street Journal, 16 March.

17 ‘Hubris at Airbus, Boeing rebuild’, 1998, The Economist, 28 November.

Exhibit 6 Selected financial data (dollars in millions except per share data)

Operation 2000 1999 1998 1997 1996

Sales and revenues Commercial airplanes 31 171 38 475 36 998 27 479 19 916 Defense and space* 20 236 19 015 19 879 18 125 14 934 Other 758 771 612 746 603 Accounting differences (844) (304) (1 335) (550) Total 51 321 57 993 56 154 45 800 35 453 Net earnings (loss) 2 128 2 309 1 120 (178) 1818 Earnings (loss) per share 2.48 2.52 1.16 (0.18) 1.88 Cash dividends 504 537 564 557 480

Per share 0.59 0.56 0.56 0.56 0.55 Other income (interest) 386 585 283 428 388 Research and development 1 441 1 341 1 895 1 924 1 633 Capital expenditure 932 1 236 1 665 1 391 971 Depreciation 1 159 1 330 1 386 1 266 1 132 Employee salaries and wages 11 614 11 019 12 074 11 287 9 225 Year-end workforce 198 000 197 000 231 000 238 000 211 000 Financial position at 31 December Total assets 42 028 36 147 37 024 38 293 37 880 Working capital (2 425) 2 056 2 836 5 111 7 783 Plant and equipment 8 814 8 245 8 589 8 391 8 266 Cash and short-term investments 1 010 3 454 2 462 5 149 6 352 Total debt 8 799 6 732 6 972 6 854 7 489 Customers and commercial financing

assets 6 959 6 004 5 711 4 600 3 888 Shareholders’ equity 11 020 11 462 12 316 12 953 13 502

Per share 13.18 13.16 13.13 13.31 13.96 Contractual backlog Commercial airplanes 89 780 72 972 86 057 93 788 86 151 Defense and space* 30 820 26 276 26 839 27 852 28 022 Total 120 600 99 248 112 896 121 640 114 173

* Including Information. Source: The Boeing Company Annual Report 2000, pp. 8, 98. A special note: For additonal financial data, as reported in the company’s annual reports and other financial documents, see Boeing’s website at www.Boeing.com.

Case 11 • Philip Condit and the Boeing 777 C-167

18 The Boeing Company Annual Report 1997, p. 19; The Boeing Company Annual Report 1998, p. 51.

19 Donlon, ‘Boeing’s big bet’, p. 40 ; John Mintz, 1995, ‘Betting it all on 777’, Washington Post, 26 March 26; James Woolsey, 1991, ‘777: A program of new concepts’, Air Transport World, April, p. 62; Jeremy Main, 1992, ’Corporate performance: Betting on the 21st century jet’, Fortune, 20 April, p. 104; James Woolsey, 1991, ‘Crossing new transpor t frontiers’, Air Transport World, March, p. 21; James Woolsey, 1994, ‘777: Boeing’s new large twinjet’, Air Transport World, April, p. 23; Michael Dornheim, 1991, ‘Computerized design system allows Boeing to skip building 777 mockup’, Aviation Week and Space Technology, 3 June, p. 51; Richard O’Lone, 1992, ‘Final assembly of 777 nears’, Aviation Week and Space Technology, 2 October, p. 48.

20 Rodgers, Flying High, p. 42. 21 Air Transport World, March 1991, p. 20 ; Fortune, 20 April 1992,

pp. 102–3. 22 Rodgers, Flying High, pp. 416, 420–4. 23 Richard O’Lone and James McKenna, 1990, ‘Quality assurance

role was factor in United’s 777 launch order’, Aviation Week and Space Technology, 29 October, pp. 28–9; Air Transport World, March 1991, p. 20.

24 Quoted in the Washington Post, 25 March 1995. 25 Quoted in Bill Sweetman, 1996, ‘As smooth as silk: 777

customers applaud the aircraft’s first 12 months in service’ Air Transport World, August, p. 71, but see also Air Transport World, April 1994, pp. 24, 27.

26 Quoted in Fortune, 20 April 1992, p. 112. 27 Rodgers, Flying High, p. 426; Design Quarterly, Winter 1992, p. 22;

Polly Lane, 1995, ‘Boeing used 777 to make production changes’, Seattle Times, 7 May.

28 Design Quarterly, Winter 1992, p. 22; The Boeing Company, 1998, Backgrounder: Pace Setting Design Value-Added Features Boost Boeing 777 Family, 15 May.

29 Boeing, 1998, Backgrounder, 15 May; Sabbagh, 21st Century Jet, p. 49.

30 Karl Sabbagh, 1996, 21st Century Jet: The Making and Marketing of the Boeing 777 (New York: Scribner), pp. 264, 266.

31 Sabbagh, 21st Century Jet, pp. 131–2. 32 Air Transport World, April 1994, p. 23; Fortune, 20 April 1992,

p. 116. 33 Washington Post, 26 March 1995; Boeing Commercial Airplane

Group, 777 Announced Order and Deliver y Summar y . . . as of 9/30/99.

34 Rodgers, Flying High, pp. 420–6; Air Transport World, April 1994, pp. 27, 31; ‘Leading families of passenger jet airplanes’, Boeing Commercial Airplane Group, 1998.

35 Sabbagh, 21st Century Jet, p. 58. 36 Quoted in Sabbagh, 21st Century Jet, p. 63. 37 Aviation Week and Space Technology, 3 June 1991, p. 50, 12 October

1992, p. 49; Sabbagh, 21st Century Jet, p. 62. 38 George Taninecz, 1995, ‘Blue sky meets blue sky’, Industry Week,

18 December, pp. 49–52; Paul Proctor, 1992, ‘Boeing rolls out 777 to tentative market’, Aviation Week and Space Technology, 12 October, p. 49.

39 Aviation Week and Space Technology, 11 April 1994, p. 37, and 3 June 1991, p. 35.

40 Quoted in Sabbagh, 21st Century Jet, pp. 68–9. 41 This was the phrase used by Boeing project managers working

on the 777. See Sabbagh, 21st Century Jet, Ch. 4.

42 Fortune, 20 April 1992, p. 116; Sabbagh, 21st Century Jet, pp. 69– 73; Wolf L. Glende, 1997, ‘The Boeing 777: A look back’, The Boeing Company, p. 4.

43 Quoted in Air Transport World, August 1996, p. 78. 44 Richard O’Lone, 1992, ‘777 revolutionizes Boeing aircraft

development process’, Aviation Week and Space Technology, 3 June 1992, p. 34.

45 O. Casey Corr, 1993, ‘Boeing’s future on the line: Company’s betting its fortunes not just on a new jet, but on a new way of making jets’, Seattle Times, 29 August; Polly Lane, 1995, ‘Boeing used 777 to make production changes, meet desires of its customers’, Seattle Times, 7 May 1995; Aviation Week and Space Technology, 3 June 1991, p. 34.

46 Seattle Times, 29 August 1993. 47 Seattle Times, 7 May 1995 and 29 August 1993. 48 Quoted in Rodgers, Flying High, pp. 419–20. 49 Sabbagh, 21st Century Jet, p. 33. 50 Ibid., p. 99. 51 Dori Jones Young, 1994, ‘When the going gets tough, Boeing

gets touchy-feely’, Business Week, 17 January 1994, pp. 65–7; Fortune, 20 April 1992, p. 117.

52 Reprinted by The Boeing Company, Executive Communications, 1992.

53 Boeing, 1998, Backgrounder, 15 May. 54 Industry Week, 18 December 1995, pp. 50–1; Air Transport World,

April 1994, p. 24. 55 Aviation Week and Space Technology, 11 April 1994, p. 37. 56 Boeing, Backgrounder, ‘Computing & design/build process help

develop the 777’, undated. 57 Seattle Times, 29 August 1993. 58 Seattle Times, 7 May 1995. 59 Seattle Times, 29 August 1993. 60 Glende, ‘The Boeing 777: A look back’, p. 10 ; Air Transport World,

August 1996, p. 78. 61 Air Transport World, April 1994, p. 23. 62 Washington Post, 26 March 1995. 63 Seattle Times, 7 May 1995; Rodgers, Flying High, p. 441. 64 Ibid., pp. 441–2. 65 Glende, ‘The Boeing 777: A look back’, p. 10. 66 Air Transport World, August 1996, p. 78. 67 ‘A new kind of Boeing’, 2000, The Economist, 22 January, p. 63. 68 ‘Vision 2016’, 1997, The Boeing Company. 69 ‘Study: Passengers voice overwhelming preference for Boeing

777’, 23 November 1999, www.Boeing.com. 70 Quoted in Sabbagh, 21st Century Jet, pp. 46–7. 71 Boeing, 1998, Backgrounder, 25 May; Michael Dornmeim,

1991, ‘777 twinjet will grow to replace 747-200’, Aviation Week and Space Technology, 3 June, p. 43; Sabbagh, 21st Century Jet, pp. 286–7.

72 Air Transport World, April 1994, p. 27; Fortune, 20 April 1992, p. 117; Sabbagh, 21st Century Jet, pp. 139–40.

73 Industry Week, 18 December 1995, p. 52; Aviation Week and Space Technology, 11 April 1994, p. 39; Seattle Times, 7 May 1995; Boeing, 1998, Backgrounder, 15 May; Sabbagh, 21st Century Jet, Ch. 24.

74 Industr y Week, 18 December 1995, p. 52; Air Transport World, August 1996, p. 71.

75 Steven Ashley, 1993, ‘Boeing 777 gets a boost from titanium’, Mechanical Engineering, July, pp. 61, 64–5; Aviation Week and Space Technology, 3 June 1991, p. 49; Boeing, 1998, Backgrounder, 15 May; Air Transport World, March 1991, pp. 23–4.

76 Boeing, 1998, Backgrounder, 15 May.

C-168

Case 12

Resene Paints Stephen Bowden Waikato Management School

This really is a fantastic company to be part of.

Every day presents new opportunities to build on

the great legacy we have.

Nick Nightingale, general manager, Resene Paints

As Nick Nightingale, general manager of Resene Paints, walked along a corridor between his office and the manufacturing plant, he looked at the can of Stipplecote cement-based paint that sat in a dis- play case. Stipplecote was the original product that his grandfather, Ted Nightingale, had developed and based the company on in 1946. In 55 years, Resene had grown into an integrated manufacturer and retailer of a wide array of high-quality paints and surface coatings. Resene operated four manufactur- ing plants in New Zealand, one in Australia and one in Fiji. In addition, a chain of 54 company-owned ColorShops and 19 franchised outlets provided the retail arm of Resene in New Zealand. A total of 600 employees worked for Resene generating over $100 million in group annual revenue and healthy profits. (All figures are in New Zealand dollars unless other- wise stated.) Resene had cultivated a stellar reputa- tion for innovation throughout its history – especially from water-based paints, colour development and environmental awareness.

Still, despite the enormous pride that Nick felt in the company’s achievements over the last 55 years, he knew that Resene faced many challenges in the future. Resene competed against large multination- als in an industry facing rising research costs. Could Resene continue to be such an innovator, or did it need

to change in some way? While dominant in the New Zealand commercial market, overall Resene trailed the market share of major competitor Dulux. Interna- tionally, Resene had a small presence in a number of countries, including Australia, Fiji, Bangladesh and China. But where should Resene focus its efforts – what range of products and markets should it be in and how should it structure the company to best take advantage of that identity?

Resene Paints A history of innovation and growth Ted Nightingale, a builder with no chemical or tech- nical training, developed Stipplecote, a paint for con- crete, simply because no such paint existed. (www. resene.co.nz/pdf/nostalgia.pdf offers a more com- plete history.) In 1951, Ted also developed New Zea- land’s first water-based paint under the brand name Resene and formed the Stipplecote Product Com- pany in 1952. Ted developed water-based paint after he heard that the resin he was familiar with through Stipplecote, PVA, could be used to make other paints. In an experimental way, with very limited resources, Ted was able to solve the problem and develop the water-based paint. In many ways, it was a process that would be repeated again and again over the his- tory of Resene as the company continued to innovate in terms of both paint types and colours. After con- siderable effort, demand for the company’s water- based paints grew strongly. The growth necessitated

Case 12 • Resene Paints C-169

expansion and resulted in moves from the original Kaiwharawhara factory to Seaview in 1967 and then to the current site in Naenae in 1992. In 1977 the company changed its name from Stipplecote Products to the present Resene Paints Ltd.

Paint and protective coatings had long been pro- duced for a wide range of purposes. Nick Nightingale viewed Resene as selling to five different markets.

First, there’s a commercial market consisting of tradespeople, architects and specifiers. While painters apply the paint, the decision on the paint to be applied is often made by others. Particularly on larger jobs an architect, an interior decorator or even a project manager specifies the paint to be used. The second market is the retail market and consists of do-it-yourself (DIY) consumers who paint their own houses and make occasional purchases of paint. The combined commercial and retail markets are referred to as the architectural and decorative coatings market. Third, is the specialty finishes market, which mainly involves textured coatings. The textured coatings are basically a construction product. Fourth, there’s a protective coatings market that includes marine products as well as industrial coatings and some architectural products like anti-graffiti systems. Finally, there’s the automotive market for paints.

While Resene began as a manufacturer of basic paints for buildings and houses, focused mainly on water-based paints, the company had widened its range of paints and coatings considerably since to offer an extensive range of products for each market. Resene moved into solvent-based paints and had a specialised plant in Upper Hutt. Resene also operated two acquired subsidiaries based in New Zealand. Altex Coatings, with manufacturing facilities both in Tauranga and Australia, was a manufacturer of pro- tective coatings for industrial and marine surfaces. Resene Automotive & Performance Coatings, located in Auckland, manufactured its own brand of automo- tive, furniture and industrial paints and a range of car care products for the New Zealand market. Resene Automotive was also the distributor in New Zealand for the world’s leading brand in automotive refinish paint – DuPont car paints. In addition, Resene oper- ated two international subsidiaries. Resene Ltd (Aus-

tralia) focused on manufacturing marine coatings as well as a full range of industrial and architectural coatings from its factory on the Gold Coast. Resene Paints Fiji Limited, in Suva, manufactured a full range of architectural, industrial and marine paints, as well as furniture lacquers for the commercial and retail customer. Outside of the paint industry, Resene owned the Cellier Le Brun Ltd wine-maker in Blen- heim.

At the same time that Resene had been going from strength to strength, however, other paint com- panies had disappeared. In the 1970s a large num- ber of small independent paint manufacturers exist- ed – probably 30 or 40 – but the industry was now dominated by the largest three firms: Orica, Resene and Wattyl. Both Orica and Wattyl were large Aus- tralian companies for whom the New Zealand paint market represented a small part of their operations. Orica, formerly ICI Australia, operated in New Zea- land through brands including Dulux, British Paints and Levenes. Wattyl distributed both Wattyl and Taubmans branded paints in New Zealand. Resene was the only paint company still doing research and development in New Zealand and as a group manu- factured the most paint in New Zealand.

The Nightingale family Resene was a very successful privately owned, family business that was still headed by the Nightingale fam- ily that founded the business. A significant difference from competitors that stemmed from the ownership by the Nightingale family was management tenure. Resene had been headed by only two people during its history – the founder Ted Nightingale and his son Tony. By contrast to the almost 30-year average ten- ure at Resene, their competitors often viewed New Zealand as a training ground and turned over senior management on a two-year cycle.

When Ted Nightingale ran the company, he was the innovator as well as the marketer and manager and everything else. In the succession plan that was implemented with Ted’s retirement, Ted’s son Tony became managing director, while the recently hired technical director, Colin Gooch, was given consider- able autonomy for the technical issues. Tony focused more on the marketing and managerial issues, although he always debated other issues with Colin.

C-170 Case 12 • Resene Paints

Given the importance of technical issues within the company, one legacy of the succession was that Tony and Colin were forced to work together and agree on how to proceed.

Resene was gradually moving through the next stage in the succession of the company. Tony was still the managing director, although illness had limited his involvement over the last few years. Two-and-a- half years ago, Nick became general manager, direct- ly under his father, with all other senior managers reporting to Nick. Of greater concern, however, Colin Gooch was set to retire in five years’ time and no obvious successor to Colin was yet apparent.

Top management Nick had been involved in jobs around the company since his youth. He was the first person to staff one of their stores on a Saturday. After completing a com- merce degree at Victoria University, Nick spent a few years overseas before returning to New Zealand and the family business. He had worked on the sales side since his return as a regional sales manager prior to becoming general manager. Reporting to Nick were all the functional managers (see Exhibit 1). In addi- tion, the heads of each of the subsidiary companies

throughout New Zealand, Australia and Fiji – except Altex, which reported directly to Tony – were respon- sible to Nick. According to Nick,

The subsidiary companies operate as separate companies and we don’t really like to tell them what to do. We do a little R&D work here in Naenae for our Australian and Fijian subsidiaries, but it’s limited due to product differences. We have just switched a major resin supplier for our Australian subsidiary to the same supplier that we use in New Zealand. That switch has led to cost savings, quality improvement, and meant that our knowledge base about that resin could be utilised in Australia.’ Resene Automotive and Altex, serving different markets with different products, were treated as stand-alone business units.

‘We require our managers to have a strong ori- entation to quality at Resene. Frankly, without that orientation you just would not last here,’ said Nick Nightingale. Often, the orientation to quality came at a cost in terms of materials used. For example, Resene had increased the weight of card they used as the backing on a colour chart for metallic paints. This had increased the cost of producing those colour

Exhibit 1 Resene organisational chart*

* Subsidiaries not included.

Production Manager

Retail Development

Manager

Logistics & Purchasing Manager

Marketing Manager

IT Manager

Sales Manager

Finance Division

Financial Accountant

General Manager

Plant 1 Manager

Plant 2 Manager

Purchasing Purchasing Production

Planning

Credit Control

Southern Regional Manager

Northern Regional Manager

R&D Team

Quality Control

Technical Services

Colour Controller

Technical Director

Case 12 • Resene Paints C-171

charts by 20 cents per card, or 9 per cent, but Nick felt that the card held up better, looked more attrac- tive and better supported the quality proposition. The higher cost structure associated with better-quality ingredients certainly led to arguments through the years. ‘Periodically Tony asks me to look at the cost of producing the paint to see if we can get that down,’ recalled Colin. ‘Eventually, I would agree to take a look, but I tended to forget and nothing much changed. I can honestly say there has never been a decision to reduce quality over the last 30 years – only to increase it.’

There was a belief among management, however, that consumers – even professional painters – did not always recognise the quality of Resene paints. Colin Gooch noted that ‘we have always sought standards for the paint that go far beyond either industry norms or even customer expectations’. However, the qual- ity had at least been recognised by the New Zealand Consumer Institute, identifying Resene as standing out above all other brands of interior acrylic paints.1 Colin believed that, ‘over time, painters will notice that they are having less come-backs [repairs] on Resene paints’.

The board of directors for Resene consisted of Tony Nightingale, Lindsay Lewer the finance director, Colin Gooch and Wellington lawyer, Adrian Elling- ham. At present, particularly since the board was heavily weighted towards active employees, meetings of the board were not highly formalised, nor regular. Important decisions involved consultation between Nick and Tony. Nick argued that, ‘we bring in specif- ic expertise as necessary – either within the company or, occasionally, through consultants. But I do see the board evolving into a more formalised role with addi- tional members added such as the manager of Altex Coatings, myself and perhaps my brother [who did not work for the company].’

One task that management at Resene had pur- sued during 2001 was the development of a vision for the company. Two alternatives had been under discussion among the management team: Resene will be an innovative supplier of paint solutions to the retail and commercial marketplace or Resene will be a world leader in the provision of paint products, colour and their technologies. We will be driven by our

successful, world-class New Zealand team which will celebrate our success. In mid-September, the manage- ment team chose to go with To be acknowledged as the leading provider of innovative paint solutions and technologies.

Human resources A significant proportion of employees had worked for Resene for many years. When Resene did recruit new staff, employees of other paint companies were generally avoided. For example, the sales force had, in recent times, recruited only four employees from competitors. According to Nick, this was because the philosophy of competitors tended to be more towards making sales, even at the expense of profits. Resene preferred to recruit from other industries – people who had an understanding of selling a quality prod- uct for a profit. Hiring technical staff, in particular, was very difficult. Resene had recently had to hire two scientists from India to obtain suitably qualified and trained staff. In general, technical recruits from competitors were more accustomed to a sterile envi- ronment with well-resourced labs, but less orienta- tion towards creativity.

Product range At its most basic level there were two types of paint – water-based and solvent-based. The difference referred to the type of solvent used in the paint for thinning – water or a petroleum derivative. While Resene pio- neered water-based paints in New Zealand, as noted, Resene later began producing solvent-based paints as well. These were produced in their Upper Hutt plant – separately from the main plant in Naenae. Solvent- based paints could have certain properties that made them desirable over water-based paints – particularly for high-gloss products. However, water-based paints were not considered dangerous goods because there was not the fire danger of a petroleum-based prod- uct. Water-based paints also cleaned up easier, had less dangerous fumes and were generally more envi- ronmentally friendly. Because of these advantages, water-based paints dominated production in Aus- tralasia. As such, paint companies were always look- ing to develop water-based versions of paints that had previously only been available as oil-based. One

C-172 Case 12 • Resene Paints

recent example was where Resene had pioneered the first truly water-based enamel in the world.

Within these two types of paint, Resene produced literally hundreds of product types, and thousands of specific SKUs for use on the huge variety of surfaces that paint could be applied to. The product range of Resene included primers, sealers, undercoats and top- coats for wood, steel, concrete, plaster or any other building material. The wide product range was sup- ported by advice on the appropriate product for any surface. Resene produced award-winning specifica- tion manuals to aid this, but also worked at a per- sonal level with clients on specific problems. Both the decorative and protective functions of paint could be compromised – no matter how good the paint was – if the paint was not able to bond with the surface it was applied to.

Manufacturing The actual manufacturing of paint involved the mix- ing together of the basic ingredients of pigment, binder, solvents and additives. At Resene, like the vast majority of paint manufacturers in Australasia, paint was produced in batches. Industry-wide these batches varied from 200 litres to 20 000 litres at a time. Resene produced in batches ranging from 200 litres to 10 000 litres. The technology for batch man- ufacturing was not capital-intensive – particularly for the production of less complex paint. The technology for continuous production of particular lines of paint did exist, but was only economic for the most popular lines of the largest manufacturers. In 2001, no con- tinuous manufacturing was done in New Zealand. As well as demand constraints, the type of product could limit the size of batch production. Resene had a product called Zylone Sheen which, if produced in too large a batch, turned into a jelly-like substance.

The manufacturing facility at Naenae had been expanded in 2001. An additional 8 per cent capacity had been built, aiding the manufacture of industrial tinters and streamlining the manufacturing process. One outcome of the expansion was that less stock needed to be carried, as the plant had greater capac- ity to produce paint as needed. Resene had the space on their present site to be able to double capacity. Dulux had recently invested $4 million on upgrading its plant in Gracefield, Lower Hutt. The introduction

of robot technology enabled increased production, in addition to improvements in waste treatment, for the two factories on site. Dulux claimed to produce 12 million litres of paint per year at the site and want- ed to grow – taking market share from competitors. Wattyl, on the other hand, had been rationalising its manufacturing, reducing from three sites to one in New Zealand.

Raw materials Resene used approximately 1000 raw materials in the manufacture of its paints and coatings. For each raw material, there were many suppliers globally. While there was variation in the exact type of product and the quality of products, there was usually a choice of quality suppliers for each important chemical. Colin Gooch noted:

For the vast majority of raw materials we pur- chase there would be at least 10 suppliers. As an example, there are many suppliers of titanium dioxide around the world, including DuPont, the company who developed the chemical, but also many others who produce just as high quality titanium dioxide. Quite often, those suppliers who did not develop particular raw materials will charge lower prices – because they did not have the development costs of the innovator. This can create something of a dilemma for paint companies. Employees involved in purchasing, whose job it is to obtain required supplies at the best cost they can, would often prefer to purchase from these lower-priced imitators. However, we have always placed a premium on maintaining relationships with innovating suppliers like DuPont so that we can be kept abreast of the latest innovations. Our competitors don’t have technical people involved in purchasing so tend to go for the cheaper option.

Colin Gooch felt that he saw more samples of new products than potentially any competing paint com- pany. ‘Suppliers know that if they have something “magic”, then we will be interested,’ Gooch noted. Suppliers had expressed to Resene the view that there has been an increasing trend among other paint com- panies towards price as the dominant concern. The strong relationships of Resene had enabled it to be the first company in the world to adopt a number of new

Case 12 • Resene Paints C-173

technologies. In return, Resene provided information back to the supply companies. This was aided by the fact that New Zealand was a good test market with sophisticated customers and harsh conditions. Gooch commented:

But the relationships are the key – principally the

willingness to share. As an example, we obtained

new pigment dispersion technology from DuPont

that was the best available – which DuPont had

up until that point refused to release to anyone.

However, when I met with the key people at

DuPont I told them about a technology that we

were developing, as well as an idea for how the

DuPont technology might be developed that were

sufficiently valuable to DuPont that they agreed to

allow us access.

For one technology, Resene had commercially available paint incorporating a new technology for two months in New Zealand before paint manufac- turers in the United States were even aware of the technology.

Product development Ideas for new products at Resene principally came from three sources: marketing, usually where Tony Night- ingale had come up with some ‘wild’ idea; technical staff, developing a new product; or suppliers, com- ing up with a new material that allowed new paints to be developed. New developments could involve all three elements simultaneously. Colin Gooch had always enjoyed the problem-solving aspect of R&D more than anything else, so even Tony’s ‘wild’ ideas had been treated as challenges by the technical staff. As Colin noted, ‘If they said to us make paint jump out of the can and on to the walls itself, then it was our job to try and get to the guts of the idea behind that to see what could be done.’

An extremely promising recent innovation had been the joint development with a Norwegian life- sciences company, Polymer Systems Ltd, of ‘sphe- romers’. Spheromers were perfectly spherical parti- cles that produced an extremely tough, cleanable and burnish-resistant surface. The dramatic performance improvements for low-sheen paints were attracting significant international interest. The problems with

prior low-sheen paints were the stimulus for Resene to try to find a technology to improve performance. That search led to contact with Polymer Systems, who were developing the technology, but unaware of the potential in paints. Resene developed the base tech- nology for paints and will receive a share of the future sales of the spheromers to other paint companies.

There was no such thing as a technician – who ran experiments and reported back results to more senior colleagues who decided what experiments to run – at Resene. All the scientists ran experiments for themselves. ‘There are subtle observations that are very difficult to record,’ observed Gooch.

If technicians alone observed these, then key

researchers would not hold valuable information.

Instead, we strongly emphasise technical expertise

at the micro-level – to the point where we have

been said to ‘build paint from the molecules up’.

And actually we take pride in doing just that –

of having an absolutely thorough understanding

of all the constituent parts involved in developing

a great paint. Importantly, one of the constituent

parts is the surface that is to be painted. Therefore,

we go to considerable lengths – far more than our

competitors – to understand potential surfaces.

Colour Resene has long had a strong reputation in the qual- ity of its colours. Paint manufacturers typically had a very large number of colours available for purchase. However, the factory production of paint in every colour would be impractical. Instead, the typical practice was to produce in the factory a base paint, often white, and add tinting pastes in-store, accord- ing to preset formulas, to create the final paint colour. This whole process varied considerably across paint companies. The variation was in part because tint- ing pastes varied – not just in their colour, but also in their concentration. Resene was the first company in the world to produce multiple base paints from the factory that allowed less tinting paste to be used to create final colours. Resene produced 14 different coloured bases from the Naenae factory.

While Resene had employed its basic colour sys- tem for many years, only in 2001 did Dulux adopt

C-174 Case 12 • Resene Paints

something similar. The cost of changing a colour sys- tem is enormous. Colin Gooch explained:

As an example, simply changing the concentration of one tinting paste without altering the shade would require the production of probably 30 000 pieces of paper to effect the change. Our blue tinting paste, for example, is used in approximately 2500 colour formulas of the 10 000 total formulas that Resene has. Each of those 2500 formulas would have to be changed because of the change in concentration. Any change to base paint or tinting paste will have a major effect on the colour system because of the scope of colours that need to be able to be produced and the interdependence of each aspect of the final paint colour. So it was a monumental undertaking when we changed from a system of one base colour to 14 base colours of paint. But it was less difficult for us to change than for our competitors because of our smaller size – particularly then.

Colin Gooch estimated:

Probably 85 per cent of paint manufacturers in New Zealand, Australia, the United States and Scandinavia used colour systems involving tinting. Elsewhere in Europe, penetration rates would be more like 40 per cent, and even lower throughout Asia. Really what drives it is the sophistication of the market and the demand for colours by customers. It’s just very difficult to compete with a limited range of colours in more colour- sophisticated markets like New Zealand.

Customers chose paint based on colour to a sig- nificant extent. Therefore, customers needed to be able to see colour and preferably visualise the final look of any colour on the surface they wanted to paint. Two critical aspects of colour visualisation that paint companies used were colour charts and test pots. Resene has been a leader in many areas of colour charts. Resene introduced a new system of colour that included strong colours for the first time in New Zealand in 1969.

‘We developed the British Standards Regis- ter system of colours into a series of colour charts that were the largest available internationally,’ noted Colin Gooch. The pressure for strong colours came

from a number of prominent Wellington architects with whom Resene had close relationships. In 1976 the ‘Total Colour Chart’ was launched, having been completely developed in-house, and replacing previ- ous charts as the largest available. ‘We’ve continued to develop our colour ranges and even developed a fan deck colour chart that allows better isolation of particular colours on a chart,’ noted Nick.

Resene was also the first company in New Zea- land to introduce a full range of test pots in 1975. Test pots enabled customers to try a small amount of paint on a particular surface before making their full pur- chase of paint. Even though colour charts and newer computer programs (such as Resene’s recently intro- duced ‘Ezypaint’) aided colour choice enormously, there was no perfect system for taking into account effects such as lighting, in any given space without actually painting the surface. Hence, test pots contin- ued to play a critical part in colour selection and were complementary to the other colour selection tools. Test pots were introduced as a promotional device for architects and interior designers, but in 2001 they accounted for more than $1 million in sales per year.

Marketing Resene has always placed great emphasis on the com- mercial segment of the market and in 2001 continued to dominate the commercial segment in New Zea- land. Indeed, the primary phrase that is used in mar- keting is, ‘Resene: the paint the professionals use.’ Partly, this focus dates back to the origins of the com- pany and the difficulties in selling to the retail market. But professionals, particularly architects and specifi- ers, were also more discerning about the type of paint to be used. As noted, architects even encouraged the development of the strong colours that helped Resene to distinguish itself from competitors. To support the commercial segment, Resene employed 65 sales reps – almost twice as many as its nearest competitor, Dulux, with 35.

Appealing to the commercial market involved direct marketing, more than mass advertising. Even with a concerted effort under way to increase its retail profile, Resene spent approximately the same amount on direct marketing as wider advertising in 2001. ‘Since I’ve been general manager the database that we use to target our marketing has grown from

Case 12 • Resene Paints C-175

2500 to 12 000,’ noted Nick Nightingale. ‘And that’s come from thorough research – including actively tracking down the owners of buildings throughout New Zealand. The database is itself segmented and each person targeted specifically.’ Resene produced a newsletter that featured new products and services as well as case studies of recent projects involving Resene paints. Resene also sent out calendars, coast- ers and many other promotional items throughout the year. Additionally, Resene sponsored the Architecture Awards of the New Zealand Institute of Architects.

Resene traditionally advertised less than the other major paint companies in New Zealand. However, this situation was changing, as shown in Exhibit 2. The trend of increasing advertising continued in 2001 with expenditures up 20 per cent with the introduction of a new series of three television commercials. Resene advertising emphasised the brand generally – and the ColorShops in particular. The competition, especially Orica, focused on particular products far more in their advertising. For example, $696 000 of Orica’s total advertising expenditure was on Dulux Exterior and Wash & Wear paints alone. Nick explained:

For the retail segment of the market, the key for us is to get customers inside a ColorShop where those customers can then be directed to the appropriate Resene product. For Orica and Wattyl, who operate through independent retailers, they try to influence a particular purchase decision prior to entering a store. The advertising of Orica and Wattyl is also aimed at fighting for extra shelf-

space from retailers. However, Orica and Wattyl

do benefit from the advertising of the retailers

themselves.

Sales A major difference between Resene and its two main competitors was that Resene owned its own retail outlets. In 2001, Resene operated 54 company- owned ColorShops as well as 19 franchised outlets (see Exhibit 3). The franchised outlets tended to oper- ate in smaller towns, where demand may not justify a dedicated ColorShop. Nick noted:

We originally opened our own stores because

we couldn’t sell through independent retailers

because the larger paint companies had control

of those channels. We tried using an agent in the

1970s, but he wasn’t overly committed to moving

our paint, it seemed. We’d always sold direct

from the factory, but those sales were limited, of

course. But we bought a hand-made wallpaper

manufacturing operation and with that came a

store in Wellington – so we started selling paint

through that. We were genuinely surprised at how

much we could sell like that.

From that original store had grown the whole chain. As such, the control of retail distribution had become a central component of Resene’s overall approach. That approach had been very successful, with double-digit growth in retail sales throughout

Exhibit 2 Advertising expenditures, 2000

TV ($000)

Press ($000)

Magazines ($000)

Total ($000)

% change 1999–2000

% change 1998–99

Paint companies Benjamin Moore 1304 251 68 1623 33.9 12.3 Dulux 1295 17 87 1399 –41.8 20 Resene 1098 123 143 1364 31.2 12.4 Retailers Mitre 10 4234 2381 138 6753 9.7 38.0 PlaceMakers 2074 1981 4055 4.5 –19.3 Benchmark 2544 640 3184 56.1 19.6 Guthrie Bowron 2739 193 2932 –18.6 62.1

Source: Marketing Magazine, April 2001, p. 23 (based on ratecard only, not actual expenditures).

C-176 Case 12 • Resene Paints

its history. Since Nick became general manager in 1999, nine new stores had been added.

In addition to the growth of the ColorShops chain, the stores themselves had been gradually upgraded. A number of stores were relocated to better locations, and more broadly, significant renovation had occurred. The new-style stores were larger, brighter and more sophisticated than their predeces- sors. The latest ColorShops in Christchurch, Dunedin and Palmerston North included quiet study spaces, colour libraries, areas for children and plenty of parking. Nick explained that, ‘in order to go after the retail market more aggressively we realised we had

to have a format that was consistent with the high- quality image of Resene. Our increased advertising needs to work in concert with better stores and improved training – I’m determined to only promise what we can deliver.’ In the ColorShops themselves, Resene offered a full complement of paint, wallpaper and accessories. Most of the merchandise in the ColorShops was sold under the Resene brand name, but there was also a limited amount of ‘ColorShop’ brand paint that was lower in price and quality, but also manufactured by Resene. Independent suppliers manufactured the wallpaper and accessories, such as brushes.

Exhibit 3 New Zealand retail locations

Region ColorShops (55) Franchises (19)

Northland Whangarei Kaitaia Kerikeri Dargaville Kaikohe Wellsford

Auckland Wairau Park Ponsonby Takapuna Devonport Birkenhead Browns Bay Orewa Warkworth Mt Eden Newmarket Onehunga Parnell Henderson New Lynn Manukau City Howick Pukekohe Albany Papakura

Waikato Hamilton Thames Cambridge Gisborne Te Awamutu Tauranga Mt Maunganui Whakatane Matamata Rotorua Taupo

Region ColorShops (55) Franchises (19)

Lower Central Napier Dannevirke Hastings Hawera New Plymouth Stratford Palmerston North Wanganui

Wellington Levin Porirua Masterton Paraparaumu Lower Hutt Upper Hutt Naenae Wellington City Wellington City Wellington City Kilbirnie Johnsonville

Nelson/ Marlborough

Nelson Blenheim

Stoke

Canterbury Christchurch Central

New Brighton

Hagley Park Sydenham Papanui Shirley Timaru Riccarton

Otago/Southland Oamaru Winton Dunedin Alexandra Invercargill Queenstown

Case 12 • Resene Paints C-177

Both trade and DIY customers were served in the ColorShops. Competitors Orica (through the Dulux brand) and Wattyl did operate trade stores through- out New Zealand, numbering 20 and 12 respectively, and these were open to the public. However, given the importance of their other distribution channels through independent retailers such as Placemakers, Mitre 10 and Guthrie Bowron, DIY sales were not targeted by either trade store chain. Benjamin Moore, a smaller operator, however, did distribute through a chain of 38 owner-operated retail outlets for its paint under the Benjamin Moore Colourworks banner. In addition to selling under their own brands, all the major paint companies manufactured house brands

for specific stores. Resene sold a very small amount of paint through The Warehouse retail chain, using the ‘NZ Paints’ brand. Dulux manufactured house brands for Mitre 10 and Guthrie Bowron, while Wattyl manufactured for Placemakers and Carters.

Distribution of paint and other supplies to the ColorShops was done on a daily basis. However, information systems to track the movement of paint through to sale were limited. There was no way of knowing exactly how much inventory was on hand at any particular store until a manual stocktake was undertaken. Relatedly, the profitability of each store was not known with precision. Resene did purchase market share data from Neilson, which was broken

Exhibit 4 Price comparison (acrylic exterior house paints – 4 litres)

White Price ($)

Benjamin Moore Benjamin Moore Moorglo 119 93 Orica British Paints 4 Seasons Gloss 65

British Paints Solarscreen Gloss 80 Dulux Weathershield 80 Levene Goldline 100% Acrylic Gloss 80

Resene Resene Enamycryl 87 Resene Hi Glo 87

Wattyl Taubmans All Weather Gloss 56 Wattyl Solagard 80

Others Damar House and Roof Gloss 55 Protec Master Stroke 300 55 Protective Paints Duralon Acrylic 61

House brands Guthrie Bowron Dimensions UVB 60 Hammer Hardware Acrylic High Gloss 40 ITM Supreme Acrylic Gloss 43 Kmart The Performer Acrylic Gloss 60 Mitre 10 Acrylic Gloss 45 The Warehouse NZ Paints 100% Acrylic Gloss 35

Brown Price ($)

Benjamin Moore Benjamin Moore Moorglo 119 93 Orica Dulux Weathershield 100

Levene Goldline 100% Acrylic Gloss 130 Resene Resene Enamacryl 103

Resene Hi Glo 103 Wattyl Wattyl Solagard 85 Others Damar House and Roof Gloss 71

Protective Paints Duralon Acrylic High Gloss 95 House brands Guthrie Bowron Dimensions UVB 80

Source: Consumer Institute of New Zealand, House Paint Test, 6 August 2001. Resene price includes standard 20 per cent ColorShop card discount. Although the table is accurate for the paint shown, house paint is largely purchased in 10-litre pales and tends to range in price from $100 to $150 approximately.

C-178 Case 12 • Resene Paints

down by region. From that research, Nick was able to track the company’s performance relative to competi- tors on a monthly basis. In general, Resene’s weakest market was Auckland.

Discounting Paint companies charge different prices to different customers and also offer a wide variety of discounts. For example, Resene had a loyalty card that entitled users to a 20 per cent discount. Resene had in excess of 100 000 cards on issue. In general, trade prices were approximately 25 per cent below general retail prices. While Resene was competitively priced in the retail segment, relative to other premium paints (see Exhibit 4), it was able to charge a 10–15 per cent pre- mium over competitors in the trade segment.

The tradition of discounting in the industry and the complexity of the pricing systems created chal- lenges for paint companies. Often the emphasis of sales staff was on sales rather than profits, and the result can be excessive discounting. Profitability at Resene had been improving in part because the level of discounts was being more closely monitored. There are two primary reasons why a trade customer may be offered a discount – volume and visibility. Certain paint projects – such as the Museum of New Zea- land, Te Papa – were prestigious and gained publicity for the paint chosen. In those cases, paint companies had added incentive to supply the paint, which led to further discounts. Overall, the highest discounts were given to Plunket and the IHC – charities to whom Resene sold basically at cost. In general, major con- tractors received the second-highest level of discount, smaller contractors a lower discount, and occasional trade customers a lower discount still.

Environmental choice Resene explicitly promoted the environmental friend- liness of its paint through its Environmental Choice range. Environmental Choice New Zealand was a program endorsed by the Ministry for the Environ- ment and administered by International Accredita- tion New Zealand (IANZ). It was aimed at improv- ing the quality of the environment by minimising the adverse environmental impacts generated by the pro- duction, distribution, use and disposal of products. Resene promoted the following pledge to custom-

ers regarding its environmentally friendly products: With no increase in price, Resene customers will enjoy safer, less hazardous paints, which are either of the same quality as before or higher. About 70 per cent of Resene’s paint products were Environmental Choice – far ahead of any other manufacturer.

New Zealand subsidiaries Altex Coatings was a paint and coatings manufac- turer for the heavy industrial and marine markets, having been purchased as a going concern by Resene in 1989. Started over 45 years ago, Altex supplied a wide range of coatings to almost every major industry sector. Structures as diverse as petrochemical plants, commercial ships, electricity pylons – and even the Auckland Harbour Bridge – had been supplied by Altex. Complementing its own range of coatings, Altex had also been a long-standing licensee for Devoe Coatings. More recently, Altex had obtained the licence from the US Paint Corporation to pro- duce its renowned ‘Awlgrip’ and ‘Awlcraft’ range of high-performance marine coatings. Altex had quickly established a strong market position in the high- performance pleasure marine market. When Altex was acquired, Resene already held licences for some competing technologies from Ameron Coatings. As such, the Altex business had to be kept separate from Resene. The stand-alone nature of Altex was partly a reflection of that history. However, Nick also believed that Altex operated better under a separate identity.

Resene had been in the automotive paint market since 1990, both manufacturing and distributing for DuPont outside of Auckland. In Auckland, a com- pany called Santano was the DuPont distributor, but in 1995, after encouragement from DuPont, Resene acquired Santano. Originally called Resene Santano, the subsidiary had changed its name to Resene Auto- motive & Protective Coatings. The company’s busi- ness was approximately evenly divided between man- ufacturing its own paint range, and acting as a local distributor for other paint companies such as DuPont. The market for automotive paint involved very low volumes of paint. The painting of an entire car nor- mally required a half to one litre of paint. More- over, since there was no car manufacturing industry in New Zealand, the market was completely reliant on repainting vehicles being repaired after accidents.

Case 12 • Resene Paints C-179

Nevertheless, recent changes meant the business did contribute profits to the group in 2001.

Tony Nightingale decided in 1996 to purchase the wine company Cellier Le Brun principally because he had a long-standing interest in wine. Resene used some of the wine produced for promotional purposes and the vineyard was painted with Resene paints. The name Cellier Le Brun had become synonymous with high-quality methode traditionelle wines. In recent years, the Terrace Road label had also been devel- oped for more moderately priced table wines with some success.

International operations Resene had a small presence in Australia. The previ- ously separate Australian manufacturing operations of Resene and Altex Coatings had been consolidated down to one plant on the Gold Coast in Queensland. The Australian manufacturing plant was comple- mented by a small retail distribution network consist- ing of four Resene ColorShops and 14 independent stockists (see Exhibit 5). Nick noted, ‘We haven’t pushed trade sales in Australia because the competi- tion has driven prices down to virtually below cost.’

In Fiji, Resene operated one small plant, as did some Australian competitors. (There was little dif- ference between paints that worked in Fiji and Aus- tralia.) The Fijian operation produced a very wide

variety of paints and coatings in small volumes. The Fijian market had shrunk about 10 per cent after recent political turmoil. There was a market in Fiji for up-market paints, but that market was under threat if more affluent sections of the community left Fiji over the political problems.

Resene was investigating export opportunities to Thailand and Japan. In Japan, where prices were quite high, Resene could cover the cost of transpor- tation and still be profitable. Nick commented, ‘Tra- ditionally the emphasis has been on white, some off- whites and perhaps beige. More recently, though, you can see European colour influences coming through in magazines which may signal future growth in the demand for stronger colours.’

The principal element of Resene’s technology licensing to date had been a tinting technology sys- tem. Resene had supplied this technology to South Africa, Zimbabwe, the Dominican Republic, Malay- sia, Indonesia and China. According to Nick:

Most international markets tend to have an ‘ICI-

type’ [orica-type] player, a major multinational

paint company who drip-fed technology into

those markets after a lag-time from their primary

markets. Our general approach has been to supply

a local competitor with technology that allows

them to compete better. In China, we’re providing

Exhibit 5 Australian retail locations

State ColorShops (4) Stockists (15)

Queensland Woolloongabba, Brisbane Butcher’s Paint Barn, Townsville Geebung, Brisbane Cairns Hardware, Atherton Brisbane Cairns Hardware, Edmonton

Cairns Hardware, Cairns Cairns Hardware, Cairns Classic Paint Supplies, Cleveland, Brisbane Goodfellows Handy Hardware, Kallangur, Brisbane Innisfail Plumbing and Paint, Innisfail Paint City Coolum, Coolum Beach Paint City Currimundi, Currimundi Paint City Maroochydore, Maroochydore Paint City Noosa, Noosaville Goodfellows Handy Hardware, Kallangur, Brisbane

New South Wales North Rocks, Sydney Taree Builders Bargain Centre, Taree South Victoria Morgans Paint Spot, Moorabbin, Melbourne

C-180 Case 12 • Resene Paints

technology to a major Chinese player who has

been losing market share to multinationals ICI and

Nippon. In Bangladesh, we’ve gone a step further,

and have a 20% stake in Resene Bangladesh with

a local partner. That was really the only way we

could enter the market. The products manufactured

are very basic, but it has the potential to provide

an avenue into the massive Indian market.

The paint industry In 2001, total sales in the Australasian architectural and decorative paint market slightly exceeded A$1 bil- lion, with New Zealand representing approximately NZ$190 million. Both Australian and New Zealand markets have shown the same limited growth as other mature markets for a number of years, at about 1–2 per cent per year. (Resene has been growing at around 6 per cent recently.) The limited amount of residential and commercial property construction during 2001 had further hindered growth. As shown in Exhib- its 6 and 7, based on Orica’s own estimates, Dulux was the market leader in both Australia and New Zealand. Only 6 per cent of paint sold in Australasia was imported.

The primary brands in Australia were identical to New Zealand with the exception of Resene itself – Dulux, Wattyl and Taubmans. However, while the Taubmans brand was manufactured by Wattyl in New Zealand, South African company Barloworld owned the brand in Australia. There were a rela- tively large number of independent paint stockists in Australia, who competed with the massive hardware chains such as Mitre 10 and BBC Hardware. The major brands in Australia – Dulux, Wattyl and Taub- mans – all distributed through those large hardware chains. The independent paint retailers tried to differ- entiate themselves from the big chains by greater cus- tomer service. However, ultimately the customer was still buying the same paint they could get elsewhere – probably cheaper. In general, Australian paint shops were not as upscale as either ColorShops or Guthrie Bowron in New Zealand.

Throughout Australasia 55 per cent of sales were to the trade and 45 per cent to the retail DIY market. The majority of retail paint sales occurred through independent hardware and decorating outlets. Chains dominated hardware and decorating retailing in both New Zealand and Australia. Some of those chains were owned by single companies, such as Benchmark,

Exhibit 6 New Zealand market shares

Source: Orica.

Others 18%

New Zealand Architectural & Decorative Coatings Market

A$150mn (25mn litres)

Resene 23%

Wattyl/ Taubmans

22%

Dulux/ Levenes

37%

Exhibit 7 Australian market shares

Source: Orica.

Others 19%

Australian Architectural & Decorative Coatings Market

A$850mn (125mn litres)

Dulux (Orica) 35%

Wattyl 25%

Taubmans (Barloworld)

21%

Case 12 • Resene Paints C-181

while others were cooperatives of independently owned stores, such as Mitre 10. In Australia, paint was the highest-margin hardware product sold, gen- erating gross margins of 35.5 per cent on average for retailers. Paint was also the single biggest category of sales for hardware stores – representing approximate- ly 15 per cent of their retail sales in Australia.

The biggest of the hardware chains in both New Zealand and Australia was Mitre 10. Under the Mitre 10 and True Value brand names, the group operated 653 stores in Australia and 205 in New Zealand. When Mitre 10 in Australia switched from Taubmans to Dulux for the supply of its house brand of paint, Taubmans lost 7 per cent of its total sales. In gener- al, price cutting on paint was pervasive in Australia. ‘Discounting, plus the cluttered appearance of most sales outlets, has encouraged consumers to view paint as a commodity.’2 One result was that tinting was not paid for by customers in Australia if done off a white base, whereas it was in New Zealand.

Competitors Dulux was the leading paint brand of the Orica group. Orica was an Australian-headquartered com- pany formerly known as ICI Australia before the par- ent company ICI (UK) sold its 64 per cent stake in 1998. A condition of the sale was that the ICI name be replaced, and so the name Orica was introduced. Orica was involved in mining services (explosives), chemicals, agricultural chemicals, and consumer products such as paint in numerous countries. The paint business operated only in Australia and New Zealand, primarily under the brand name Dulux. In June 2001, a new CEO was hired after recent poor performance by the group. In New Zealand, the Dulux name itself has been around since 1939.

The principal paint business for Orica was in Australia, predominantly through the Dulux brand. R&D was centralised in Clayton, Victoria at the A$12 million technology centre for the Consumer Products division, opened in November 2000. Over- all within Orica, the Consumer Products division generated A$638 million (17 per cent) of corporate sales and 21 per cent of the A$235 million corporate profits in 2000. The approach of the division was to

emphasise leading brands, established technology, overlapping customers, and overlapping channels surrounding a customer focus. Dulux Trade operated 69 Dulux Trade Centres throughout Australasia, had 175 aligned depots and distributorships, and boasted a customer base of 40 000. Overall, as market lead- er, Dulux sold 35 per cent of the paint purchased in Australasia by volume and 38 per cent by value of what they estimated to be a A$1.1 billion total mar- ket. Dulux believed its strategy for success was based around brands, technology, innovation, colour lead- ership, distribution and customer satisfaction. In unaided brand awareness tests in Australia, Dulux trailed only Telstra and McDonald’s for awareness, beating Coca-Cola and far outstripping any other paint brand.

Dulux operated three Australian manufacturing facilities in Queensland, Western Australia, South Australia plus the New Zealand operation in Wel- lington. The Rocklea plant in Queensland had com- pleted a A$17 million upgrade in 2000 that incor- porated two fully automated and six semi-automated robotic filling lines and the implementation of flex- ible manufacturing technology. The Rocklea plant was the largest paint manufacturer in Australia, the upgrade increasing the capacity from 40 million litres per year to over 60 million.

Wattyl was also a multinational competitor head- quartered in Australia. Wattyl was solely a paint company with manufacturing operations in Aus- tralia, New Zealand, the United States, Thailand, Malaysia and Indonesia. Founded in Sydney in 1915, Wattyl became a public company in 1959. Since then, Wattyl’s development has been heavily influenced by acquisitions, having purchased at least nine other Australian paint companies. Wattyl has had a pres- ence in New Zealand since 1970, when it acquired Solway Products. In 1989 that presence was expand- ed greatly through the acquisition of Samson Gold-X. The Taubmans brand in New Zealand was acquired in 1995, establishing Wattyl as a major player in the market. Outside Australasia, expansion has been driven by the acquisition of companies such as the Dimet Group (Asia) and Coronado Paint (USA).

C-182 Case 12 • Resene Paints

During the financial year to 30 June 2001, Wattyl had corporate revenues of A$528 million, but experienced losses of A$22 million. In March 2001, Wattyl’s managing director resigned. Subsequently, the management and board of Wattyl instigated a major strategic review of operations. While Wattyl had faced a number of one-off costs such as bad debts in the United States and an Australian strike, it also believed that it had not re-invested sufficiently in plant in recent times. While Wattyl was still profitable in both Australia and New Zealand, 2001 performance was poor in both the Asian and US markets. As a result, Wattyl wrote down its investments in Asia and the United States and was looking to exit Asia completely. In seeking to remedy the situation in Australia, Wattyl has reduced the number of plants from eight to three, established more efficient warehousing, sold surplus properties, and introduced a major new premium interior wall paint.

Barloworld is a large South African conglomerate with interests including cement, lime, laboratory equipment, lasers and steel tubes. Barloworld has paint manufacturing operations in South Africa, the United Kingdom and Australia under different brands. The Taubmans brand had been in Australia for over 100 years; however, prior to its sale to Barloworld in 1996, it had begun to flounder, benefiting Wattyl and Dulux. In 1992, Taubmans had market share of 22 per cent, but that fell to 15 per cent by the time of the sale. The new ownership had turned that around and the combined market share of Taubmans and Barloworld’s other Australian brand, Bristol Paints, had risen from 23 per cent to 29 per cent since 1998, taking over the number two spot in the industry.3 Nevertheless profits had been more difficult to come by and the Taubmans/Bristol group made losses in 2000 (see Exhibit 8). Speculation existed that Barloworld would look to exit Taubmans.

The 120-store retail arm of Bristol Paints was moving towards increased franchising, with company-owned stores converted into franchisees. The stores employed 500 staff throughout Australia and represented the largest chain of retail and trade stores for paint and wallpaper. In addition, six fran- chised Bristol decorator centres opened in China in 1999 and a further four in 2000. The entire range sold in China was produced in Australia. As part of Barloworld, both Bristol and Taubmans had access to the Nova Paint Club. The Nova Paint Club was a worldwide association of 15 paint companies that provided a framework for the exchange of technical information, technology and expertise across all their areas of operation.

Smaller paint companies existed in both Aus- tralia and New Zealand. Benjamin Moore Pacific in New Zealand, for example, began as a joint venture between Benjamin Moore, the large US paint com- pany, and local owners. However, the local owners had subsequently taken full ownership and operated under a licensing agreement from Benjamin Moore (US). As noted, Benjamin Moore did have a retail presence through franchised retail outlets around New Zealand. However, the number of Benjamin Moore Colourworks stores had been diminishing as stores switched to competing retail chain Colour Plus. Colour Plus was associated with Wattyl prod- ucts, so the switching allegiance was cutting off the primary outlets that Benjamin Moore had. Retailers were believed to be switching in order to gain better brand support.

Most small paint companies did not have chains of stores associated with them, however. Often they were specialised firms that had a reputation in a par- ticular product that allowed them to sell direct to the trade. In New Zealand, Rotorua-based Damar had an alliance with Amway that had resulted in the website

Exhibit 8 Barloworld’s regional paint results

(A$mn)

Australia South Africa Other Africa Europe

1999 2000 1999 2000 1999 2000 1999 2000

Sales 192 218 216 220 9 17 19 21 Operating profit 0.8 (2.3) 12 12 0.2 1.2 1.8 2 Assets 104 109 102 101 5 7 9 9

Source: Barloworld Limited Annual Report 2000.

Case 12 • Resene Paints C-183

PaintDirect. Damar concentrated more on the low- margin road-marking business. Other small competi- tors tried to sell direct or through any independent retailers that will stock them.

The future Throughout its first 55 years in existence, Resene Paints had shown that it had the capabilities to com- pete effectively in New Zealand against its larger multinational competitors. Having traditionally been strong in the commercial market, Resene had, in more recent years, made a concerted and successful push at the retail market through its own chain of ColorShops. But within New Zealand the prospects for growth in its current markets were not limitless. Although there was still room for growth in the New Zealand market, longer-term growth prospects appeared to be outside New Zealand. Internation- ally, Resene had very small operations in Australia and Fiji. Clearly, Australia was a large opportunity,

but was it the right opportunity for Resene? Were Asia or elsewhere more desirable regions? Should Resene itself even look to operate in other countries, or should it focus on developing technologies in New Zealand to be licensed overseas, such as the newly developed spheromer paint flatting agent? Or should Resene focus its resources on continuing to grow the New Zealand market for the time being? As Nick Nightingale stepped off the 18th green at Parapar- aumu Beach Golf Club, having shot 91 in a losing effort, he knew he couldn’t afford to be as wayward in his choice of markets.

Notes 1 Consumer Institute of New Zealand, 1998, ‘Interior Acrylic

Paints’, April.

2 N. Shoebridge, 1997, ‘Taubmans, “with imagination”, tries to paint its way out of a corner’, Business Review Weekly, 10 November 1997, p. 78.

3 Barloworld Limited Annual Report 2000, p. 32.

C-184

Case 13

Sony Corporation: The vision of tomorrow Kulwant Singh Nitin Pangarkar National University of Singapore National University of Singapore

Loizos Heracleous Abhinav Singh National University of Singapore National University of Singapore

At the advent of the 21st century, Sony Corporation was at a crucial juncture in its long and illustrious his- tory. At the threshold of the much anticipated world of total digital convergence, the electronics maker turned media and communications giant seemed to have it all: next-generation Internet-aware gadgets and compelling content to pump through them, a vibrant culture of innovation resulting in cutting-edge research and development, and a world-class market- ing acumen that had made Sony a global mega-brand. Despite having all the arms in its arsenal, some tough decisions nevertheless lay ahead for the company. Chief among them were: How to manage the com- pany’s mix of diverse businesses to achieve inter-unit coordination and synergies? What paths, in terms of new product development, to take in the unexplored realm of total digital convergence? And, above all, how to communicate and sell the new Sony identity to the customers, shareholders and employees?

Introduction: It’s a Sony In 2002, Japan-based Sony Corporation was the world’s largest consumer electronics company, a sig- nificant player in the media industry and the fastest-

growing computer and communication equipment maker. The Sony brand was one of the world’s most recognisable and trusted brands – thanks to half a century of relentless innovation, bringing an array of trend-setting electronics products into the market. Sony ranked 21st in the BusinessWeek/Interbrand list of the World’s 100 Most Valuable Brands with an estimated value of US$14 billion1 – and the first among its industry peers.

In 1999, for the third year in a row, Sony was recognised as one of the world’s 100 Best Managed Companies by Industry Week magazine.2 The Trini- tron, the Walkman, the Betamax, the Camcorder, the Compact Disc, the MiniDisc, the venerable Play- Station and the robot dog Aibo were some of the Sony innovations that had created all new markets of their own. It’s a Sony – the company’s tagline for its elec- tronic audio and video products – was a stamp of quality, cutting-edge technology and reliability.

The company also had a strong media indus- try presence, with its record label boasting artists such as Michael Jackson, Bruce Springsteen, Jenni- fer Lopez, Celine Dion and Mariah Carey. The film- making division was behind blockbusters such as Spiderman, Men in Black, Air Force One, Charlie’s

Case 13 • Sony Corporation C-185

Angels, Stuart Little and many hit television shows syndicated to various TV and cable channels around the world. The success of the PlayStation had made Sony the leader in the console gaming market. Sony was also the world’s fastest-growing personal com- puter maker,3 albeit still ranking eighth in worldwide market share, with its VAIO brand of personal com- puters and CLIÉ line of hand-helds fast threatening larger players such as HP-Compaq and Dell. Having also a presence in semiconductors, electronic com- ponents, mobile phones and even robots, Sony was well positioned to compete in the emerging world of total digital convergence – a vision of the future where multifunctional devices could seamlessly talk to each other, and multimedia content was ubiqui- tous through these networks. But in this uncertain future world of technology-driven digital entertain- ment, Sony, like its competitors, wasn’t too sure of what exactly constituted the winning formula.

Sony’s history: The making of a dream The two visionaries Sony Corporation traced its roots to the Tokyo Tsu- shin Kogyo (The Tokyo Telecommunications Engi- neering Corporation), or Totsuko, established on 7 May 1946 by Masaru Ibuka – a gifted engineer, and Akio Morita – a marketing-savvy innovator. Both Ibuka and Morita had honed their engineering skills while serving the government, developing mili- tary equipment for the Second World War. After the war, they moved to war-damaged Tokyo and brought together a small team of trusted war-time engineers to start a company whose main aim was to create a stable work environment where engineers who had a deep and profound appreciation for technology could realize their societal mission and work to their hearts’ content.4 Seeking to help rebuild post-war Japan with its engineering know-how but lacking in capital and infrastructure, the company started out by repairing radio sets. Its first product was an electric rice cooker, followed by other innovative appliances such as an electrically heated cushion and a good-quality record pick-up. In 1958, the company was renamed Sony – a

term derived from the Latin word sonus, which was the root of words such as sound and sonic; and also from sonny which meant little son. Hence, Sony sig- nified a small group of young people who have the energy and passion toward unlimited creation.5 The fact that this name was much simpler to remember and more marketable to an international consumer base than Totsuko, of course, helped.

The trailblazers – Sony’s famous products In 1950, Sony produced the G-Type, Japan’s first tape recorder, followed by the P-Type – its portable version. TR-55, Japan’s first transistor radio, was launched in 1955, followed by the world’s first pocket transistor radio in 1957. In 1960, Sony launched the world’s first direct-view transistor television, and in 1963, the world’s first VCR. In 1968, the legendary Trinitron colour-TV set the industry standards of pic- ture quality and design.

In 1975, Sony brought the theatre home by launching the Betamax – the world’s first home-VCR. In 1979, Sony launched the Walkman – the world’s first personal audio tape player – to a sceptical mar- ket. But the product made history by starting a revo- lution of personal audio products. The term Walk- man has even been included in the Oxford English Dictionary since 1986. In 1982, Sony pioneered the compact disc, in association with Philips. Apart from these innovations, Sony also launched the digi- tal audio tape, the home-use Handycam video cam- era, the mini-disc, flat-panel and high-definition TVs (HDTV), and digital cameras.

Sony also played a key role in the development of the digital versatile disc, or DVD. The market-leading PlayStation game console was launched in 1994. In the late 1990s, Sony entered the computer market by launching its VAIO line of multimedia-capable PCs in 1996 and the CLIÉ series of handheld computers in 2000.

In 1999, it launched the world’s first entertain- ment robot, the dog-like Aibo, which became a run- away success. Sony engineers were also working on intelligent humanoid robots, following the success of Aibo.

C-186 Case 13 • Sony Corporation

Globalisation and diversification While Sony was launching these innovative prod- ucts, it was also expanding out of Japan to become a global player. Ibuka and Morita had earlier visited the United States and Europe in the early 1950s to study the latest technologies – for example, the transistor. There, they discovered a huge market for electronic products. During his visit to Philips in 1953, Morita thought, ‘Holland resembles Japan in many ways. If a company like Philips can succeed in the international market, there’s no reason why Totsuko can’t.’6 He thus directed Sony to start concentrating on exports to the international market, with a goal of earning at least half of its total revenues from overseas sales. This was followed by setting up overseas offices to supervise marketing and sales activities. Sony’s first major overseas office, the Sony Corporation of Amer- ica (SONAM), was established in New York City in February 1960 to do ‘business with Americans like an American company’.7 With a capital investment of US$500 000, the office was actually located in a small warehouse, employing six people. This was fol- lowed by offices in Hong Kong and Zurich. A radio factory in Shannon, Ireland was Sony’s first overseas manufacturing facility. The Sony Technology Centre in San Diego, established in 1972, was the first con- sumer electronics manufacturing facility opened by a Japanese company in the United States.

These initial establishments were followed by Sony opening offices and plants in many countries. Sony leveraged on its vast pool of talented engineers to produce innovative audio and video products, as well as various electronic components. Under the leadership of Norio Ohga, who was Sony’s president from 1982 to 1995, Sony’s view of its business was transformed from an electronics company to an entertainment company. Ohga took the bold step of establishing the music, pictures and gaming businesses to pioneer Sony’s foray into the content arena. Akio Morita also wanted Sony to move into the content business, so that it could have higher market power, believing that if Sony had controlled the rights to enough movies, its Beta video format would not have lost out to Matsushita’s rival VHS format in the 1970s.

This foray into the content business was achieved by the acquisition of US-based CBS records in 1988 and the Hollywood studio, Columbia Pictures (along with its television subsidiary Columbia Tristar Tele- vision Group) in 1989. Hence, Sony Music Enter- tainment (SME) and Sony Pictures Entertainment – two of the world’s largest content producers – were formed. Ohga, being a visionary, was also instrumen- tal in Sony’s foray into the game business in 1994. The PlayStation game console directly took on estab- lished players such as Nintendo and Sega, subse- quently dominating the market. These moves were coupled with a renewed and innovative marketing strategy and product planning, projecting Sony’s new stylish, modern image. Nobuyuki Idei, who took over the helm from Ohga in 1995, continued the process of continuous reinvention at Sony, pushing the compa- ny into the digital networks and convergence era, by launching personal and handheld computers, mobile phones and a host of hybrid devices that herald- ed the integration of audio-visual and information- technology products. In 1996, Sony launched So-net, a broadband network provision service in Japan. Sony had also diversified into the financial services business, providing banking and insurance services in the Japanese market. Sony Bank, an Internet-based bank for middle-class Japanese investors, was opened in 2001.

A culture of innovation – the ‘Sony DNA’ Technical innovation and marketing superiority had been the two central pillars of the Sony establishment. These pillars were put in place by the company’s founders, who, through their complementary skills and enthusiastic leadership, set the foundations of a true culture of innovation at Sony. Ibuka was a vision- ary, adept at imagining applications of emerging tech- nologies to everyday life. Leading the research and new product development efforts, he was an inspiring leader, responsible for shaping much of Sony’s open- minded corporate culture, and infusing the spirit of innovation in Sony’s employees. To complement Ibuka’s skills, Morita was a true marketing pioneer, and was instrumental in making Sony a household name worldwide, by searching for new markets and growth opportunities.

Case 13 • Sony Corporation C-187

The modern corporate culture at Sony was artic- ulated by the term Sony DNA, a metaphorical refer- ence to the traits inherited from the two founders and other leaders. The meaning of the term, and Sony’s raison d’etre, was summarised by Kunitake Ando, Sony’s president and chief operating officer, in 2002:

If Sony is going to be different from all the others, it has to really step ahead. It’s the difference between originality and a copy machine. We are not like a Dell. We are trying always to come up with something new, to create innovative products. That’s basically Sony’s DNA. The path is not always smooth. But if you lose your mission, your DNA, you lose your reason for being. Sony’s reason for being has always been to create something new, to create more dreams, to make things fun.8

Sony described itself as follows, on its news and information website:

Sony is a company devoted to the CELEBRATION of life. We create things for every kind of IMAGINATION. Products that stimulate the SENSES and refresh the spirit. Ideas that always surprise and never disappoint. INNOVATIONS that are easy to love, and EFFORTLESS to use, things that are not essential, yet hard to live without. We are not here to be logical. Or predictable. We’re here to pursue INFINITE possibilities. We allow the BRIGHTEST minds to interact freely, so the UNEXPECTED can emerge. We invite new THINKING so even more fantastic ideas can evolve. CREATIVITY is our essence. We take chances. We EXCEED expectations. We help dreamers DREAM.9

The making of a global brand The term Sony DNA also captured Sony’s extra- ordinary flair for the design and marketing of its products. Sony’s successful product launches were always accompanied by an elaborate marketing and positioning effort, and doing things differently often earned it handsome premiums for its products. For example, one of its devices was a wireless access point that joined components in a local area network and provided access to the Internet. Traditional models of such devices were plain, flat and ugly plastic boxes

with thick antennae jutting out. But Sony’s version had a glassy, opaque surface, stood vertically and had cleverly concealed the antennae – giving the product a smart and very agreeable look.10

These design innovations were backed by zeal- ous marketing efforts, resulting in the creation of sev- eral successful sub-brands within the Sony umbrella such as Trinitron, Walkman, WEGA, VAIO, which also strengthened the umbrella Sony brand. Sony also often relied on revitalising its mature brands to repo- sition them. The Walkman brand was relaunched in 2000, this time for the mini-disc format, with a tagline The Walkman Has Landed. The launch was supported by broadcast, print and on-line advertis- ing, Internet and dealer events and promotions, and grassroots public relations campaigns, to target the Generation Y target market.11

As a result of these efforts, Sony had become one of the world’s greatest brands, rated the number one brand in the United States by the 2000 Harris poll,12 and as the world’s 21st most valuable brand in 2002.13 Norio Ohga, Sony’s chairman until 2003, said:

In April of every year a large number of new

employees join the company. And what I always

say to them is that we have many marvelous assets

here. The most valuable asset of all are the four

letters, S, O, N, Y. I tell them, make sure the basis

of your actions is increasing the value of these

four letters. In other words, when you consider

doing something, you must consider whether your

action will increase the value of SONY, or lower

its value.14

Winds of change: Sony prepares for the future The modern consumer electronics industry was cre- ated with the launch of the VCR in the 1970s, but had changed surprisingly little until the mid-1990s. Computers and mobile telephones had been launched, but they had become separate industries in their own right. During this time, the main players in the con- sumer electronics industry had remained broadly the same – dominated by firms such as Sony, Philips and Matsushita (makers of Panasonic and JVC).15 Each of

C-188 Case 13 • Sony Corporation

these analogue consumer electronic devices had their own standards and market leaders. Hence, market- leading VCRs were made by different firms than the ones that made market-leading audio equipment. But in the mid-1990s, with the advent of a host of digi- tal devices with mass market potential, this equation was changing quickly. These devices were made by firms outside the consumer electronics world, and were technically similar to computers – heralding the digital convergence. They increasingly incorpo- rated features of consumer electronics devices – for example, an MP3 personal stereo – but, being digi- tal, were inherently different in their underlying tech- nology from their traditional counterparts. The PC was fast becoming the home’s information and enter- tainment hub in developed countries. This evolution of the computer industry towards the consumer elec- tronics industry promised a profound and long-term impact on the traditional consumer electronics com- panies. The message was clear – the wave of digital convergence was coming as the boundaries between the computer and other devices blurred, as virtually all media, from a movie to a telephone call, could be transmitted and processed as a string of ones and zeros.16 Consumer electronics companies could ignore this trend only at their own peril.

The transformation of Sony for this digital age had started well in time, when Nobuyuki Idei, a young executive, was surprisingly appointed the CEO of the company in 1995. Norio Ohga had actually bypassed about a dozen more senior managers to give Idei the job, a bold move highlighting the need for the company to reinvent itself at the end of the analogue age. Idei had his task cut out: to remake the company for the network age. He quickly announced his vision for Sony by coining the phrase ‘Digital Dream Kids’,17 underlining the ambitions of a company that had a new youthful zeal in the digital era. He summarised his vision by declaring,

We have to change our culture from the manu- facturing industry to knowledge-based global culture. Kind of a reinvention of the business model itself.18

He knew that Sony had come a long way since the days of Ibuka and Morita and compared the old Sony to a prop plane that he was outfitting for jet propul-

sion, by transforming the company that made stand- alone products shipped in boxes to one that produced an almost organic swarm of interconnected devices, services and experiences, all riding on the blurred pulses of a ubiquitous wide-spectrum network.19 Investors liked Idei’s convergence idea, and Sony’s market value had tripled by 1999, partly fuelled by the Internet boom.

Restructuring and cost control Idei’s appointment was immediately followed by sig- nificant restructuring. He split the group’s unwieldy audio/video products company and created a new division for information technology products. He also announced that the consumer electronics group would restructure to become less dependent on making television sets, video recorders and portable stereos, due to these products’ commoditisation and falling margins, and concentrate more on new net- working opportunities.20 He also started the com- pany’s drive to convert as many as possible of its analogue products into digital, since manufacturing digital products was relatively cheaper and they also commanded higher margins.21

Traditionally, Sony was a high-cost producer – a drawback that it used to compensate for by extract- ing higher premiums on its innovative products and designs. But its innovations and designs were swift- ly being replicated by cheap electronics producers at home (for example, Matsushita) and abroad (for example, Samsung), pushing down industry margins. These low-cost producers had even captured a signifi- cant market share in a number of markets in Asia, Latin America and Russia, by charging up to 40 per cent less than Sony’s prices. Cost control was hence Idei’s top agenda. To cut costs, he shut down 15 of its manufacturing centres worldwide, leaving Sony with 55 plants by 2003, a workforce reduction of 17 000 workers, 22 and a greater reliance on contract manu- facturers such as Flextronics and Solectron. Much of the production was moved overseas to low-cost coun- tries such as China, and 12 of the company’s Japanese plants were placed under a rationalised structure to further control costs.23 Sony’s loss-making low-cost electronics subsidiary, Aiwa, as well as the music and movies businesses, were restructured to reduce costs. Three of the group’s publicly traded subsidiaries –

Case 13 • Sony Corporation C-189

Sony Music Entertainment (Japan), Sony Chemicals and Sony Precision Technology – were brought back into the group as wholly owned units, strengthening the balance sheet to provide the financial muscle for the company’s digital foray. In 2003, Sony announced that it would restructure its loss-making music busi- ness, Sony Music Entertainment, by slashing 1000 jobs, trimming its roster of artists and combining back office operations to cut costs.24 In 2003, Idei also announced that Sony would organise itself more like an American company.25

Focusing on core strengths CEO Idei knew that Sony’s core strength lay in its abil- ity to innovate and come up with revolutionary prod- ucts. Throughout the change process, this was a trait that had to remain unchanged. It was clear that Sony did not expect its next breakthrough to come from a single new electronic device.26 The focus had shifted from stand-alone devices to networked ones, and the onus was on Sony’s engineers to realise the digital dream. Kunitake Ando, Sony’s president and chief operating officer, also vowed that despite emphasis on network-based content and services, Sony would not lose its focus on hardware.27 Sony R&D labs were continuously working on next-generation wonders such as paper-thin TV displays, high-definition video projectors that turned entire walls into film screens and digital chopsticks – a digital pointer that allowed a user to freely move a file or an image from a screen and transfer it to another device, just like a chopstick. Sony was blurring the lines between these gadgets by blending their features.

Game for change One of the most important strategic decisions that Sony made in the mid-1990s was to enter the video game market. Norio Ohga envisioned the importance of the video game consoles in Sony’s digital strat- egy, and the PlayStation was launched worldwide in 1995. Ken Kutaragi, an engineer atypical to Sony’s culture of internal cooperation, was the champion of the PlayStation, developing the new console with his team of engineers in a relatively independent manner from the rest of the company. Owing to the domi- nant position of Sega and Nintendo in the console market, game developers were initially reluctant to

support Sony’s new format. But Sony pushed forward with the PlayStation, eventually convincing the devel- opers of the system’s superior design and capabilities. By 2000, the PlayStation had dominated the market to become the world’s largest-selling game console, with a 70 per cent market share and 80 million units sold.28 This was followed by the famous launch of the console’s new avatar, the PlayStation 2, in 2000 – when eager customers tumbled over one another to obtain the first machines.29 The PlayStation 2 offered a substantial jump in performance and versatility, with new features such as Emotion Engine and Graphics Synthesizer making possible more complex effects such as facial expressions and clothes flutter- ing in the wind. Over 10 million units were sold in the first year, and by 2003, PlayStation 2 accounted for about half of Sony’s total profits and could be found in 50 million homes.30 By then, Sega had exited the console business altogether to concentrate on gaming software, while Nintendo still held on by launching its GameCube system. However, Sony’s unexpected new rival was none other than Microsoft, which had launched the X-Box, its own gaming console in 2001. Despite a US$500 million marketing campaign, the X-Box had sold only 10 million units by 2003, being a far second in console market share.

Sony had a strong business case to support its foray into the game business, although its move was met with scepticism in 1994. Goldman Sachs predicted the global sales of games to be US$17.5 billion and consoles to be US$8.7 billion in 2002, the former equalling the total box office revenues of the film industry and catching up even with the sales of music CDs31 (see Exhibit 1). Sales of games were expected to overtake music CD sales in Europe by 2005.32 A survey also found that 60 per cent of Americans played video games, and 61 per cent of these game-buffs were adults; 43 per cent were women and their average age was 28, implying that this form of entertainment was now mainstream.33 Similar trends were observed in Europe and Japan too. All this was happening while music and film companies were losing money and the global economy was facing a slowdown. Due to its recession-proof nature and lucrative prospects, the gaming industry was the next big frontier for many entertainment companies.

C-190 Case 13 • Sony Corporation

However, a presence in the game console market had far more strategic implications for Sony, and was indeed an important part of its future digital game plan. The first, and probably less important, reason was that the gaming industry was not yet as competi- tive as the consumer-electronics industry and there was potential for high margins through product dif- ferentiation and margins on gaming software. More importantly, Sony’s vision for the game console was that it could be the next entertainment hub in homes of the future, equipped with multimedia capabilities and connected to other devices with a broadband net- work. It would then allow players to compete with other gamers on the network, and would be a gate- way to a host of multimedia services and content. The console was thus a centrepiece of Sony’s vision of digital convergence and a new way to distribute its content.

The PlayStation 2 was already equipped with some multimedia and network capabilities, with even more network awareness expected in future models. These consoles were thus akin to Trojan Horses,34 a new breed of consumer electronics products, doubling up as a television, home computer, game console and video recorder. The entry of software giant Microsoft into the game console market was a testimony to the device’s unlimited potential. An analyst commented, ‘Games are the engine of the next big wave of com-

puting. Kutaragi is the dance master, and Sony is call- ing the shots.’35

Computers hold the key Concerned that Silicon Valley was invading its turf, Sony decided to mount its own assault on the com- puter industry.36 Idei was aware that an ability to make information technology products was crucial to survival in the new era of digital competition, with the computer as its centrepiece. Being new to the busi- ness, Sony failed to capitalise upon its powerful brand in its early attempts to enter the PC market through the high-margin notebook-PC segment. Collabor- ating with Intel and former marketers from Apple Computer, Sony launched its VAIO (Video-Audio Integration Operation) line of multimedia-capable notebooks in 1996. Initial adoption was slow, as the users found the price too steep given the notebook’s features. But Sony decided to learn from the experi- ence, saying that it needed PC expertise more than it needed the profit.37 Idei commented, ‘If you are not making computers, you can’t keep up.’38 Undaunted by its initial failures, Sony continued to improve its line of computers, add new features and slash produc- tion costs, also launching the CLIÉ range of handheld computers in 2000. Sony’s persistence finally paid off, and by 2002, it was the fastest-growing major PC maker in the world, ranking eighth in overall market share. Its CLIÉ handheld computers commanded a

Exhibit 1 The growing market for games

Source: ‘Console wars’, The Economist, 20 June 2002.

* Includes games for consoles, PCs and handhelds. Source: Goldman Sachs; Screen Digest; IFPI; Merrill Lynch.

0 2000 2001 2002 2003

Games software*

Global Sales, $bn

Cinema box-office receipts

DVD/video

CDs10

20

30

40

Case 13 • Sony Corporation C-191

22 per cent market share, second only to Palm.39 An analyst described Sony’s ascent in the PC market:

They’re borrowing from several of the success strategies in the PC business. They have a bit of the operational excellence of Dell, some of the gaga design of Apple and some of the total solutions idea from IBM – only targeted at the home retail market.40

Sony’s latest computer models offered seamless interconnectivity with its other digital devices. Mark Hanson, Sony’s vice president in charge of marketing the VAIO line, concluded:

Our original intent was to figure out how the PC could help consumer-electronics usage, and (then) bridge them. And the technology is there where we can do what many can’t. We’re now better able to show why we got into the PC business.41

Content with the current content On the content side, Sony avoided any extravagance during the mergers and acquisitions boom in the media industry in the late 1990s, which resulted in under- performing conglomerates such as AOL Time Warner and Vivendi Universal. One possible reason was that Sony still remembered the difficulties it faced when its acquisition of movie and music businesses was on the verge of failure and almost brought the whole company down. Sony had finally recovered through extensive cost-cutting efforts, but the promised syn- ergies were not realised. Moreover, the rationale for the merger wave was the convergence of content and distribution. In its dream of digital convergence, how- ever, Sony saw its own networked devices as the dis- tribution channels for its content. Hence, in a way, Sony already had what these media giants were trying to achieve, avoiding the merger wave of the late 1990s (and the woes that it eventually brought to the merg- ing conglomerates) and could instead focus on devel- oping its next-generation gadgets.

Sony’s main weakness in the content business was its absence in the American TV networks arena, which were the strongholds of its competitors such as AOL Time Warner, Viacom and Disney. Being a Japanese company, Sony was not allowed to set up broadcast networks in the US, while the difficul-

ties resulting from its acquisitions prevented it from creating cable networks in the early 1990s.42 Real- ising that it was rather late to start cable channels in the fiercely competitive US market, Sony tried to make up for it by investing in satellite broadcasting in Japan (through a partnership with Rupert Murdoch’s News Corp) and many other countries outside the US and Europe. By globalising production, Sony exploit- ed a shift in demand in international markets, where American programming was gradually being replaced by locally produced programs in the prime-time slots.43 By 1999, Sony had set up production facili- ties and TV channels in most of the big countries in Latin America and Asia, and was making 4000 hours of foreign-language programs, as compared to 1700 hours of English-language programs.44 This strategy worked in favour of Sony. By 2003, many of its local channels were performing extremely well – for exam- ple, the Sony Entertainment Channel in India, which consistently scored top viewer ratings in a country of 1 billion viewers.

Sony’s disciplined approach in the media business had begun to pay dividends. As a result of its cost- focused operations, its TV series production busi- ness was posting healthy returns in 2003,45 while its movies business was the most profitable one in Holly- wood in 2002, thanks to blockbusters such as Spider- man.46 Only the music business was a concern, due to falling sales and widespread piracy. As of 2003, strin- gent cost-cutting measures were under way to turn the division around.47

The promise of broadband One point where Sony was in consensus with its com- petitors – whether in the media industry or consumer electronics or information technology – was that broadband was the next big wave making digital con- vergence possible. And, like many of its competitors, Sony staked its future on broadband. This was also Sony’s chance to justify its costly acquisitions of con- tent businesses a decade ago, by pushing its content to consumers through broadband devices. Kunitake Ando said:

The concept that consumer electronics devices

can access all sorts of content while connected to

a network is the biggest trend, and as broadband

C-192 Case 13 • Sony Corporation

rolls out and becomes more commonly available

– which will happen by 2005 – companies have

to make it happen by introducing more types of

products.48

Broadband networks were next-generation net- works providing high-speed, high-bandwidth, access to the Internet, hence enabling the seamless trans- fer of multimedia-rich content. Thus, broadband was the main thread running through the trellis of Sony’s future vision of connected devices with rich content flowing through them. Broadband was also the technological prerequisite to such concepts as on-line music and movie distribution, multi-player gaming and other interactive services. Kunitake Ando believed that in 2002, Sony was better positioned than any other company to make the transition to the broadband world.49 Its seasoned executives knew how to design consumer products that were both sexy and functional; it had a proven global distribution system and was in constant touch with consumers; it had a deep understanding of both networking techno- logy and successful information technology products. Ando also believed that Sony had finally found the synergy between the hardware and the content sides of its business, a point where the other convergence- seeking conglomerates were struggling.50

Strategic alliances Sony believed that in the future world of networked entertainment, size mattered. Although it avoided jumping on the merger bandwagon, it saw alliances as a valuable means of growth. The development of the PlayStation itself was aided by alliances forged between hardware designers and creative game- software developers; so were other innovations such as the compact disc, a result of an alliance with Philips. Nobuyuki Idei outlined the importance of alliances to Sony:

We also recognize that the broadband era requires

more resources than the Sony Group alone has.

This is why we began several years ago to promote

‘soft alliances’ with partners sharing the same

vision. Many companies have expressed an interest

in these soft alliances. I believe that this kind of

cooperation with partners having outstanding

technology, content, telecommunication networks

and other key resources is essential.51

He also revealed that Sony was more interested in forging ‘soft alliances’ than the riskier strategies of mergers and acquisitions:

The opposite of soft alliances is hard alliances,

which include mergers and acquisitions. Since

purchasing the Music and Pictures businesses,

more than ten years have passed, and we have

experienced many cultural differences between

hardware manufacturing and content businesses.

This experience has taught us that in certain areas

where hard alliances would have taken ten years

to succeed, soft alliances can be created more

easily. Another advantage of soft alliances is the

ability to form partnerships with many different

companies. We aim to provide an open and

easy-to-access environment where anybody can

participate and we are willing to cooperate with

companies that share our vision. Soft alliances

offer many possibilities.52

Mobile phones were an integral element of Sony’s network strategy. But Sony had never really been suc- cessful in capturing any substantial market share in the industry. To quickly overcome this shortcoming, Sony pooled resources with the Swedish phone maker, Ericsson, to launch a joint venture – Sony Ericsson Mobile Communications (SEMC) in October 2001.

Ericsson was a major player in the mobile phone business, and had introduced several technical inno- vations over the years. But it had witnessed its mar- ket share fall against its arch-rival – Finland-based Nokia. Kunitake Ando summarised the motives of the alliance:

As one of the originators of GSM, a transmission

standard, Ericsson is known as a company with a

high level of vanguard technology and is the best

in the world when it comes to the technology used

for mobile communication base stations. Sony’s

strength lies in its ability to create new products,

particularly in the crucial product-planning

and design stages. By uniting this strength with

Ericsson’s excellent telecommunications tech-

nology and ability to set standards, SEMC is

Case 13 • Sony Corporation C-193

seeking to become a global market leader in mobile

phones.53

Although Sony Ericsson was still making losses as of 2003, Sony and Ericsson had both pledged more resources into the venture. Its phones were highly regarded by technology enthusiasts and the youth for their advanced and user-friendly features, and the company predicted that its next-generation handsets could finally turn things around.54

Other alliances included PressPlay, an on-line music distribution site launched by Sony Music in partnership with Universal Music Group in 2001, and Sony’s alliance with Palm Corporation to use its oper- ating system for the CLIÉ handheld. Sony planned to use the open-source Linux operating system for many of its other devices, including the CoCoon set-top box.

These alliances provided Sony an alternative to Microsoft products, and thus helped to keep its licens- ing costs down. Although Sony waited for broadband infrastructure to be widely available in order to realise the hidden potential for its game consoles, it never- theless struck another alliance with America Online (AOL) in 2001. The deal gave the PlayStation 2 users access to the web, email and other services operated by AOL, the world’s largest Internet service provider with 29 million subscribers at the time.55 A special Internet browser was also developed for the pur- pose, and Sony designed additional equipment such as hard disk drives, mouse and keyboard to connect to the console. This, according to Sony, was just a glimpse of things to come in the broadband world, and was ‘an important first step taking PlayStation 2 into the online and broadband environment’, accord- ing to Kaz Hirai, president of Sony Computer Enter- tainment.56 Sony was also partnering with IBM and Toshiba to develop the next-generation cell micro- processor technology, an extremely fast and network- capable multipurpose chip that would be the heart of future Sony devices, including the PlayStation 3.57 Other alliances included a consortium of nine com- panies – including Sony, Philips, Samsung, Sharp and Thomson – pushing for the adoption of their Blu-Ray DVD recording standard over a rival standard from NEC and Toshiba.58

At the crossroads: Sony in 2002 The year 2002 was a crucial one in the history of Sony. It was believed that the broadband revolution was just about to take place and that the world could finally witness the company’s vision taking shape. The rise of China as a manufacturing powerhouse was having important implications for manufacturing-based companies such as Sony, while Korean competitors such as Samsung and LG were fiercely challenging Sony’s innovations in consumer electronics with low-priced products. Growing digital piracy was fast eroding the profits of music- and movie-making companies. Finally, a global economic slowdown, apprehensions of terrorist attacks and an unstable geopolitical landscape were set to test Sony’s resilience as a global corporation.

Sony’s organisation As a result of Nobuyuki Idei’s restructuring efforts, the structure of Sony Corporation in 2002 was designed with cost-effectiveness in mind. The com- pany was broadly divided into six business areas, each further divided into smaller business units (see Exhibit 2).59 1 Electronics Businesses consisted of audio, video,

televisions, information and communications, semiconductors, components and other businesses.

2 Game Businesses consisted of game console and software businesses conducted mainly through Sony Computer Entertainment Inc.

3 Music Businesses consisted of Sony Music Entertainment Inc. (SMEI) and Sony Music Entertainment (Japan) Inc. (SMEJ).

4 Pictures Businesses consisted of motion picture and television businesses, conducted mainly through Sony Pictures Entertainment Inc. (SPE).

5 Financial Services Business consisted of Sony Life Insurance Co. Ltd, Sony Assurance Inc., Sony Financial International Inc. and Sony Bank Inc.

6 Other Businesses consisted of location-based entertainment businesses, Internet-related businesses (So-net), conducted by Sony Communication Network Corporation, advertising agency business and other businesses.

C-194 Case 13 • Sony Corporation

Sony’s performance in 2002 In 2000, Sony had reported losses of US$354 mil- lion in one six-month period – shaking investors’ confidence in its broadband vision. Nobuyuki Idei declared that grand talk of the long-term future could wait until Sony showed a better command of the pres- ent.60 Idei then embarked on a bold restructuring ini- tiative to cut costs in the electronics and content busi- nesses. As a result, Sony posted an all-time-high net sales figure for 2001 of US$53 billion – 3 per cent above the previous year. But the operating income of US$1.01 billion – 40 per cent below the previous year’s income – highlighted Sony’s eroding margins. Vindicating Sony’s foray into the game business, the game division strongly boosted Sony’s bottom line, generating 53 per cent of the total operating income, despite comprising just 12 per cent of total sales (see Exhibit 3). Sales of the PlayStation 2, in the second year since its launch, had risen by 52 per cent. The profitability of the game business was safeguarded by a significant drop in manufacturing costs and an increase in the gross margins on software. Around 18 million PlayStation 2 consoles and 122 million cop- ies of game software were sold. The game division’s performance hence more than offset the losses made

in the electronics business, which had suffered a 3 per cent decrease in sales due to a slump in global demand for semiconductors and components, reduced sales of consumer electronics, and losses made in the mobile phone business due to quality issues. Sony’s VAIO computers, though, gained global market share faster than any other computer brand. Despite contraction of the global music industry, an increase in digital piracy and terrorist attacks in the US, increased sales in Japan contributed to sales growth of 5 per cent in the music business, but a decrease of 2 per cent in operating income.

The pictures business recorded a 15 per cent increase in sales and a more than seven-fold increase in operating income, due to some blockbusters, strong DVD sales, successful game shows and structural reforms. The financial services business recorded a 7 per cent increase in revenue and a 27 per cent increase in operating income, as Sony grew its presence in the financial industry. The other business segments recorded a 6 per cent decrease in sales and overall losses due to losses in advertising business, location- based entertainment businesses in Japan and the US, and at Sony Communication Networks Corporation (SCN). (Appendix A shows Sony’s group financial results by business segments.)

Exhibit 2 Sony’s organisational units in 2002

Source: Sony Corporation Annual Report 2002.

Games

Music

Pictures

Financial Services

Others

Electronics Audio, Video, Televisions, Information and Communications, Semiconductors, Components, Other Businesses

Sony Computer Entertainment Inc. (Playstation and associated software)

Sony Music Entertainment Inc. Sony Music Entertainment (Japan) Inc.

Sony Pictures Entertainment Inc. Columbia Tristar Television

Sony Life Assurance Co. Ltd., Sony Assurance Inc., Sony Finance International, Sony Bank

Sony Communication Network Corporation (So-net), advertising and location-based entertainment

Case 13 • Sony Corporation C-195

‘Do you dream in Sony?’: Sony’s dream of the future Nobuyuki Idei came out with the tagline Do you dream in Sony? to spur innovation inside the com- pany and to prepare consumers for things to come. Sony strongly believed that its clout in consumer electronics, combined with its media content, would allow it to steer digital convergence in its favour.61 With its portfolio of 1000 digitised films, 33 000 hours of TV programming and more than 500 000 hours of songs, Sony was eagerly awaiting this con- vergence, so that it could provide all this content to the consumers.62

If everything in the future went Sony’s way, the consumers could see a whole new world of rich con- tent delivered anytime, anywhere through broad- band networks on a spectrum of devices that would be hybrids of computers and consumer electronics. Sony identified four categories of gateway products that would help it to implement its future strategy. The first would be an intelligent set-top box, called CoCoon, which could learn its users’ preferences and could record TV programs of their taste. The CoCoon would be connected to the DVD player, the TV and, of course, the Internet. Another gateway product would be the PlayStation 3, which, apart from being 1000 times faster than its predecessor, would support

movie-like multi-player network games and could also be used to surf the multimedia-rich Internet in 3-D. It would also simultaneously handle various tasks – for example, recording a TV show while play- ing a game. Next-generation VAIO notebooks, CLIÉ handhelds and Airboard portable wireless TV/Inter- net display devices would serve as the third gate- way device, equipped with intelligent software to learn their user’s preferences and communicate them to other Sony devices through RoomLink wireless links. The mobile phone, the fourth gateway device, would be equipped with cameras and also work in synch with other devices through the Bluetooth technology. All these gizmos, including digital still and movie cameras, would be connected to a home server device, which would be based on the modular cell microprocessor technology, and would store and coordinate all the information in these devices. Each device would eventually have a certain number of cells, whose computing power could be harnessed by other devices on the network, should the need arise.

Sony also planned to make personal robots that would evolve from their current pet status of Aibos to become intelligent, humanoid-shaped companions. They would again communicate with all the other devices, and also help their master manage his per- sonal information by remembering appointments, etc. Toshitada Doi, head of Sony’s Digital Creatures Lab- oratory, believed that the personal robots would be

Exhibit 3 PlayStation’s contribution to Sony’s income

* Year ending 31 March 2002. Source: ‘The complete home entertainer?’, The Economist, 27 February 2003. † Calculated as if operating loss in electronics segment were zero.

Winning games Share by business sector*

Sales and operating revenue, %

Operating income†, %

64

8 14

53

13

20

8

8

12

Electronics

Games

Music

Pictures

Other

C-196 Case 13 • Sony Corporation

Sony’s most profitable line of products and the robot industry would one day be ‘bigger than the computer industry’.63 He said, ‘PCs will continue to grow, but robots will grow faster. When this will happen, I don’t know – maybe 30 years. But maybe ten years to 15 years.’64 Kunitake Ando also expressed optimism about the future of robots:

We are hoping that robots will create a new type

of industry. Initially, it will be for entertainment

and for giving comfort, but we think there is a

long-term future for robots, and we are adding

new technology to our robots so they will quickly

become more intelligent and more useful in day-

to-day life.65

Difficult road ahead: Sony’s future challenges Sony’s future vision sounded very exciting, but many real hurdles lay ahead.

All for one The biggest internal challenge that Sony faced in achieving its digital convergence ambitions was to achieve seamless cooperation between its various subsidiary companies by selling the network vision internally. This was no easy task, given different sub- sidiaries’ different expectations and goals.

Traditionally, despite attempts at discovering syn- ergies, there had been little cooperation between the content people in the United States and the techni- cal wizards in Japan. Even the product units used to work rather independently – the development of Play- Station under Ken Kutaragi being the prime example. Kutaragi worked outside the company’s mainstream and forged his own alliances with various parties. PlayStation was highly successful, but Sony wondered if it could enjoy similar luxuries of independence in the networked future. It also wondered if innovation could still be maintained by compromising upon this independence.

To counter the low-cost imitators of its main- stream products that threatened its profits, Sony had decided to keep at the forefront of innovation. Now that Sony was making innovative interconnect-

ed digital multimedia products, the content business, already plagued by piracy, was even more concerned about the implications of these new devices for its copyrighted content. As a producer of both content and devices, this was a dilemma for Sony that many other competitors did not have to worry about. As a result, competitors were already making many de- vices that Sony ought to have made.66 Sony had, on the other hand, equipped its MP3 players with unpop- ular anti-piracy software, greatly affecting their mar- ket acceptance..67

Nobuyuki Idei was working actively to achieve organisational integration. In 2002, he started an ini- tiative called NACSS (Network Application and Con- tent Service Sector), an effort aimed at bridging the hardware and content businesses. Masayuki Nozoe, a veteran with experience in both consumer electron- ics and movie groups, was appointed to head the ini- tiative.

Extensive reorganisation was done to change the organisational mind-set. Such efforts showed promis- ing results, and by 2003, Sony had witnessed a dra- matic increase in internal cooperation. When develop- ing new games, Sony’s developers now kept in mind not only the PlayStation, but also the CLIÉ and Sony Ericsson phones. The Walkman was integrated with VAIO PCs and Sony’s on-line music service, Press- Play. Engineers always kept the network in mind while designing new devices. There was also increased coop- eration between the hardware and content managers through emails and videoconferences. Nobuyuki Idei was satisfied by the developments:

It took almost two years for everyone to grasp the

network concept and go in the same direction.

Now we’re all going the same way. The horizontal

and vertical are more balanced.68

Howard Stringer, CEO of Sony USA, said:

The company was built in a vertical silo fashion,

to cultivate the independence that was prized by

Mr. Morita. At the end of the analog age, the

operating companies actually didn’t get along well.

Now everybody in every aspect of the company is

talking to each other. If you keep talking about

networks, you have to practice good networking

in your own company.69

Case 13 • Sony Corporation C-197

Idei had managed to persuade even Kutaragi to be a team player and cooperate more closely with everyone, by giving him greater responsibility. About Kutaragi, Idei said, ‘He’s kind of a symbol for Sony, how the rule breaker can survive with the rule maker. And now, the rule breaker has become the rule maker.’70

The standards war Being a consumer electronics company, Sony was well aware of the importance of standards – having learned its lesson early when its Beta video format had lost a fiercely fought battle against Matsushita’s VHS for- mat. But Sony had won more standards battles than it had lost, the compact disc being one of them. In the age of digital convergence, it could be a winner- takes-all situation in a standards war. The number of companies, including Sony, fighting it out over the new DVD recording standard was a testimony to the high stakes involved in modern standards battles.71 Evidently, the age of convergence was expected to bring with it the fiercest standards battles ever, with rival players such as Microsoft, Samsung, Nokia, Sun Microsystems, etc., all pushing their own formats and protocols for market dominance. Sony’s broad- band dream could only be a reality if its own stan- dards prevailed. Joining alliances for joint standard specification was a good risk-mitigation strategy.

Competition in the 21st century Sony had traditionally competed with a somewhat stable set of rivals – the likes of Philips, Matsushita, Toshiba and Samsung. Competitive issues the com- pany usually faced were important but less complex, such as cheap producers of commodity electronics eroding Sony’s margins. But thanks to the age of con- vergence, Sony had suddenly found itself up against an overwhelming set of adversaries, including, but not limited to, computer makers such as HP and IBM, PC makers such as Dell, Apple and Palm, network equipment makers such as Cisco and 3Com, software makers such as Microsoft and Sun, media companies such as AOL Time Warner and Vivendi Universal, game makers such as Nintendo, photographic equip- ment makers such as Kodak and Fuji, and mobile phone makers such as Nokia and Motorola. This complex, multi-dimensional competition was a bitter

reality of the world of digital convergence, where the boundaries between traditional industry segments had disappeared. Sony had entered the terrains of these companies in the media, computer, gaming and networking markets, and had also witnessed these very players enter Sony’s traditional fortes. Microsoft was now making game consoles, Apple was making personal digital stereos, 3Com was making network radios, and Nokia was making PDAs. And with most of its competitors nurturing grand broadband visions of their own and staking their future on them, Sony’s digital dream did not seem that unique.

The world of digital convergence also meant that one company could not do everything on its own, necessitating selective cooperation with its competi- tors. An example was Sony’s dependence on Intel for VAIO chips and Microsoft for its software. This trend was rather unfamiliar to Sony, which had been hitherto fiercely independent when it came to launch- ing new consumer electronics products. The tradi- tional consumer electronic model also meant com- panies operating huge manufacturing plants on their own. But such plants now had to give way to third- party contract manufacturers such as Flextronics and Solectron, so that the company could concentrate on swiftly designing innovative new products, as man- ufacturing superiority and efficiency were no longer the basis of competition.72 This outsourcing trend had significantly reduced the barriers to entry into the industry.

The scourge of piracy The proliferation of the Internet and digital gadgets translated into easier piracy of digitised copyrighted content. In the 1970s, Sony, as a consumer electronics company, had fiercely fought in the Supreme Court – and won – for consumers’ right to make personal cop- ies of content using its VCRs and tape recorders.73

Now, being one of the world’s biggest owners of copyrighted content itself, Sony was in a strange dilemma. Its past attempts to design its devices to pre- vent copying had resulted in consumer displeasure. Kunitake Ando thoughtfully rued, ‘When you have a problem like this, I really wish we were a simple hard- ware company.’74

Meanwhile, piracy continued unabated, eating into the revenues in the music business. Despite an

C-198 Case 13 • Sony Corporation

increase in demand, global music sales paradoxically fell by 9 per cent in 2002.75 Illegal copies and sales in countries such as Russia, China, Brazil and Ukraine were estimated to cost movie and music companies US$7 billion a year.76

With international sales fast becoming major revenue earners for US-based content producers, the piracy trend spelled doom to the industry. If this trend continued, many movie and music producers, includ- ing Sony’s content divisions, could go out of business – leaving the digital convergence dreams unfulfilled. In 2003, Sony teamed up with AOL Time Warner and Viacom to form an association to urge the US govern- ment to step up its anti-piracy measures.77

Technology adoption The most interesting part of Sony’s digital conver- gence dream was that it was, after all, still a dream. Despite elaborate preparation for the next genera- tion of networked entertainment, the networks them- selves remained conspicuously missing from the pic- ture. By mid-2003, not a single product from Sony had yet incorporated any of the features that Idei and Ando proudly proclaimed in their dreams. Sony had bet too much on broadband, but there were no elab- orate broadband networks in place to realise those dreams.

Although a technical reality for some years, the broadband networks had not caught on at the pace that Sony would have liked. Even in the United States, the traditional trendsetter in network technologies, broadband was slow to replace the slower dial- up access networks. Japan, however, showed faster adoption. By 2005, half of Japan’s households were expected to have a broadband connection, compared to just 30 per cent of American households.78 The prices of such services were not helping either: cost- ing US$50 per month in the US, compared to US$20 per month in Japan.79 The situation was even worse in other parts of the world – many developing countries with high market potential had not even seen the first wave of the digital transformation. In 2002, about 30 per cent of Sony’s Walkman sales were units that still used the traditional cassette tape for which the Walk-

man was first launched in 1979.80 A sceptical analyst wondered:

This is the first time in Sony’s history that they

are producing products that are ahead of the

infrastructure’s ability to use them. When they

came out with the first transistor radios and

Trinitron TVs, the broadcasters were already

there. When they came out with the Walkman,

everyone was already using cassettes. There’s a

huge question mark about broadband networks.81

Sony, having no relationships with telecom and infrastructure companies, could only wait – but not forever. An analyst commented:

Even though it’s a chicken-and-egg situation, you

have to have the vision and drive toward it. A

small or even medium-sized company can’t afford

to make that bet. Sony has some insulation from

risk. The company has revenues from so many

other spaces and products that it can fill in the

profit gaps even in the short term.82

Even if broadband networks became mainstream, the consumers’ acceptance of Sony’s convergence products could not be taken for granted. Sony’s first attempt at an Internet appliance, the eVilla, a desk- top web-browsing device, had miserably failed in 2001.83 Sales of the Airboard, the network Walkman and third-generation (3G) phones had also been omi- nously discouraging.

Defining the redefined ‘Sony’ Sony still faced the daunting task of selling its broad- band vision and new identity to the customers. Sony had to shed the consumer electronics company image and explain to users what its new products actually did. In addition, Sony’s shareholders and employees had to be part of Sony’s grand vision. Sony had indeed done quite a lot in the past to successfully change its image from a pure consumer electronics company to a total entertainment company, later adding informa- tion technology products to its portfolio. Nobuyuki Idei described Sony’s public image in the broadband

Case 13 • Sony Corporation C-199

era as a ‘Global Media and Technology Company’.84 According to Sony:

In essence, Sony, the box manufacturer, is being replaced by a new Sony – a customer-centric entity centered around broadband entertainment, yet driven by the venture spirit of Sony’s founding days.85

But the task of projecting an image of a player in the digital convergence industry was much more com- plex, given that most people still did not understand what this convergence actually meant. A good exam- ple of this point was the problem Sony faced in mar- keting its otherwise highly innovative product – the Airboard, a combination of TV and PC with an LCD screen. Kunitake Ando revealed:

People don’t know what it is, whether it’s a PC or a TV or something else. We try to explain the concept, but people find it difficult. And dealers don’t know how to sell it. In the meantime Sharp’s Aquos, a simple LCD TV, sells so well. But Airboard is so much more than Aquos!86

He went on to explain:

The biggest hurdle is actually the dealers who may not be sure how or even where to sell devices. Do you put something like the Airboard with TVs or with PCs? We have faced this problem in the past, and we have managed to educate them. What we don’t want to do is make it too hard on the consumer to use the device. We have even created a user-friendly committee within the company to make sure that we don’t run into that problem.87

But one thing that Sony did not want to do was give up. Dreams were an integral part of Sony, and fervently following them, despite failures, was part of Sony’s culture. Kenichi Ohmae, a management guru, pointed out that Sony ‘has failed in the past with its Beta video format and its purchase of Columbia Pic- tures. But it has repeatedly displayed the dynamism to bounce back.’88 Kunitake Ando emphasised his company’s determination: ‘We don’t want to go back to being a box company. If we lose our dreams it’s not Sony at all.’89

C-200 Case 13 • Sony Corporation

Appendix A Table A1 Sony’s consolidated income statement (for the year ended 31 March 2002)

Consolidated Statements of Income

Sony Corporation and Consolidated Subsidiaries – Year ended 31 March

Yen in millions Dollars in millions

2000 2001 2002 2002

Sales and operating revenue: Net sales ¥6 238 401 ¥6 829 003 ¥7 058 755 $53 073 Financial service revenue 412 988 447 147 483 313 3 634 Other operating revenue 35 272 38 674 36 190 272

6 686 661 7 314 824 7 578 258 56 979 Costs and expenses: Cost of sales 4 596 086 5 046 694 5 239 592 39 396 Selling, general and administrative 1 478 692 1 613 069 1 742 856 13 104 Financial service expenses 389 679 429 715 461 179 3 468

6 463 457 7 089 478 7 443 627 55 967

Operating income 223 204 225 346 134 631 1 012

Other income: Interest and dividends 17 700 18 541 16 021 120 Royalty income 21 704 29 302 33 512 252 Foreign exchange gain, net 27 466 – – – Gain sales of securities investments and other, net 28 099 41 709 1 398 11 Gain on insurances of stock by equity investees 727 18 030 503 4 Other 50 603 60 073 44 894 337

146 299 167 654 96 328 724 Other expenses: Interest 42 030 43 015 36 436 274 Loss on devaluation of securities investments 2 015 4 230 18 458 139 Foreign exchange loss, net – 15 660 31 736 239 Other 61 148 64 227 51 554 386

105 193 127 132 138 184 1 038 Income before income taxes 264 310 265 868 92 775 698

Case 13 • Sony Corporation C-201

Table A1 Sony’s consolidated income statement (for the year ended 31 March 2002) (continued)

Sales and Operating Revenue by Business Segment

Yen in millions Dollars in millions

2000 2001 2002 2002

Current ¥120 803 ¥121 113 ¥114 930 $864 Deferred (26 159) (5 579) (49 719) (374)

94 644 115 534 65 211 490

Income before minority interest, equity in net losses of affiliated companies and cumulative effect of accounting changes 169 666 150 334 27 564 208 Minority interest in income (loss) of consolidated subsidiaries 10 001 (15 348) (16 240) (121) Equity in net losses of affiliated companies 37 830 44 455 34 472 259

Income before cumulative effect of accounting changes 121 835 121 227 9 332 70

Cumulative effect of accounting changes (2001: Including ¥491 million income tax expense 2002: Net of income taxes of ¥2,975 million) – (104 473) 5 978 45 Net income 121 835 16 754 15 310 115 Electronics – Customers 4 397 202 4 999 428 4 793 039 36 038 Intersegment 273 800 473 966 517 407 3 890 Total 4 671 002 5 473 394 5 310 446 39 928 Game – Customers 630 662 646 147 986 529 7 418 Intersegment 24 074 14 769 17 185 129 Total 654 736 660 916 1 003 714 7 547 Music – Customers 665 047 571 003 588 191 4 422 Intersegment 41 837 41 110 54 649 411 Total 706 884 612 113 642 840 4 833 Pictures – Customers 494 332 555 227 635 841 4 781 Intersegment 394 0 0 0 Total 494 726 555 227 635 841 4 781

Financial Services – Customers 412 988 447 147 483 313 3 634 Intersegment 25 774 31 677 28 932 218 Total 438 762 478 824 512 245 3 852 Other – Customers 86 430 95 872 91 345 686 Intersegment 55&7132 60 526 55 042 414 Total 141 562 156 398 146 387 1 100 Elimination – (421 011) (622 048) (673 215) (5 062) Consolidated total ¥6 686 661 ¥7 7314 824 ¥7 578 258 $56 979

Note: Electronics intersegment amounts primarily consist of transactions with the game business. Music intersegment amounts primarily consist of transactions with game and pictures businesses. Other intersegment amounts primarily consist of transactions with the electronics business.

C-202 Case 13 • Sony Corporation

Table A2 Sony’s segment-wise sales information (for the year ended 31 March 2002)

Electronics Sales and Operating Revenue to Customers by Product Category

Yen in millions Dollars in millions Year ended 31March Year ended 31 March

2000 2001 2002 2002

Audio ¥733 431 ¥756 393 ¥747 469 $5 620 16.7% 15.1% 15.6%

Video 665 429 791 465 806 401 6.063 15.1% 15.8% 16.8%

Televisions 636 213 703 698 747 877 5 623 14.5% 14.1% 15.6%

Information and communications 1 031 661 1 322 818 1 227 685 9 231 23.5% 26.5% 25.6%

Semiconductors 164 196 237 668 182 276 1 371 3.7% 4.7% 3.8%

Components 568 387 612 520 572 465 4 304 12.9% 12.3% 12.0%

Other 597 885 574 866 508 866 3 826 13.6% 11.5% 10.6%

Total ¥4 397 202 ¥4 999 428 ¥4 793 039 $36 038

Note: The above table is a breakdown of electronics sales and operating revenue to customers by product category. The electronics business is managed as a single operating segment by Sony’s management. However, Sony believes that the information in this table is useful to investors in understanding the sales contributions of the products in the business segment. In addition, commencing with the first quarter ended 30 June 2001. Sony has partly resigned its product category configuration in the electronics business. In accordance with this change, results of the previous years have been reclassified to conform to the presentation for the year ended 31 March 2002. Sales of mobile phones are no longer recorded in the ‘Information and Communications’ category as of the third quarter of the current fiscal year. From the third quarter, sales of mobile phones manufactured by Sony Ericsson Mobile Communications are recorded in the ‘Other’ product category.

Table A3 Sony’s profit or loss by business segment (for the year ended 31 March 2002)

Profit or Loss by Business Segment

Yen in millions Dollars in millions Year ended 31 March Year ended 31 March

2000 2001 2002 2002

Operating income (loss): Electronics ¥98 573 ¥247 083 ¥(8 237) $(62) Game 76 935 (51 118) 82 915 623 Music 28 293 20 502 20 175 152 Pictures 35 920 4 315 31 266 235 Financial Services 23 309 17 432 22 134 166 Other (9 648) (9 374) (8 584) (64) Total 253 204 228 840 139 669 1 050 Elimination 10 520 13 503 16 207 122 Unallocated amounts: Corporate expenses (40 698) (16 997) (21 245) (160) Consolidated operating income 223 204 225 346 134 631 1 012 Other income 146 299 167 654 96 328 724 Other expenses (105 193) (127 132) (138 184) (1 038) Consolidated income before income taxes ¥264 310 ¥265 868 ¥92 775 $698

Case 13 • Sony Corporation C-203

Table A4 Sony’s profit or loss by geographic segment (for the year ended 31 March 2002)

Sales and Operating Revenue by Geographic Segment

Yen in millions Dollars in millions Year ended 31 March Year ended 31 March

2000 2001 2002 2002

Japan ¥2 121 249 ¥2 400 777 ¥2 248 115 $16 903 31.7% 32.8% 29.7%

United States 2 027 129 2 179 833 2 461 523 18 508 30.3% 29.8% 32.5%

Europe 1 470 447 1 473 789 1 609 111 12 098 22.0% 20.2% 21.2%

Other Areas 1 067 836 1 260 434 1 259 509 9 470 16.0% 17.2% 16.6%

Total ¥6 686 661 ¥7 314 824 ¥7 578 258 $56 979

Note: Classification of geographic segment information shows sales and operating revenue recognised by location of customers.

Notes 1 ‘The world’s 100 most valuable brands’, by BusinessWeek /

Interbrand, www.finfacts.com/brands.htm. 2 ‘The Sony Electronics corporate overview’, Sony Electronics News

& Info, http://news.sel.sony.com/corporateinfo/overview. 3 ‘Sony becoming a sleeper PC giant’, CNET News.com,

23 September 2003. 4 ‘The founding prospectus of Tokyo Tsushin Kogyo’, by Masaru

Ibuka, May 1946, www.sony.net / SonyInfo /CorporateInfo / History/prospectus.html.

5 ‘The Origin of “Sony” ’, www.sony.net/SonyInfo/CorporateInfo/ History/origin.html.

6 Sony Corporation of America, ‘Sony history – Chapter 8’, www. sony.net/Fun/SH/.

7 Ibid. 8 ‘Sony re-dreams its future’, Fortune, 25 November 2002. 9 ‘The Sony brand’, Sony Electronics News & Info, http://news.sel.sony.

com/corporateinfo/sony_brand/. 10 ‘The complete home entertainer? ’, The Economist, 27 February

2003. 11 ‘The Sony brand.’ 12 Ibid. 13 ‘The world’s 100 most valuable brands.’ 14 ‘The Sony brand.’ 15 ‘Gadget wars’, The Economist, 8 March 2001. 16 ‘Boot up the television set’, The Economist, 26 June 1997. 17 ‘In their dreams’, The Economist, 24 February 2000. 18 ‘Sony’s new day’, Newsweek, 27 January 2003. 19 Ibid. 20 ‘Multimedia is the message’, The Economist, 11 March 1999. 21 ‘Boot up the television set.’ 22 ‘Multimedia is the message.’ 23 ‘The complete home entertainer? ’ 24 ‘Sony reportedly ready to cut jobs’, MSNBC News, 20 February

2003. 25 ‘The Complete Home Entertainer? ’

26 Ibid. 27 ‘Sony re-dreams its future.’ 28 ‘In their dreams.’ 29 ‘The gamers come out to play’, The Economist, 17 May 2001. 30 ‘The complete home entertainer? ’ 31 ‘Console wars’, The Economist, 20 June 2002. 32 Ibid. 33 Ibid. 34 ‘The gamers come out to play.’ 35 ‘Sony takes pioneering direction for video console’, The Seattle

Times, 10 March 2003. 36 ‘Boot up the television set.’ 37 Ibid. 38 Ibid. 39 ‘Sony becoming a sleeper PC giant.’ 40 Ibid. 41 Ibid. 42 ‘The weakling kicks back’, The Economist, 1 July 1999. 43 Ibid. 44 Ibid. 45 ‘Sony’s push for cable series profits’, Electronic Media, 17 February

2003. 46 ‘Spiderman lifts Sony’s profits’, BBC News, 28 July 2002. 47 ‘Sony reportedly ready to cut jobs.’ 48 ‘Vision series: Kunitake Ando’, CNET News.com, 5 December

2002. 49 ‘Sony re-dreams its future.’ 50 Ibid. 51 Sony Corporation Annual Report 2002. 52 Ibid. 53 Ibid. 54 ‘The complete home entertainer? ’ 55 ‘The gamers come out to play.’ 56 Ibid. 57 ‘Sony takes pioneering direction for video console.’ 58 ‘Battle of the blues’, The Economist, 12 December 2002. 59 Sony Corporation Annual Report 2002.

C-204 Case 13 • Sony Corporation

60 ‘The complete home entertainer? ’ 61 Ibid. 62 ‘Sony re-dreams its future.’ 63 ‘Sony’s new day.’ 64 ‘Sony re-dreams its future.’ 65 ‘Vision series: Kunitake Ando.’ 66 ‘The complete home entertainer?.’ 67 ‘Gadget wars.’ 68 ‘Sony re-dreams its future.’ 69 ‘Sony’s new day.’ 70 Ibid. 71 ‘Battle of the blues’; ‘Shan’t play’, The Economist, 21 August

1997. 72 ‘Gadget wars.’ 73 ‘Sony’s new day.’ 74 Ibid.

75 ‘The complete home entertainer? ’ 76 ‘AOL, Sony, other companies form anti-piracy group’, The Detroit

News, 14 March 2003. 77 Ibid. 78 ‘Sony re-dreams its future.’ 79 Ibid. 80 ‘Sony’s new day.’ 81 ‘Sony re-dreams its future.’ 82 Ibid. 83 Ibid. 84 Sony Corporation Annual Report 2002. 85 ‘The Sony brand.’ 86 ‘Sony re-dreams its future.’ 87 ‘Vision series: Kunitake Ando.’ 88 ‘Multimedia is the message.’ 89 ‘Sony’s new day.’