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# 108137 Cust: Cengage Au: Hill Jones Pg. No. 219 Title: Strategic Management Server:

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Case 16: AB Electrolux Challenges Times in the Appliance Industry C219

125,000 5,000

4,000

3,000

In co

m e fo

r th e p

e rio

d , S

E K

2,000

1,000

100,000

75,000

N e t

sa le

s, S

E K

50,000

25,000

0 2002 2003 2004 2005 2006 2007 2008 2009

Sales (SEK) Income (SEK)

Exhibit 5 Sales & Net Income (8 year period)

Exhibit 7 Cash & Long-Term Debt to Equity

0.70

0.60

0.50

0.40

0.30

0.20

0.10

2006 2007 2008 2009 0.0

C a sh

(S E

K )

L o

n g

-T e rm

d e b

t to

e q

u it

LT Debt/Equity Cash(SEK)

Exhibit 6 Quarterly Sales

29,000

28,000

27,000

26,000

25,000

S a le

s (S

E K

m )

24,000

23,000

22,000

21,000 Q1 Q2 Q3 Q4

YTD 20102008 2009

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Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).

Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

# 108137 Cust: Cengage Au: Hill Jones Pg. No. 220 Title: Strategic Management Server:

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Section A: Business-Level StrategyC220

4.5 4.0

3.5

3.0

2.5

O p

e ra

ti n

g m

a rg

in , %

2.0

1.5

1.0

0.5

0.0 2005 2006 2007 2008 2009

120,000

100,000

80,000

60,000

40,000

20,000

0 2005 2006 2007 2008 2009

Inventories Net salesAccount receivables

240 Electrolux AB

220 200 180 160 140 120

P ri

100 80 60 40 20 0 2005 2006 2007 2008 2009 2010 2011

0 2 4 6 8 10 12 14

E a rn

in g

s & d

iv id

e n

d s p

e r sh

a re

16 18 20 22 24

Price Earnings Dividends

Exhibit 8 Operating Margin

Exhibit 9 A/R, Inventory & Sales

Exhibit 10 Electrolux 5 Year Stock Price Performance

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Case 16: AB Electrolux Challenges Times in the Appliance Industry C221

On August 4 Keith McLoughlin was appointed Chief Operations Officer Major Appliances. Keith McLoughlin was previously President and CEO of Major Appliances North America.

President and CEO Hans Stráberg

Major Appliances Europe

Enderson Guimarães

Professional Products

Alberto Zanata

Floor Care and Small Appliances

Morten Falkenberg

Major Appliances Asia/Pacific

Gunilla Noroström

Major Appliances Latin America

Ruy Hirschheimer

Major Appliances North America

Kevin Scott

Human Resources and Organizational Development

Carnia Malmgren Heander

Communications and Branding Lars Göran Johansson

Legal Affairs Cecilia Vieweg

Chief Financial Officer Jones Samuelson

Exhibit 11 Electrolux Organization Structure

Future manufacturing footprint

Why keep plants in HCC?

In 2011, Electrolux will have approximately 60% of its plants in LCC. The remaining approximately 40% will be in HCC due to reasoning described in the figure to the left.

No net-present value case 20%

Efficient, profitable plant 10%

Declining segments 10%

HCC 40%

LCC 60%

HCC

Exhibit 12 Manufacturing Footprint

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Section A: Business-Level StrategyC222

Works Cited

BusinessWeek. “Electrolux Redesigns Itself.” November 27, 2006.

China Daily. “No Cheap Labor? “China Increase Minimum Wages.” July 2, 2010. <http://www.chinadaily.com.cn/ china/2010-07/02/content_10053553.htm>.

Dale, Larry. Relative Price Elasticity of Demand for Appli- ances. Economic Analysis. Berkely: United States Department of Energy, 2008.

“ECOSAVINGS.” Welcome to Electrolux USA. Web. 26 July 2010. <http://www.electrolux.com/ecosavings/>

Electrolux Annual Report 2009. <http://ir.electrolux.com/ files/Elux_ENG_Ars09_Del1.pdf>.

Electrolux Blogspot. 18 March 2008. 15 July 2010 <http:// electrolux-inspiro.blogspot.com/>.

GE Appliances. 20 July 2010 <http://www.geappliances .com/?cid53113&omni_key5ge_appliances>.

Electrolux Company History. <http://www.electrolux.com/ history_timeline.aspx>.

Electrolux Product Overview. <http://www.electrolux.com/ node573.aspx>.

Electrolux. “Electrolux Professional Laundry Systems.” Elec- trolux Professional Laundry Systems—Home. Web. 25 July 2010. <http://www.laundrysystems.electrolux.com/ node237.aspx?lngNewsId51122>.

Goldman Sachs. “Global Economics Paper No: 170.” 7 July 2008. Web. <http://www2.goldmansachs.com/ideas/global- economic-outlook/expanding-middle.pdf>.

Google Finance Electrolux. 15 July 2010 <http://www.google .com/finance?q5eluxy>.

Google Finance GE. 10 July 2010 <http://www.google.com/ finance?q5NYSE:GE>.

Google Finance Whirlpool. 20 July 2010 <http://www.google .com/finance?q5NYSE:WHR>.

Google Patents. July 2010 <www.google.com/patents>.

Hunger, J. David. “The U.S. Major Home Appliance Industry (1996): Domestic versus Global Strategies.”

LG. 20 July 2010 <www.lg.com>. Market Research. 1 February 2010. 7 July 2010 <http://

w w w. m a r k e t r e s e a r c h . c o m / p r o d u c t / d i s p l a y. a s p ? productid52614446>.

“Microsoft Hohm.” Conserve Energy, Save Money—Micro- soft Hohm. Web. 26 July 2010. <http://www.microsoft- hohm.com/location/us/01701/default.aspx>.

Rising, Malin, “Electrolux Q2 Profits Rise, Helped by Cost Savings,” iStockAnalyst. <http://www.istockanalyst .com/article/viewiStockNews/articleid/4319345>.

Sandstrom, Gustav. “Electrolux’s Net Nearly Doubles—WSJ. com.” Business News & Financial News—The Wall Street Journal—WSJ.com. Web. 26 July 2010. <http:// online.wsj.com/article/SB10001424052748704335904 574496642329931268.html>.

Schmit, Julie. USA Today. 23 February 2010. 20 July 2010 <http://www.usatoday.com/tech/news/2010-02-23- energyrebates23_ST_N.htm>.

Times Colonist. 3 July 2010. 20 July 2010 <http://www .timescolonist.com/technology/Electrolux1make1 vacuums1from1plastic1ocean1trash/3232456/story.html>.

United States Department of Labor. “Thailand.” <http://www .dol.gov/ilab/media/reports/iclp/sweat/thailand.htm>.

United States Government American Recovery and Reinvest- ment Act. <www.recovery.gov>.

Yahoo Finance. 2010. 8 July 2010 <http://biz.yahoo.com/ p/310conameu.html>.

Yahoo Finance. 9 July 2010 <http://finance.yahoo.com/q/ co?s5WHR1Competitors>.

Yahoo Finance Electrolux. 7 July 2010 <http://www.google .com/finance?q5PINK:ELUXY>.

The Electrolux process for consumer-focused product development ensures that a product is not created until a decision has been made regarding the consumer need that it will fulfill and the consumer segment that will be targeted.

STRATEGIC MARKET PLAN

IDENTIFICATION OF CONSUMER OPPORTUNITIES

PRIMARY DEVELOPMENT

CONCEPT DEVELOPMENT

COMMERCIAL LAUNCH PREPARATION

PRODUCT DEVELOPMENT

Exhibit 13 Electrolux Product Development Process

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http://www.chinadaily.com.cn/china/2010-07/02/content_10053553.htm

http://www.electrolux.com/ecosavings/

http://ir.electrolux.com/files/Elux_ENG_Ars09_Del1.pdf

http://electrolux-inspiro.blogspot.com/

http://www.geappliances.com/?cid53113&omni_key5ge_appliances

http://www.electrolux.com/history_timeline.aspx

http://www.electrolux.com/node573.aspx

http://www.laundrysystems.electrolux.com/node237.aspx?lngNewsId51122

http://www2.goldmansachs.com/ideas/global-economic-outlook/expanding-middle.pdf

http://www.google.com/finance?q5eluxy

http://www.google.com/finance?q5NYSE:GE

http://www.google.com/finance?q5NYSE:WHR

http://www.google.com/patents

http://www.lg.com

http://www.marketresearch.com/product/display.asp?productid52614446

http://www.microsoft-hohm.com/location/us/01701/default.aspx

http://www.istockanalyst.com/article/viewiStockNews/articleid/4319345

http://online.wsj.com/article/SB10001424052748704335904574496642329931268.html

http://www.usatoday.com/tech/news/2010-02-23-�energyrebates23_ST_N.htm

http://www.timescolonist.com/technology/Electrolux1make1vacuums1from1plastic1ocean1trash/3232456/story.html

http://www.dol.gov/ilab/media/reports/iclp/sweat/thailand.htm

http://www.recovery.gov

http://biz.yahoo.com/p/310conameu.html

http://finance.yahoo.com/q/co?s5WHR1Competitors

http://www.google.com/finance?q5PINK:ELUXY

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Case 16: AB Electrolux Challenges Times in the Appliance Industry C223

Endnotes

1 Electrolux 2009 Annual Report. http://ir.electrolux.com/ files/Elux_ENG_Ars09_Del1.pdf

2 Market Research, http://www.marketresearch.com/ product/display.asp?productid52614446

3 USA Today, http://www.usatoday.com/tech/news/2010- 02-23-energyrebates23_ST_N.htm

4 Relative Price Elasticity of Demand for Appliances, Larry Dale

5 Appliances Industry Overview, http://biz.yahoo.com/ ic/310.html

6 Whirlpool Competitors, http://finance.yahoo.com/q/ co?s5WHR1Competitors

7 Appliances Industry Overview 8 Whirlpool Competitors 9 GE Appliances, http://www.geappliances.com/?cid53113&

omni_key5ge_appliances 10 Google Finance, http://www.google.com/finance?q5ge&

rls5com.microsoft:en-us&oe5UTF- 11 Whirlpool Competitors 12 LG, www.lg.com 13 “United States Government American Recovery and

Reinvestment Act.” www.recovery.gov 14 China Daily. “No Cheap Labor? “China Increase Mini-

mum Wages.” July 2, 2010. http://www.chinadaily.com. cn/china/2010-07/02/content_10053553.htm

15 Goldman Sachs, http://www2.goldmansachs.com/ideas/ global-economic-outlook/expanding-middle.pdf

16 Electrolux 2009 Annual Report 17 Electrolux 2009 Annual Report 18 Electrolux 2009 Annual Report 19 Electrolux 2009 Annual Report 20 Electrolux 2009 Annual Report

21 Electrolux 2009 Annual Report 22 Electrolux 2009 Annual Report 23 Electrolux 2009 Annual Report 24 Electrolux 2009 Annual Report 25 Electrolux 2009 Annual Report 26 Electrolux 2009 Annual Report 27 Electrolux 2009 Annual Report 28 Electrolux 2009 Annual Report 29 Electrolux 2009 Annual Report 30 Electrolux 2009 Annual Report 31 Electrolux 2009 Annual Report 32 Electrolux 2009 Annual Report 33 Electrolux 2009 Annual Report 34 Electrolux 2009 Annual Report 35 Electrolux 2009 Annual Report 36 Electrolux 2009 Annual Report 37 Electrolux 2009 Annual Report 38 Electrolux 2009 Annual Report 39 Electrolux 2009 Annual Report 40 Electrolux 2009 Annual Report 41 Electrolux 2009 Annual Report 42 Electrolux Professional Laundry Systems, http://www

. l a u n d r y s y s t e m s . e l e c t r o l u x . c o m / n o d e 2 3 7 . aspx?lngNewsId51122

43 Electrolux 2009 Annual Report 44 Electrolux 2009 Annual Report 45 Electrolux 2009 Annual Report 46 Electrolux 2009 Annual Report 47 Electrolux 2009 Annual Report 48 Electrolux 2009 Annual Report 49 Electrolux 2009 Annual Report

25843_case16_ptg01_hr_C209-C223.indd 223 1/20/12 2:07 PM

http://ir.electrolux.com/

http://www.marketresearch.com/

http://www.usatoday.com/tech/news/2010-02-23-energyrebates23_ST_N.htm

http://biz.yahoo.com/

http://finance.yahoo.com/q/

http://www.geappliances.com/?cid53113&

http://www.google.com/finance?q5ge&

http://www.lg.com

http://www.recovery.gov

http://www.chinadaily.com

http://www2.goldmansachs.com/ideas/

http://www

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CASE 17

Since the passage of the Airline Deregulation Act in 1978, eight major U.S. air carriers filed for bank- ruptcy. All were old, established carriers flying do- mestic as well as international routes. Three of the major carriers—Pan American Airways, Eastern Air- lines, and Trans World Airways (TWA)—were even- tually liquidated and their assets were sold to rival carriers. Two others—Continental Airlines and U.S. Air—filed for bankruptcy protection at least twice. And the remaining three—United, Delta, and North- west Airlines—were operating in 2005–2006 under Chapter 11 of the Bankruptcy Code. Alone among all U.S. international majors, American Airlines (AA) had never filed for bankruptcy protection.

American’s financial position was stronger than that of its competitors all through the era of deregu- lation. During the first two decades of the new era, Robert Crandall ran AA, first as President (1980– 1985), and then as CEO (1985–1998). An executive widely regarded as the industry’s most innovative strategist, Crandall introduced the frequent-flier program and the two-tier wage system, expanded American globally, formed alliances with other car- riers, and established a successful regional airline af- filiated with AA.

As Crandall retired in 1998, Donald Carty was selected CEO. An insider whose tenure was over- shadowed by the terrorist attack of September 11, 2001, Carty was a lackluster leader, and his career ended in a public scandal that led to his replacement by Gerald Arpey in April 2003. Arpey needed to act quickly. Following the unprecedented losses incurred by American as a result of the September 11 attack— a loss of over $5 billion dollars during 2001 and 2002, and an additional loss of over $1 billion in the

first quarter of 2003—American Airlines was on the brink of bankruptcy.

What should Arpey do?

Should Arpey follow the strategies undertaken by Crandall to cut operating cost, improve AA’s finan- cial position, and turn the carrier profitable? Should Arpey, rather, reject some of the policies introduced by his predecessor? Or should he, instead, introduce brand new innovative strategies applicable to the airline industry in the 21st century?

To assess Arpey’s strategic choices, this case looks back at the experience of his legendary predecessor. How precisely did Robert Crandall manage to turn American around?

The Airline Industry The airline industry dates back to the Air Mail Service of 1918–1925. Using its own planes and pilots, the Post Office Department directly operated scheduled flights to ship mail. With the passage of the Air Mail Act (Kelly Act) of 1925, the Post Office subcon- tracted air mail transport to private companies and thereby laid the foundation of a national air trans- port system. The Post Office paid contractors sub- stantial sums and encouraged them to extend their routes, buy larger planes, and expand their services.

The formative period of the private airline indus- try was the Great Depression. The five or six years following Charles Lindbergh’s 1927 flight across the Atlantic were years of mergers and acquisitions in which every major carrier came into existence, mostly through the acquisition of smaller lines. American,

American Airlines Since Deregulation: A Thirty-Year Experience, 1978–2007

This case was presented in the October 2006 Meeting of the North American Case Research Association at San Diego California. Copy- right Isaac Cohen and NACRA. I am grateful to the San Jose State University College of Business for its support.

Isaac Cohen San Jose State University

C224

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C225Case 17: American Airlines Since Deregulation: A Thirty-Year Experience, 1978–2007

by an interstate airline servicing the Chicago- Minneapolis city pair market (339 miles) were more than double those charged by an intrastate airline (Pacific Southwest Airlines) serving the Los Angeles- San Francisco market (338 miles). The experience of Southwest Airlines in Texas—like that of Pacific Southwest Airlines in California—Breyer and Ken- nedy concluded, demonstrated the efficiency of the free market and the urgent need for deregulation.4 Three years later, in 1978, Congress deregulated the airline industry.

Company Background The early history of American Airlines dates back to 1929 when dozens of small airline companies merged together to form American Airways, a subsidiary of an aircraft manufacturing /airline service conglomer- ate called the Aviation Corporation (AVCO). From the outset, American Airlines shipped mail along the Southern sub-continental route from Los Angeles to Atlanta via Dallas. With the passage of the Air Mail Act of 1934, Congress prohibited aircraft manu- facturing firms from owning airline companies and redistributed existing airmail contracts on a new, competitive bidding basis. To bid successfully on the new contracts, American Airways changed its name to American Airlines, and reorganized itself as stand alone company, independent of AVCO. Winning back its original government contracts, AA resumed its airmail operations and moved aggressively to ex- pand its nascent passenger service.5

For the next 35 years, 1934–1968, a single CEO—Cyrus Rowlett Smith—ran American Airlines. A Texan, C. R. Smith managed to improve AA per- formance in the 1930s and led the company to sus- tained growth during the following three decades. He paid particular attention to two critical aspects of airline management, namely, aircraft technology and labor relations.

Smith played a key role in the introduction of the DC-3 aircraft in 1936, a well-designed, and ef- ficient plane with two piston engines. The first com- mercially viable passenger aircraft ever produced, the DC-3 dominated the world’s airways until after WWII. Because AA operated the largest fleet of DC- 3s in the industry, it soon became the industry leader, carrying about 30% of the domestic passenger traf- fic in the late 1930s.6

United, Delta, Northwest, Continental and Eastern Airlines were all formed during this period. The in- crease in passenger transport during the 1930s led, in turn, to growing competition, price cutting, bank- ruptcies, and serious safety problems. It convinced the architects of the New Deal that the entire trans- port system—not just the air mail—required federal regulation. The outcome was the passage of the Civil Aeronautics Act (CAA) of 1938.1

The CAA had two major provisions. First, it prohibited price competition among carriers, and second, it effectively closed the industry to newcom- ers. The Civil Aeronautics Board (CAB) required that all air carriers flying certain routes charge the same fares for the same class of passengers. Similarly, the CAB required all applicants wishing to enter the in- dustry to show that they were “fit, willing and able” to do so and that their service was “required by the public convenience and necessity.” Typically, between 1950 and 1975 the board denied all 79 applications it had received from carriers asking to enter the do- mestic, scheduled airline industry.2 The number of scheduled air carriers was reduced from 16 in 1938 to just 10 in the 1970s, following mergers, consoli- dations, and route transfers among carriers.3

By the mid-1970s, the airline industry had expe- rienced serious financial troubles. Rising fuel prices, an economic recession, and the introduction of ex- pensive wide-body aircraft (Boeing 747s, Lockheed L-1011s, and McDonnell Douglas DC-10s) led to climbing costs, higher fares, reduced traffic, falling revenues, and a growing public demand for opening up the airline industry to competition. As a result, in 1975, a Senate subcommittee chaired by Edward Ken- nedy held hearings on the airlines. Working closely with Kennedy was a Harvard law professor named Stephen Breyer, who later became a U.S. Supreme Court Justice. A specialist in regulation, the author of Regulation and Reform, and the Staff Director of the Kennedy hearings, Breyer helped Kennedy build up a strong case against airline regulation.

Together, Breyer and Kennedy contrasted intra- state air service—which had never been regulated by the CAB—with interstate service—which had been regulated since 1938. The figures were astounding. Air fares charged by an interstate carrier flying the New York-Boston route (191 miles) were almost double the fares charged by an intrastate carrier (Southwest Airlines) flying the Houston-San An- tonio route (also 191 miles), and air fares charged

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C226 Section A: Business-Level Strategy

Spater to resign in 1973 and invited C.R. Smith to rejoin American as a caretaker for a short transi- tional period. Smith served just seven months until the board recruited Albert Casey, a media executive, to head the company.10

Casey’s early years at American coincided with the political debate over airline deregulation. On the one side, AA financial results during these years were impressive: Casey turned a loss of $34 million in 1975 to a record profit of $122 million in 1978, and raised AA’s cash position from $115 million in 1974 to $537 million in 1978. But on the other, Casey opposed deregulation. Casey’s management team believed that airline deregulation would pro- mote competition with low-cost carriers and shift passenger traffic away from transcontinental and semi-transcontinental routes—AA’s most profit- able ones—to short and medium haul routes. “We opposed [deregulation] all the way,” Casey recalled years later. “We had the wrong route structure. We had the wrong aircraft . . . We weren’t equipped right. [And w]e had very unfavorable union contracts.”11

Notwithstanding his opposition to deregulation, Casey expected Congress to pass the deregulation act. To prepare for the passage of the act, Casey undertook two early initiatives which later contrib- uted to AA’s eventual success under deregulation. First, he established a major hub airport at Dallas/ Fort Worth (D/FW) and moved the company’s headquarters from New York to Dallas. Second, he promoted Robert Crandall to the presidency of American Airlines.

The Crandall Era, 1980–1998 Crandall’s management style was distinctly differ- ent from that of Casey. Casey had a personable, re- laxed, and jolly manner. Crandall was famous for his charismatic, intense, and combative style. Casey was diplomatic. Crandall was forthright, temperamental, and impatient. “The [airline] business is intensely, vigorously, bitterly, savagely competitive,”12 Cran- dall once said, adding, “I want to crush all my com- petition. That is what competition is about.”13

Crandall served as AA President for five years, and as CEO for 13 years. During the early period of 1980–1985, Casey turned over to Crandall the day-to-day operation of the company, and focused his attention on American’s financial performance.14

Working together with Donald Douglas on the design and development of the DC-3, C. R. Smith lay the foundations for long lasting relations be- tween AA and the Douglas (since 1967, McDonnell Douglas) Corporation. Not until 1955 did Smith se- lect a Boeing model over a Douglas one [AA ordered its first jet—the B-707—from Boeing),7 but soon thereafter American Airlines resumed its customer relations with Douglas. The two companies con- tinued cooperating for decades. In 2005, long after C.R. Smith had retired, and nearly a decade after the Boeing Company bought the McDonnell Douglas Corporation, American Airlines’ fleet was made up of 327 MD-80 McDonnell Douglas planes, and 320 Boeing planes (the B-737, 757, 767, and 777 mod- els), a 46/45% mix which reflected AA’s traditional ties with the McDonnell Douglas Corporation.8

C. R. Smith, in addition, played a central role in shaping AA’s labor relations. AA employees, like the employees of virtually all other major airlines, had become highly unionized by the late 1940s, and sub- sequently, the company experienced growing labor troubles. Responding to two large-scale pilot strikes that shut down American airlines in 1954 and 1958, C. R. Smith proposed the establishment of a coop- erative arrangement among air carriers known as the Mutual Aid Pact (MAP). Thinking in terms of the en- tire industry, Smith saw the pact as a self- protecting measure designed to check the rising power of unions. Originally established in 1958 by American and five other carriers (United, TWA, Pan American, Eastern, and Capital), the pact authorized airlines benefiting from a strike that shut down one or more carriers to transfer their strike-generated revenues to the struck carrier(s), an arrangement which re- duced the financial losses of the struck carrier(s) and thereby increased management bargaining power across the industry. In its several different forms, the MAP survived for twenty years, providing AA and its rival carriers with a measure of protection against lengthy strikes.9

Smith’s last four years at American Airlines, 1964–67, were AA’s most profitable. In 1968, he re- tired, and was succeeded by George Spater, a corpo- rate lawyer whose tenure at American was marred by recession and scandal. Spater not only failed to improve AA’s performance during the recession of the early 1970s, but he also admitted making ille- gal corporate contributions to President Nixon’s re- election campaign. As a result, the AA board forced

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C227Case 17: American Airlines Since Deregulation: A Thirty-Year Experience, 1978–2007

Introducing the Two-Tier Wage System Dubbed “the father of the two-tier pay scale,” Crandall had little to do with the origins of the two-tier plan. The idea grew out of management’s endless discussions of the need to achieve low cost growth. Rejecting em- ployee concessions as an insufficient means to attain a low cost operation, Crandall nurtured the two-tier idea and transformed it from an abstract notion into a concrete policy—practical, consistent, and effective.18

The two-tier wage system distinguished between two types of employees: current employees paid by an A-scale and newly-hired employees paid by a B-scale. Initially, under the system established by Cran- dall at American, the two scales were not intended to merge at all; in other words, the top pay received by B-scale employees was expected to be significantly lower than the top pay received by A-scale employees. To persuade AA’s labor unions to accept the two-tier plan, Crandall offered employees job security, job ex- panding opportunities, higher wages and benefits, and profit sharing. He also threatened to shrink the carrier unless the unions accepted the two-tier deal. Believ- ing that lay-offs were eminent, American unionized employees agreed to the new wage structure, and in 1983, AA signed the industry’s first two-tier contracts with its principal unions, the Allied Pilots Association (APA, representing the pilots), the Transport Workers Union (TWU, representing the machinists and other ground workers), and the Association of Professional Flight Attendants (APFA, representing the flight atten- dants). AA’s major competitors—United, Delta, U.S. Air, and others—negotiated similar labor agreements. Consequently, the number of two-tier union contracts signed in the airline industry jumped from eight in 1983, to 35 in 1984, and then to 62 in 1985.19

AA’s two-tier wage plan resulted in a significant pay gap between old and new employees. A newly- hired B-727 captain with a five year experience earned $68 an hour or less than half the $140 paid to his/her veteran counterpart. Such a wage gap led to substantial cost savings: between 1984 and 1989 American Airlines’ labor cost fell from 37% to 34% of the carrier’s total expenses.20

Creating a Holding Company In 1982, Crandall oversaw the formation of the AMR Corporation—a holding company created “to provide [American] with access to sources of

During the later period, Crandall assumed full re- sponsibility for AA’s financial performance, be- coming one of the industry’s longest serving chief executives. As both President and CEO, Crandall developed a large body of corporate level strategies which helped American gain a competitive advan- tage over it rivals.

Developing the Hub and Spoke System The hub and spoke system was the product of airline deregulation. During the regulatory era, government rules restricted the entry of carriers into new travel markets. With the coming of deregulation, such re- strictions were removed, and airlines were free to es- tablish their own connecting hubs for the purpose of transferring passengers from incoming to outgoing flights. Utilizing the hub-and-spoke system, carriers were able to cut costs in at least two ways. First, cen- tralizing aircraft maintenance in hubs reduced the fleet’s maintenance costs, and second, increasing the carriers’ load factor and bringing it close to capacity resulted in a more efficient operation. In addition, the hub-and-spoke system resulted in greater flight frequency for passengers—a service benefit valued especially by business travelers.15

Throughout the first two years of his presidency, 1981–1982, Crandall added 17 new domestic cities to AA’s D/FW hub, and seven new international des- tinations (in Mexico as well as the Caribbean). The sheer number of daily flights AA operated in D/FW climbed from 100 to 300 in 1981 alone. Building its central hub in D/FW, American shifted passen- ger traffic away from other carriers serving Dallas’s outlaying cities, subjecting these carriers to relentless competitive pressure. Braniff International Airways is a case in point. The leading carrier serving the D/FW airport in the 1970s, Braniff filed bankruptcy and suspended operation in 1982 largely as a result of the cutthroat competition it was subject to by American Airlines in the Dallas area.16

Under Crandall’s direction, AA expanded its hub and spoke operations in the 1980s, establishing ma- jor hubs in Chicago, Miami, and San Juan, Puerto Rico, and focusing on long-haul fights, the most profitable segment of the industry. By the mid 1990s, these new hubs—together with the D/FW one— had all become major international airports serving passengers flying to destinations in Europe, South America, Central America, and the Caribbean.17

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destinations in the U.S., Canada, and the Caribbean; employing 10,000; and generating $1 billion in rev- enue, American Eagle was named “Airline of the Year” by Commuter World magazine in 1998.24

American Eagle’s growth helped improve AMR’s financial results. Originally, American Eagle operated as a regional carrier feeding passengers to American Airlines flights. But by the mid-1990s, Crandall had replaced a growing number of routes flown by AA pilots with routes flown by American Eagle pilots, a move which resulted in substantial labor cost sav- ings, given the higher pay received by American than Eagle pilots (in 1997 AA pilots earned an average yearly pay of $120,000 and Eagle pilots $35,000).25

Upgrading the Computer Reservation System (CRS) The Sabre computer reservation system was born in 1962, following a decade-long research effort carried out jointly by American Airlines engineers and IBM technicians. Initially, Sabre lagged behind comparable CRS systems used by its competitors, namely, United’s Apollo, TWA’s PARS, and Eastern Airlines’ System One. But by the mid-1970s, with the appointment of Crandall to the position of AA’s Vice President for Marketing, Sabre received a new lease of life. As marketing chief, Crandall controlled the company’s budget for technology research and development. He recruited a strong team of Sabre computer engineers, and supplied the team with ample funding. At the same time, he launched a cam- paign to build an industry-wide CRS owned jointly by the major airlines, and used by travel agents. Con- fident that its own CRS was ahead of its competitors, United declined to join the industry-wide project, and instead, decided to sell its Apollo system’s ser- vices directly to travel agents. Crandall reacted quickly. Implementing a carefully crafted back-up plan, he sent hundreds of sales people and techni- cians to travel agents all across the country, offering them a variety of Sabre services. Caught unprepared, United was unable to deliver its own computer reser- vation system’s services until months later. The result was a swift victory of American over United in the race to wire travel agents.26

Sabre provided American Airlines with several in- formation technology services. First, it calculated the yield of each American flight, setting and resetting the price of every seat sold. Second, it managed an

financing that otherwise might be unavailable.”21 AMR owned American Airlines together with sev- eral other non-airline subsidiaries, an arrangement which gave management greater flexibility in shift- ing assets among airline and non-airline subsidiaries, and in identifying new profit sources. Equally impor- tant was the protection AMR gave the airline from the swings of the business cycle: profits generated by AMR’s nonairline units were expected to mitigate the impact of the industry’s periodic downturns.

Consider the following example. During the downturn of 1990–1993, Crandall devised a “tran- sition plan” that called for shifting assets from AMR’s unprofitable airline operation to its profit- able nonairline businesses. He even suggested leav- ing the airline business altogether. As AA’s losses were mounting—and profits generated from AMR’s non-airline units were increasing—Crandall threat- ened to sell AA and keep instead AMR’s nonairline subsidiaries only.22

AMR’s principal subsidiary—apart from AA— was the Sabre computer reservation system. Owned by AMR, Sabre (Semi Automatic Business Research Environment) had become AMR’s most profitable unit during the 1990s, generating far higher returns on sales than the airline itself. In 1995, for instance, Sabre recorded total sales of $1.5 billion, or 9% of AMR revenues, and an operating profit of 19%.23

Building a Regional Airline Another subsidiary of AMR was American Eagle. American Eagle was established in 1984 as AA’s re- gional affiliate. Operating under the affiliate name, several small regional airlines were franchised by AA to supply connecting flights to American air services. From the start, American Eagle offered customers “seamless service,” that is, assigned seats, boarding passes, and frequent flyer mileage. In 1987, AMR be- gan acquiring American Eagle’s franchised carriers, and in 1990, it consolidated these carriers into six airline systems that served the D/FW, Nashville, New York City, Chicago, Raleigh/Durham and San Juan regional markets. To better coordinate planning, op- eration, schedules, training, and marketing of com- muter services, AMR sought further consolidation. Accordingly, in 1998, it merged the six regional air- lines into a single entity carrier, the America Eagle Airlines, creating the world’s largest regional air- line system. Operating 1,450 daily flights to 125

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any seat traveling any distance at any time. It could find out how early business travelers booked their flights, how far in advance coach passengers did so, and how sensitive each of these two groups was to fare price changes. With Sabre’s growing computer capabilities, American began offering a large vari- ety of discounted fares, as Don Reed, author of Bob Crandall and American Airlines, explained:

Instead of offering first-class, coach, and one level of discount fares, American began offering several layers of discounts. The bigger the savings off full- fare prices, the more restrictions the tickets had. The more modest the savings, the fewer restrictions. So fourteen-day and seven-day advance purchase dis- count fares cost more than twenty-one-day fares, but they were less restricted. Because of this sliding scale of discounts, American could juggle the per- centage of seats on any airplane allocated to one fare type or another. . . . By the late 1980s American would be able to, and often did, juggle the mix of fares right up until the moment of departure.30

Sabre’s yield management system gave American a clear competitive advantage over its rivals. On any given flight, AA was able to offer a variety of dis- counted fares using projections based on past experi- ence. Sabre’s technology permitted Crandall to match or undercut the cheaper fares offered by competitors by simply lowering American’s own discount prices for some seats and/or increase the number of seats available at the lowest price category. There was no need to reduce fares on all seats. While competitors lacking American’s technology were unable to match AA’s price flexibility, they soon introduced their own yield management systems; nevertheless, American Airlines managed to retain its leadership position in the field for decades.

Pioneering the Frequent-Flyer Program Just as Sabre promoted the development of AA’s yield management system, so did it facilitate the in- troduction of American’s AAdvantage frequent flyer program, an innovation that allowed regular passen- gers to earn free tickets on miles traveled with Amer- ican. And just as the hub-and spoke system was the outgrowth of deregulation, so was the frequent flyer program. While deregulation promoted competition, the frequent flyer program protected carriers from the competitive market forces by creating brand loy- alty among travelers.

inventory of close to one billion spare parts used by American’s fleet in its maintenance facilities. Third, it directed the routing and tracking of all baggage and freight. And fourth, it supplied American with ongoing data on aircraft fuel requirements, take off weight, and flight plan.27

More important were Sabre’s travel services. Sa- bre provided travel agents around the world with fares and schedules for flights offered by hundreds of carriers, not only American and American Eagle. In 1997, Sabre signed a comprehensive 25-year agree- ment to manage the information technology infra- structure of U.S. Air, and in addition, it renewed a five-year contract with Southwest Airlines to oper- ate the carrier’s reservation and inventory systems. Sabre and Canadian Airlines International signed a similar agreement in 1994.

Sabre’s clients, it should be noted, were not lim- ited to the airline industry. Both the London Un- derground and the French National Railway were Sabre’s customers in the 1990s, the first contracted Sabre to manage its train and crew scheduling, the second, to design its computer reservation system. Under Crandall’s leadership, furthermore, Sabre signed agreements with both Dollar Rent-a-Car and Thrifty Rent-a-Car to manage each company’s reser- vation system.28

Under Crandall’s leadership, Sabre had become the U.S. largest computer reservation system with a 40% share of all travel agent bookings in 1996. Nearly 30,000 travel agent offices in 70 countries subscribed to Sabre, and more than 2.5 million indi- vidual passengers subscribed to Travelocity, Sabre’s Internet service. In 1995, the total value of travel- related products and services reserved through Sabre was estimated at $40 billion.29

Promoting Yield Management Developing a revenue maximizing process called yield management was impossible without enhanced computer capabilities. To fill all empty seats on a given flight, American Airlines needed to obtain information pertaining to the desirable number of seats that could be sold at full versus discount fares, and the optimal mix of fares that could maximize the yield of a given flight. Obtaining such informa- tion required complex computer calculations based on the carrier’s past performance. Hence the key role played by Sabre. Sabre could track any passenger on

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into new travel markets, promoted the development of hub-and-spoke systems, and as such, prompted the leading domestic airlines—United, American, and Delta—to begin serving a growing number of international destinations.

From the outset, AA’s domestic hub system sup- ported international expansion, helping the car- rier fill empty seats on overseas flights. In the early 1980s, Crandall extended AA’s route network to Mexico and the Caribbean, but not until 1990 did he launch a massive drive at global expansion, add- ing many more overseas destinations in Europe and Latin America.

Crandall’s decision to extend AA’s international route network was informed by air-traffic projec- tions. Over the ten-year period 1990–2000, U.S. air traffic was expected to grow at a modest rate of 3%-4% a year while transatlantic air traffic, as well as traffic between the U.S. and Latin America’s destinations, was projected to increase at an annual rate of 6%-7%. To take advantage of these projec- tions, Crandall committed $11 billion, or half of AA’s investment budget, to global expansion over the five year period, 1990–1995. He also made two important acquisitions, both in 1989–1991. He first bought TWA’s Chicago-London route in 1989, and six more TWA-London routes in 1991. He next ac- quired Eastern Airline’s Latin America route system in 1990. In the Latin American market, AA used its strong Miami hub to handle traffic from 20 cit- ies in 15 South and Central American countries. In the European market, Crandall embarked on what he called a “fragmentation strategy,” namely, the break-up of the traditional route system linking one international city to another, for example, New York—London (and flying large commercial aircraft such as the 400-seat Boeing B-747), and replacing it with a route system that linked less congested cites like Chicago and Brussels or Chicago and Glasgow (and flying smaller 200-seat aircraft such as the Boeing B-767).35

Five years later, Crandall’s plan achieved its main goals. By the mid-1990s, AA had become the dominant U.S. carrier serving Latin America, and the number two U.S. carrier serving Europe, closely behind Delta. In Latin America, AA carried 58% of all U.S. airline traffic to and from the region, served 27 nations, and opened two new U.S. gateway hubs, one in New York, the other in Dallas/Fort Worth, in addition to its principal one in Miami. In the

Crandall introduced the AAdvantage program— the first in the industry—in 1981, a year after he became president. Managed by Sabre, the frequent flyer innovation was an effective marketing pro- gram which lowered the advertising costs by target- ing individuals AAdvantage card-holders reachable through mailing and/or email distribution lists. Sabre had been gathering information on passen- gers early on. As Mike Gunn, AA’s Vice President for Marketing under Crandall noted: “one reason we were able to seize the competitive edge was that we already knew who many of our best customers were and how to reach them quickly. As other air- lines struggled to match our initiative and identify their base of frequent-flyers, we were already placing AAdvantage cards and welcome letters in the hands of our best customers.”31

More than one million passengers joined AAd- vantage before the end of 1981, and another million joined the frequent flyer programs introduced by other airlines in 1981 in response to AAdvantage. Ten years later, 28 million travelers were card- carrying members of at least one frequent flyer pro- gram, and they held, on average, membership in 3.5 programs. American Airlines’ program was the industry’s largest. In 1991, American’s frequent flier program had one million members more than that of its closest competitor, United, and four million more than Delta, the nation’s third largest carrier.32

At the time Crandall left office in 1998, the frequent flyer program had become an airline in- dustry standard feature. It impacted other indus- tries as well and generated both revenues and profits for the airlines. American sold miles to a variety of companies which awarded, in turn, AA miles to loyal customers as an incentive. In 1998, over 2,500 companies awarded miles to custom- ers using the AAdvantage Incentive Miles program, most of which were retail stores and food serving establishments.33

Expanding Internationally Before the passage of the airline regulation act in 1978, American Airlines had virtually no interna- tional presence. The dominant U.S. international carriers at the time were TWA and Pan America World Airways, and neither United nor Delta Air- lines served any foreign destinations.34 The Deregu- lation Act removed government restrictions on entry

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Escalating the War with the Unions, 1990–1998 AA’s labor relations under Crandall may be divided into two, distinctly different, periods: 1980–1989 and 1990–1998. In the 1980s, relations between labor and management at American were, for the most part, cooperative and peaceful. Crandall, as discussed, managed to convince the leadership of the pilots’, flight attendants’, and machinists’ unions to negotiate and sign two-tier labor agreements which allowed management to place newly hired employ- ees on a lower, B-type wage scale.

In the 1990s, by contrast, labor relations at American were stormy and contentious. Contract negotiations were long and difficult to conclude, and labor disputes triggered strikes, strike threats, and repeated instances of federal intervention to avert strikes. As a consequence, labor disputes were costly, resulting in revenue and income losses.

One major cause of the 1990s labor troubles was the lingering dissatisfaction—expressed by AA employees—with the two-tier wage system. For any unionized job, B-scale employees were paid much lower wages than their veteran counterparts, and over the years, these lower paid employees had turned extremely resentful toward management. As Crandall hired a growing number of B-scale re- cruits in the 1980s and 1990s, the “B-scalers” had eventually become the majority of all AA’s union- ized employees.

Two labor disputes at American during the 1990s stand out. The first involved a strike staged by the Professional Association of Fight Attendants. In 1993, 21,000 fight attendants struck American airlines during Thanksgiving Day weekend, crip- pling the carrier and ruining whatever prospects management had of posting profits that year (AA ended the year with a small loss of $110 million on $15.8 billion in revenues). Union leaders pointed out that Crandall’s unwillingness to bend during negotiations precipitated the strike. Industry ana- lysts agreed, noting Crandall’s compulsion to keep labor cost-low. As the strike entered its fifth day, President Clinton intervened and pressured both sides to accept binding arbitration. The dispute was later settled, but the flight attendants remained disgruntled.38

A pilots’ strike-threat underlay the second la- bor dispute. In November 1996, the Allied Pilots

transatlantic travel market, AA’s share accounted for 23% of all airline traffic. In 1995, American derived 14%-15% of its airline revenues from the Latin America market, and 13% from the European market. As expected, both international markets were quite profitable: in 1996, AA generated an op- erating profit margin of 10% in Latin America, and 8% in Europe.36

Forming Alliances Signing code-sharing agreements with foreign car- riers was another growth strategy undertaken by Crandall. Code-sharing allowed American to as- sign its two letter code—AA—to flights operated by another carrier, thereby offering passengers flights to destinations not served by American. Enhanced by shared computer reservation systems and joint frequent-flyer programs, such agreements enabled American to increase its passenger traffic without extending its own route network, hence saving the carrier the expensive and risky cost of starting new international services.

American signed its first code-sharing agreement with Canadian Airlines International (CAI) in 1995. The agreement extended AA’s route network to doz- ens of Canadian cities served by CAI and linked CAI route system to dozens of U.S. destinations served by AA. Seeking to extend AA’s route structure to Asia, Crandall signed another code-sharing agreement with CAI in 1997. The 1997 agreement offered AA passengers trans-Pacific service on flights operated by CAI between Vancouver and Taipei. To further increase its Asia-bound traffic, American formed an alliance with China Eastern Airlines in 1998—the first code-sharing agreement between a U.S. car- rier and an airline based in the People Republic of China. Under the agreement’s provisions, American placed its code on fights operated by China Eastern from Los Angeles and San Francisco to both Shang- hai and Beijing, thereby offering passengers from destinations as distant as Latin America full service to Mainland China. Finally, in September 1998, a few months after Crandall stepped down, Ameri- can Airlines announced the formation of OneWorld Alliance, a code-sharing agreement signed by five international carriers: American Airlines, British Airways, Canadian Airlines International, Qan- tas Airway (Australia), and Cathy Pacific Airlines (Hong Kong).37

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Donald Carty and the September 11, 2001 Terrorist Attack Donald Carty served as American Airlines CEO for five years. An AA’s career executive, he was hand picked by Crandall to lead the carrier, first as Presi- dent, and then, following Crandall’s retirement in 1998, as CEO. Carty’s five year tenure was marred by labor troubles, recession, and terrorism, and ended in a public scandal: as a result of the September 11, 2001 attack, American Airlines was losing sev- eral million dollars a day, yet in Spring 2003, at the time the carrier was inching towards bankruptcy, AA’s senior executives—including Carty—received undisclosed bonuses and pension guarantees worth millions of dollars.

Carty’s labor problems began early on. In 1999, he convinced the AMR board to acquire a small

Association’s board of directors approved a tentative pilots’ contract, and presented it to the union mem- bership for ratification. Persuaded by a dissident group of grassroots union activists made largely of B-scale pilots, the membership rejected the contract by a margin of almost two to one. The union leader- ship, in turn, hardened it position, and threatened to strike the carrier. As the strike deadline approached, President Clinton intervened, invoking a rarely used provision of the 1926 Railway Act which empowered him to appoint a three-member emergency board to help settle the dispute. In the meantime American’s losses were mounting. By April 1997, AA lost at least $100 million in advanced bookings, as passengers avoided flying an airline facing impending walkout days. The contract was eventually ratified, but here again, the pilots remained embittered, and they con- tinued resenting Crandall’s heavy-handed manage- ment methods.39

Improving Financial Results, 1985–1997 AA’s financial performance under Crandall needs to be analyzed in conjunction with Crandall’s evolv- ing strategy. Serving as CEO for 13 years, Crandall shaped and reshaped his strategy, paying close atten- tion to changes in the business cycle. In the 1980s, Crandall undertook a growth strategy that resulted in a rapid expansion of American Airlines’ fleet, as well as workforce. The larger AA grew, the lower were its costs, the higher its revenues, and the larger its profits. In the early 1990s, as the air travel mar- ket slid into a protracted recession, and AA experi- enced four years of losses, Crandall embarked on a retrenchment strategy, laying off employees, ground- ing old planes, exiting unprofitable markets, and out- sourcing selected services. Following the recession of 1990–1993, the industry expanded once again, and Crandall introduced a second growth plan. His re- newed efforts at increasing revenues and improving profits were sustained by AA’s industry-leading yield management system, its formidable AAdvantage fre- quent flyer program, and its extensive global route network. Notwithstanding the labor troubles of 1996–1997, the carrier had become profitable again, posting a net income of over $1 billion in 1996, close to $1 billion in 1997, and $1.3 billion in 1998, as Exhibit 1 shows, and reducing its debt as a percent- age of capitalization from 83% in 1994 to 66% at the end of 1996.40

Revenues Net Income Income as

($Mil.) ($Mil.) % of Revenues

1985 6.131 346 5.6%

1986 6.018 279 4.6%

1987 7,198 198 2.8%

1988 8,824 477 5.4%

1989 10,480 455 4.3%

1990 11,120 (40) —

1991 12,887 (240) —

1992 14,396 (935) —

1993 15,816 (110) —

1994 16,137 228 —

1995 16,910 167 1.0%

1996 17,753 1,067 5.7%

1997 18,570 985 5.3%

1998 19,205 1,314 6.8%

Exhibit 1 Robert Crandall’s American Airlines Highlights of Financial Data, 1985–1998

Sources: “AMR Corporation,” Hoover’s Handbook of American Business, 1992, p. 110, 2002, p. 165.

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$550 million during the first half of 2001.43 Less than three months later, the 9/11 terrorist attack erupted, destroying two AA passenger jets at mid air, and shut- ting down all airline travel in the U.S. for two days.

The impact of the 9/11 attack on American’s fi- nancial performance was long lasting. As shown in Exhibit 2, AA lost $1.8 billion in 2001, and a record $3.5 billion in 2002. In April 2003, following an- other loss of a billion dollar during the first quarter of the year, American Airlines was nearly bankrupt.

To avoid filing bankruptcy under Chapter 11, Carty asked the three unions representing the ma- jority of AA employees to agree to major wage and benefit concessions. The leadership of each union accepted management’s demand for a concessional contract and put the issue before the membership for a vote. Within two weeks, AA employees ratified a collective bargaining agreement that gave the carrier back a total of $1.8 billion, or 20% of the carrier’s annual payroll.44

A day later the deal began to unravel. Follow- ing the contract ratification, union leaders, as well as members, learned from news reports that the AMR corporation awarded Cary and five other executives bonuses that equaled twice their annual salaries, and set aside a $41 million trust that was intended to protect the pensions of 45 executives in the event of bankruptcy. As it turned out, the carrier delayed fil- ing a report detailing these executive compensation plans with the Security and Exchange Commission until after the contract vote was completed.45

The belated disclosure angered the employees and prompted two of the three unions to call for another contract vote. Carty, in turn, sent a letter to

low-cost commuter airline called Reno Air. The pro- posed acquisition evoked a staunch opposition on the part of American pilots. Believing that Carty planed to replace them with low-paid Reno pilots, members of the Allied Pilots Association staged an 11 days sickout which forced American to cancel 6,700 fights, left 600,000 passengers stranded, and cost the carrier $225 million in lost earnings. Also in 1999, AA flight attendants rejected a tentative contract offer and threatened to strike the carrier. In 2001, AA’s flight attendants agreed to accept a con- tract agreement only after exhaustive negotiations that ended hours before a strike deadline.41

Notwithstanding these labor differences, Carty moved to expand the airline by merger, purchas- ing TWA—a trunk-line carrier experiencing serious financial problems. Approved in April 2001, AA’s merger with TWA created the nation’s largest air- line, adding 188 commercial airplanes to American’s fleet (TWA’s 104 McDonnell Douglas MD-80 jets fit nicely into AA’s fleet), and providing American with a central hub at St. Louis. The cost of the transaction was just $742 million—a modest sum by any indus- try standards—and more important, the merger was supported by all major unions. Backed by the union- ized employees of both carriers, Carty managed to integrate the two companies smoothly, earning the praise of industry analysts.42

Yet the TWA acquisition was untimely. The merger was approved at the time the entire airline industry was moving rapidly into a recession. Fol- lowing the merger’s approval in Spring 2001, busi- ness travel dropped precipitously, leisure travel fell too, and fuel prices were rising. As a result, AA lost

Revenues Net Income Income as Stock Prices

($Mil.) ($Mil.) % of Revenues FY Close

1998 19,205 1,314 6.8% $26.54

1999 17,730 985 5.3% 29.95

2000 19,703 813 5.7% 39.19

2001 18,963 (1,762) — 22.30

2002 17,299 (3,511) — 6.60

Exhibit 2 Donald Carty’s American Airlines Highlights of Financial Data, 1998–2002

Source: “AMR Corporation,” Hoover’s Handbook of American Business, 2005, p. 88.

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for Mr. Arpey . . . I can honestly [say] there’s not a person I have more respect for or trust in.”49

Arpey’s turnaround plan was based on several elements. First, Arpey believed that in order to com- pete successfully in the post 9/11 world, American Airlines needed to shift its strategic focus from rev- enue growth to cost reduction. To achieve this goal, he introduced a cooperative labor management scheme, a continuous improvement program, and other labor cost cutting-measures. Second, Arpey realized that American could take advantage of its global positioning to expand profitable interna- tional operation and curtail unprofitable domestic services. To achieve this goal, he sought to form closer alliances with foreign carriers. Altogether, Arpey embarked on four distinct strategies in his ef- forts to turn American around:

International Expansion. Referring to his plan to expand AA’s international operation, Arpey explained:

One of the things that we can capitalize on is the depth and breath of our network. Its one of the ways that we can compete more effectively with low-cost carri- ers that operate primarily in the domestic market . . . We have very aggressive plans internationally . . . Our strengths include a very broad network that spans the globe. . . the [industry’s] largest frequent- flyer program, Admiral airport clubs, and a great first-class product. . . [W]e get more revenue per pas- senger than the low cost carrier[s and] . . . we can sustain a revenue premium.50

Arpey expected AA’s international service to grow from over 30% of capacity in 2005 to 40% by the end of the decade. He planned to expand, above all, trans-Pacific travel service. In 2005, American in- troduced two nonstop services to Japan, operating flights between Chicago and Nagoya, and between Dallas and Osaka. Similarly, in 2005, AA started a nonstop service to India, flying the 7,500-mile route between Chicago and New Delhi, American’s lon- gest, in 14–15 hours. American also competed ag- gressively over the contested rights to serve China, planning to introduce a Chicago-Shanghai nonstop service as early as approval by the Chinese govern- ment was granted. Additionally, AA formed alliances with Aloha Airlines and Mexicana Airlines, on the one side, and consolidated its code sharing agree- ment with British airways, on the other.51

Labor-Management Cooperation. To improve his relations with the unions, Arpey instituted an open

AA employees apologizing for his conduct, and an- nouncing the cancellation of the proposed bonuses: “My mistake was failing to explicitly describe these retention benefits . . . Please know that it was never my intention to mislead you.”46 The disclosure, in addition, surprised several members of the AMR board who felt misled by top management, believing that Carty had discussed the executive compensation package with the union leaderships prior to the con- tract vote. In response to the mounting public outcry over the disclosure, AMR board of directors sought Carty’s resignation. Pressured by the board, Carty promptly stepped down, and the directors moved at once to elect a new CEO.47

The Future: Gerard Arpey’s American Airlines, 2003— A few board members suggested rehiring Robert Crandall. Others rejected Crandall’s choice and sought instead a candidate that was likely to cre- ate a sense of management continuity in AA and act quickly to save the company from filing bankruptcy. Such a candidate, the majority of directors agreed, was American Airlines President Gerard Arpey. Elected by the board to replace Carty, Arpey had 24 hours to save the carrier. Crafting a revised labor management agreement that included the essential $1.8 billion cuts in wages and benefits, and offered the employees a number of additional nonmonetary gains, Arpey managed to convince the union lead- erships to approve the new labor agreement and thereby save the carrier from filing for bankruptcy protection. Passing his first test as a chief execu- tive, Arpey outlined a key management objective he would strive to accomplish throughout his tenure as AA CEO: “There is a definite need to rebuild trust [between management and labor} within the com- pany. I hear that loud and clear. . .and I commit my- self to earning everybody’s trust.”48

Gerard Arpey spent his entire career at Ameri- can Airlines, joining the company as a financial analyst in 1982. Before accepting the top job, the 46 year old Arpey sought, and received, the ap- proval of AA’s union leaders: “He said he wouldn’t take the position unless . . . he had our support, “ John Darrah, President of the Allied Pilots Associa- tion recalled, adding, “I have a great deal of respect

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In addition to the team headed by Arpey and the union presidents, Overland facilitated the formation of seven regional JLTs located in different airports and maintenance bases throughout AA network. A local JLT met once a month to review the region’s fi- nancial performance and to evaluate employee cost- saving ideas.56

Overland presence at AA enhanced employee motivation and morale. The higher level of em- ployee motivation was reflected, first and foremost, in the growing number of cost savings suggestions initiated by employees. While AA management rou- tinely ignored employee suggestions in the past [one union leader observed], Overland consultants now encouraged the adoption of such suggestions. And while Arpey’s management team was actively solicit- ing employee ideas, no employee whose ideas were adopted received any compensation; on the con- trary, helping the company was the employee’s sole motivation.57

As a result of implementing employee-identified cost-saving ideas, AA saved about $100 million in 2004.58 The overall decline in labor cost was larger. Partly as a consequence of introducing cost-saving ideas, and partly as a result of implementing the landmark concessional contract of April 2003, AA unit labor cost under Arpey declined by more than 20% in two years, as shown in Exhibit 3.

door policy. During his first two years in office, Arpey spent more time meeting union leaders than the time spent for this purpose by any other chief executive in the company’s 75 years history. “You demonstrate commitment by where you put your time,” he told a Financial Times reporter in 2005. “We are trying to make our unions our business partners.”52 Unlike Crandall and Carty, Arpey constantly highlighted the importance of getting AA employees involved in the business of airline management. Once elected CEO, he traveled widely, visited AA operations in one city after another, conducted town-hall meetings with AA employees, and solicited employee suggestions. “I try to spend as much time as I can [with the em- ployees] when I travel,” Arpey explained in a 2004 interview, “going to break rooms, talking to agents at the gate, talking to flight attendants on board [of] the airplane, riding jump seats, and . . . answering all the e-mail[s I] get.”53

Still, Arpey was unable to change AA’s climate of labor-relations single-handedly. He needed external help. To improve labor management relations at American, Arpey hired an employee- relations consultancy called the Overland Resource Group in Summer 2003. Instrumental in improving labor-relations at Boeing, Ford, and the Goodyear Corporation, the Overland group instructed AA managers to follow three fundamental principles, or maxims, in their relations with AA’s employ- ees: “Involve before Deciding,” “Discuss before Implementing,” and “Share before Announcing.” More important, the Overland group created a Joint Leadership Team (JLT) chaired by Arpey and the national presidents of AA’s three main unions (representing the pilots, flight attendants, and me- chanics and ground workers), and attended by the company CFO as well as four vice presidents, on management side, and three representatives of each union, on labor side. The team met once a month to discuss issues ranging from AA’s corporate- level strategies to union demands and grievances. The team also reviewed AA’s financial data on a quarterly basis, an arrangement that helped senior union officials understand the airline business.54 To help team members communicate, two Overland consultants attended all JLT meetings, acting as the dialogue facilitators. To ensure an honest, open, and free-flowing discussion with no fear of repri- sal, each JLT participant signed a non disclosure agreement.55

Network 4Q-02 CASM

4Q-04 CASM

American 3.93 3.12

Continental 3.10 30.2

Delta 4.01 3.67

Northwest 3.98 3.82

United 4.51 3.25

U.S. Airways 4.15 3.11

Network 4.01 3.34

Exhibit 3 Labor Cost of U.S. Network Carriers, 4th Quarter 2002 and 4th Quarter 2004, Cents Per Available Seat-Mile (CASM)

Sources: Eclat Consulting, Aviation Daily, May 4, 2004, p. 7, and May 26, 2005, p. 7

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assembly. Together, the two teams helped AA cut an engine’s overhaul turnaround time from 53 days in 2003 to 40 days in 2004, an improvement of 25% in a single year.62

Continuous Improvement teams helped AA cut costs in still other ways. To service American Airlines fleet, company mechanics used thousands of drill bits monthly at a cost of $20 to $200 a piece. Two AA mechanics invented a drill bit-sharpening tool which refurbished bits for reuse at a cost saving of $300,000–400,000 a year. And in 2004, a CI team came up with the idea of reusing parts of obsolete DC-10 coffee makers on other AA airplanes, gener- ating a one-time savings of $675,000.63

Taken together, all these improvements helped AA reduce its maintenance cost by 34% in two years (2002–2004). A comparison between American’s main- tenance cost reduction and that of five other U.S.-based network carriers shows that AA led the way, exceeding the industry average by 13 percentage points, and well ahead of any of its competitors (Exhibit 4).

Other Cost Cutting Measures. “Simplification and standardization drives efficiency,”64 Arpey said in 2004, and he moved quickly to both simplify and standardize AA’s fleet of aircraft. To simplify the fleet, Arpey reduced the number of aircraft types flown by American from 14 to 6, retiring many old mod- els. The move reduced American spending on spare parts as well as crew training, especially pilots and

Continuous improvement The Continuous Improvement (CI) program was implemented across all AA’s maintenance facilities. During 2001–2004, United Airlines, Northwest Airlines, and U.S. Airways closed several of their maintenance bases, and sought instead to outsource heavy maintenance to outside contractors.59 Ameri- can Airlines, by contrast, kept maintenance work in house, and launch a massive drive at efficiency, seek- ing productivity gains in the shop floor.

The Continuous Improvement program had three main goals: the elimination of waste in any form, the standardization of maintenance work, and the op- timal utilization of “human talent.” The idea—and practice—of CI was based on the assumption that workers, not managers, were the real experts, and that employee empowerment was critical for build- ing effective work teams. The CI program addressed a variety of issues ranging from shop floor reorga- nization to engine-overhaul turnover time reduc- tion. To achieve these objectives, a “5S” technique (“sort, strengthen, standardize, shine, sustain”) was introduced throughout AA’s maintenance facilities. At American’s largest maintenance base in Tulsa, Oklahoma, for example, Continuous Improvement teams in the avionic shop used the 5S technique to free nearly 12,000 sq. ft. of floor space and thereby save the company $1.5 million in inventory cost.60

Employee-identified CI ideas included new ways to reduce the cost of replacing aircraft parts and com- ponents. On the McDonnell Douglas MD-80 model, for instance, the cargo door torque (spring) tube needed to be replaced once a year. To do so, the com- pany bought new tubes at a cost of $660 per tube. The CI team investigated the issue and ascertained that repairing broken tubes at a cost of only $134 per unit saved the company a total of $250,000 a year. On the Boeing 737, similarly, AA economized by replacing passenger light bulbs and cabin windows only when needed. In the past, AA replaced all light bulbs and cabin windows at the same time regardless of whether the bulbs were burned out or the windows worn out. The selective replacement of light bulbs and cabin windows saved AA $100,000 per year.61

American used CI teams to reduce engine over- haul times as well. One team of engine mechanics drafted a series of diagrams showing the most ef- ficient way to disassemble a jet engine. Another de- vised a “point-of-use tool box” which contained all the tools necessary for an engine’s assembly and dis-

Network 4Q02 CASM

4Q04 CASM

% CASM

American 1.65 1.09 34%

Continental 0.96 0.93 3%

Delta 0.98 0.92 6%

Northwest 1.43 1.08 24%

United 1.41 1.24 12%

U.S. Airways 1.67 1.30 22%

Network 1.36 1.08 21%

Exhibit 4 Maintenance Cost of U.S. Network Carriers, 4th Quarter 2002 and 4th Quarter 2004, Cents Per Available Swat Mile (CASM)

Source: Eclat Consulting, Aviation Daily, May 4, 2004, p.7, and May 26, 2005, p.7

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any other network carriers save Continental. Ameri- can’s stock prices too performed well. Following a sharp drop in AMR stock price during the post 9/11 years, AMR’s stock more than doubled in value in 2005, rising 101% and outperforming the share prices of all major U.S. carriers, including Southwest Airlines. AA’s cash position, furthermore, was stron- ger than that of other network carriers. AA managed to increase its cash surplus from $3 billion in 2004 to $4.3 billion in 2005, a margin sufficiently com- fortable to give the carrier a greater staying power in the industry than its rivals.68

Nevertheless, American Airlines still faced a number of daunting challenges. First and most im- portant was the need to achieve profitability. During Arpey’s first three years in office, AMR continued to post large losses that amounted to $1.2 billion in 2003, $0.8 billion in 2004, and $0.9 billion in 2005. While analysts were impressed by AA’s cost-cutting measures (as well as its collaborative labor manage- ment relations, strong cash position, rising fares, and trimmed capacity), and while AA stock doubled in value in 2005 in anticipation of profits in 2006, the continual increase in fuel costs during 2006 clouded AA’s recovery prospects.69

Another concern pertained to labor relations. AA employees resented a stock-related bonus paid to American managers in 2006. The payout was au- thorized by an 18 year old “Long Term Incentive Program” which tied executive pay to AA’s stock

mechanics training. In addition, Arpey standardized aircraft seating, arranging all seats on a given air- craft type in a single configuration, as the two fol- lowing examples suggest. Under Carty’s leadership, the MD-80 fleet had two seating configurations, one designed to serve AA’s business routes, the other to serve AA’s low fare routes. Under Carty likewise, the B-777 had two seating configurations, one aimed at flights over the Pacific, the other at flights over the Atlantic. In an effort to simplify both aircraft main- tenance and flight schedules, Arpey standardized all seating on the MD-80 and B-777 models in a single arrangement, a reconfiguration that resulted in sub- stantial cost savings.65

Arpey reversed two other Carty’s initiatives, first, the creation of more legroom for passengers, and sec- ond, the transformation of TWA’s St. Louis hub into a major AA hub. In 2000, Carty launched the “More Room in Coach” marketing campaign in an attempt to increase revenues. AA, accordingly, removed more than 7,000 economy seats from its fleet, reducing the fleet’s seating capacity by 6.4%. Carty’s initiative, however, failed to generate the expected revenues, and therefore Arpey decided to undo it. In 2004, AA added two rows of seats to its fleet of 140 B-757s and 34 A-300s, and used both models to serve low-fare leisure markets. In 2005, AA added six more seats to its B-737 fleet, seven more to its fleet of MD-80s and B-767s, and nine more seats to its fleet of B-777s. The change in seating capacity was projected to generate a revenue increase of over $100 million a year.66

Lastly, Arpey announced early on his decision to scale back significantly AA’s St. Louis operation. Ex- pecting TWA’s central hub in St. Louis to fit nicely into American route system, Carty, as noted, pur- chased TWA in 2001. Arpey, however, did not share Carty’s vision. To improve AA’s financial perfor- mance, Arpey shifted flights from routes out of the St. Louis hub to more profitable routes out of AA’s Chicago and Dallas hubs. As a result, AA laid off more than 2,000 employees at the St. Louis airport in 2003 alone.67

Future Prospects and Concerns One result of the successful implementation of Arpey’s turnaround strategy was the deep decline in AA’s operating costs. As shown in Exhibit 5, by 2005, American operating costs were lower than those of

Exhibit 5 Operating Cost of U.S. Network Carriers, 1st Quarter 2005, Cents in Available Seat Mile (CASM)

Source: Back-Aviation Solutions in Micheline Maynard and Jeremy Peters, “Circling a Decision,” New York Times, August 18, 2005.

Network 1Q05 CASM

American 9.9

Continental 9.9

United 10.4

U.S. Air 10.7

Northwest 11.2

Delta 12.2

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Northwest, American’s commitment to protecting its employees’ pensions was embedded in a collective bargaining agreement: a key union demand incor- porated into the 2003 labor agreement that saved AA from bankruptcy was the preservation of the car- rier’s pension plan intact. In 2006, Delta, Northwest, United, and other network carriers were all engaged in a process of converting their pension plans from defined benefit plans (plans that paid employees life- time retirement pensions funded by the employer) to the less expensive defined contribution plans (plans that operated like retirement saving accounts funded by both the employee and the employer). American Airlines, accordingly, experienced a growing com- petitive pressure to convert its pension plans too, but such a move was likely to jeopardize the long- standing industrial peace at American which Arpey had worked so hard to craft and preserve.71

performance. Because AA’s stock prices outperformed the stock prices of its five competitors (United, Delta, Continental, U.S. Air, Northwest) in 2005, American’s top 1,000 mangers were eligible to share $80 million in cash. The payout, however, was viewed by Ameri- can’s unionized employees as extra compensation for managers not shared by other AA employees. A letter sent by top management to members of the Allied Pilots Association congratulating the pilots on saving $80 million in fuel cost in 2005—an amount equiva- lent to management’s bonus—angered the pilots fur- ther, and threatened to undermine the cooperative labor relations at American.70

A final concern stemmed from AA’s pension cri- sis. In 2005, American’s pension plans were under- funded by about $2.7 billion. To be sure, AA’s funding deficit was smaller than that of Delta ($5.3 billion) and Northwest ($3.8 billion), yet unlike Delta and

Endnotes

1 Henry Ladd Smith, Airways: the History of Commer- cial Aviation in the United States (1942, reprinted, New York: Russell and Russell, 1964).

2 Stephen Breyer, Regulation and Its Reform (Cambridge Mass.: Harvard University Press, 1982), p. 205.

3 Thomas K. McCraw, Prophets of Regulations (Cambridge Mass.: Harvard University Press, 1984), p. 3.

4 McCraw, Prophets of Regulations. pp. 266–67; Breyer, Regulation and Its Reform, pp. 204–5.

5 Smith, Airways, Chapters 12, 16, 22. 6 “AMR Corporation,” Hoover’s Handbook of American

Business 1992 (Austin: Hoovers Business Press, 1992), p. 110, “AMR Corporation,” International Directory of Company Histories (Detroit: St. James Press, 1999). p. 23.

7 Robert Serling, Eagle: The Story of American Airlines (New York: At. Martin, 1985), p. 280.

8 “Carrier Profile,” Aviation Daily, April 5, 2005. 9 Mark Kahn, “Airlines,” in Gerald Somers, ed., Collec-

tive Bargaining: Contemporary American Experience (Bloomingdale, Illinois: Industrial Relations Research Association Series, 1980), pp. 354–58; Serling, Eagle, pp. 270–73, 304–306.

10 Dan Reed, The American Eagle: The Ascent of Bob Crandall and American Airlines (New York: St. Martin, 1993), Chapter 2.

11 Dan Reed, American Eagle, pp. 100–2. The quotation is on page 101.

12 Cited in Stewart Toy and Seth Payne, “The Airline Mess,” Business Week, July 6, 1992, p. 50.

13 Cited in, “American Airlines Loses its Pilot,” Economist, April 18, 1998, p. 58.

14 Reed, American Eagle, p. 207.

15 Steven Morrison and Clifford Winston, The Evolution of the Airline Industry (Washington D.C.: The Brooking Institution, 1995), pp. 44–45.

16 Reed, American Eagle, pp. 158–164, 174–175. 17 AA, in addition, established secondary hubs in Nash-

ville, Tennessee, Raleigh/Durham, North Carolina, and San Jose, California, but following the recession of the early 1990s, American closed these three hubs, with- drawing from unprofitable short-hall travel markets. See Suzanne Loeffelholz, “Competitive Anger,” Finan- cial World, January 10, 1989, p. 31; and Perry Flint and Danna Henderson, “American at Bay,” Air Trans- port World, March 1997. Online. ABI database, Start Page 28.

18 Dan Reed, American Eagle, pp. 204–205. 19 Seth Rosen, “A Union Perspective,” in Jean McKelvey,

Ed. Cleared for Takeoff: Airline Labor Relations Since Deregulation (Ithaca, New York: ILR Press, 1988), p. 22; Robert Crandall, “The Airlines: On Track or Off Course,” in McKelvey, Ed. Clear for Takeoff, p. 352; Dan Reed, American Eagle, p. 202–204.

20 Financial World, January 10. 1989, pp. 29–30. 21 According to the company’s annual report cited in

“AMR Corporation,” International Directory of Com- pany Histories, p. 24.

22 Don Bedwell, Silverbird: The American Airlines Story (Sandpoint Idaho; Airway International Inc. 1999), pp. 137, 244.

23 Perry Flint, “Sabre Unlimited,” Air Transport World, November 1996, p. 95.

24 Bedwell, Silverbird, p. 132, and Chapter 20. 25 Ronald Lieber, “Bob Crandall’s BOO-BOOS,” Fortune,

April 28, 1997, p. 368; Don Lee and Jennifer Oldham,

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48 Cited in the Wall Street Journal, April 28, 2003; but see also New York Times, April 27, 2003.

49 Cited in Eve Tahmincioglu, “Back from the Brink,” Work- force Management, Dec. 2004. Online. ABI Data Base. Start page 32. See also Sara Goo, “Key Union Accepts Cuts at American,” Washington Post, April 26, 2003.

50 Cited in Melanie Trottman, “Boss Talk,” Wall Street Journal, Dec. 30, 2004.

51 David Field, “The American Way,” Airline Business, Dec. 2004, p. 31; “American Enters India,” Aviation Daily, July 13, 2005.

52 Cited in Caroline Daniel, “A Top Flight Employee Strat- egy,” Financial Times, April 4, 2005.

53 Cited in the Wall Street Journal, Dec. 30, 2004. 54 Financial Times, April 4, 2005; Workforce Management,

Dec. 2004, Start page 32. 55 Workforce Management, Dec. 2004, Start page 32. 56 Financial Times, April 4, 2005. 57 Workforce Management, Dec. 2004, Start page 32. 58 Workforce Management, Dec. 2004, Start page 32. 59 Perry Flint, “Rewired for Success: American Embraces

Continuous Improvement,” Air Transport World, August 2004, 39.

60 Air Transport World, August 2004, 39. 61 Air Transport World, August 2004, 39. 62 Air Transport World, August 2004, 39. 63 Workforce Management, Dec. 2004, Start page 32. 64 Cited in Airline Business, Dec. 2004, p. 31. 65 Wall Street Journal, Dec. 30, 2004; Michael Maynard,

“No Longer on the Brink, American Air is Still in Peril,” New York Times, March 18, 2004; Scott McCartney, “Low Cost Rivals Prompt American Airlines to Try Flying Like One of Them,” Wall Street Journal, June 8, 2004; Airline Business, Dec. 2004, p. 31.

66 Airline Business, Dec. 2004, p. 33; Edward Wong, “American Air is Adding Seats,” New York Times, May 22, 2003; “American Looks to Counteract $1.4 Billion Fuel Cost Increase,” Aviation Daily, March 13, 2005.

67 Wall Street Journal, June 8, 2004; Edward Wong, “In a Sign of Stronger Finances, American Reports a Profit,” New York Times, Oct. 23, 2003.

68 Melanie Trottman, “AMR Investors Bet on Clearer Skies Ahead,” Wall Street Journal, Feb. 16, 2006; Caroline Daniel, “In Hard Times, Saving Dollars Makes Sense,” Financial Times, March 15, 2005.

69 “AMR Company Records, Financials,” Hoovers. Online. ABI Data Base. Wall Street Journal, Feb. 16, 2006.

70 Scott McCartney, “Airline Discord May Hurt Travelers,” Wall Street Journal, Feb. 7, 2006.

71 Brad Foss, American Path Less Traveled,” Seattle Times, June 11, 2005.

“American Woos Wary Travelers,” Los Angeles Times, Feb. 16, 1997.

26 Reed, American Eagle, Chapter 5; Bedwell, Silverbird, pp. 130–131, 250–251.

27 Kenneth Labich, “The Computer Network that Keeps American Flying,” Fortune, September 24, 1990, p. 46.

28 Bedwell, Silverbird, p. 248. 29 Air Transport World, November 1996, p. 95. 30 Reed, American Eagle, p. 184. 31 Cited in Bedwell, Silverbird, p. 161. 32 Reed, American Eagle, pp. 176–177; Morrison and

Winston, The Evolution of the Airline Industry, p. 59. 33 Bedwell, Silverbird, p. 161. 34 Seth Rosen, “Corporate Restructuring,” in Peter

Cappelli, ed., Airline Labor Relations in the Global Era (Ithaca, New York: ILR press, 1995). p. 33.

35 Kenneth Labich, “American Takes on the World,” For- tune, September 24, 1990, pp. 41–42, Read, American Eagle, pp. 249, 251, 269, and “AMR Corporation,” International Directory of Company Histories, p. 24.

36 Air Transport World, March 1997. Online. ABI Data Base. Start page 28.

37 Bedwell, Silverbird, pp. 233–236; “AMR Corporation,” International Directory of Company Histories, p. 25.

38 Jeri Clausing, “Crandall’s Hard-Ball Style Legendary,” Seattle Times, November 25, 1993; James Peltz, “A ‘Mel- lower AMR Chief?” Los Angeles Times, Feb. 14, 1997.

39 Fortune, April 28, 1997, p. 368; Los Angeles Times, Feb. 14, 1997; Scott McCartney, “The Deal Breakers,” Wall Street Journal, Feb. 11, 1997; “American Airlines Loses its Pilot,” Economist April 18, 1998, p. 58.

40 Air Transport World, March 1997, Start page 28. 41 Peter Elkind, “Flying for Fun & Profits,” Fortune, Oct. 25,

1999, pp. 36–37; James Peltz, “Carty Has Been Forced to Guide AMR Through Turbulent Times,” Los Angeles Times, Nov. 14, 2001; John Helyar, “American Airlines: A Wing and a Prayer,” Fortune, Dec. 10, 2001, p. 182.

42 Los Angeles Times, Nov. 14, 2001; “American, TWA Deal Approved,” Aviation Daily, April 10, 2001; and U.S. Senate. TWA/American Airlines Workforce Integration. Hearing before the Committee on Health, Education, and Pensions. 108thCong., 1st Sess., June 12, 2003, p. 24.

43 Los Angeles Times, Nov. 14, 2001. 44 Scott McCarthney, “At American, 48 Hours of Drama

Help Airline Avert Bankruptcy, Wall Street Journal, April 28, 2003.

45 Brad Foss, “How It All Went Wrong,” Chicago Sun Times, April 27, 2003.

46 Cited in Chicago Sun Times, April 27, 2003. 47 Wall Street Journal, April 28, 2003; and Edward Wong

and Micheline Maynard, “A Taut, Last-minute Stretch to Save an Airline,” New York Times, April 27, 2003.

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CASE 18

In July 2007, Jim Keyes, former CEO of the 7-Eleven retail chain replaced John Antioco as CEO of Block- buster Inc. announcing that, “Blockbuster has a world-class brand and is a highly regarded leader in the home entertainment industry. I look forward to the opportunity to work with the Blockbuster team to better serve our customers and to position Block- buster for profitable growth and an even stronger future.” Yet Blockbuster’s stock continued to fall— dropping 90% in 2009 alone—and it was forced to declare bankruptcy in September 2010. Why did Blockbuster’s business model fail? What caused one of the most well-known media rental companies to fail in its battle to deliver media to customers in the 2000s? To answer this question, we need to look at the forces that propelled Blockbuster into becom- ing the number one distributor of movies and other entertainment media, and then how forces such as increasing competition and changing technology led to its decline and fall.

Blockbuster’s History David Cook, the founder of Blockbuster, took the skills he had developed in providing consulting and computer services to the petroleum and real estate industries and used them to entered the video-rental business based on a concept of an IT-enabled “video superstore.” He opened his first superstore, called “Blockbuster Video,” in Dallas in 1985.

Cook’s idea for a video superstore resulted from his analysis of the changing forces in the video rental industry that were occurring during the 1980s. For example, the number of households that owned

VCRs was rapidly increasing, and so were the num- ber of video-rental stores being established to meet their needs. In 1983, 7,000 video-rental stores were in operation, by 1985 there were 19,000, and by 1986 there were over 25,000, of which 13,000 were individually owned. These “mom-and-pop” video stores offered a highly limited selection of videos and were often located in out-of-the-way strip shop- ping centers where rents were low. These small stores used little IT; usually customers brought an empty box to the video-store clerk who would exchange it for a tape if it was available—a procedure that was time-consuming, particularly at peak times such as evenings and weekends.

Cook realized that as VCRs had become more widespread, and the number of film titles available steadily increased, customers would begin to de- mand a larger and more varied selection of titles from video stores. Moreover, they would demand more convenient locations and quicker in-store ser- vice than mom-and-pop stores could offer. He re- alized that the time was right to develop the next generation of video-rental stores using advanced IT to speed customer transactions.

The Video Superstore Concept Cook’s business model for his new video super- stores was based upon several different strategies. First, Cook decided that to give his superstores a unique identity that would appeal to custom- ers, the stores should be highly visible stand-alone structures—rather than part of a shopping center. Also, superstores were to be large, between 4,000

Blockbuster, Netflix, and the Media Entertainment Rental Industry in 2011

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the companies’ stock symbols and download the latest company reports from their homepages.

Gareth R. Jones Texas A&M University

C240

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Case 18: Blockbuster, Netflix, and the Media Entertainment Rental Industry in 2011 C241

By 1986, Blockbuster owned 8 stores and had fran- chised 11 more to interested investors who could see the potential of this new approach to video rental. Initially, the company opened stores in markets with a minimum population of 100,000; franchises were located in Atlanta, Chicago, Detroit, Houston, San Antonio, and Phoenix. New stores, which cost about $500,000 to $700,000 to equip, grossed an average of $70,000 to $80,000 a month. Their owners be- came millionaires within months.

Early Growth and Expansion John Melk, an executive at Waste Management Corp., who had purchased a Blockbuster franchise in Chicago, changed the history of the company when, in 1987, he contacted H. “Wayne” Huiz- inga, a former Waste Management colleague, to tell him about the enormous revenue and profit his franchise was generating. Huizinga had experience in growing small companies in fragmented indus- tries. In 1955, he quit college to manage a 3-truck trash-hauling operation; in 1962 he bought his first operation, Southern Sanitation and then merged it with other small sanitation companies such as Ace Partnership, Acme Disposal, and Atlas Refuse Ser- vice to form Waste Management in 1968. Huizinga continued to use Waste Management stock to buy more than 100 more companies that provided such services as auto-parts cleaning, dry cleaning, lawn care, and portable-toilet rentals, and used their cash flows to purchase hundreds more sanitation firms. By the time Huizinga sold his stake in Waste Management in 1984, it was a $6 billion Fortune 500 company and Huizinga’s stake made him a billionaire.

Huizinga had a low opinion of video retailers, but he agreed to visit a Blockbuster store where, in- stead of finding a dingy store renting X-rated mov- ies, he found a brightly lit family video supermarket full of customers. Huizinga and other Waste Man- agement executives saw the opportunity to make Blockbuster a national chain and agreed to purchase 33% of Blockbuster from Cook for $18.6 million in 1986. Then in 1987, CEO David Cook decided to re- sign and sell the majority of his stock to pursue other opportunities. Huizinga took over as CEO, and his goal was to make Blockbuster the industry leader in the U.S. video-rental market.

and 10,000 square feet, well- lit and brightly col- ored, hence the bright blue and yellow “Blockbuster Video” sign. Each store would need ample parking and would be located in the vicinity of a large urban population to maximize its rental-customer base.

Second, each superstore was to offer a wide variety of videos, such as adventure, children’s, in- structional, and video game titles. Believing that movie preferences differ in different locations, Cook decided to allow each store to offer a different se- lection of 7,000–13,000 film titles, organized alpha- betically in over 30 categories. New releases were stocked separately and alphabetically against the back wall of each store to make it easier for custom- ers to make their selections. Cook’s superstores also targeted the largest market segments, adults in the 18- to 49-year-old group, and children in the 6- to 12-year-old group. Cook believed that if his stores could attract children, their families probably would follow. New releases were carefully chosen based on reviews and box-office success to maximize their ap- peal to families.

Third, believing that many customers, particu- larly those with children, wanted to keep tapes for longer than a 1-day period, he created the con- cept of a longer, 3-day rental periods for $3. If the tape was available it was behind the cover box and customers would take the tape to the check- out counter where the clerk would scan the cas- sette and membership card. The rental amount was computed by the IT system and due at the time of rental. Movie returns were scanned and any late or rewind fees were recorded on the ac- count and automatically charged the next time a member rented a tape. This system reduced cus- tomer checkout time and increased convenience, it also provided Blockbuster with marketing data on customer demographics. Finally, believing that customers wanted to choose a movie and quickly leave, Cook decided that his superstores would of- fer customers the convenience of long operating hours and quick service, generally from 10:00 a.m. to midnight 7 days per week.

These different strategies made Blockbuster’s business model successful and customers flocked to its new stores. Wherever Blockbuster opened, local mom-and-pop stores were usually forced to close down because they could not compete with the num- ber of titles and the quality of service that a Block- buster store could provide due to its advanced IT.

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Blockbuster’s growing buying power also helped reduce its costs, as the largest purchaser of video- tapes, it was able to negotiate large discounts from retail prices charged by movie studios. At that time, cassettes were bought for around $40 each, and then rented for 3 nights for $3. Its cash investment on “hit” videotapes was recovered in a few months, then additional revenues were all profit. Blockbuster continued to developed its IT to create a highly ef- ficient distribution system to move extra copies of movies that were declining in popularity at some stores to other stores where demand was increasing. The ability to transfer tapes to the location where they were most demanded was very important; cus- tomers wanted new tapes on the shelves when the movies were released. This is still true today as cus- tomers demand rapid access to their favorite movies and TV shows.

New-Store Expansion With Blockbuster’s functional-level competencies in place to facilitate rapid expansion, Blockbuster began to use its skills in store location, distribu- tion, and sales. At first, Blockbuster focused on large markets, preferring to enter a market with a potential capacity for 500 stores—normally a large city. Later, Blockbuster decided to enter smaller market segments, such as towns with a minimum of 20,000 people within driving dis- tance. All stores were built and operated using the superstore concept described earlier. Taking ad- vantage of its rapidly developing functional skills, Blockbuster steadily increased its number of new- store openings until, by 1993, it owned more than 2,500 video stores.

Blockbuster’s rapid growth also came from ac- quisitions, as it began to acquire many smaller, re- gional video chains to gain a significant market presence in a city or region. In 1987, for example, the 29 video stores of Movies To Go were acquired to expand Blockbuster’s presence in the Midwest. Blockbuster then used this acquisition as a starting point for opening many more stores in the region. Similarly, in 1989, it acquired 175 video stores to develop a presence in southern California. In 1991, it took over 209 Erol’s Inc. stores to obtain a strong- hold in the Mid-Atlantic states.

Blockbuster’s Explosive Growth Huizinga and his new top management team mapped out Blockbuster’s new business model and strategies to grow the company. Store location was critical, and Huizinga moved quickly to obtain the best store locations in each geographic area into which Block- buster expanded. They developed a “cluster strategy” whereby they targeted a particular geographic mar- ket, such as Dallas, Boston, or Los Angeles, and then opened up new stores one at a time until they had sat- urated the market. Thus, within a few years, the local mom-and-pop stores found themselves surrounded and unable to compete with Blockbuster, and closed down. As a result, its sales continued to soar and its cluster strategy eventually allowed Blockbuster into 133 major markets, where it reached over 75% of the U.S. population.

To further its marketing reach, it introduced “Blockbuster Kids,” a promotion aimed at attract- ing the 6- to 12-year-old age group to strengthen the company’s position as a family video store. It worked, and to further its family-oriented strategy, each store stocked 40 titles recommended for children, and a kids’ clubhouse with televisions and toys so that children could amuse themselves while their parents browsed for videos. To attract customers and build brand recognition, Blockbuster also formed alliances with companies like Domino’s Pizza, McDonald’s, and PepsiCo.

Blockbuster made great progress on the opera- tions side of the business to reduce its cost structure. Blockbuster’s IT was constantly upgraded to allow it to provide fast checkout and effective inventory management. The company designed its point-of- sale computer system to make rental and return transactions easy; this system was available only to company-owned and franchised stores. To increase the speed at which individual stores received new movie titles, and to support its stores, Blockbuster opened a new 25,000-square-foot distribution cen- ter in Dallas where up to 200,000 videotapes at a time were removed from the original containers and affixed with security devices, bar-coded and then placed into a hard plastic rental case. In 1987, the physical facilities of the distribution center were ex- panded to double capacity to 400,000 videocassettes and Blockbuster began to open more distribution fa- cilities around the country.

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Pay-per-view movies seemed like a major threat to video-rental stores because PPV allows cable cus- tomers to pay their cable company a fee to watch a scheduled movie, concert, or sporting event on their TVs. Already, the prospect that customers would be able to access a “media provider” through some kind of digital device such as a PC or TV set-top box and choose to watch movies of their choice on their televi- sions for a fee seemed an increasing threat. Also, tele- phone companies such as AT&T and Verizon were realizing the potential for offering entertainment me- dia including TV and movies through DSL networks of fiber-optic cables that were rapidly being installed throughout the country. Huizinga claimed Block- buster was not overly concerned about the growth of digital methods of purchasing entertainment media because U.S. households had limited access to such services, and they were expensive. He was right be- cause these kinds of digital networks did not take off in popularity until the late-1990s. But today, en- tertainment media are being increasingly routed to customers through either fiber-optic cables, phone lines, or satellite dishes, and these services bypass lo- cal video-rental stores. This has been a major factor in the decline of Blockbuster as discussed below.

Huizinga Sells Blockbuster to Viacom Although Blockbuster, with its rapid growth and large positive cash flow, seemed poised to become an entertainment powerhouse, Huizinga knew there were real problems ahead. The rapid advances in digital technology, including faster broadband Inter- net access, meant that video-on-demand (VOD) was increasingly likely to become the way of the future. Some analysts were already suggesting that Block- buster was a “dinosaur.” Also, even within the video- rental business, new store chains such as Hollywood Video had begun to expand rapidly, not recognizing the threat from digital channels. Blockbuster faced increased competition even in its existing business.

Huizinga decided that the time was ripe to sell Blockbuster; his chaining and franchising strategies had made it the industry leader with a huge cash flow. His opportunity came when Sumner Redstone, chairman of Viacom, had become involved in an aggressive bidding war to buy the movie company Paramount Studios. Redstone recognized the value of Blockbuster’s huge cash flow in helping to fund

Licensing and Franchising Recognizing the need to rapidly build market share and develop a national brand name, Huizinga also increased Blockbuster’s franchising program that helped.

Blockbuster to rapidly expand. By 1992, the company had more than 1,000 franchised stores compared to its 2,000 company-owned stores. How- ever, despite its rapid growth, Blockbuster still con- trolled only about 15% of the market, and in 1993, Blockbuster announced plans for a new round of store openings and acquisitions that would give it a 25–30% market share within 2 or 3 years.

The Home-Video Industry By 1990, revenues from video rentals exceeded the revenues obtained in movie theaters—something that is still true in 2011, hence the major competition between companies like Netflix, Amazon.com, and Apple to control movie and TV show distribution channels. Video rental revenues were $11 billion in 1991, compared to movie theaters’ $4.8 billion.

Blockbuster’s rapid growth had put it in a com- manding position. By 1990, it had no national competitor and was the only company operating beyond a regional level. However, Blockbuster faced many competitors at the local and regional levels and competition in the industry was fierce because new competitors could enter the market with rela- tive ease—the only purchase necessary was video- tapes. However, unlike small video-rental companies, Blockbuster was able to negotiate discounts with tape suppliers because it bought new releases in such huge volumes.

However, an increasing problem facing Blockbuster in the 1990s was the variety of new ways in which customers could view movies and other kinds of enter- tainment because of the growth of digital technology spurred by the rapid popularity of PCs and gaming consoles. Blockbuster had always faced competition from specialized cable TV channels such as HBO, and, of course, movie theaters, but now digital technology began to give customers more ways to watch mov- ies. New technological threats included pay-per-view (PPV) or video-on-demand (VOD) systems, digital compression, and direct broadcast satellites.

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13 months, Fields resigned and Viacom’s stock fell to a 3-year low. Redstone argued that this was ab- surd because Blockbuster generated $3 billion in rev- enue and $800 in cash flow. However, the increasing threat of video-on-demand and Pay-per-view media streaming—something that only became a real threat in the 2010s—worried investors, and analysts won- der if Blockbuster could recover.

Once again, Redstone looked for a CEO who could turn Blockbuster around, and in the news was John Antioco, the head of PepsiCo’s Taco Bell restau- rant chain. In just 8 months, Antioco introduced a new menu, new pricing, and new store setup that had turned Taco Bell’s mounting losses into rising profits. Antioco seemed the perfect choice as Blockbuster’s new CEO, and after assessing the situation, he real- ized the need to focus on reorganizing Blockbuster’s value chain to simultaneously reduce costs and at- tract more customers to generate more revenues.

Blockbuster’s biggest expense was the capital invested in its videos; this was the logical place to start, and Antioco and Redstone examined the way Blockbuster obtained its movies. It was presently purchasing tapes from big studios such as MGM and Disney at the high price of $65, and this high price limited its ability to purchase enough copies of a par- ticular hit movie to satisfy customer demand when the movie was released on tape. The result was that customers were left unsatisfied and major revenues were lost. Perhaps there was a better way to manage the process for both the movie studios and Block- buster to raise revenues from movie tape rental? Blockbuster proposed that it should enter into a revenue sharing agreement with the movie studios whereby the studios would supply Blockbuster with tapes at cost, around $8, therefore allowing it to purchase 800% more copies of a single title. Block- buster would then split rental revenues with the stu- dios 50/50! Their analysis suggested that this would grow the market for rental tapes by 20–30% each year, and revenues would increase for both Block- buster and the movie studios.

While this deal was being negotiated in 1997, video rentals at Blockbuster dropped 4% more, and the studios that had hesitated to enter into this radically different revenue-sharing agreement came on board. The new revenue sharing agreement had amazing results, and the profitability for both par- ties increased dramatically as Blockbuster’s market share increased from less than 30% to over 40% in

the debt needed to take over Paramount. Ignoring the risks involved in taking over Blockbuster, in 1994 Viacom acquired the company for $8.4 billion in stock (further details about the logic behind the acquisition are found in the Viacom case, and Huizinga cashed in his huge stockholdings—more billions for him).

Just the next year, in 1995, a tidal wave of prob- lems hit the Blockbuster chain. First, a brutal price war hit the video-rental industry as new video chain start-ups fought to find a niche in major markets and increase their market share and revenues. Second, movie studios started to lower the price of tapes, re- alizing they could make more money by selling them directly to customers rather than letting companies like Blockbuster make the money through tape rent- als. Third, as Blockbuster’s video operations ex- panded, it had become obvious that the company did not have the materials management and distribution systems needed to manage the complex flow of prod- ucts to its stores. Overhead costs started to soar, so that together with declines in revenues, the company turned from making a profit to a loss!

Blockbuster’s Problems Grow By 2000 Blockbuster’s falling cash flow was now a threat to Viacom, which was burdened by the huge debt it in- curred to buy Paramount, and Viacom’s stock price dropped sharply. Redstone reacted by firing its top managers and searching for an experienced execu- tive to turn the Blockbuster division around. To con- trol Blockbuster’s soaring cost structure, Redstone looked for an executive with experience in low-cost merchandising, and in 1996, he pulled off a coup by hiring William Fields, who was expected to become Walmart’s next CEO. An IT and logistics expert, Fields began to make plans for a huge state-of-the- art distribution facility that would serve all of Block- buster’s U.S. stores and replace its outdated facility. He also developed a new state-of-the-art point-of- sale merchandising information system that would give Blockbuster real-time feedback on which videos were generating the most money, and when they should be transferred to stores in other regions to make the most use of Blockbuster’s stock of videos— its most important capital investment.

These moves increased costs, however, and Blockbuster’s performance continued to decline in 1997 with a drop in profit of 20%. After only

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VHS tapes to focus on the booming market for DVD rentals. By the end of 2001, the company achieved record revenues, strong cash flow, and increased profitability while it lowered its debt by more than $430 million. Since 1997, Antioco had grown Block- buster’s revenues from $3.3 billion to over $5 billion and turned free cash flow from a negative position to over $250 million for 2001. Its stock had risen as investors realized that the company now had a busi- ness model that generated cash. By 2002, it was clear the future was in DVDs, and Blockbuster announced it was switching into DVDs and phasing out its VHS tapes. DVDs swept away VHS tapes much as CDs swept away vinyl records; DVD rentals increased 115% and in the spring of 2002, Blockbuster made $66 million in net income.

Antioco searched for more ways to broaden Blockbuster’s product line to keep revenues increas- ing, and in 2002, he decided its stores should carry a full lineup of GameCube, Xbox, and PlayStation games to rent and sell video games in its stores. Renting games was attractive to customers because could try any game and decide whether they liked it before they were forced to pay the high price of buying the game. Video games seemed to be a natu- ral, complementary product line, and in May 2002, Blockbuster announced that it wanted to become the biggest rental and retail source of video games. Blockbuster’s new product line was a success, and it pushed to double its video game rentals by 2003. To help achieve this goal, in the summer of 2002, Blockbuster began to offer $19.95 monthly rental service for unlimited video game rentals. This fit well with Blockbuster’s family profile, since parents could come into a store to rent a DVD while their children picked up a video game.

A major problem for Blockbuster developed in 2002, when movie studios began to sell DVDs of their new hit movies directly to the public, pricing the DVDs low to generate sales. DVD sales took off when it turned out customers liked the idea of a home-movie library and the movie studios generated billions in DVD sales. However, this was a major blow to Blockbuster as rentals of its new hit DVDs declined, and Antioco tried to make the best of it by starting to sell DVDs in its stores, too. However, movie studios obtained such high revenues from DVD sales, that they started to reduce their wholesale DVD prices for major low-cost retailers like Walmart and Best Buy. Within a few years, the price of DVDs

the next 5 years, during which it once again became profitable—this was a major turning point for Block- buster. Nevertheless, in the short run, this change hurt Blockbuster’s performance, and in 1998, Viacom an- nounced it would record a $437 million loss charge to write down the value of its Blockbuster videotape inventory. This write down wiped out Viacom’s prof- its for 1998, and Redstone announced that a spinoff or initial public offering to make Blockbuster an in- dependent company was likely because the unit was punishing Viacom’s stock price and threatening its future profitability.

By the end of 1998, there were signs of a turn- around as the revenue sharing agreement drove revenues sharply higher, same-store video rentals increased by 13% in 1998, for example. The move to a revenue sharing agreement had allowed Block- buster’s managers to develop strategies to increase responsiveness to customers that allowed them to pursue their business model in a profitable way. With the huge increase in the supply of new tapes made possible by the revenue sharing agreement, Blockbuster was now able to offer the Blockbuster Promise to its customers, promising that their cho- sen title would be in stock or “next time, it’s free.” Also, lower prices could now be charged for older video titles to generate additional revenues without threatening profitability. It turned out that the real threat to Blockbuster in the late-1990s was not from new technologies like video-on-demand, but the lack of the right product strategies to keep customers happy—like having the products in stock that they wanted. Netflix did understand this, however, as dis- cussed below, and this difference in their business models led to the dramatic change in their fortunes in the 2010s.

Blockbuster in the 2000s Blockbuster’s new business model was apparently working, and Viacom orchestrated a successful initial public stock offering in 1999 to divest the company. It turned out that 1999 was the first of 4 consecutive years of same-store sales increases at Blockbuster. A major reason was that in 2000, Blockbuster increased the number of DVDs titles it carried because they had much higher profit mar- gins than VHS tapes—DVDs rented for a couple of dollars more. The result was dramatic as revenues soared, and in 2001, it eliminated 25% of its stock of

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the need for a bricks-and-mortar (B&M) rental store, and the potential effects of these new tech- nologies on Blockbuster’s revenues had depressed its stock price for years, despite not yet becoming a major threat.

However, Antioco was convinced that broad- band competition was the major challenge facing the company and ignored the threat from emerg- ing competitors such as Netflix and Redbox, which had developed business models focused upon gain- ing profits from the physical rental of DVDs (this is discussed in more detail below). As early as 2000, Antioco had announced that Blockbuster’s goal was to be the dominant provider of streaming movies, and for its stores to gain a leadership position in a broadband world. To do this, he needed to from agreements with entertainment content providers— the movie studios—and gain more control of the content or “entertainment software” end of the busi- ness. In 2000, Blockbuster announced an agreement with MGM to digitally stream and download recent theatrical releases, films, and television program- ming from the MGM library to Blockbuster’s Web- site for PPV consumption. It started to roll out its “Blockbuster on Demand” PPV, arguing that video rentals and PPV could exist side by side. Initial test- ing of the program started in 2001, and Blockbuster announced it would try to form similar agreements with other movie studios. It even signed a deal with TiVo, a maker of set-top digital recorders, to offer a VOD service through broadband using TiVo’s re- corders. TiVo agreed to put demonstration kiosks in over 4,000 Blockbusters stores to serve its 65 million customers. However, all these moves failed to es- tablish Blockbuster as a major player in the PPV delivery market—it had no distinctive competence in this market.

The problem was that Antioco was too early to rush into the digital download market, which was still dominated by a swarm of competing technologies, all championed by different com- panies striving to gain the leadership position in the broadband market. There were no barriers to entry and no way for a company like Blockbuster that had no digital expertise to achieve a leader- ship position. This became clear in 2005, when 5 major movie studios—Sony, Time Warner, Univer- sal, MGM, and Paramount—announced a plan to bypass powerful “middlemen” like Blockbuster

had dropped dramatically as these stores started to discount DVD prices to sell millions of copies, and Blockbuster was forced to follow suit. Blockbuster’s DVD revenues collapsed as both its DVD rentals and sales dropped sharply and its profits plunged as sales at Blockbuster stores fell by 6% in 2003.

Blockbuster had to find new ways to increase rental revenues, and quickly. To reduce customers’ incentive to buy DVDs and build their own movie libraries, Blockbuster tested a new marketing strat- egy in 2004. For a monthly fee of $24.99, it offered unlimited DVD rentals in its stores. In another major move, it also announced in 2004 that it would end the expensive late fees when customers failed to re- turn their tapes on time. This may have pleased cus- tomers, but it turned out that late fees were a major contributor to Blockbuster’s revenues and profits; it was estimated that late fees accounted for over 35% of Blockbuster’s profit! While it hoped no late fees would translate into more rentals, this did not hap- pen and instead, actually reduced revenues in 2004 and 2005 while its profits turned into losses in 2004; it lost a staggering $1.25 billion during this time. To reduce its cost structure, Blockbuster closed almost a thousand of its weakest stores and took a huge tax write-off. By 2005, Blockbuster only operated 5,000 B&M stores, but this was still very expensive now that its revenues did not cover its costs, and were rapidly falling.

Growing Competition in Rental and Retail Movie and Game Entertainment One major reason why Blockbuster’s revenues con- tinued to fall was because of increasing competition from other channels of distributing movies, and from the emergence of new competitors with newer business models.

The Growing Use of Broadband Distribution Channels Since the early-2000s, new digital PPV and VOD technologies that involve the direct download or streaming of movies and TV shows to customers over cable, satellite, DSL, or other forms of broadband connection, had been a growing threat to Blockbust- er’s business model. These new technologies bypass

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Competition from New Online and B&M Retailers: Netflix and Redbox Antioco was so fixated upon the digital download distribution channel that he discounted the fact that a combination of online and B&M, or just B&M, DVD rental stores could prove to be a profitable business model in the rapidly changing entertain- ment rental industry. Why would customers want DVDs by mail if they get them through its stores? In 2000, Antioco had been approached by Netflix CEO and cofounder Reed Hastings about forming a partnership. Reed proposed to Blockbuster that Net- flix would use their brand name online and that they run the Netflix brand in its stores, but Blockbuster did not think Netflix would survive because a mail DVD distribution channel would only be a tiny mar- ket segment. Why?

Netflix was founded in 1997, and its business model was based upon customers ordering a DVD online and receiving it through the mail. This was a more convenient way to rent movies than to go to a B&M store. At first, this model did not work because just like Blockbuster, Netflix charged a set fee for each movie rented and this didn’t prove popular. Then, Reed Hastings added a new strategy—one Blockbuster had adopted in 2004 when it offered customers unlimited in-store DVD rental for $19–95 a month. Reed Hastings changed Netflix’ business model into a subscription model that allowed customers to pay a flat monthly fee of $17 a month, and they could keep as many as three DVDs at one time. Once they send the movies back, by popping them into a postage-paid envelope and dropping them in a mailbox, customers could im- mediately receive more DVDs; Netflix did not limit the number of DVDs that could be ordered in any one month.

Netflix kept DVDs in a warehouse and mailed them out as orders came in, but like Amazon.com, Netflix soon found that it needed a sophisticated re- gional distribution system to get DVDs to customers, and back from them quickly enough for the monthly service to work—to avoid customer complaints about slow delivery. It took Netflix several years to create the B&M infrastructure necessary to man- age the huge inventory of DVDs necessary to ensure quick delivery of even the most popular recent mov- ies. However, obviously, using the Internet and mail

and HBO and offer their own PPV service directly to customers. These companies were also too early because the technology they proposed to use was quickly superseded by advanced new ways of downloading digital content.

Eventually, in the late-2000s, these companies all took a stake in and signed up with a new kind of streaming video company—Hulu. In 2011, for ex- ample, Hulu had established itself as a leading en- tertainment streaming company, and it was rumored that Apple might buy it to complement its new iCloud digital entertainment download and storage service. Apple has clearly intended to try to establish itself as the leading PPV entertainment content download service provider. However, many other companies also offered similar services. In 2006, Amazon.com launched a form of PPV service which allowed its customers to download a wide range of movie con- tent, and it has continued to develop its digital en- tertainment download business on its cloud service and launched the Amazon Kindle Fire in 2011, In 2010 Google announced it would use its advertising model to gain revenues from its popular YouTube channel to expand its media entertainment offerings and there was a rumor that both Google and Apple were interested in buying Hulu. Moreover, digital pi- racy was still a major problem as many Websites still offered illegal downloading of movie and TV shows free of charge.

Antioco’s perception that digital downloads would become a major threat proved correct. By 2007, movie studios and distributors such as Amazon.com and Apple were fighting to become the hub of choice. Antioco, however, had staked Block- buster’s future on becoming the leader in the digi- tal entertainment content world, but the company did not have the technology or the expertise to play this pivotal role any more than movie studios, new online dot.coms, cable operators, or satellite provid- ers, could. Moreover, it was clear that entertainment content providers were willing to make agreements with any company that could provide them with rev- enues by distributing their digital content when they were losing billions because of illegal downloading. Essentially, it was the wrong strategy, not the wrong technologies that caused the crisis at Blockbuster, and by 2006, its stock dropped to a low of $5 as revenues plunged and losses dramatically increased (see Table 1).

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Given that Blockbuster had 48 million mem- bers, this online DVD service seemed to be the right strategy to increase future revenues. However, in the short term, the problem for Blockbuster was that the new service required a major financial investment in order to set up the online infrastructure and national marketing campaign. This also led to its huge losses in 2004 and 2005, and its stock price fell from $20 a share to $10 share; investors became concerned it could not provide the online service in a cost- effective way. Analysts also wondered if Netflix had gained the first-mover advantage, making competi- tion difficult.

By the end of 2006, Antioco announced that af- ter a shaky start, Blockbuster had achieved its goal of 2 million subscribers to Total Access. Neverthe- less, Netflix and Blockbuster were now locked in a vicious battle for subscribers, and both companies were paying heavily for online ads on major Web- sites such as eBay and Yahoo!. Once again, Antioco argued that because customers no longer had to choose between renting online or renting in-store, they never needed to be without a movie, and this would make Blockbuster.com the fastest growing online DVD rental service in 2007. As Table 1 sug- gests he was wrong, in fact, the highest number of subscribers the total access program achieved was 3 million, and the new service was never profit- able; it simply drained away Blockbuster’s scarce resources.

to deliver DVDs to customers is a far less expensive way to rent DVDs than managing a chain of B&M video stores. Netflix also went to work to attract customers, and through massive online advertising and mailing campaigns it began to attract increasing numbers of customers and became a real threat to Blockbuster. By 2004, Netflix had over 1.4 million customers, and the success of its business model showed Antioco he had made a mistake. Blockbuster had to respond, but it was too late as the revenues and profits of the two companies between 2004 and 2010 shown in the Table 1 confirm.

In late-2004, Blockbuster announced it would launch an online DVD rental service—Blockbuster Total Access—although Antioco still argued this seg- ment would only ever reach about 3 million custom- ers. Blockbuster claimed its new program would be better than Netflix’ because customers who ordered DVDs online could then return them to Blockbust- ers stores if they chose. Antioco argued Blockbuster’s business model was the best because it was the only company able to provide a simultaneous online and bricks-and-mortar service that would give custom- ers more options and better service. For example, if Blockbuster customers returned DVDs to their local store, as part of its Total Access service they would then receive a coupon for a free in-store rental. Block- buster hoped that by getting customers into its stores, it could generate more rental, sales, and revenues from selling other kinds of products such as candy.

Year Blockbuster Revenue Blockbuster Net Income Netflix Revenue Netflix Net Income

2004 6,053 –1,250 506 22

2005 5,864 –588 682 42

2006 5,523 55 997 49

2007 5,542 –74 1,205 70

2008 5,290 –374 1,365 83

2009 5,065 –310 1,670 116

2010 4,062 –558 2,660 214

Table 1 Blockbuster Versus Netflix Revenues and Profits 2004–2010 (All data in millions of dollars)

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this acquisition—why would merging the operations of two failing retailers result in a turnaround?

Also, the increasing competition between compa- nies such as Amazon.com, Apple, and Hulu to domi- nate the digital entertainment streaming industry added to Blockbuster’s problems and those of Net- flix. Netflix, like Blockbuster, was now confronted with the need to offer a digital movie and stream- ing TV download service as DVDs, now superseded by the unpopular high-definition “Blue-ray” format, were threatening its DVD format model. One rea- son its stock price soared in 2010 was that Netflix announced its own entertainment streaming service as a part of its DVD service for as low a price as $10 month. Netflix, however, like all other entertain- ment channel providers, had to negotiate prices with the content providers—movie studios and TV chan- nels. In June 2011, Netflix announced a 60% increase in the price of its combined DVD/streaming service to pay for the costs of this content and to build the infrastructure necessary to operate digital streaming. It stock price plunged as analysts decided the jump to $16 for both plans might cost it 2–3 million cus- tomers, and they saw no reason why content pro- viders would continue to form alliances with the company—just as they had abandoned Blockbuster years before. However, CEO Reed Hastings, follow- ing the approach of Steve Jobs of Apple, had focused his efforts on developing close personal relation- ships with its content providers, and the 17 million subscribers who paid money for their content, was a major force to reckon with—especially now that Blockbuster was in Chapter 11.

As for Blockbuster, in May 2011, it was bought by the DISH satellite network for a few hundred million dollars. Analysts were unclear why DISH de- cided to purchase the chain as it would now have to fund the costs of running its B&M stores, and Blockbuster’s assets seemed to offer few ways to complement its satellite TV and movie distribution channel. However, in the 1990s, DISH and Block- buster had formed an alliance to sell DISH satellite packages in its stores and to share video-on-demand revenues, although Blockbuster never gained control of this market. By July 2011, DISH announced that it would be able to continue to operate 1,500 Block- buster stores that would serve 100 million custom- ers; it had hoped to continue to operate 3,000 stores, but their franchisees decided to liquidate. As noted

DVD Rental Kiosks A second major source of B&M competition emerged in 2004 when Redbox, a division of Coinstar, best known for its coin-money counting machines, be- gan offering video rentals for $1 a night through vending machines at fast-food restaurants, grocery stores, and other retail outlets. This was a low cost channel of distribution and a way of stealing away Blockbuster customers; overhead costs were a frac- tion of those involved in running a huge chain of B&M stores. Blockbuster responded by opening its own line of Blockbuster Express kiosks, made by NCR, the well-known maker of cash registers, and by 2010, there were 15,000 kiosks in operation com- pared to the 24,000 operated by Redbox. However, as its profitability collapsed, Blockbuster could not afford to run the kiosks, and licensed the ownership of the kiosks back to NCR, which ran them in 2011. These kiosks generated substantial revenues and in 2010, Coinstar announced that revenues from its Redbox kiosks had increased by 38%. In 2011, af- ter Blockbuster’s bankruptcy and purchase by DISH Network Corp., discussed below, DISH sued NCR, arguing that NCR had lost the right to use the Block- buster brand name. NCR put the Blockbuster kiosks up for sale, and in 2011 it seemed that either DISH or Coinstar was the most likely buyer for the kiosks.

The Future of the Rental Entertainment Industry As the figures in the table suggest, Blockbuster’s losses continued to increase and it was forced to enter Chapter 11 bankruptcy in September 2010. Block- buster had failed in its battle with Netflix, which had over 17 million subscribers by 2010, increasing prof- its, and a soaring stock price that reached more than $300 by June 2011. By 2010, it also had no cash to continue to operate its chain of 5,000 stores, or its rental kiosks and its digital broadband download strategy was history. In late-2007, it had replaced Antioco as CEO with James Keyes, who decided to focus Blockbuster’s strategy on building in-store sales. With this in mind, Keyes proposed that Block- buster should acquire Circuit City, the electronics re- tailer, which also had a failed business model, while he gave control of Blockbuster’s profitable kiosk rental operations back to NCR. Analysts laughed at

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Although designed to allow subscribers to re- duce their monthly rentals this new strategy was a disaster; Netflix would have to manage two different groups of customers and sacrifice any gains by of- fering some combination of DVD plus digital media downloads. Within weeks, Hastings announced this new strategy was dead—Netflix would continue to offer both kinds of media rental services—but its subscribers were by now totally confused and angry at the changes it had made to its services.

Netflix’s share price began to plunge in September 2011. And then when in late October 2011 it an- nounced that it had lost 800,000 U.S. subscribers, and that the costs of entering global markets in Europe and Central America would result in losses in 2012, its stock price plunged by 35% on October 25th 2011—from over $300 to $75 a share in a few months! Its new strategy had resulted in a major disaster and this opened the way for new competi- tors to enter the market and try to take away its dominant position.

As noted earlier, competitors such as Amazon .com, Apple, Hulu, and Google have also invested major capital resources to become the future leaders in digital entertainment media downloading. Also, DISH is seeking to rebuild its Blockbuster franchise. The fight continues for companies to become a ma- jor players in this very profitable industry, as digital technology continues to improve and change every company’s competitive advantage and position. As Blockbuster—and then Netflix—learned, new tech- nology is not enough to succeed. A company must develop the business model and strategies necessary to profit from changing industry opportunities to become a major player in the digital entertainment market, or to become a leader in a niche, such as Redbox in the DVD rental kiosk segment. There are many ways to make money—and lose money quickly—in the rapidly changing media entertain- ment rental industry.

earlier, it also started a legal battle over the rights to control the Blockbuster name in its DVD kiosk busi- ness with NCR. Because Blockbuster’s major B&M competitors such as Hollywood Video had also been forced into bankruptcy in the 2000s, it was the only B&M rental chain left.

In September 2011 DISH announced it would offer its subscribers a media download rental sys- tem similar to Netflix’s that would be available to its subscribers at a discount price. It also boosted Blockbusters media download rental offerings to ordinary customers in October 2011 to attract new users. Something that became possible after Netflix’s disastrous change in rental strategy that by November had wiped $10 billion off its market value—dropping the value of the company from $16 to $6 billion!

The Netflix Fiasco Riding its wave of success by the summer of 2011 Netflix’s share price had soared to over $300 as investors became convinced it would be company the industry leader in the DVD and media entertainment download industry. However, Netflix, like Blockbuster before found itself dependent on the suppliers of entertainment content and of course they wanted to charge the highest price they could for their media content. To keep their business Netf- lix had to agree to pay higher prices but the result of this was that it was forced to charge higher prices to its subscribers. In August 2011 it announced large in- creases in monthly fees that generated an enormous amount of customer protest. Even though it was still relatively inexpensive, Netflix learned the hard way that customers do not like to pay for online digital content. As the number of its subscribers plummeted Hastings announced the company would separate into two different companies—Netflix would now become the supplier of digital download media, while a new company called “Quickster” would take over as the supplier of DVD rentals.

Endnotes

www.blockbuster.com, 1990–2010. blockbuster.com, Annual and 10K Reports, 1990–2010.

www.netflix.com, 1998–2011. Netflix.com, Annual and 10K Reports, 1998–2010.

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CASE 19 How SAP’s Business Model and Strategies Made it the Global Business Software Leader—Part 1

In 1972, after the project they were working on for IBM’s German subsidiary was abandoned, 5 German IBM computer analysts left the company and founded Systems Applications and Products in Data Processing, known today as SAP. These ana- lysts had been involved in the provisional design of a software program that would allow information about cross-functional and cross-divisional financial transactions in a company’s value chain to be coor- dinated and processed centrally—resulting in enor- mous savings in time and expense. They observed that other software companies were also developing software designed to integrate across value-chain activities and subunits. Using borrowed money and equipment, the 5 analysts worked day and night to create an accounting software platform that could integrate across all the parts of an entire corpora- tion. In 1973, SAP unveiled an instantaneous ac- counting transaction processing program called R/1, one of the earliest examples of what is now called an enterprise resource planning (ERP) system.

Today, ERP is an industry term for the multimod- ule applications software that allows a company to manage the set of activities and transactions neces- sary to manage the business processes for moving a product from the input stage, along the value chain, and to the final customer. As such, ERP systems can recognize, monitor, measure, and evaluate all the transactions involved in business processes such as product planning, the purchasing of inputs from suppliers, the manufacturing process, inventory and order processing, and customer service. Essentially, a fully developed ERP system provides a company

with a standardized information technology (IT) platform that provides managers with complete in- formation about all aspects of its business processes and cost structure across all functions and divisions. This allows managers at all levels to (1) continually search for ways to perform these processes more ef- ficiently and lower its cost structure, and (2) improve and service its products and raise their value to cus- tomers. For example, ERP systems provide informa- tion that allows for the redesign of products to better match customer needs and that result in superior re- sponsiveness to customers.

To give one example, Nestlé installed SAP’s new- est ERP software across its more than 150 U.S. food divisions in the 2000s. Using its new IT platform, corporate managers discovered that each division was paying a different price for the same flavoring— vanilla. The same small set of vanilla suppliers was charging each individual division as much as they could, and different divisions paid prices that varied widely depending upon their bargaining power with the supplier. Before the SAP system was installed, corporate managers had no idea this was happen- ing because their old IT system could not compare and measure the same transaction—purchasing vanilla—across divisions. SAP’s standardized cross- company software platform revealed this problem, and hundreds of thousands of dollars in cost savings were achieved by solving this one transaction diffi- culty alone. This is why ERP systems can save large companies hundreds of millions and billions of dol- lars over time, and explains why SAP’s ERP became so popular.

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (SAP), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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fit their own internal business processes, the more difficult and expensive the implementation process would become—and the harder it would, in turn, become for companies to realize the potential gains from cost savings and value added to the product by SAP’s software.

SAP’s outsourcing consulting strategy allowed it to penetrate global markets quickly and eliminated the huge capital investment needed to employ the thousands of consultants required to provide this service on a global basis. On the other hand, for con- sulting companies, the installation of SAP’s popular software became a major money-spinner and they earned billions by learning how to install its ERP system. Consequently, SAP did not enjoy the huge revenue streams associated with providing software consulting services, such as the design, installation, and maintenance of an ERP platform on an ongo- ing basis. It earned only a small amount of revenue by training external consultants in the intricacies of how to install, customize, and maintain its ERP sys- tems within its customer base. This was a major er- ror because revenues from consulting over time are often as great as that those that can be earned from selling complex software applications. By focusing on ERP software development, SAP could forfeit high consulting profits and also become dependent upon consulting companies that were now the ex- perts in the installation/customization arena—such as Accenture and IBM.

The Changing Global Landscape This decision had unfortunate long-term con- sequences because SAP began to lose first-hand knowledge of its customers’ emerging problems and an understanding of the changing needs of its customers—something especially important as growing global competition, outsourcing, and the increasing use of the Internet to facilitate cross- company commerce had become major competi- tive factors changing the ERP industry and software applications market. For a company with a goal to provide a standardized platform across functions and divisions, this outsourcing consulting strategy seemed like a major error to many analysts. SAP’s failure to work quickly to expand its own consult- ing operations to run parallel to those of external consultants, rather than providing a training service

Focus on Large Multinationals SAP first focused its R/1 software on the largest multinational companies with revenues of at least $2.5 billion because they would reap the biggest cost savings there. Although relatively few in number, these companies, mostly large global product manu- facturers stood to gain the most benefit from ERP, and they were willing to pay SAP a premium price for its product. Its focus on this influential niche of companies helped SAP develop a global base of lead- ing companies. Its goal, as it had been from the be- ginning, was to create the global industry standard for ERP by providing the best business applications software infrastructure—and it succeeded in 2011— it still has the largest installed base of the world’s most well-known companies.

ERP and Consulting In its first years, SAP not only developed ERP soft- ware, but it also used its own internal consultants to physically install it on-site at its customers’ corpo- rate IT centers, manufacturing operations, and simi- lar locations. Determined to increase its customer base quickly, however, SAP switched strategies in the 1980s. It decided to focus primarily upon the de- velopment of its ERP software and to outsource (to external consultants), more and more of the highly complex implementation consulting services needed to install and service its software on-site in a par- ticular company. It formed a series of strategic alli- ances with major global consulting companies such as IBM, Accenture, and Cap Gemini to install its R/1 system in its growing base of global customers.

ERP installation can often be a long and compli- cated process. A company cannot simply adapt its information systems to fit SAP’s software; it must re- work the way it performs its value-chain activities so that its business processes—and the IT system that measures and evaluates these business processes— can become compatible with SAP’s software. SAP’s claim to fame was that by modeling its business processes on its ERP platform, which contains the solutions needed to achieve best industry practices across its operations, a large company could expect a substantial increase—often 10% or more in perfor- mance. However, the more a particular company’s managers wanted to customize the SAP platform to

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who understood the problems of implementing a rapidly growing company’s strategy on a global basis; the need to develop a sound corporate infra- structure was being shoved aside—something that had cost it billions of dollars in lost profits over the decades.

The Second Generation R/2 ERP Platform In 1981, SAP introduced its second-generation ERP software, R/2. Not only did it contain many more value-chain/business process software modules, but it also linked its ERP software seamlessly to the exist- ing or legacy databases and communication systems used on a company’s mainframe computers. This allowed for greater connectivity and ease of use of ERP throughout a company at all levels and across all subunits. The R/1 platform had largely been a cross-organizational accounting/financial software module; the new software modules could handle procurement, product development, and inventory and order tracking. Of course, these additional com- ponents needed to be compatible with one another so that they could be seamlessly integrated together on-site, at a customer’s operations, and with its exist- ing or legacy IT system.

SAP did not develop its own database manage- ment software package; its system was designed to be compatible with Oracle’s database manage- ment software, the global leader in this segment of the software applications industry. Once again, this would have repercussions later, when Oracle began to rapidly develop its own ERP software platform during the 2000s, essentially moving from database software into ERP and other kinds of business soft- ware applications. As part of its push to make its R/2 software the global industry standard for the next decades, SAP also developed new “middleware” software that will allow the hardware and software made by different global computer companies to work seamlessly together on any particular com- pany’s IT system. This is also an industry in which Oracle competes.

Recognizing that the way value-chain activities and business processes are performed differs from industry to industry because of differences in man- ufacturing and other business processes. SAP also spent a lot of time and money customizing its basic

to these consultants to keep them informed about its constantly changing ERP software, left the door open for IBM and Accenture to dominate the soft- ware consulting industry—and they still do today.

To some degree, SAPs decision to focus upon soft- ware development and outsource more than 80% of installation was a consequence of its German found- ers’ “engineering” mindset. Founded by computer program engineers, SAP’s culture was built upon values and norms that emphasized technical innova- tion, and the development of leading-edge ERP soft- ware algorithms and best practices. SAP’s managers poured most of its profits into research and develop- ment (R&D) to fund new projects that would in- crease its ERP platform’s capabilities; they had little desire to spend money on developing its consulting services. Essentially, SAP became a product-focused, not a customer–focused company since it believed R&D would produce the technical advances that would be the source of its competitive advantage and allow it to charge its customers a premium price for its ERP platform. By 1990, SAP spent more than 30% of gross sales on R&D.

Global Sales and Marketing Problems SAP’s top managers, who had focused on developing its technical competency, had another unfortunate consequence. They underestimated the enormous problems involved in developing and implementing its global marketing and sales competency to increase its large customer base—and to attract new kinds of customers—especially smaller companies. The need to build an efficient global structure and con- trol system to effectively manage its own operations was largely ignored because managers believed the ERP platform would sell itself! Indeed, SAP’s focus on R&D and neglect of its other functions made its sales, marketing, and internal consultants and train- ing experts feel as if they were second-class citizens— despite the fact that they brought in new business and were the people responsible maintaining good relationships with SAP’s growing customer base.

The classic problem of managing a growing busi- ness from the entrepreneurial to the professional management phase was emerging in SAP and its rev- enues and profits were slowing as a result. SAP’s top managers were not experienced business managers

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management, financial accounting, asset manage- ment, human resources management, project sys- tems, and sales and distribution. R/3 was designed to meet the diverse demands of its previous global clients. It could operate in multiple languages, con- vert exchange rates, and additional functions, on a real-time basis.

By the 1990s, however, as it now dominated the ERP market for large companies, SAP realized that for its sales to expand quickly it also needed to ad- dress the needs of small- and medium-sized businesses (SMBs). Recognizing the huge potential revenues to be earned from SMB customers, SAP’s engineers de- signed the R/3 platform so that it could be configured for smaller customers as well as customized to suit the needs of a broader range of industries in which they competed. Furthermore, SAP designed R/3 to be “open architecturally,” meaning that using its mid- dleware, the R/3 could operate with whatever kind of computer hardware or software (the legacy system) a SMB was presently using.

Finally, in response to customer concerns that SAP’s standardized system meant huge implementa- tion problems in changing their business processes to match SAP’s standardized solution, SAP introduced some limited customization opportunity into its soft- ware. Using specialized software from other compa- nies, SAP claimed that up to 20% of R/3 could now be customized to work with the company’s existing operating methods and thus would reduce the prob- lems of learning and implementing the new system. However, the costs of doing this were extremely high and became a huge generator of fees for consulting companies. SAP used a variable-fee licensing sys- tem for its R/3 system; the cost to the customer was based upon the number of users within a company, upon the number of different R/3 modules that were installed, and upon the degree to which users utilized these modules in the business planning process.

SAP’s R/3 far outperformed its competitors’ products in a technical sense and once again allowed it to charge a premium price for its new software. Be- lieving that competitors would take at least 2 years to catch up, SAP’s goal was to get its current cus- tomers to switch to its new product and then rap- idly build its customer base to penetrate the growing ERP market. In doing so, it was also seeking to es- tablish R/3 as the new ERP market standard in or- der to lock in customers before competitors could offer viable alternatives. This strategy was vital to its

ERP platform to accommodate the needs of com- panies in different kinds of industries. Increasingly, over time, ERP companies recognized that their long-term competitive advantage depended upon be- ing able to provide the ERP software solutions that must be customized by industry to perform most ef- fectively. Its push to become the ERP leader across industries, across all large global companies, and across all value-chain business processes required a huge R&D investment.

SAP Becomes a Global Leader In 1988, SAP went public on the Frankfurt stock ex- change to raise the necessary cash to fund its grow- ing global operations, and by 1990, it had become a global leader of business applications software as its market capitalization soared. SAP now dominated ERP software sales in the high-tech and electronics, engineering and construction, consumer products, chemical, and retail industries. Its product was in- creasingly being recognized as superior to the other ERP software being developed by companies such as PeopleSoft, S. D. Edwards, and Oracle. The main reason for SAP’s increasing competitive advantage was that it was the only company that could offer a potential customer a broad, standardized, state- of- the-art solution that spanned a wide variety of value- chain activities spread around the globe. By contrast, its competitors, like PeopleSoft, offered more- focused solutions aimed at one business process, such as hu- man resources management.

SAP Introduces the R/3 Solution SAP’s continuing massive investment in developing new ERP software resulted in the introduction of its R/3, or third-generation, ERP solution in 1992. Essentially, the R/3 platform expanded upon its previous solutions; it offered seamless, real-time integration for over 80% of a company’s business processes. It had also embedded in the platform hundreds, and then thousands, of industry best prac- tice solutions, or templates, that customers could use to improve their operations and processes. The R/3 system was initially composed of seven differ- ent modules corresponding to the most common business processes: production planning, materials

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SAP customers’ needs were being poorly served and the number of complaints about the cost and dif- ficulty of installing its ERP software was increasing. Since large external consulting companies made their money based upon the time it took their consultants to install a particular SAP system, many customers complained that consultants were deliberately taking too long to implement the new software to maximize their earnings and were even pushing inappropriate or unnecessary R/3 modules. For example, Chevron spent over $100 million and 2 years installing and getting its R/3 system operating effectively. In one well-publicized case, FoxMeyer Drug blamed SAP software for the supply chain problems that led to its bankruptcy and the company’s major creditors, and sued SAP alleging that the company had promised R/3 would do more than it could. SAP responded that the problem was not the software but the way the company had installed it, but SAP’s reputation was harmed nevertheless.

SAP’s policy of decentralization was also some- what paradoxical because the company’s mission was to supply software that linked functions and divisions rather than separated them, and the char- acteristic problems of too much decentralization of authority soon became evident throughout SAP. In its U.S. subsidiary, each regional SAP division started developing its own procedures for pricing SAP software, offering discounts, dealing with cus- tomer complaints, and even rewarding its employ- ees and consultants. There was a complete lack of standardization and integration inside SAP America and between SAP’s many foreign subsidiaries and their headquarters in Germany. This meant that little learning was taking place between divisions or con- sultants, there was no monitoring or coordination mechanism in place to share SAP’s own best prac- tices between its consultants and divisions, and or- ganizing by region in the U. S. was doing little to build core competences. For example, analysts were asking: “If R/3 has to be customized to suit the needs of a particular industry, why didn’t SAP use a mar- ket structure and divide its activities by the needs of customers based in different industries?” These problems slowed down the process of implementing SAP software and prevented quick and effective re- sponses to the needs of potential customers.

SAP’s R/3 was also criticized as being too stan- dardized because it forced all companies to adapt to what SAP had decided were best industry practices.

future success because, because of the way an ERP system changes the nature of a customer’s business processes once it is installed and running; there are high switching costs involved in moving to another ERP product, costs that customers want to avoid.

SAP’s Growing Global Implementation Problems R/3’s growing popularity led SAP to decentralize more and more control of the marketing, sale, and installation of its software on a global basis to its overseas subsidiaries. While its R&D and software development remained centralized in Germany, it be- gan to open wholly-owned subsidiaries in most ma- jor country’s markets. By 1995, it had 18 national subsidiaries; today, it has over 50. In 1995, SAP es- tablished a U.S. subsidiary to drive sales in the huge and most profitable market—the U.S. market. Its German top managers set the subsidiary a goal of achieving $1 billion in revenues within 5 years. To implement this aggressive growth strategy, and given that R/3 software needs to be installed and custom- ized to suit the needs of particular companies and industries, several different regional SAP divisions were created to manage the needs of companies and industries in different U.S. regions. Also, the regional divisions became responsible for training an army of both internal and external consultants on how to in- stall and customize the R/3 software. For every inter- nal lead SAP consultant, there were soon about 9–10 external consultants working with SAP’s customers to install and modify the software—which again boosted IBM and Accenture’s profits.

Problems with its U.S. Operations The problems with its policy of decentralization soon caught up with SAP, however. Because SAP was growing so fast, and demand for its product was increasing so rapidly, it was hard to provide the thorough training consultants needed to perform the installation of its software. Often, once SAP had trained an internal consultant, that consultant would leave to join the company for which he or she was performing the work, or even to start an industry- specific SAP consulting practice! The result was that

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New Implementation Problems To a large degree, SAP’s decision to decentralize control of its marketing, sales, and installation to its subsidiaries was due to the way the company had operated from its beginnings. Its German founders had emphasized the importance of excellence in in- novation as the root value of its culture, and SAP’s culture was often described as “organized chaos.” Its top managers had operated from the beginning by creating as flat a hierarchy as possible to create an internal environment where people could take risks and try new ideas of their own choosing. If mistakes occurred or projects didn’t work out, employees were given the freedom to try a different approach. Hard work, teamwork, openness, and speed were the norms of their culture. Required meetings were rare and offices were frequently empty because most of the employees were concentrating on research and development. The pressure was on software develop- ers to create superior products. In fact, the company was proud of the fact that it was product driven, not service oriented. It wanted to be the world’s leading innovator of software, not a service company that installed it.

Increasing competition led SAP’s managers to realize that they were not capitalizing on its main strength—its human resources. In 1997, it estab- lished a human resources management (HRM) de- partment and gave it the responsibility to build a more formal organizational structure. Previously it had outsourced its own HRM. HRM managers started to develop job descriptions and job titles, and put in place a career structure that would motivate employees and keep them loyal to the company. They also put in place a reward system, which included stock options, to increase the loyalty of their techni- cians, who were being attracted away by competi- tors or were starting their own businesses because SAP did not then offer a future: a career path. For example, SAP sued Siebel Systems, a niche rival in the customer relationship software business, in 2000 for enticing 12 of its senior employees, who it said took trade secrets with them. SAP’s top managers realized that they had to plan long term and that innovation by itself was not enough to make SAP a dominant global company with a sustainable com- petitive advantage.

At the same time that it started to operate more formally, it also became more centralized to

When consultants reconfigured the software to suit a particular company’s needs, this process often took a long time, and sometimes the system did not perform as well as had been expected. Many companies felt that the software should be configured to suit their business processes and not the other way around, but again SAP argued that such a setup would not lead to an optimal outcome. For example, SAP’s retail R/3 system could not handle Home Depot’s policy of allowing each of its stores to order directly from suppliers, based upon centrally negotiated contracts between Home Depot and those suppliers. SAP’s cus- tomers also found that supporting their new ERP platform was expensive and that ongoing support cost 3–5 times as much as the actual purchase of the software, although the benefits they received from its R/3 system usually substantially exceeded these costs.

The Changing Industry Environment Although the United States had become SAP’s big- gest market, the explosive growth in demand for SAP’s software had begun to slump by 1995. Com- petitors such as Oracle, Baan, PeopleSoft, and Marcum were catching up technically, often because they were focusing their resources on the needs of one or a few industries, or on a particular kind of ERP module (for example, PeopleSoft’s focus on the human resources management module). Indeed SAP had to play catch-up in the HRM area and develop its own to offer a full suite of integrated business solutions. Oracle, the second largest software maker after Microsoft, was becoming a particular threat as it expanded its ERP offerings outward from its leading database knowledge systems and began to offer more and more of an Internet-based ERP plat- form. As new aggressive competitors emerged and changed the environment, SAP found it needed to change as well.

Competitors were increasing their market share by exploiting weaknesses in SAP’s software. They be- gan to offer SAP’s existing and potential customers ERP modules that could be customized more eas ily to their situation and that were less expensive than SAP’s. SAP’s managers were forced to reevaluate their business model, and their strategies and the ways in which they implemented this model.

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allowing them to obtain the majority of revenues from servicing SAP’s growing base of R/3 installa- tions. SAP’s top managers, with their engineering mindset, did not appreciate the difficulties involved in changing a company’s structure and culture, either at the subsidiary or the global level. They were disap- pointed in the slow pace of change because their cost structure remained high, although their revenues were increasing.

New Strategic Problems By the mid-1990s, despite its problems in implement- ing its strategy, SAP was the clear market leader in the ERP software industry and the 4th largest global software company because of its recognized com- petencies in the production of state-of-the-art ERP software. Several emerging problems posed major threats to its business model, however. First, it was becoming increasingly obvious that the development of the Internet and broadband technology would become important forces in shaping a company’s business model and processes in the future. SAP’s R/3 systems were specifically designed to integrate information about all of a company’s value-chain activities, across its functions and divisions, and to provide real-time feedback on its ongoing perfor- mance. However, ERP systems focused principally on a company’s internal business processes; they were not designed to focus and provide feedback on cross-company and industry-level transactions and processes on a real-time basis. The Internet was changing the way in which companies viewed their boundaries; the emergence of global e-commerce and online cross-company transactions was changing the nature of a company’s business processes both at the input and output sides.

At the input side, the Internet was changing the way a company managed its relationships with its parts and raw materials suppliers. Internet-based commerce offered the opportunity of locating new, low-cost suppliers. Developing Web software was also making it much easier for a company to cooper- ate with suppliers and manufacturing companies and to outsource activities to specialists who could per- form the activities at lower cost. A company that pre- viously made its own inputs or manufactured its own products could now outsource these value-chain ac- tivities, which changed the nature of the ERP systems

encourage organizational learning and to promote the sharing of its own best implementation prac- tices across divisions and subsidiaries. Its goal was to standardize the way each subsidiary or division operated across the company, thus making it easier to transfer people and knowledge where they were needed most. Not only would this facilitate coop- eration, it would also reduce overhead costs, which were spiraling because of the need to recruit trained personnel as the company grew quickly and the need to alter and adapt its software to suit changing in- dustry conditions. For example, increasing customer demands for additional customization of its software made it imperative that different teams of engineers pool their knowledge to reduce development costs, and that consultants should not only share their best practices, but also cooperate with engineers so that the latter could understand the problems facing cus- tomers in the field.

The need to adopt a more standardized and hi- erarchical approach was also being driven by SAP’s growing recognition that it needed more of the stream of income it could get from both the training and in- stallation sector of the software business. It began to increase the number of its consultants. By having its consultants work with SAP’s software developers they became the acknowledged experts and leaders when it came to specific software installations and could command a high price. SAP also developed a large global training function to provide the extensive ERP training that consultants needed and charged both individuals and consulting companies high fees for attending these courses so that they would be able to work with the SAP platform. SAP’s U.S. subsidiary also moved from a regional to a more market-based focus by re-aligning its divisions, not by geography, but by their focus on a particular sector or industry, for example, chemicals, electronics, pharmaceuticals, consumer products, and engineering.

Once again, however, the lines of authority be- tween the new industry divisions and the software development, sales, installation, and training func- tions were not structured well enough, and the hoped-for gains from increased coordination and cooperation were slow to be realized. Globally, too, SAP was still highly decentralized and remained a product-focused company, thus allowing its subsid- iaries to form their own sales, training, and instal- lation policies. Its subsidiaries continued to form strategic alliances with global consulting companies,

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saw Web-based computing, not PC-based comput- ing, as the choice of the future. SAP’s stock price also began to reflect the beliefs of many people that ex- pensive, rigid, standardized ERP systems would not become the software choice as the Web developed. One source of SAP’s competitive advantage was based on the high switching costs of moving from one ERP platform to another. However, if new Web- based platforms allowed both internal and external integration of a company’s business processes, and new platforms could be more easily customized to answer a particular company’s needs, these switch- ing costs might disappear. SAP was at a critical point in its development.

The other side of the equation was that the emer- gence of new Web-based software technology al- lowed hundreds of new software industry start-ups, founded by technical experts equally as qualified as those at SAP and Microsoft, to enter the industry and compete for the wide-open Web-computing mar- ket. The race was on to determine which standards would apply in the new Web-computing arena, and who would control them. The large software mak- ers like Microsoft, Oracle, IBM, SAP, Netscape, Sun Microsystems, and Computer Associates had to de- cide how to compete in this totally changed industry environment. Most of their customers, companies large and small, were still watching developments before deciding how and where to commit their IT budgets. Hundreds of billions of dollars in future software sales were at stake, and it was not clear which company had the competitive advantage in this changing environment.

Rivalry among major software makers in the new Web-based software market became intense. Rivalry between the major players and new players, like Netscape, Siebel Systems, Marcum, I2 Technol- ogy, and SSA, also intensified. The major software makers, each of which was a market leader in one or more segments of the software industry, such as SAP in ERP, Microsoft in PC software, and Oracle in data- base management software, sought to showcase their strengths to make their software compatible with Web-based technology. Thus, Microsoft strove to de- velop its Windows NT network-based platform and its Internet Explorer Web browser to compete with Netscape’s Internet browser and Sun Microsystems’ open-standard Java Web software programming lan- guage, which was compatible with any company’s proprietary software, unlike Microsoft’s NT.

it needed to manage such transactions. In general, the changing nature of transactions across the company’s boundaries could affect its ERP system in thousands of ways. Companies like Commerce One and Ariba, which offered this supply-chain management (SCM) software, were rapidly growing and posing a major threat to SAP’s “closed” ERP software.

At the output side, the emergence of the Inter- net also radically altered the relationship between a company and its customers. Not only did the Internet make possible new ways to sell to whole- salers, its largest customers, or directly to individual customers, it also changed the whole nature of the company—customer interface. For example, using new customer relationship management (CRM) soft- ware from software developers like Siebel Systems, a company could offer its customers access to much more information about its products so that custom- ers could make more-informed purchase decisions. A company could also understand customers’ chang- ing needs so it could develop improved or advanced products to meet those needs; and a company could offer a whole new way to manage after-sales service and help solve customers’ problems with learning about, operating, and even repairing their new pur- chases. The CRM market was starting to boom.

In essence, the Internet was changing both industry- and company-level business processes and providing companies and entire industries with many more avenues for altering their business processes at a company or industry level, so that they could lower their cost structure or increasingly differenti- ate their products. Clearly, the hundreds of indus- try best practices that SAP had embedded in its R/3 software would become outdated and redundant as e-commerce increased in scope and depth, and of- fered improved industry solutions. SAP’s R/3 system would become a dinosaur within a decade unless it could move quickly to develop or obtain competen- cies in the software skills needed to develop Web- based software.

These developments posed a severe shock to SAP’s management, who had been proud of the fact that, until now, SAP had developed all its software internally. They were not alone in their predica- ment. The largest software companies, Microsoft and Oracle, had been caught unaware by the quickly growing implications of Web-based computing. The introduction of Netscape’s Web browser had led to a collapse in Microsoft’s stock price because investors

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write and enforce contracts for the future develop- ment and supply of an industry’s inputs. Although these niche players could not provide the full range of services that SAP could provide, they had become increasingly able to offer attractive alternatives to customers seeking specific aspects of an ERP system. Also, companies like Siebel, Marcum, and I2 claimed that they had the ability to customize their low-price systems, and prices for ERP systems began to fall.

In the new software environment, SAP’s large customers started to purchase software on a “best of breed” basis, meaning that customers purchased the best software applications for their specific needs from different, leading-edge companies rather than purchas- ing all of their software products from one company as a package—such as SAP offered. Sun Microsystems began to promote a free Java computer language as the industry “open architecture” standard, which meant that as long as each company used Java to craft their specific Web-based software programs, they would all work seamlessly together, and there would no longer be an advantage to using a single dominant platform like Microsoft’s Windows or SAP’s R/3. Sun Microsystems was (and still is) trying to break Microsoft’s hold over the operating system industry standard, Windows. Sun Microsystems wanted each company’s software to succeed because it was “best of breed,” not because it locked customers in and created enormous switching costs for them should they con- template a move to a competitor’s product.

All these different factors caused enormous prob- lems for SAP’s top managers. What strategies should they use to protect their competitive position? Should they forge ahead and offer their customers a broad, proprietary, Web-based ERP solution and try to lock them in to continue to charge a premium price? Should they move to an open standard and make their R/3 ERP Internet-enabled modules com- patible with solutions from other companies, and forge alliances with those companies to ensure that the software seamlessly operated together? Since SAP’s managers still believed they had the best ERP software and the capabilities to lead in the Web software arena, was this the best long-run competi- tive solution? Should SAP focus on making its ERP software more customizable to its customers’ needs, and make it easier for them to buy selected modules to reduce the cost of SAP software? This alternative might also make it easier for them to develop ERP modules that could be scaled back to suit the needs

SAP also had to deal with competition from large and small software companies that were breaking into the new Web-based ERP environment. In 1995, SAP teamed with Microsoft, Netscape, and Sun Microsys- tems to make its R/3 software Internet-compatible with any of their competing systems. Within one year, it introduced its R/3 Release 3.1 Internet-compatible system, which was most easily configured, however, when using Sun’s Java Web-programming language. SAP raised new funds on the stock market to under- take new rounds of the huge investment necessary to keep its Web-based R/3 system up to date with the dramatic innovations in Web software develop- ment, and to broaden its product range to offer new, continually emerging Web-based applications, for ex- ample, applications such as the corporate intranets, business-to-business (B2B) and business-to customer (B2C) networks, Website development and hosting, security and systems management, and streaming au- dio and video teleconferencing.

Because SAP had no developed competency in Web software development, its competitors started to catch up. Oracle emerged as its major competitor; it had taken its core database management software, which was used by thousands of large companies, and overlaid it with Web-based operating and applications software. Oracle could now offer its huge customer base a growing suite of Web software, all seamlessly integrated. The suite of software also allowed them to perform Internet-based ERP value chain business processes. While Oracle’s system was nowhere near as comprehensive as SAP’s R/3 system, it allowed for cross-industry networking at both the input and out- put sides, it was cheaper and easier to quickly imple- ment, and it was easier to customize to the needs of a particular customer. Oracle began to take market share away from SAP.

New companies like Siebel Systems, Commerce One, Ariba, and Marcum, which began as niche players in some software applications such as SCM, CRM, intranet, or Website development and host- ing, also began to build and expand their product offerings so that they now possessed ERP modules that competed with some of SAP’s most lucrative R/3 modules. Commerce One and Ariba, for ex- ample, emerged as the main players in the rapidly expanding B2B industry SCM market. B2B is an in- dustry-level ERP solution that creates an organized market and thus brings together industry buyers and suppliers electronically, and provides the software to

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manufacturing operations. CRM, known as the “front-end” of the business, provides companies with solutions and support for business processes directed at improving sales, marketing, customer service, and field service operations. CRM programs are rapidly growing in popularity because they lead to better customer retention and satisfaction and higher revenues. In 1998, SAP followed with indus- try solution maps, business technology maps, and service maps, all of which were aimed at making its R/3 system dynamic and responsive to changes in industry conditions.

Also in 1998, recognizing that its future rested on its ability to protect its share of the U.S. market, SAP listed itself on the New York Stock Exchange and be- gan to expand the scope of its U.S. operations, both to encourage internal “organic growth,” meaning growth through internal new venturing, and to allow it to develop a U.S. top management team that could develop the strategies and business model necessary to allow it to respond to the growing competition it was facing. As with all growing businesses, the need to manage the fit between its strategy and structure had become its major priority—SAP’s R&D culture was hurting it in its battle with agile competitors, and had to be changed.

of medium and small firms, which were increasingly becoming the targets of its new software competi- tors. Once these new firms established toeholds in the market, it would only be a matter of time before they improved their products and began to compete for SAP’s installed customer base. SAP realized that it had to refocus its business model, especially because rivals were rapidly buying niche players and, at the same time, filling gaps in their product lines to be able to compete with SAP.

Protecting its Competitive Position In 1997, SAP sought a quick fix to its problems by releasing new R/3 solutions for ERP Internet- enabled SCM and CRM solutions, which con- verted its internal ERP system into an externally based network platform. SCM, now known as the “back end” of the business, integrates the business processes necessary to manage the flow of goods, from the raw material stage to the finished prod- uct. SCM programs forecast future needs, and plan and manage a company’s operations, especially its

Endnotes

www.sap.com, 1988–2011. SAP Annual Reports and 10K Reports, 1989–2011. SAP 10K Reports, 1989–2011.

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CASE 20 SAP and the Evolving Global Business Software Industry in 2011—Part 2

As Part 1 discusses, by 1997, SAP realized the need to release new Internet-enabled ERP R/3 solutions, which converted its internal ERP system into an externally-based network platform, to satisfy cus- tomers needs for SCM and CRM. Recall that SAP’s Supply Chain Management (SCM) integrates the business processes necessary to manage the flow of goods from the raw material stage to the finished product—it is a set of supply value-chain solutions designed to control costs and increase differentiation over the product life-cycle. By, for example, forecast- ing future product developments, and then devising solutions to more effectively manage a company’s value-chain operations, especially its manufacturing operations, to increase performance. Customer Rela- tionship Management (CRM), at the front-end of the value chain, provides companies with solutions and support for business processes directed at improving sales, marketing, customer service, and field service operations. By 2000, CRM programs were rapidly growing in popularity because they lead to better customer retention and satisfaction and higher rev- enues and profits for the companies that make them part of their IT system.

The mySAP.com Initiative Like most software applications companies, SAP had been slow to recognize the enormous potential of the Internet to build a company’s global competitive ad- vantage in so many different ways. In 1999, however, SAP’s realization of the growing importance of the Internet was made apparent by major changes to its

business model and strategies when it introduced its mySAP.com (mySAP) initiative. The strategy behind mySAP was to allow the company to regain leader- ship of the Internet Web-based ERP, SCM, and CRM markets, and to promote its ability to develop new Internet-based software applications as they have evolved over time. In essence, the mySAP initiative was a comprehensive ebusiness platform designed to promote internal collaboration inside a client com- pany, and collaboration with other companies in its supply chain. mySAP demonstrated several elements of top managers changing strategic thinking for how to succeed in the 2000s.

First, to meet its customers’ needs in a new elec- tronic environment, SAP used the mySAP platform to change itself from a vendor of ERP components to a provider of ebusiness solutions. The platform would be the online portal through which customers could view and understand the way its Internet- enabled R/3 modules could match their evolving needs. Customers wanted to be able to leverage new ebusi- ness technologies to improve basic business goals like increasing profitability, improving customer satisfac- tion, and lowering overhead costs. In addition, cus- tomers wanted total solutions that could help them manage their relationships and supply chains.

mySAP would offer a total solutions ERP package, including SCM and CRM applications that would no longer force customers to adapt to SAP’s standard- ized architecture. Rather, mySAP software was de- signed to help facilitate a client company’s transition into ebusiness and provide them with the advantages offered by the Internet. Of course, mySAP solutions would also create value for clients by building on

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (SAP), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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particular solutions best met their specific needs; they no longer had to buy the whole package. At the same time, all mySAP offerings were fully com- patible with the total R/3 system so that customers could easily expand their use of SAP’s products. SAP was working across its entire product range to make its system easier and cheaper to use. SAP realized that repeat business is much more important than a 1-time transaction, so they began to focus on seeking out and developing new, related solutions for their customers to keep them coming back and purchas- ing more products and upgrades.

Fourth, SAP was announcing that in the fu- ture, its mySAP solutions would be designed to fit and support the needs of large, medium, and small companies, and it intended to compete in all market segments. SAP would broaden its mySAP ebusiness solution packages so it would target not only large corporations, but also small- and medium-sized business enterprises (SMEs). mySAP allowed SAP to provide several simpler and cheaper versions of its application software, such as low-cost ERP solu- tions that could be scaled down to suit the needs of smaller firms. Also, for SMEs that lacked the internal resources to maintain their own business applica- tions on-site, mySAP offered hosting for data centers, networks, and applications. Small businesses could greatly benefit from the increased speed of installa- tion and reduced cost possible through outsourcing and by paying a fee to use mySAP in lieu of pur- chasing SAP’s expensive software modules. SAP also focused on making its R/3 mySAP offerings easier to install and use, and reduced implementation times and consulting costs in turn reduced the costs of sup- porting the SAP platform for both small and large organizations.

To support its mySAP initiative, SAP had con- tinued to build in-house training and consulting ca- pabilities to increase its share of revenues from the services side of its business. SAP’s increasing Web- based software efforts paid off because the company was now better able to recognize the problems ex- perienced by customers. This result led SAP to rec- ognize both the needs for greater responsiveness to customers, and customization of its products to make their installation easier. Its growing customer awareness had also led it to redefine its mission as a developer of business solutions, the approach em- bedded in mySAP, rather than as a provider of soft- ware products.

SAP’s established core competencies, including its industry best practices. In addition, mySAP solu- tions would also allow a client company to leverage its own core competencies and build its competitive advantage from within, SAP created a full range of front- and back-end ERP products available through its mySAP.com portal that were specific to different industries and manufacturing technologies. These changes meant that it could compete in niche mar- kets and make it easier to customize a particular ap- plication to an individual company’s needs. mySAP showed it was offering customers not product-based solutions but customer-based solutions. Its mySAP ebusiness platform solutions are designed to be a scalable and flexible architecture that supports data- bases, software applications, operating systems, and hardware platforms from almost every major vendor.

Second, mySAP provided the evolving IT platform that would allow SAP’s own product offerings— software applications—to expand and broaden over time, something especially important because Web- based applications software was evolving in ever more varied and unexpected ways as new high-tech software companies recognized a new niche in the market and were striving to develop software ap- plications that companies would want to buy and use. In essence, SAP had begun to pursue related di- versification, and other major software applications makers, such as rivals Oracle and Microsoft, were, too. All these competitors were branching out into more segments of the software industry to capitalize on higher-growth emerging software segments, and to fill the niches to keep potential competitors from invading their core software markets and stealing away their customers.

Third, SAP realized that price was becoming a more important issue because both large software companies and new software startups competition were increasingly offering companies lower-priced software solutions and solutions to persuade these companies to shift their loyalties and abandon SAP’s software platform. Major rivals, Oracle and Micro- soft had begun to offer good deals to companies to build their market share; they offered their software at discount prices or packed their ERP software with their other software such as database or PC software to generate demand for their product. SAP focused on making mySAP more affordable by breaking up its modules and business solutions into smaller, sepa- rate products. Customers could now choose which

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SAP also began to use acquisitions to speed its entry into crucial new segments of the Web software market. For example, SAP acquired Top Tier Soft- ware Inc. in 2001 to gain access to its iView tech- nology. This technology allows seamless integration between the Web software of different companies and is critical for SAP because it lets customers drag- and-drop and mix information and applications from both SAP and non-SAP platform-based systems. Top Tier was also an enterprise portal software maker, and in 2001, SAP used these competencies to create a new U.S. subsidiary called SAP Portals, which would deliver state-of-the-art enterprise portal products that would result in greater business efficiency and attract more customers. It also opened SAP hosting to provide hosting and Web maintenance services to its new portal customers.

By 2002, SAP believed that its alliances and ac- quisitions had given it a competitive advantage it could use to sustain its position as the dominant business applications software company. Its alli- ances with other software makers promoted mySAP as the industry standard and the dominant player in the ERP Web software market. SAP’s managers were therefore shocked when it became clear that Microsoft, which also recognized the enormous po- tential of Web software ERP sales, particularly in the SME segment of the market, was also planning to compete in this fast-growing market segment. In 2002, Microsoft had bought two companies that competed in the SME segment to bolster its own Web software offerings such as its suite of office products including email, word processing and other important applications that it could now bundle with its ERP offerings to SMEs. Microsoft’s goal was clearly to become a formidable competitor for SAP, and with its competencies in a wide area of software products and huge resources, it could quickly and easily develop an ERP system with Web-based solutions that integrated with its other applications software.

SAP’s number of global software installations and customers increased steadily between 1998 and 2002 when SAP was still the industry leader with a worldwide market share of over 30%. Oracle was next with a 16% share of the market, and Microsoft had around 7%. SAP claimed that it had 10 million users and 50,000 SAP installations in 18,000 com- panies in 120 countries in 2002, and that 1/2 of the world’s top 500 companies used its software.

To improve the cost effectiveness of mySAP installations, SAP sought a better way to manage its relationships with consulting companies. It moved to a parallel sourcing policy, in which several consult- ing firms competed for a customer’s business, and it made sure an internal SAP consultant was always in- volved in the installation and service effort to moni- tor external consultants’ performance. This helped keep service costs under control for its customers. Because customer needs changed so quickly in this fast-paced market and SAP continually improved its products with incremental innovations and ad- ditional capabilities, it also insisted that consultants undertake continual training to update their skills, training for which it charged high fees. In 2000, SAP adopted a stock option program to retain valu- able employees after losing many key employees— programmers and consultants—to competitors like IBM.

Indeed, strategic alliances and acquisitions be- came increasingly important parts of its strategy to reduce its cost structure, enhance the function- ality of its products, and build its customer base. Because of the sheer size and expense of many Web-based software endeavors, intense competi- tion, and the fast-paced dynamics of this industry, SAP’s top managers began to realize they could not go it alone and produce everything in-house. SAP’s overhead costs had rocketed in the 1990s, as it pumped money into building its mySAP initia- tive. Intense competition seemed to indicate that continuing massive expenditures would be nec- essary. SAP’s stock price had decreased because higher overhead costs meant falling profits despite increasing revenues. SAP had never seemed to be able to enjoy sustained high profitability because changing technology and competition had not al- lowed it to capitalize on its acknowledged position as the ERP industry leader.

Given existing resource constraints and time pressures and the need to create a more profitable business model, in the 2000s, SAP’s managers real- ized that they needed to partner with companies that had developed the “best of breed” software applica- tions in various niches of the Web software market. Now SAP could avoid the high R&D outlays nec- essary to develop new software itself. In addition, synergies with its software partners might make it possible to bring new mySAP products to the market more quickly and efficiently.

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developments among groups, providing expert solutions, and ensuring all the different mySAP ap- plications seamlessly worked together.

Each mySAP product group is now composed of a collection of cross-functional product development teams focused on their target markets. Teams are given incentives to meet their specific sales growth targets and to increase operating effectiveness, in- cluding reducing the length of installation time. The purposes of the new product group/team approach was to decentralize control, make SAP more respon- sive to the needs of customers and to changing tech- nical developments, and still give SAP centralized control of development efforts. To ensure that its broadening range of software was customizable to the needs of different kinds of companies and indus- tries, SAP enlisted some of its key customers as “de- velopment partners” and as members of these teams. Customers from large, mid-sized, and small compa- nies were used to test new concepts and ideas. Within every mySAP product group, cross-functional teams focused upon customizing its products for specific customers or industries.

At the global level, SAP grouped is national sub- sidiaries into 3 main world regions: Europe, the Americas, and Asia/Pacific. This grouping made it easier to transfer knowledge and information be- tween countries and serve the specific demands of national markets inside each region. Also, this global structure made it easier to manage relationships with consulting companies and to coordinate regional marketing and training efforts, both under the ju- risdiction of the centralized marketing and training operations.

Thus, in the 2000s, SAP had begun to operate with a loose form of matrix structure. To increase internal flexibility and responsiveness to customers while at the same time boosting efficiency and mar- ket penetration, the world regions, the national sub- sidiaries, and the salespeople and consultants within them constitute one side of the matrix. The central- ized engineering, marketing, and training functions and the 20 or so different mySAP product groups compose the other side. The problem facing SAP is to coordinate all these distinct subunits so they will lead to rapid acceptance of SAP’s new mySAP platform across all the national markets in which it operates.

In practice, a salesperson in any particular coun- try will work directly with a client to determine what type of ERP system he or she needs. Once it

Implementing mySAP SAP’s problems were not just in the strategy area, however. Its mySAP initiative had increased its over- head costs dramatically, and it still could not find the appropriate organizational structure to make the best use of its resources and competencies. It con- tinued to search for the right structure for servicing the growing range of its products and the increasing breadth of the companies, in terms of size, industry, and global location, it was now serving.

Recall that in the mid-1990s, SAP had begun to centralize authority and control to standard- ize its own business processes and effectively man- age knowledge across its organizational subunits. While this reorganization helped reduce costs, un- fortunately it also lengthened the time it took SAP to respond to the fast-changing Web software ERP en- vironment. To quickly respond to changing customer needs, the needs for product customization, and the actions of its rivals, SAP now moved to decentral- ize control to teams of software engineers who were experts in a business process or in a particular indus- try, and who now worked with its local salesforce to manage customer problems where and when they arose. SAP’s managers felt that in a market domi- nated by high rivalry among ERP vendors and in which customers had more bargaining power to ob- tain software and services cheaper and easier to use, it was important to get close to the customer. SAP had now put into place its own applications soft- ware to integrate across its operating divisions and subsidiaries and allow them to share best practices and new developments. Thus, it hoped to avoid the problems it had experienced in the past when it had decentralized too much authority.

SAP also changed the way its three German engineering groups worked with the different mySAP products groups. Henceforth, a significant part of the engineering development effort would take place inside each mySAP product engineering group so that the software engineers, who write and improve the specific new mySAP software applications, were joined with the sales force for that group. Now they could integrate their activi- ties and provide better customized solutions. The software engineers at its German headquarters, besides conducting basic R&D, would be respon- sible for coordinating the efforts of the different mySAP engineering groups, sharing new software

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information, and business processes across busi- ness and technology boundaries. Enterprise SOA utilizes open standards to enable the integration of the software applications of most different software companies no matter upon what particular technol- ogy, for example, JAVA or LINUX, it is based. SAP NetWeaver is now the foundation for all Enterprise SOA SAP applications and mySAP Business Suite solutions; it also powers SAP’s partners’ solutions and custom-built applications. Also NetWeaver in- tegrates business processes across various systems, databases, and sources—from any business software supplier—and is marketed to large companies as a service-oriented application and integration plat- form. NetWeaver’s development was a major strate- gic move by SAP to drive companies to run all their business software using a single SAP platform.

Although SAP was developing and upgrading its products at a fast pace throughout the early-2000s, the continuing worldwide recession continued to limit or reduce the company’s IT expenditures. SAP, like all other computer hardware and software com- panies, suffered as its revenues fell and SAP’s stock price plunged in 2002 from $40 to almost $10 as the stock market crashed. However, while SAP’s revenues fell by 5% in 2003 because of lower ERP and con- sulting sales, its profit doubled because it had finally brought its global cost structure under control and was making better use of its resources. Strict new controls on expenses had been implemented, a hir- ing freeze imposed, and the company was focusing its German programmers to work on urgent problems. Consequently, its stock was back up to $35 by the end of 2003 as its future growth prospects looked good.

As a part of its major push to reduce costs, SAP began to outsource the enormous amount of routine programming involved in improving and creating ad- vanced applications to low-cost countries overseas, such as India. In 2003, SAP recruited 750 software programmers in India, this number grew to 1,500 in 2004, and 5,000 in 2006. SAP used its growing army of low-cost Indian programmers to work the bugs out of its mySAP modules and to increase their reliability when they were installed in a new com- pany. This prevented embarrassing blows-ups that sometimes arose when a company implemented SAP’s ERP for the first time. Fewer bugs also made it easier to install its modules in a new company, which reduced the need for consulting and lowered costs, leading to more satisfied customers. Increasingly,

is determined which system will be used, a project manager from the regional subsidiary or from one of the mySAP groups is appointed to assemble an installation team from members of the different product groups that have the expertise required to implement the new client’s system. Given SAP’s broad range of evolving products, the matrix struc- ture allows SAP to provide those products that fit the customer’s needs in a fast, coordinated way. SAP’s policy of decentralizing authority and placing it in the hands of its employees enables the matrix system to work. SAP prides itself on its talented and profes- sional staff that can learn and adapt to many differ- ent situations and networks across the globe.

Developments in the Early-2000s In April 2002, SAP announced that its revenues had climbed 9.2%, but its first-quarter profit fell 40% because of a larger-than-expected drop in license rev- enue from the sale of new software. Many custom- ers had been reluctant to invest in the huge cost of moving to the mySAP system and the 2000 economic recession reduced IT expenditures. SAP announced it had several orders for mySAP in the works, however, and that it believed the 18,000 companies around the world using its flagship R/3 software would soon move to mySAP once their own revenues and profits recovered. In the meantime, SAP announced that it would introduce a product called R/3 Enterprise that would be targeted at large R/3 customers to show them what mySAP can accomplish once it is up and running in their companies.

SAP’s managers believed these initiatives would allow the company to jump from being the third largest global software company to being the second, ahead of main competitor Oracle. They also won- dered if they could use its mySAP open system archi- tecture to overcome Microsoft’s stranglehold on the software market and bypass the powerful Windows standard. Microsoft is the largest global software company.

Pursuing this idea, SAP put considerable re- sources into developing a new business computing solution called SAP NetWeaver that is a Web-based, open integration and middleware application plat- form that serves as the foundation for enterprise service- oriented architecture (Enterprise SOA) and allows the integration and alignment of people,

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version of its R/3 mySAP Business Suite; it is much easier to install and maintain and much more afford- able for SMEs. To develop All-in-One, SAP’s software engineers took its mySAP Business Suite modules designed for large companies and scaled them down for users of small companies. All-in-One is a reduced version of SAP’s total range of products such as SAP Customer Relationship Management, SAP ERP mod- ules, SAP Product Lifecycle Management, SAP Supply Chain Management, and SAP Supplier Relationship Management. Despite its reduced size, it is still a com- plex business solution and one that requires a major commitment of IT resources for a SME.

Recognizing the need to provide a much simpler, limited, and affordable ERP solution for smaller companies, SAP decided to also create a second SME ERP solution. SAP decided not to begin anew to de- velop a software package based on its R/3 platform, as it did with its All-in-One solution. Rather, it took a new path and bought an Israeli software company called TopManage Financial Solutions in 2002, and rebranded its system as SAP Business One. SAP Busi- ness One would be a much more limited ERP soft- ware package that integrates CRM with financial and logistic modules to meet a specific customer’s basic needs. However, it still provides a powerful, flexible SME solution and is designed to be easy to use and affordable. Business One works in real time, the software suite manages and records the ongo- ing transactions involved in a business such as cost of goods received, through inventory, processing and sale, and delivery to customers, and automatically records transactions in a debit and credit account. In 2005, SAP began reporting revenues from the SME market segment separately from revenues for its larger customers, one way of showing its commit- ment to SME customers.

The Changing Competitive Environment By 2004, achieving rapid growth by increasing the number of new large business customers was becom- ing more and more difficult, simply because SAP’s share of the global ERP market had now grown to 58%—one of the major reasons it entered the SME ERP market. SAP reported that because of slowing ERP sales it expected single digit growth in the next few years—growth worth billions in revenues, but still growth that would not fuel a rapid rise in its stock price.

SAP also began to use the advanced skills of its Indian research center programmers to cooperate in the development of new mySAP ERP modules to serve new customers in an increasing number of in- dustries or “vertical markets.” By 2006, SAP’s Indian research group was bigger than its research group in Waldorf, Germany and has been growing ever since. Outsourcing has saved the company billions in de- velopment costs and had continuously contributed to its rising profitability in the 2000s.

The Growing Small- and Medium- Enterprise Market In 2003, SAP changed the name of its software from mySAP.com to mySAP Business Suite because more customers were now licensing its software suite rather than purchasing it. Part of this change oc- curred because of the many upgrades SAP was con- tinuously releasing, and in a licensing arrangement, its clients could expect continual free upgrades as it improved its ERP modules as a part of their con- tract. However, while SAP continued to attract new, large business customers, the market was becoming increasingly saturated; it already had around 50% of the global large business market by 2003. To pro- mote growth and increase sales revenues, SAP began a major push to increase its share of the SME market segment of the ERP industry.

The small size of these companies, and so the lim- ited amount of money they had to spend on business software, was a major challenge for SAP, which had primarily worked with multinational companies that had huge IT budgets. Also, there were major compet- itors in this market segment that had specialized in meeting the needs of SMEs to avoid direct competi- tion with SAP—and they had locked up a significant share of business in this ERP segment. By focusing primarily on large companies, SAP had left a gap in the SME market. Other large software companies, such as Oracle and Microsoft, but also newcom- ers such as Siebel, PeopleSoft, and salesforce.com, rushed to develop their own SME ERP products and services to compete for revenues in the fast-growing SME market segment—worth billions of dollars.

To attract SME customers as quickly as possible, SAP decided to develop two primary product offer- ings customized to their needs: SAP All-in-One and SAP Business One. SAP All-in-One is a streamlined

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Oracle kept up the pressure. Between January 2005 and June 2007 it acquired 25 more business software companies in a huge acquisition drive to build its distinctive competencies and market share in ERP software. PeopleSoft brought Oracle exper- tise in HRM solutions, and J. D. Edwards’ expertise in SCM solutions. Then in a major acquisition of Siebel Systems, Oracle bought a leading CRM soft- ware developer. These acquisitions allowed Oracle to dramatically increase its range of ERP offerings and build market share with small- and medium- sized businesses. Before purchasing Seibel, for ex- ample, Oracle had a 6.8% share of this market; now it could add Seibel’s 11% market share to become one of the top 3 CRM suppliers—alongside SAP and Salesforce.com.

Oracle, already a major supplier of middleware, also wanted to be able to offer companies middle- ware that allowed them to seamlessly connect different ERP software packages from different com- panies. In turn, it developed a new ebusiness suite called Oracle Fusion middleware that would allow companies to leverage their existing investments in the software applications of other companies, in- cluding SAP, so that they work seamlessly with Or- acle’s new ERP modules. Fusion is Oracle’s answer to SAP’s NetWeaver because it gives SME customers no incentive to move to SAP’s All-in-One or Business One suite. Indeed, Fusion became a threat to SAP because many of oracle’s ERP modules such as its CRM and HRM solutions often better fit the needs of SMEs than SAP’s. Thus, many companies decide to keep their existing PeopleSoft installations and then choose more offerings from Oracle’s growing array business applications.

The third leading SME ERP supplier, Microsoft, is also keeping up the pressure. Using the competen- cies from its acquisition of Great Plains and Navi- sion, it released a business package called Microsoft Dynamics NAV, ERP software that can be custom- ized to the needs of SME users, to their industries, and scaled to their size. Microsoft’s advantage lies in the compatibility of its ERP offerings with the Windows platform, which is still used by more than 85% of SMEs, especially as it can offer substantial discounts when customers choose both types of soft- ware. Also, as Microsoft continues to introduce new versions of its Windows and Office software, such as Windows 8, it can use low-cost pricing to convince its customers to upgrade to its new ERP software.

However, competition in the SME market was also increasing as its business software rivals watched SAP develop and introduce its All-in-One and Business One solutions. SAP’s rapid growth in this segment led to increasing competition and to a wave of consolidation in the ERP industry. In 2003, PeopleSoft, the leader in the HRM software module segment, bought J. D. Edwards & Son, a leader in SCM, to enlarge its product offerings and strengthen its market share against growing competition from SAP and Oracle. However, Oracle, the leading da- tabase software management company also realized the stakes ahead in the rapidly consolidating busi- ness applications software market.

Essentially, the problem was that all the major competitors needed to be able to offer potential customers—large or small—a broad range of busi- ness software applications so that it could bundle them together and offer them at a reduced price. For example, most large companies already were using Oracle’s database software, if it could provide them with an ERP solution to meet their needs at a lower cost than SAP or Microsoft, it could grow its market share. While SAP had never made billion-dollar ac- quisitions, preferring “organic growth” from the in- side or small acquisitions, the opposite was the case with Oracle.

Its CEO Larry Ellison decided that to compete with SAP in the ERP market, Oracle would have to make major acquisitions to rapidly expand Oracle’s range of business modules to complement the suite of ERP modules it had been internally developing, and gain market share. Only through acquisitions could it quickly develop an ERP suite with the breadth of SAP’s to meet the needs of SMEs. Also, Ellison de- cided it could use its new competencies, combined with its existing database competences to attack SAP in the large company segment that Oracle now also regarded as a major growth opportunity.

In 2004, Oracle had begun a hostile takeover of PeopleSoft, which had also acquired several other ERP companies to build its competitive advantage. PeopleSoft’s top managers battled to prevent the takeover, but Oracle offered PeopleSoft’s custom- ers special low-cost licensing deals on Oracle data- base software and guaranteed them the changeover to its software would be smooth. It finally acquired PeopleSoft—and the resources and customers neces- sary to gain a large market share in the SME segment at the expense of SAP and Microsoft—in 2005.

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by the mid-2000s. New Internet companies, such as salesforce.com (which had become a major software as a service (SaaS) competitor to SAP by 2011), were offering SMEs the ability to license ERP modules services, especially CRM modules, and then access these modules online and store their databases on the Internet hosting company’s Website. This was a game changing move for large ERP companies be- cause it signaled to SMEs that on-demand Internet providers such as salesforce.com could offer much lower prices—even if they were less customized. SAP’s answer was to introduce a SaaS platform available to customers through on-demand and hosted delivery—and since 2007, SAP had been ex- panding the number of ERP modules it had offered through its “Business by Design” software suite, that by 2011, had become a part of its cloud computing services. Its SaaS service that will use its NetWeaver middleware also allowed customers to seamlessly in- tegrate the software of different vendors and make possible real-time upgrades and improvements.

In 2007, Henning Kagermann, who was now partnered at the top by deputy CEO Leo Apotheker, now embarked upon a major change in strategy. As noted earlier, SAP was proud of its “organic growth” or internal R&D to develop new software prod- ucts. However, in March 2007, Oracle announced it would acquire Hyperion Solutions, a global pro- vider of business intelligence software that provided performance-enhancing solutions for $3.3 billion. In doing so, it was entering a new segment of the ap- plications software market—one that might prove to be disruptive. The growing power of mathematical algorithms to offer radical changes to a company’s strategy to enhance performance seemed to fit well with the products of an ERP company that was continuously trying to improve best practices. SAP thought this might be a disruptive game-changing move by Oracle, and determined to respond quickly, it was forced to acquire the leading company in the Business Intelligence segment, Business Objects, for $6.8 billion. Today, SAP Business Objects has be- come the fastest growing of SAP’s different software businesses, business intelligence (BI) and the indus- try leader—outcompeting Oracle’s BI applications obtained through its acquisition of Hyperion. Oracle does not have the complementary skills needed to push the boundaries in BI. While BI generated only 7% of SAP’s revenues in 2007, it is expected to gen- erate over 15% in 2011. SAP has leveraged all its

SAP has worked hard to develop strategic alliances with all kinds of software companies to respond to the challenge from Oracle and Microsoft. By 2007, it had formed contracts with over 1,000 independent software vendors (ISVs) that have helped it expand its offerings, and it has jointly developed 300 new ERP solutions for the 25 industries it now serves, and all these applications are all powered by SAP NetWeaver. An important alliance was announced with IBM in 2006, IBM would invest $40 million over the next 5 years to develop the capabilities nec- essary to install SAP’s new software. Also, SAP will integrate NetWeaver with IBM’s new cloud comput- ing data storage offerings for large companies.

SAP also made many small acquisitions to improve its competitive position in various industries and to develop Web-based products to help companies utilize the Internet more effectively. For example, in the retail software industry, it acquired companies like Triver- sity and Khimetrics. Triversity provides point of sales, store inventory, customer relations and service solu- tions for retail companies, and Khimetrics helps retail- ers price and position products to manage demand, improve margins, and predict sales and income. It also acquired TomorrowNow, that specialized in provid- ing maintenance and support services for PeopleSoft and J. D. Edwards & Company customers (that were now Oracle clients). SAP also created “safe passage programs” designed to help companies switch to SAP solutions from software applications now owned by Oracle. SAP also planned to develop a variety of new- generation products, including new SAP industry so- lutions, and more applications for SMEs—in a direct challenge to Oracle’s Fusion software.

Strategic Moves 2006–2008 In 2006, SAP’s CEO Henning Kagermann announced 4 major priorities for the next decade—to increase market share, especially in SME; to increase profit- ability by improving productivity and efficiency; to better serve SAP users with new software applica- tions products and expand to new industries; and to help customers transition to and gain benefits from the rapidly developing software on-demand or soft- ware as a service (SaaS) segment of the Web-based applications segment.

SAP’s need to focus upon the on-demand applica- tions segment reflected its rapid rise in importance

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companies, that wanted to install and implement SAP’s software applications “on premise” mean- ing that the software installation was maintained and upgraded across a company’s global facilities. Second, the need to provide a suite of software ap- plications, especially CRM solutions that could be obtained on-demand, the SaaS solution that allowed SMEs to lease an SAP business solution package and use it to process and store their data on the Inter- net or in the cloud, as described earlier. And, third, to provide SAP solution’s “on device,” meaning that SAP’s customers could access its solution from their laptops, smartphones, and other mobile devices.

The last “on device” method of delivering SAP’s services was most problematic since it lacked ad- vanced capabilities in mobile software applications. In 2010, co-CEOs, McDermott and Snabe decided that a major new acquisition was necessary if SAP was to keep up with Oracle and Microsoft, which already had their own mobile platforms up and running. In 2010, they decided to acquire Sybase, a leader in the kind of software that helps corporate customers run applications on mobile devices for $5.8 billion, which would allow its corporate customers to run SAP ap- plications, and link into their company’s database on mobile devices from anywhere in the world. SAP will use the purchase to cater to customers that want em- ployees to use tablets and smartphones while work- ing: “This will literally connect the shop floor to the corner office,” CEO McDermott announced. Also, Sybase is strong in the telecom and financial sectors where SAP is weak, so that it will be able to expand its existing client base. Sybase CEO John Chen will continue to run Sybase as an independent unit com- plementing all of SAP’s other software services. SAP Sybase is expected to contribute significantly to SAP Business Objects’ revenues and profits over time, and give it one more competitive advantage over Oracle, which was fighting to develop a major presence in mobile computing applications in 2011. Sybase can work with Microsoft’s mobile platform as well as Apple’s iPhone and Google’s Android systems.

Competitive Advantage in 2011 In 2011, SAP was working closely with customers and partners worldwide, to develop a product and services strategy that would enable customers to use its enterprise application software wherever and

existing competences and applied them to Business Objects—and vice-versa—to increase the value of its BI services to customers. In addition, in 2010 SAP Business Objects announced a revolutionary new “in-memory computing solution” that speeds the processing of real-time information in ways that lead to new solutions and practices that can dramatically increase performance. SAP claims that this is a dis- ruptive technology and one that will change the BI and ERP markets and give it a competitive advan- tage over its rivals.

Apotheker is Replaced by Two Co-CEOs In 2008, Leo Apotheker became CEO of SAP, and because of the new global recession, he presided over the first annual drop in revenue at SAP since 2003, as customers refrained from purchasing new software. Moreover, SAP’s global cost structure had soared as its workforce increased and it entered new markets like Business Intelligence. At the same time, Oracle had, since 2005, spent more than $42 billion to acquire additional ERP and business applications software, and claimed it was winning market share at the expense of SAP, by becoming a one-stop shop for customers—beginning with the PeopleSoft acqui- sition. Microsoft was also claiming gains in market share in the SME segment, and so were smaller play- ers such as salesforce.com in CRM, and Sage another niche player in the growing global ERP market. Or- acle’s sales almost doubled to $23.3 billion between 2005 to 2009, while SAP’s sales rose 42%.

SAP’s board of directors decided that change was necessary; in 2010, he was replaced by dual CEOs, Bill McDermott, who took control of SAP global field operations, and Jim Hagemann Snabe, who took control of business solutions and technol- ogy. Their dual roles reflect SAP’s continuing need to coordinate its global matrix structure to manage its growth across world regions, countries, and the large and SME customer’s segments, while providing the business applications package best tailored to the needs of different customers in different countries.

By 2010, it had become clear that three major stra- tegic priorities were now facing all ERP companies. First, the need to provide the best-customized suite of business solutions to companies, especially large

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It also announced that its profits would exceed its previous forecast as it was taking market share away from Oracle as its second-quarter software license sales grew 26%, compared to Oracle that reported a 19%. Its stock price also soared as investors now be- lieved SAP was developing the right business model and strategies to beat Oracle and maintain its domi- nance as the biggest global business software maker.

SAP’s Co-CEOs Bill McDermott and Jim Hage- mann Snabe announced that their goal was to in- crease SAP’s profits by 10% per year, driven by increases in its mobile products, on-demand services, and its new real-time business solution analytics technology “Hana.” “The pipeline for Hana is the biggest in the history of SAP,” McDermott proudly announced, “The Hana in-memory product, or High-Performance Analytic Appliance, is designed to speed up analysis of business data. It comes on servers from companies such as Hewlett-Packard Co., International Business Machines Corp., Dell, and Cisco Systems Inc.” McDermott also said SAP was benefiting from the use of Apple’s iPad tablet among executives, who can use the device to take advantage of SAP’s software that provides them with mobile access to real-time business analytics. “By 2014, 6.5 billion workers worldwide will be on mo- bile devices. What you are seeing is a generational change,” he announced.

Indeed, SAP provides the software for the order fulfillment process behind Apple’s iTunes download system and Apple, and other large companies are experimenting with its Hana in-memory technology. SAP formed alliances with major companies such as Verizon, Dell, and Amazon.com, to sell its mobile products, Hana, and its SOA software as a service. McDermott also announced that unlike Oracle, SAP’s future focus would be on organic growth from internal new venturing across its software divisions. Clearly, that battle in the business software industry is escalating. In July 2011, Oracle also announced many improvements to its software suite for busi- nesses of all sizes, and niche players such as sales- force.com continue to grow their sales.

whenever they need it–on premise, on demand, or on device. SAP’s NetWeaver technology platform will serve as the foundation for all its SAP Business Suite applications.

SAP “Business Suite” that contains a complete set of software solutions aimed at large customers; SAP “All in One Suite” that can be tailored to the needs of companies with 100–2500 employees; and SAP “Business One” and “Business By Design” that es- sentially offer a cost-effective package of on-demand business solutions that can be hosted on SAP’s re- mote cloud computing network.

SAP is also working to be able to offer all its cus- tomers the advantage of cloud computing as it ad- vances, and as it becomes more reliable and secure. SAP Business Objects solutions are continually being upgraded and developed to help companies optimize business processes on premise, on demand, and on device.

SAP believes that it is has developed a competitive position in these three areas, and developed a suite of software applications suited to the needs of dif- ferent sized companies that will allow it to compete effectively against Oracle, now it major rival, in the next decade. However, many analysts believe that its share of the large and SME segments, particularly in CRM, may decline by 2–5% in the next 2–3 years; it is expected to more than double its share of the growing BI market. If it can develop and leverage its competencies in BI solutions and its Sybase mobile platform applications across market segments—and develop first-rate cloud computing solutions—it may be able to gain 2–5% market share.

SAP’s ability to retain and grow its market share is critical because this determines how well its stock price will perform in the 2010s. The higher its stock price rises, the more existing and new global cus- tomers will be attracted to use its growing business software applications; stock increases show it has achieved sustainable competitive advantage. In July 2011, SAP announced record revenues for the quar- ter and that it would exceed its profit forecast for the year as its software and service licenses soared.

Endnotes

www.sap.com, 1998–2011. SAP Annual Reports and 10K Reports, 1998–2011. SAP 10K Reports, 1998–2011.

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CASE 21 How Amazon.com Became the Leading Online Retailer by 2011

Since its founding in 1995, Amazon.com (Amazon) has grown from an online bookseller to a virtual re- tail supercenter selling products as diverse as books, toys, food, and electronics for which it is best known today. On Amazon’s main storefront, customers can discover anything they might want to buy online and it endeavors to offer customers the lowest possible prices. However, its less well-known that by 2010 it had become the world’s biggest provider of ser- vice oriented software (SOA), combined with cloud computing solutions that can be accessed by all kinds of customers including individuals, small- and medium-sized businesses, and large corporations— just one more kind of online retail storefront for vir- tual products such as data processing and storage. In 2011, its business mission states that its goal is to be “Earth’s most customer-centric company” for three primary customer groups: consumer custom- ers, seller customers, and developer customers.

In many ways, the last decade has been a wild ride for Amazon as its revenues, profits, and stock price initially soared and then plunged as a result of the dot-com boom and then bust of the early- 2000s. But, since hitting a low of $8 in 2001, in the last decade—and especially in the last 3 years—its stock has soared. It was over $210 in July 2011— an incredible increase. It has also been a wild ride for Amazon’s founder, Jeff Bezos, who through all the turmoil in its performance, consistently champi- oned his company and claimed investors had to look long term to measure the success of Amazon’s busi- ness model. He originally said he did not expect his company to become profitable for several years, and his forecast turned out to be correct. But, his claims are correct, and every year in his annual letter to

shareholders, he includes his 2007 letter that stated why its business model would succeed (see his 2010 letter on the Amazon.com investors’ Webpages).

Amazon’s Beginnings: The Online Bookstore Business In 1994, Jeffrey Bezos, a computer science and elec- trical engineering graduate from Princeton Univer- sity, was growing weary of working for a Wall Street investment bank. Seeking to take advantage of his computer science background, he saw an entrepre- neurial opportunity as he observed that Internet us- age was enormously growing every year as tens of millions of new users were becoming aware of its potential uses. Bezos decided the bookselling market offered an excellent opportunity for him to take ad- vantage of his IT skills in the new electronic, virtual marketplace. His vision was an online bookstore that could offer millions more books to millions more customers than a typical brick-and-mortar (B&M) bookstore. To act upon his vision, he packed up his belongings and headed for the West Coast to found his new dot-com start-up. On route, he had a hunch that Seattle, the hometown of Microsoft and Starbucks, was a place where first-rate software de- velopers could be easily found. His trip ended there, and he began to flesh out the business model for his new venture.

What was the vision for his new venture? To build an online bookstore that would be customer-friendly, easy to navigate, provide buying advice, and offer the broadest possible selection of books at low prices.

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (AMZN), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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they would all receive significant percentages of the company’s stock. In May 1997, Amazon.com’s stock began trading on the NASDAQ stock exchange.

Building Up Amazon’s Value Chain Amazon’s rapid growth continued to put enormous pressure on the company’s physical warehousing and distribution capabilities. The costs of operating an online Website, for example, continuously improv- ing the capabilities of the Website’s software, and maintaining and hosting the computer hardware and Internet bandwidth connections necessary to serve customers, are relatively low given the hundreds of millions of visits to its Website and the millions of sales that are completed. However, Bezos soon found out that the costs of developing and maintaining the physical B&M infrastructure necessary to obtain and stock supplies of books and then package and ship the books to customers, were much higher than he had anticipated—as was the cost of the employees required to perform these activities.

Soon, developing and maintaining the physi- cal B&M side of Amazon’s value chain became the source of the greatest proportion of its oper- ating costs, and these high costs were draining its profitability—given the low prices at which it was selling its books. Also, price competition was also heating up because of new competition from B&M booksellers such as Barnes & Noble and Borders, that had been late to recognize the potential of the Inter- net and now opened their own online bookstores to compete with Amazon. In fact, in 1997, as it passed the 1-million-different-customers-served point, Am- azon was forced to open up a new 200,000-square- foot warehouse and distribution center and expand its old one to keep pace with demand.

Bezos then sought ways to increase the motiva- tion of his employees across all the company. Work- ing to quickly fill customer orders is vital to an online company; minimizing the wait time for a product like a book to arrive is a key success factor in build- ing customer loyalty. On the other hand, motivat- ing Amazon’s rapidly expanding army of software engineers to develop innovative customer-oriented software, such as its patented 1-Click (SM) Internet ordering and payment software, was also vital to

Bezos’ original mission was to use the Internet to of- fer books “that would educate, inform and inspire.” From the beginning, Bezos realized that, compared to a physical B&M bookstore, an online bookstore could offer customers a much larger and much more diverse selection of books. There are about 1.5 mil- lion books in print, but most B&M bookstores stock only around 10,000 books; the largest stores in ma- jor cities might stock 40,000 to 60,000. Moreover, online customers would be able to easily search for any book in print using computerized catalogs. There was also scope for an online company to find ways to tempt customers to browse books in differ- ent subject areas, read reviews of books, and even ask other shoppers for online recommendations— all of which would encourage people to buy more books. One of Amazon’s popular features is the us- ers’ ability to submit product reviews on its Website. As part of their reviews, users rate the products on a scale from 1 to 5 stars and then provide detailed information that helps other users decide whether to purchase the products. In turn, the users of these rat- ings can then rate the usefulness of the reviews, so the best reviews are those that rise to the top and are read first in the future!

Operating from his garage in Seattle with a hand- ful of employees, Bezos launched his online venture in 1995 with $7 million in borrowed capital. Be- cause Amazon was one of the first major Internet or dot-com retailers, it received an enormous amount of free national publicity, and the new venture quickly attracted an increasing number of book buy- ers. Book sales quickly picked up as satisfied Internet customers spread the good word and Amazon be- came a model for other dot-com retailers to follow. Within weeks, Bezos was forced to relocate to larger premises, a 2,000-square-foot warehouse, and hire new employees to receive books from book publish- ers and fill and mail customer orders as book sales soared. Within 6 months, he was once again search- ing for additional capital to fund his growing venture; he raised another $7 million from venture capital- ists, which he used to move to a 17,000-square-foot warehouse that was now required to handle increas- ing book sales. As book sales continued to soar month by month over the next 2 years, Bezos de- cided that the best way to raise more capital would be to take his company public and issue stock. This, of course, would reward him as the founder and the venture capitalists who had funded Amazon because

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media celebrity as he worked to further Amazon’s visibility with customers. He spends a great deal of time flying around the world to publicize his com- pany and its activities, and he has succeeded because Amazon is in the top five of the best recognized dot- com companies.

The Amazon Associates program, created in 1996 to attract new customers to its retail storefront and grow sales, is another important strategy. Any person or small business that operates a Website can become affiliated to Amazon by putting an official Amazon hyperlink to Amazon’s Website on its own Website. If a referral results in a sale, the Associate receives a commission from Amazon. By 2004, Ama- zon had signed up over 1 million Associates and by 2007, about 40% of Amazon’s revenues were gen- erated from the sales of its Associates, who pay a commission to Amazon to advertise and sell their products on its Website.

By 1998, Amazon could claim that 45% of its business was repeat business, which translated into lower marketing, sales, and operating expenses, and higher profit margins. By using all his energies to act on the online bookselling opportunity, Bezos had given his company a first-mover advantage over rivals, which has been an important contributor to its strong position in the marketplace. Nevertheless, Amazon still had yet to make a profit, just as Bezos had predicted.

The Bookselling Industry Environment The book distribution and bookselling industry was changed forever in July 1995 when Jeff Bezos brought virtual bookseller Amazon.com online. His new company changed the entire nature of the envi- ronment. Previously, book publishers had indirectly sold their books to book wholesalers that supplied small bookstores, directly to large book chains like Barnes & Noble or Borders, or to book-of-the month clubs. There were so many book publishers and so many individual booksellers that the industry was relatively stable, with both large and small book- stores enjoying a comfortable, nonprice competi- tive niche in the market. In this stable environment, competition was relatively low, and all companies enjoyed good revenues and profits.

sustaining its competitive advantage. To ensure good responsiveness to customers, Bezos implemented a policy of decentralizing significant decision-making authority to employees and empowered them to find ways to meet customer needs quickly. Because Amazon.com employed a relatively small number of people—about 2,500 worldwide in 2000—Bezos also empowered employees to recruit and train new employees to quickly learn their new jobs. And to motivate employees, Bezos decided to give all em- ployees stock in the company. Amazon employees own over 10% of their company, a factor behind Amazon.com’s rapid growth.

In fact, Jeff Bezos is a firm believer in the power of using teams of employees to spur innovation. At Amazon, teams are given considerable autonomy to develop their ideas and experiment without in- terference from managers. Teams are kept deliber- ately small, and, according to Bezos, no team should need more than “two pizzas to feed its members”; if more pizza is needed, the team is too large. Am- azon’s “pizza teams,” which usually have no more than about 5–7 members, have come up with many innovations that have made its site so user-friendly. For example, one team developed the “Gold Box” icon that customers can click on to receive special offers that expire within an hour of opening the trea- sure chest; another developed “Bottom of the Page Deals,” low-priced offers for products such as bat- teries and power bars, and one more team developed the “Search Inside the Book” feature discussed later. These teams have helped Amazon expand into many different retail storefronts and provide the wide range of IT services it does today. Indeed, Bezos and his top managers believe that Amazon is a technol- ogy company first and foremost, and its mission is to use and develop its technological expertise to sell more and more goods and services in ways that sat- isfy customers and keep its profit growing. Hence, the enormous buildup of its SOA software services and on-demand cloud computing services as dis- cussed below.

Since the beginning, Bezos has personally played a very important part in energizing employees and representing his company to customers. He is a hands-on, articulate, forward-looking executive who puts in long hours and works closely with employees to find innovative and cost-saving solutions to prob- lems. Moreover, Bezos has consistently acted as a fig- urehead for his company and has become a national

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customer service. Now they were faced with com- petition from an online bookstore that could offer customers all 1.5 million books in print at signifi- cantly lower prices. Thousands of small, specialized B&M bookstores closed their doors nationwide in the 2000s, as the large B&M bookstores struggled to compete.

Competition increased by 2000 as large B&M bookstores began a price war with Amazon that re- sulted in falling book prices; this squeezed Amazon’s profit margins and put more pressure on it to con- tain its increasing operating costs. Amazon and its largest competitors, Barnes & Noble and Borders, announced a 50% discount off the price of new best- selling books to defend their market shares; they were locked in a fierce battle to see which company would dominate the bookselling industry in the new millen- nium. Barnes & Noble did manage to establish an on- line presence and its storefront has continued to exist into the 2010s, although it has never regained market share from Amazon. Border’s online bookstore was a complete failure, and in 2002, it announced all refer- rals to its online storefront would be referred to Ama- zon, for which it would receive a commission. This arrangement was a disaster for now Border’s had given up on online retailing, as a B&M bookstore. Its performance continued to decline, its agreement with Amazon was ended in 2008, and in 2011, Border’s liquidated and its stores were closed. By 2011, the value of Barnes & Noble, also suffering heavily from competition from Amazon, had dropped to $1 billion from over $30 billion, and many analysts wondered how long it would survive as Amazon became the on- line portal of choice for most major book publishers as the digital downloading book business became the way of the future as discussed below.

From Online Bookstore to Internet Retailer Although Bezos initially focused on selling books, he soon realized that Amazon’s rapidly developing IT competences could be used to sell many other kinds of products online. But, he was cautious because he also now understood how high were the value-chain costs involved in stocking and delivering a wide range of different products to customers. However, Ama- zon’s slowing growth in the late-1990s led many of

Amazon.com’s Web-based approach to buy- ing and selling books changed all this. First, since it was able to offer customers quick access to all of the 1.5 million plus books in print and discount the prices of its books, a higher level of industry compe- tition immediately developed. Second, it also nego- tiated directly with the large book publishers over price and supply because it wanted to quickly get books to its customers; the industry value chain and Amazon, therefore, gained more power over pub- lishers because it is a powerful buyer. All players— book publishers, wholesalers and bookstore chains had to rethink their strategies. Third, as a result of these factors and continuing improvements in IT and the speed of the Internet, the competitive forces in the bookselling business began to rapidly change and lower prices became a major priority.

As the first in the online bookselling business, Amazon was able to capture customers’ attention and establish a first-mover advantage. Its entry into the bookselling industry using its new IT posed a major threat for B&M bookstores, and Barnes & Noble, the largest U.S. bookseller, and Borders, the second largest bookseller, realized that with its com- petitive prices, Amazon would be able to siphon off a significant percentage of industry revenues. These B&M bookstores decided to launch their own online ventures to meet Amazon’s challenge and to con- vince book buyers that they, not Amazon, were still the best places to shop for books. However, being first to market with a new way to deliver books to customers resulted in satisfied customers who became loyal customers. Once a customer had signed up as an Amazon customer, it was often difficult to get that person to register again at a competing Website.

Amazon’s early success also made it difficult for the hundreds of new “unknown” online booksell- ers who entered the market to survive because they faced the major hurdle of attracting customers to their Websites rather than to Amazon.com’s. Even the major B&M competitors such as Barnes & No- ble and Borders that now imitated Amazon’s online business model faced major problems in developing a major online presence let alone attracting away Amazon’s customer base.

If large B&M bookstores had problems attract- ing customers, small specialized B&M bookstores were in desperate trouble. Their competitive advan- tage has been based on providing customers with hard-to-find books, a convenient location, and good

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Bezos was being increasingly criticized as much too slow to take advantage of Amazon’s brand name and core skills and to use them to sell other kinds of products online—much like a general B&M retailer sells many different kinds of products in the same store. Bezos responded that he had to make sure his company’s business model would successfully work in book retailing before he could commit his com- pany to a widespread expansion into new kinds of retail ventures. However, Amazon’s plunging stock price forced him into action, and from 2000 for- ward, it expanded its storefronts and began to sell a wider range of electronic and digital products, such as cameras, DVD players, and MP3 players. To achieve a competitive advantage in these new prod- uct categories, Amazon used its expertise in retailing software to provide customers with more in-depth information about the nature of the products they were buying and to offer users better ways to review, rank, and comment on the products they bought on its Website. Customers were increasingly seeing the utility of Amazon’s service—especially because of its low prices.

Bezos pushed Amazon and its “pizza teams” to find new ways to use its core skills to expand into different kinds of retail segments, and by 2003, it had developed 23 different storefronts. By 2006, Amazon had 35 storefronts selling products as var- ied as books, CDs, DVDs, software, consumer elec- tronics, kitchen items, tools, lawn and garden items, toys and games, baby products, apparel, sporting goods, gourmet food, jewelry, watches, health and personal-care items, beauty products, musical in- struments, and industrial and scientific supplies. Increasingly consumers came to see Amazon as the low-price retailer for many products. Customers be- gan to visit B&M retail stores to view the physical product, but then they would go online to buy from Amazon. Customers can avoid paying state sales tax when they buy online, and for high-ticket items, this is an important savings, often amounting to a 10% price advantage (although sometimes there are ship- ping costs).

New Problems As time went on, however, customers increasingly be- gan to compare the prices charged by different online retail Websites to locate the lowest priced product,

its stockholders to complain that the company was not on track to becoming profitable fast enough, so Bezos began to search for other products that could profitably be sold over the Internet. One growing on- line business was music CDs, and he realized CDs were a good fit with books, so in 1999, Amazon announced its intention to become the “earth’s big- gest book and music store.” The company used its IT competences to widen its product line by selling music CDs on its retail Website. The strategy of sell- ing CDs also seemed like a good move because the leading Internet music retailers at this time, such as CDNow, were struggling—they had also discovered the high physical costs associated with delivering products bought online to customers. Amazon now had built up its skills in this area, and its online re- tail competencies were working to its advantage; for example, its IT now allowed it to constantly alter the mix of products it offered on its storefront to keep up-to-date with changing customer needs.

Amazon also took many more steps to increase the usefulness of its retail sites to attract more cus- tomers and get its established customers to spend more. For example, to entice customers to send books and CDs as presents at important celebration and holiday shopping times such as birthdays, Christ- mas, and New Year’s, Amazon opened a holiday gift store. Customers could take advantage of a gift- wrapping service as well as using a free greeting card e-mail service to announce the arrival of the Amazon gift. Amazon began to explore other kinds of online retail ventures; for example, recognizing the grow- ing popularity of online auctions pioneered by eBay, Bezos moved into this market by purchasing Live- bid.com, the Internet’s only provider of live online auctions at that time. Also in 1999, it entered into an agreement with Sotheby’s, the famous auction house, to enter the high end of the online auction business. In making these moves, it was attempting to compete in eBay’s auction segment of the market—a move that not only failed because eBay had the first mover advantage, but also because, fixed-price sales were becoming the most popular segment of the market, as discussed later.

Nevertheless, starting in 2000, Amazon’s stock price fell sharply as investors believed that intense competition from Barnes & Noble and other online retailers like eBay might keep its operating margins low into the foreseeable future. Despite his com- pany’s moves into CDs and the auction business,

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sold in direct competition with Amazon’s own prod- ucts as its service operations software brings up the offerings of all sellers for a particular product. How- ever, this has proved to be a major advantage, and in 2011, 40% of Amazon’s sales revenue was gener- ated by the millions of associates who pay to estab- lish storefronts on its Website and pay it fees when their products are sold on its Website. The Internet bubble burst in the early-2000s strengthened Ama- zon’s competitive advantage; thousands of cut-price online retailers went out of business—because they had no source of competitive advantage. Despite that its own stock price plunged too, Amazon was now the strongest dot-com in the most important retail segment—the fixed-price segment.

Many well-known B&M retailers that had also established virtual storefronts found they could not make their online storefronts profitable in the 2000s because of high operating costs. The few that did succeed, such as Lands’ End, did so because they al- ready possessed well-developed catalog operations that were obviously suited to Internet retailing— paradoxically Sears, which had been the strongest in catalog sales, had shut down its operations by the 1990s when shopping malls and chain stores like Walmart had come to dominate U.S. retailing.

Over the 2000s, tens of thousands of other estab- lished B&M companies that found online retailing too complex and expensive also formed agreements with Amazon (or eBay) to operate their online stores. As noted earlier, Amazon seized this opportunity to get into the new business of using its proprietary retail IT to design, operate, and host other compa- nies’ online storefronts for them for a fee. By 2007, Amazon also had many online storefronts developed to sell its SOA retail solutions. Amazon had become an IT services company as well, and today its other Websites such as its major IT SAO service site (www. amazonservices.com) and its affiliates program (https://affiliate-program.amazon.com/), detail the enormous range of services that it offers to poten- tial sellers, or “developers,” as Amazon often calls them. A noted above, its SOA software services divi- sion has become a major source of its rapidly rising revenues and profits—and it continues to expand its retail IT activities as it moves to become a leader in cloud computing and storage.

Branching off into these new retail market seg- ments also allowed Amazon to more fully utilize its

and many dot-coms, desperate to survive in a highly competitive online retail environment, undercut Amazon’s prices and put more pressure on its profit margins. To strengthen Amazon’s competitive posi- tion and make it the preferred online retailer, Bezos moved aggressively to find ways to attract customers, such as by offering them free shipping or “deals of the day.” To make its service more convenient, Amazon also began to forge alliances with B&M companies like Toys“R”Us, Office Depot, Circuit City, Target, and many others. Now, customers could buy prod- ucts online at Amazon’s Website, but if they wanted their purchases immediately, they could pick them up from these retailers’ local B&M stores. Amazon had to share its profits with these retailers, but it also avoided high product stocking and distribution costs. These alliances also helped Bezos quickly transform his company from “online bookseller” to “leading Internet product provider.” His goal was for Amazon to become the leading online retailer across many market segments and drive out the weaker online competitors in those segments, consolidating many segments of the online retail industry. As it happened, he also drove out the weakest B&M retailers, such as Circuit City and Border’s, which were giving up on online operations, and forced to liquidate.

Amazon’s Online Retail SOA Software Platform Small- and medium-sized businesses quickly dis- covered the high costs of operating the value chain functions necessary to deliver products to customers, which helped Bezos. Increasingly, Amazon began to offer its online services to these companies, such as Borders and Waldenbooks in the book business, but also to Sears and Target; as noted above, these book- sellers were also eventually forced to close down their B&M operations. Weaker companies became Amazon Associates and began directing Internet traffic from their Websites to Amazon’s instead in return for sales commissions.

Amazon soon realized the important revenues associates could bring in, and began offering all kinds of small- and medium-sized companies the op- portunity to establish storefronts on Amazon.com, and offer their products—many of which are often

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its marketplace services retail storefront is part of its amazonservices.com Website reflecting its move into related diversification by its continual effort to share and leverage its core IT competences across its different storefronts. eBay bought a company called half.com to compete with Amazon Marketplace, and today it is Amazon’s main rival as both companies compete to provide a profitable fee-based service to sellers of used products.

In the 2000s, as Amazon became the acknowl- edged leader in Internet retailing, it took advantage of its skills to offer a SOA consulting service to virtual and B&M retailers and to create for them a unique, customer-friendly storefront using Ama- zon’s proprietary IT. As discussed above, this con- sulting service has proved to be a very profitable business activity, especially because in the process of designing storefronts and SOA services for other companies, Amazon’s software engineers found new opportunities to improve its own IT software services by learning from its “leading customers.” However, to protect its competitive advantage and proprietary IT, Amazon also started lawsuits against other virtual or B&M companies that had started to imitate services such as its 1-Click checkout system and infringe other proprietary software it claims is protected by patents. By 2011, many high-tech companies had begun to launch lawsuits claiming others had infringed on their patents; this became a multibillion dollar issue by 2011 as Google, Ap- ple, and Oracle fought to claim the ownership of touch-screen, mobile payment, and other kinds of software services.

Global Expansion Since IT is not specialized to any one country or world region, a virtual company can use the Internet and WWW to sell to customers around the globe— providing, of course, that the products it sells meet the needs of overseas consumers. Bezos was quick to realize that Amazon’s IT could be profitably trans- ferred to other countries to sell books. However, the ability to enter new overseas markets was limited by one major factor: Amazon.com offered its customers the biggest selection of books written in the English language, so overseas customers had to be able to read English. Where to locate them?

expensive warehouse and distribution system; faster sales across product categories increased inventory turnover and reduced costs. Moreover, its alliances with retailers to sell their products on its Website al- lowed it to reduce the quantity of expensive mer- chandise it needed to purchase and warehouse until sold, which, in turn, helped its profit margins. In ad- dition, by offering many different kinds of products for sale, customers could now “mix” purchases and add a book or CD to their electronic product order, and so on, which led to economies of scale and scope for Amazon. Essentially, Amazon was pursuing re- lated diversification, by giving customers more and more reasons to visit its site, and hoped to drive busi- ness and sales across all its product categories, using its 1-Click system to make the transactions as easy as possible for consumers.

However, from the beginning, to keep its operat- ing costs low, Amazon adopted a low-key approach to providing customer service; it did not reveal a customer service telephone number anywhere on its U.S. Website. However, as the complexity of its business has grown and fraud has increased, it rec- ognized the need to provide some level of service, and in 2006, Amazon added to its Website an e-mail link. Using this link, customers provide their phone numbers, and Amazon customer service reps make outbound calls to provide whatever help is needed, for example, with parcel tracking information. Cus- tomer service is handled by datacenters in different countries all around the world and Amazon has out- sourced most of this activity to minimize costs.

Amazon’s venture into the online auction mar- ket failed in the early-2000s and was shut down, but now its top managers can focus all their energies on building its competences in the fixed-price retailing market, and by expanding into new kinds of retail formats. In 2001, Amazon added a new retail service that turned out to be highly profitable and important to maintaining its leadership position in online re- tailing. Amazon launched zShops, a fixed-price retail marketplace that became the foundation of its highly successful Amazon Marketplace Service. This retail service allows customers to sell their used books, CDs, DVDs, and other products alongside the identi- cal brand-new products that Amazon offers on the product pages of its retail Website. This significantly added to its sales revenues, and Amazon has con- tinually added to its offerings over the 2000s. Today,

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New Acquisitions and Business Opportunities To make better use of its resources and capabilities and to maintain its profit growth, Amazon began to acquire many small specialized retail and IT compa- nies. Its strategy to acquire small IT companies was to strengthen its distinctive competencies in SOA IT and to develop more kinds of Web-based IT com- mercial services that it could sell to both B&M and online companies. Bezos has always preached that Amazon is first and foremost a technology company and that its core skills drive its retail mission. Its goal in buying small retail companies was to find new opportunities to increase sales of its existing retail storefronts and to allow it to establish storefronts in new segments of the retail market. Some acquisitions have been successful, and some have not.

For example, Amazon bought Internet Movie Database (www.IMDb.com), a company that hosts a comprehensive list of all movies in existence. Ama- zon transformed it into a commercial venture whose function is to help customers easily find and identify DVDs to purchase and to make related suggestions to encourage additional purchases on its Website. Similarly, Amazon acquired Exchange.com, which specialized in hard-to-find book titles at its Biblio- find.com Website, and hard-to-find music titles and memorabilia at MusicFile.com. The acquisition also helped Amazon develop user-friendly search engines to help customers identify and buy its products, once again using its 1-Click system.

Amazon bought PlanetAll.com, which operated a Web-based address book, calendar, and reminder service that had over 1 million registered users, and Junglee.com, an XML-based data-mining start-up that had technology for searching and tracking In- ternet users’ Website visits based on their personal interests. As it purchased these companies, Amazon absorbed these technologies and employees into its IT operations to improve its retail software services. For example, PlanetAll’s “relationship-building” software applications were folded into Amazon’s Friends and Favorites area, and its new employees went on to build community-focused features for Amazon’s Website including the Amazon.com Mar- ketplace and Amazon.com Purchase Circles. Ama- zon was driven by the goal of developing superior Web-based techniques for attracting and keeping

An obvious first choice would be the United Kingdom, followed by other English-speaking nations such as Australia, New Zealand, India, and Germany (of any nation in the world, Germany has one of the highest proportion of English-as-a- second- language speakers because English is taught in all its schools). To speed entry into overseas markets, Amazon searched for Internet book retailers that had gained a strong foothold in their local domes- tic market and acquired them. In the UK, Amazon bought Bookpages.com in 1996, installed its propri- etary IT, replicated its value creation functions, and renamed it Amazon.co.uk. In Germany, it acquired a new online venture, ABC Bücherdienst/Telebuch.de, and created Amazon.de in 1998. Amazon continued its path of global expansion, and by 2006, it also operated retail Websites in Canada, France, China, and Japan, and shipped its English language books to customers anywhere in the world. All these ven- tures have been tremendously successful and have significantly added to its revenues and profits.

To facilitate the growth of its global IT and dis- tribution retail systems across all market segments, Amazon also established SOA software product and service development centers in England, Scotland, In- dia, Germany, and France. Just as Amazon expanded the range of products/software services it sold on its U.S. Websites, it also increased the range of products/ services it sold abroad as its warehouse and distribu- tion systems became strong enough to sustain its ex- pansion and its local managers selected the product mix best suited to the needs of local customers.

Developments in the 2000s Amazon finally turned its first profit in the fourth quarter of 2002—a meager $5 million, just $0.01 per share on revenues of over $1 billion—but this was an important signal to investors. In fact, Ama- zon’s stock price soared again in the early-2000s as investors believed its business model would enable it to become an online retail leader. Its stock price in- creased from $6 in 2001 to $60 by 2004. Amazon’s net profits also increased to $35 million in 2003 and to $588 million in 2004, while its revenues more than doubled to $7 billion in the same period. Ama- zon’s future looked bright as it became the largest Internet retailer and achieved a dominant position in many market segments.

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actual products—and its efforts failed. Customers do not like to be tracked across the WWW and efforts to prevent Web tracking have increased in the 2010s. Even Amazon’s own efforts are considered invasive by many people as it stores personal information in order to offer customized product choices.

In the effort to keep its customers loyal, Amazon began providing a range of new customer services. In 2006 it launched Amazon Prime, a $79 per year ser- vice that allows users to get unlimited free two-day shipping for a year on all eligible items bought from its storefronts. Also, in 2006, it began its first cloud computing data storage product called Amazon S3 that allows users to store data for $0.15 per gigabyte per month—something that was soon rendered use- less when Google began to offer its customers free online data storage that has expanded to hundreds of gigabytes. In 2007, Amazon entered the grocery delivery business when it launched Amazon Fresh, a new grocery storefront that sold a wide variety of nonperishable food and household items that, once ordered, can be reordered using Amazon’s shopping- list software. To ensure competitive pricing with B&M grocery stores, customers receive free shipping on purchases of canned and packed food products over $25.

In the 2000s, Amazon continued to refine its SOA business software solutions to make it easier and faster for businesses to take advantage of its expanding array of services. By 2010, its increasing expertise made it simple for small or large businesses to use services such as Fulfillment by Amazon and WebStore by Amazon to manage many aspects of their value chains. Essentially, Amazon was offering companies a value-chain outsourcing service. For example, Fulfillment by Amazon allows small busi- nesses to use Amazon’s own order fulfillment and after-order customer services, and gives their cus- tomers the ability to benefit from Amazon’s shipping offers. Fulfillment by Amazon performs the value chain activities that allow small online businesses to minimize the costs required to store, pick, pack, ship, and provide customer service for the products they sell online. After paying Amazon’s service fee, small businesses ship their products to an Amazon fulfill- ment center that stores and sends those products to customers who order them on the small business’ or Amazon’s storefront. Amazon also manages post- order customer service such as customer returns and

Internet customers when rivalry with eBay, Apple, and Google increased because these companies started to enter each other’s businesses. For example, the online download music business when Apple introduced its online music download iTunes store, and thus leapfrogged over Amazon to control this market—although Amazon still controls the online sales of music CDs.

Amazon started its own online music store in 2007 selling downloads in the MP3 format after se- curing agreements with the four major record com- panies, however, its music download service never obtained the success of Apple’s iTunes, which has prospered because of its link to the iPod and now the iPhone. In another venture into entertainment content, Amazon launched a digital download video service called Amazon Unbox in 2007. This new download service offered customers thousands of television shows, movies, and other video content from more than 30 studio and network partners from Hollywood and around the world. Unbox claimed to be the only video download service to offer DVD-quality pictures, however, within weeks this new download service had generated negative comments from users; the number of movies down- loaded was disappointingly few because the service’s poor software caused many glitches and very slow— hours—of download time. Essentially, Amazon was too early to enter this vital Movie/TV Content Streaming Download Service. Even in 2011, it was still uncertain which company and which digital format would prevail, and customers were confused as competitors such as Google’s YouTube, Netflix’s streaming offerings, Hulu’s content, and Apple’s new video content services, were competing to be the next industry standard. In addition, many Websites still offered illegal downloading free of charge. The online entertainment streaming market segment is a complex one in which to compete, but also a vital one given the enormous growth in downloading us- ing smartphones and tablet computers that has oc- curred in the 2010s.

Amazon also acquired several companies to enter and grow in the search engine market to find ways to track its customers across the WWW to personalize the retail service it could offer and, therefore, boost sales. However, it did not understand that Google’s search engine business model was based on increas- ing online advertising revenues—not offering them

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meaningless (see Appendix). Proof that its business model was working, and one measure of Amazon’s growing dominance, was the increase in the number of repeat customers—from 45% in 2005, to 59% in 2007, and to over 70% by 2010. Repeat business is a major indicator of a company’s ability to grow its business and profit growth.

The Amazon’s Kindle Reader Arrives In 2007, Amazon pushed to dominate the online the online book-downloading business when it an- nounced its new Kindle book reader. Its new $399 3G device with free Internet connection was based on technology developed by a company it had ac- quired in 2005. The Kindle allows customers to download digital versions of books in print and also allows Amazon to offer these digital books at greatly discounted prices—including new books and best- sellers. By 2008, Amazon announced that the Kindle had become its best selling product and that digital downloads were increasing rapidly; spurred by the acceptance of the Kindle, it offered a cheaper non- 3G version. By 2011, its special offer Kindle was selling for $114 and $139, its free 3G version for $189, and its top-of-the-line DX version for $379. Why the fall in price? Apple’s iPad tablet computer was overshadowing the Kindle’s amazing popularity and growing dominance. The Kindle was a black and white reader optimized for reading print in all light- ing conditions; the iPad was a full-color touch screen device that could access the Internet and download all kinds of digital applications, not just eBooks.

Nevertheless, many analysts claimed that Ama- zon realized too late that the money to be made was not in the hardware itself, but in the money it received from the digital content—books and magazines that users downloaded. In 2010, Amazon announced that for the first time its Kindle digital books sales exceeded that of its paper-based books. Some ana- lysts wondered why Amazon was not giving away its reader free of charge, but there was speculation in 2011 that Amazon was planning to introduce a new advanced color version of the Kindle to rival the iPad. But in July 2011, Amazon announced that it would begin to allow students to rent textbooks in e-book format for its Kindle readers for as much

refunds for businesses that use Fulfillment by Ama- zon. Small businesses benefit from the cost savings that result when Amazon’s service fees are lower than the costs of performing the value chain service themselves.

WebStore by Amazon allows businesses to create their own privately branded e-commerce Websites using Amazon technology. Businesses can choose from a variety of Website layout options and can customize their sites using their own photos and branding. For example, Seattle Gift Shop now has its own WebStore at www.seattlesgifts.com. WebStore by Amazon users pay a commission of 7% (price in- cludes credit card processing fees and fraud protec- tion) for each product purchased through their site and a monthly fee of $59.95. As one business owner commented, “Not only has WebStore increased my sales dramatically, but also its easy-to-use tools give me complete control of the look and feel of my site.” WebStore allows small businesses to build their brand name while using Amazon’s easy-to-use flex- ible “back-end” technology—including Amazon’s 1-Click checkout system—and allows them to refer customers through the Amazon Associates program if they choose.

Amazon’s Growing Dominance in the Retail Sector All of Amazon’s expenditures to develop the new IT platforms necessary to launch complex digital storefronts that sell books, music, and video, and build the SOA services side of its business increased its operating costs and reduced its profit margins in 2007. So, too, did Amazon’s need to open enor- mous new warehouses or “fulfillment” centers in many different states during the late-2000s. In 2011, for example, it announced it would open a fourth 1.2 million square-foot facility in Phoenix, Arizona, bringing its total capacity in that state to over 4 mil- lion square feet. Rising costs, together with increas- ing competition from Apple, eBay, and especially Google led many analysts to wonder if Amazon could maintain its rapid growth—something that led to Bezos’ 2007 letter to shareholders, pointing out that once again his company’s strategy was to build the infrastructure that would lead to long-term growth and profits and that short term results were

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lar business. Of course, this also meant large expen- ditures on servers and datacenters to support AWS expansion, but this is completely in keeping with Bezos’s 2007 letter to shareholders. Amazon believes revenues may reach $3 billion by 2015 as individuals and companies outsource more of their data center needs. The growing popularity of AWS is that it is “on-demand” software and services; business cus- tomers are charged a fee based on how much they use its SOA and there are no upfront costs to prevent potential customers from trying out its services.

Amazon’s Future Prospects Jeff Bezos and his top management team seem com- mitted to leveraging Amazon’s core competencies in whatever ways they can to find to realize the value of the company’s assets. The range of possible services Amazon can offer appears endless. Today, Amazon is the leading fixed-price product Internet retailer. It has over 34,000 employees and in 2010 it earned $700 million on $10.7 billion revenues. This was a huge increase in profit from the year before, and its stock price soared in early-2011 as investors became convinced it would remain the industry leader. Only eBay was now a major competitor, but its failure to enter and capitalize on the fixed-price market sooner had resulted in a major decline in its stock price as the growth of the online auction market slowed in the 2000s. Customers today favor the fixed-price format as long as they are offered lower prices than they can get in B&M stores. Also, customers like the daily deal kind of online offers pioneered by Grou- pon and other companies such as LivingSocial that has Amazon as a major investor.

Record Sales in 2011 Finally, another sign that Amazon’s business model and strategies are working came in July 2011 when Amazon reported its second quarter results. Its rev- enues had increased by 50% compared to the same quarter in 2010 as its product sales increased and its Kindle e-reader and digital-media services rev- enues soared. However, its profit also dropped by 8% because operating expenses rose by 54%. Why? Following its business model, Amazon has been

as 80% off the list price, and that the three major textbook companies had signed up for this service.

A sign of Bezos’ commitment to this product came in his 2010 letter to shareholders, where demonstrating the prowess of Amazon’s software engineers, he announced a new Kindle application Whispersync, a “Kindle service designed to ensure that everywhere you go, no matter what devices you have with you, you can access your reading library and all of your highlights, notes, and bookmarks, all in sync across your Kindle devices and mobile apps. The technical challenge is making this a reality for millions of Kindle owners, with hundreds of millions of books, and hundreds of device types, living in over 100 countries around the world—at 24/7 reliability.” To enlarge the content for its Kindle device, Amazon announced in 2011 that it had acquired The Book Depository, an online bookseller that offers 6 million specialized books for delivery worldwide.

More Moves in SOA and Cloud Computing In March 2011, Amazon launched Cloud Drive, Amazon Cloud Player for the Web, and Amazon Cloud Player for Android. Together, these services enabled individual customers to securely store mu- sic in the cloud and play it on any Android phone, Android tablet, Mac or PC, and now iPad, wherever they are located. Customers can easily upload their music library to Amazon Cloud Drive and can save any new Amazon MP3 purchases directly to their Amazon Cloud Drive for free. In July 2011, Amazon announced three improvements to Amazon Cloud Drive and Cloud Player to better compete with Google and Apple’s alternatives: storage plans that include unlimited space for music for $20 a year, free storage for all Amazon MP3 purchases and a Cloud Player iPad application. It also offered any customer 5GBs of free storage to encourage customers to try out its new services.

By 2010, Amazon’s engineers had developed ad- vances in data management, which led to new ar- chitectures and cloud storage and data management services that could be scaled to the needs of compa- nies from small, to medium to large. It renamed its IT customer storefront Amazon Web Services (AWS) and analysts expect it to become its next billion dol-

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media content—much more so than Apple and the Market for tablets computers was weakening in late 2011 as customers were wondering exactly what they were buying as new much more powerful and lightweight laptops were being introduced.

Nevertheless, when on October 25th 2011 Amazon reported that its third quarter profit had plunged by 73% because of the high costs neces- sary to create the new Kindle Fire and the IT infra- structure to support it—plus its huge investment in IT cloud computing—investors immediately reacted be sending its stock price down by $30 or 15%. Throughout its history its stock price has soared or plunged as investors try to evaluate the future results of its strategy; but its CEO Jeff Bezos just seems to be having fun as he strives to create the most successful company he can—the one that adds the most value for its customers and stockholders.

What new strategies will Bezos pursue to take Amazon to the next level? Are any new mergers and acquisitions on the horizon? How many more B&M companies will Amazon drive out of business?

spending billions to build its IT infrastructure to build its cloud computing and entertainment stream- ing services IT infrastructure to serve both individ- ual and business customers. And, investing a billion more to build new state-of-the-art fulfillment centers to be able to distribute the products that it sells un- der its own name, and under the names of the mil- lions of companies that now use its services to sell their products on its Website.

The Kindle Fire: Building New Opportunities and Threats Then, at the end of September 2011 the long awaited new color Kindle download media device that would rival Apple’s iPad was introduced by Bezos to wide acclaim. Amazon decided to sell the new Kindle Fire for $199, lower than it cost to produce, because Bezos believes that Amazon will make its profits from all the books, magazines, movies, music, and TV shows that users can now download to its new touch screen device. Amazon controls important

Appendix AdApted from AmAzon.com 2007 Letter to ShArehoLderS We believe that a fundamental measure of our suc- cess will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current mar- ket leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital veloc- ity, and correspondingly stronger returns on invested capital.

Our decisions have consistently reflected this. We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and rev- enue growth, the degree to which our customers con- tinue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will con- tinue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise. Because of our

emphasis on the long term, we may make decisions and weigh tradeoffs differently than some companies.

Accordingly, we want to share with you our fundamental management and decision-making ap- proach so that you, our shareholders, may confirm that it is consistent with your investment philosophy:

• We will continue to focus relentlessly on our cus- tomers.

• We will continue to make investment decisions in light of long-term market leadership consid- erations rather than short-term profitability con- siderations or short-term Wall Street reactions.

• We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.

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of continually reinforcing a cost-conscious cul- ture, particularly in a business incurring net losses.

• We will balance our focus on growth with em- phasis on long-term profitability and capital management. At this stage, we choose to priori- tize growth because we believe that scale is cen- tral to achieving the potential of our business model.

• We will continue to focus on hiring and retaining versatile and talented employees, and continue to weight their compensation to stock options rather than cash. We know our success will be largely affected by our ability to attract and re- tain a motivated employee base, each of whom must think like, and therefore must actually be, an owner.

• We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.

• When forced to choose between optimizing the appearance of our GAAP accounting and maxi- mizing the present value of future cash flows, we’ll take the cash flows.

• We will share our strategic thought processes with you when we make bold choices (to the extent competitive pressures allow), so that you may evaluate for yourselves whether we are mak- ing rational long-term leadership investments.

• We will work hard to spend wisely and maintain our lean culture. We understand the importance

Selected Sources

www.amazon.com, 2011. Amazon.com, Annual and 10K Reports, 1997–2011.

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CASE 22

With almost 18,000 employees, eBay, headquartered in San Jose, California, manages and hosts the well-known global online auction and shopping Website that people all around the world visit to buy and sell goods and services. In 2010, eBay generated $9.5 billion in rev- enue, up from $4.5 billion in 2005, but it generated only $3.5 billion in earnings (measured by EBITDA) compared to $2.1 billion in 2005. Prior to 2007, eBay had been a stellar performer on the stock exchange un- der the guidance of Meg Whitman, its first CEO; the company’s stock market valuation was $46 billion in 2007, making investors extremely happy. But since 2007, eBay has experienced increasing competition and so many problems that its stock price has dramati- cally fallen—so much so that in July 2011, its market valuation had dropped to $43 billion. Why? Investors became worried its business model would not be so profitable in the future because the online auction mar- ket was becoming mature and opportunities for growth were declining. In addition, the nature of competition in online retailing was changing and Amazon.com had emerged as the top online retail portal. Its stock plunged in value as it seemed likely that eBay’s busi- ness model had run out of steam. But to understand the sources of eBay’s success and the current challenges it faces, it is necessary to explore the way eBay’s business model and strategies have changed over time.

eBay’s Beginnings Until the 1990s, the auction business was largely fragmented; thousands of small city-based auction houses offered a wide range of merchandise to local

buyers. And a few famous global houses, such as Sotheby’s and Christie’s, offered carefully chosen se- lections of high-priced antiques and collectibles to limited numbers of dealers and wealthy collectors. However, the auction market was not very efficient, for there was often a shortage of sellers and buyers, and so it was difficult to determine the fair price of a product. Dealers were often able to influence auction prices and obtain bargains at the expense of sellers. Typically, dealers were able to buy at low prices and then charge buyers high prices in the bricks-and- mortar (B&M) antique stores that are found in every town and city around the world; they reaped high profits. The auction business was changed forever in 1995, when Pierre Omidyar developed innovative software that allowed buyers around the world to bid online against each other to determine the fair price for a seller’s product.

Omidyar founded his online auction site in San Jose on September 4, 1995, under the name “Auction Web.” A computer programmer, Omidyar had previ- ously worked for Microsoft, but he left that com- pany when he realized the potential opportunity to develop new software that provided an online plat- form to connect Internet buyers and sellers. The en- trepreneurial Omidyar changed his company’s name to eBay in September 1997, and the first item sold on eBay was Omidyar’s broken laser pointer for $13.83. A frequently repeated story that eBay was founded to help Omidyar’s fiancée trade PEZ Candy dispens- ers was fabricated by an eBay public relations man- ager in 1997 to interest the media. Apparently the story worked, for eBay’s popularity grew quickly by word of mouth, and the company did not need to

eBay and the Online Auction and Retail Sales Industry in 2011

This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case go to http://finance.yahoo.com or www.google.com/finance and input the company’s stock symbol (eBay) and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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Thus, eBay does not need to develop all the high-cost functional activities like inventory, shipping, and purchasing to deliver products to customers, unlike Amazon.com, for example. So, eBay operates with a low cost structure given the huge volume of prod- ucts it sells and sales revenues it generates—hence the high revenues and profits it earned before until 2007, as mentioned earlier. Also, word of mouth en- abled eBay to avoid paying high advertising costs, an especially important consideration early on because these are a major expense for many online portals seeking to gain a reputation. And, as far as buyers are concerned, eBay is also low cost, for under cur- rent U.S. law, sellers located outside a buyer’s state do not have to collect sales tax on a purchase. This allows buyers to avoid paying state taxes on expen- sive items such as jewelry and computers, which can save them tens or even hundreds of dollars, and makes purchasing on eBay more attractive.

To make transactions between anonymous Inter- net buyers and sellers possible, however, Omidyar’s software had to reduce the risks facing buyers and sellers. In particular, it had to convince buyers that they would receive what they paid for, and that sell- ers would accurately describe their products online. Also, sellers had to be convinced that buyers would pay for the products they committed to purchase on eBay, although of course they were able to wait for the money to arrive in the mail, so their risk was lower; however, many buyers do not pay or pay ex- tremely late. To minimize the ever-present possibility of fraud from sellers misrepresenting their products, or from buyers unethically bidding for pleasure and then not paying, eBay’s software contains a method for building and establishing trust between buyers and sellers—building a reputation over time.

After every transaction, buyers and sellers can leave online feedback about their view of the other’s behavior and the value of the transaction they have completed. They can fill in an online comment form, which is then published on the Web for each seller and buyer. When sellers and buyers consistently act in an honest way in more and more transactions over time, they are able to build an increasingly stronger positive feedback score that provides them with a good reputation for honesty. More buyers are attracted to a reputable seller, so the seller obtains higher prices for their products. Sellers can also de- cide if they are dealing with a reputable buyer—one who pays promptly, for example. Over time, this

advertise until the early-2000s. Omidyar had tapped into a huge unmet buyer need and people flocked to use auction software platform. Another major rea- son eBay did not advertise in its early years was that its growing global popularity had put major pres- sure on its internal computer information systems, both its hardware and software. In particular, the technology behind its search engine—which was not developed by Omidyar but furnished by indepen- dent specialist software companies–could not keep pace with the hundreds of millions of search requests that eBay’s users generated each day. eBay was also installing powerful servers as quickly as it could to manage its fast-growing global database, and it was recruiting computer programmers and IT managers to run its systems at a rapid rate.

To finance eBay’s rapid growth, Omidyar turned to venture capitalists to supply the hundreds of mil- lions of dollars his company required to build its online IT infrastructure. Seeing the success of his business model, he was quickly able to find willing investors. As part of the loan agreement, however, the venture capitalists insisted that Omidyar give control of the running of his company to an experienced dot. com top manager. They were very aware that found- ing entrepreneurs often have problems in building and implementing a successful business model over time. They recommended that Meg Whitman, an ex- ecutive who had had great success as a manager of several software start-up companies, be recruited to become eBay’s CEO, while Omidyar would assume the role of chairman of the company.

eBay’s Evolving Business Model From the beginning, eBay’s business model and strategies were based on developing and refining Omidyar’s auction software to create an easy-to- use online market platform that would allow buyers and sellers to meet and transact easily and inexpen- sively. eBay’s software was created to make it easy for sellers to list and describe their products, and easy for buyers to search for, compare, and bid on the products they wanted to purchase. The magic of eBay’s software is that the company simply provides the electronic conduit between buyers and sellers; it never takes physical possession of the products that are listed, and their shipping is the responsibility of sellers and payment the responsibility of buyers.

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advanced in the 2000s, eBay recruited its own search experts from other companies such as Yahoo! and Google. Today, it has its own in-house search tech- nology teams who continually refine and improve its own proprietary search engine software to make it more appealing to its sellers and buyers—and to keep up with competitors. CEO Whitman looked for new ways to improve eBay’s business model, while the most pressing concerns were keeping the eBay Website up and running 24 hours per day, and keep- ing its online storefront meeting the needs of its rap- idly increasing number of buyers and sellers.

First, to take advantage of the capabilities of eBay’s software, the company began to expand the range and categories of the products it offered for sale to increase revenue. Second, it increased the num- ber of retail or “selling” formats used to bring sellers and buyers together. For example, its original retail format was the 7-day auction format, where the last bidder within this time period “won” the auction, provided the bid met the seller’s reserve or minimum price. Then, it introduced the “buy-it-now” format where a buyer could make an instant purchase at the seller’s specified price, and later a real-time auc- tion format in which online bidders, and bidders at a B&M auction site, compete against each other in real time to purchase the product up for bid. In this format, a live auctioneer, not the eBay auction clock, decides when to close an auction.

Beyond introducing new kinds of retail formats, over time eBay continuously strived to improve the range and sophistication of the information services it provides its users—to make it easier for sellers to list, describe, present, and ship their products, and for buyers to make better purchasing decisions. For example, software was developed to make it easier for sellers to list their products for sale and upload photographs and add or change information to the listing—however eBay began to charge more for these services. Buyers were also able to take advan- tage of the new services offered in what is called My eBay; buyers can now keep a list of “watched” items so that over the life of a particular auction they can see how the price of a product has changed and how many bidders are interested in it. This is a useful ser- vice for buyers because frequently bidders for many items enter in the last few minutes to try to “snipe” an item or obtain it at the lowest possible cost. As the price of an item becomes higher, this often

became more difficult because new “unknown” buy- ers come into the market continuously, so eBay de- veloped online mechanisms so sellers can refuse to deal with any new or existing buyer if they wish, and can remove that buyer’s bid from an auction.

eBay generates the revenues that allow it to oper- ate and profit from its electronic auction platform by charging a number of fees to sellers (buyers pay no specific fees). In the original eBay model, sellers paid a fee to list a product on eBay’s site and paid a fee if the product was sold by the end of the auction. As its platform’s popularity increased and the number of buyers grew, eBay increased the fees it charged sellers. The eBay fee system is quite complex, but in the United States in 2006, eBay took between $0.20 and $80 per listing, and 2%–8% of the final price, depending on the particular product being sold, and the format in which the product sold. In addi- tion, eBay acquired the PayPal payment system that charges substantial fees of its own; this is discussed in detail below.

This core auction business model worked well for the first years of eBay’s existence. Using this basic software platform, every day tens of millions of prod- ucts such as antiques and collectibles, cars, comput- ers, furniture, clothing, books, DVDs and a myriad of other items are listed by sellers all around the world on eBay and bought by the highest bidders. The in- credible variety of items sold on eBay suggests why eBay’s business model has been so successful—the same set of auction platform programs, constantly improved and refined over time from Omidyar’s original programs, can be used to sell almost every kind of product, from low-priced books and maga- zines costing only cents, to cars and antiques cost- ing tens or hundreds of thousands of dollars. Some of the most expensive items sold include a Frank Mulder 4Yacht Gigayacht ($85 million), a Grumman Gulfstream II jet ($4.9 million), and a 1993 San Lorenzo 80 Motor Yacht (just under $2 million). One of the largest items ever sold was a World War II submarine that had been auctioned off by a small town in New England that decided it did not need the historical relic anymore.

Meg Whitman’s biggest problem was to find search engine software that could keep pace with the increasing volume of buyers’ inquiries. Initially, small independent suppliers provided this software; then IBM provided this service. But as search technology

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transactions between buyers and sellers and drove up eBay’s revenues and profits, something that re- sulted in a huge increase in the value of its stock.

Competition in the Retail Auction Industry eBay’s growing popularity and growing user or cus- tomer base made it increasingly difficult for the hun- dreds of other online auction houses that had also come online to compete effectively against it. Indeed, its competitive advantage was increasing because both sellers and buyers discovered that they were more likely to find what they wanted and get the best prices from a bigger auction Website’s user base or market. And, from the beginning, eBay controlled the biggest market of buyers and sellers, and new users became increasingly loyal over time. So even when large, well- known online companies such as Yahoo! and AOL at- tempted to enter the online auction business, and even when they offered buyers and sellers no-fee auction transactions, they found it was impossible to grow their user bases and establish themselves in this mar- ket. From network effects, eBay had obtained a first- mover advantage and was benefiting from this.

The first-mover advantage eBay gained from Pierre Omidyar’s auction software created an unas- sailable business model that effectively gave eBay a monopoly position in the global online auction mar- ket. Even today, there are few online or B&M sub- stitutes for the auction service that eBay provides. For example, sellers can list their items for sale on any kind of Website or bulletin board, and special- ist kinds of Websites exist to sell highly specialized kinds of products like heavy machinery or large sail- boats, but for most products, the sheer reach of eBay guarantees it a dominant position in the marketplace. Because there has been little new entry into the on- line auction business, the fees eBay charges to sellers steadily increased as it grew, and skimmed off ever more of the profit in the auction value chain. eBay decided it did not have to worry about the power of buyers or sellers to complain about fee increases because it has access to millions of individual buyers and sellers. Sellers would only be a threat to eBay if they could band together and demand reductions in eBay’s fees and charges.

encourages more buyers to bid on it, so there is value to buyers (although not sellers, who want the highest prices possible) to wait or just bid a minimal amount so they can easily track the item.

By creating and then continually improving its easy-to-use retail platform for sellers and buyers, eBay revolutionized the auction market, bringing together international buyers and sellers in a huge, never-ending yard sale. eBay became the means of cleaning out the “closets of the world” with its user- friendly platform.

New Types of Sellers Over time, eBay also encouraged the entry of new kinds of sellers into its electronic auction platform. Initially, it focused on individual, small-scale sell- ers; however, it then sought to attract larger-scale sellers using its eBay Stores selling platform, which allows sellers to list not only products up for auc- tion but also all the items they have available for sale, perhaps in a B&M antique store or warehouse. Store sellers then pay eBay a fee for these “buy it now” sales. Hundreds of thousands of eBay stores became established in the 2000s, greatly adding to eBay’s revenues.

Also, during the 2000s, small specialized online stores and large international manufacturers and retailers such as Sears, IBM, and Dell began to open their own online stores on eBay to sell their products using competitive auctions for “clearance goods” and fixed-priced buy-it-now storefronts to sell their latest products. By using eBay, these companies es- tablished a new delivery channel for their products, and they were able to bypass wholesalers such as discount stores or warehouses that take a much larger share of the profit than eBay does through its selling fees.

Software advances arrived faster and faster in the 2000s, in part due to eBay’s new Developers Pro- gram that allowed independent software developers to create new specialized applications that seam- lessly integrate with eBay’s electronic platform. By 2005, there were over 15,000 members in the eBay Developers Program, comprising a broad range of companies creating software applications to support specialized eBay sellers and buyers, as well as eBay Affiliates. All this progress helped speed and smooth

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EachNet, a leading e-commerce company in China, for $150 million to enter the Chinese market. And, in 2004, it bought Baazee.com, an Indian auction site, and took a large stake in Korean rival I nternet Auction Co. In 2006, eBay acquired Tradera.com, Sweden’s leading online auction-style marketplace, for $48 million, in 2009 it acquired Gmarket, Korea’s leading online marketplace.

All these global acquisitions helped eBay to re- tain its dominant presence in the global online auc- tion business to facilitate transactions both inside countries and between countries to build up revenue. Once eBay was up and running in a particular coun- try, network dynamics took effect, and it became dif- ficult for a new auction start-up to establish a strong foothold in its domestic online auction market. But, eBay has faced serious competition in countries such as Japan and Hong Kong, where Yahoo! gained a head start over eBay and thus gained the first-mover advantage in these countries; in China, too, eBay has run into major opposition. Thus, by 2011, significant global expansion was difficult because the cost of overseas online auctions sites had become extremely expensive and eBay’s goal was to protect its market share around the world.

Expanding its Value Chain Activities Providing more kinds of value-chain services that add value and create revenue and profit at different stages of the online auction and retail value chain is a second way in which eBay has grown the revenues from its auction model. This strategy emerged gradu- ally as it sought new sources of revenues to bolster its bottom line.

eBay Drop-Off Stores One service it created in the early-2000s to encour- age more business from individuals who want to sell their goods online—but lacked the computer skills to do so—was eBay Drop Off. eBay licenses reputa- ble eBay sellers that have consistently sold hundreds of items using its platform to open B&M consign- ment stores in cities where anybody can “drop off” the products they want to sell. The owner of the

This happened first during the early-2000s. Meg Whitman, desperate to keep eBay’s revenues grow- ing to protect its stock price, started to continuously increase the fees charged to eBay stores to list their items on eBay. Store sellers rebelled and used the eBay community bulletin boards and chat rooms to register their complaints. eBay realized there was a limit to how much it could charge sellers. It would have to find new ways to attract more buyers to the sellers’ products, and get them better prices, if was going to be able to increase the fees it charged sellers. Or it would have to find new ways to extract profit from the auction value chain.

New Ways to Grow eBay’s Value Chain Meg Whitman always preached to eBay’s employees that to maintain and increase the value of its stock (and many employees own stock options in the com- pany), eBay must (1) continually attract more buyers and sellers to its auction site, and (2) search for ways to generate more revenue from these buyers and sell- ers. To create more value from its auction business model, eBay has adopted many other kinds of strate- gies to grow profitability over time.

International Expansion Online, buyers from any country in the world can bid on an auction, and so it became clear early on that one way to grow eBay’s business would be to repli- cate its business model in different countries around the world. Accordingly, eBay quickly moved to estab- lish storefronts around the world customized to the needs and language of a particular country’s citizens. Globally, eBay established its own online presence in countries like the United Kingdom and Australia, but in other countries, particularly non-English-speaking countries, it often acquired the national start-up on- line auction company that had stolen the first-mover advantage in a particular country. In 1999, for exam- ple, eBay acquired the German auction house Alando for $43 million and changed it into eBay Germany. In 2001, eBay acquired MercadoLibre, Lokau, and iBazar, Latin American auction sites, and estab- lished eBay Latin America. In 2003, eBay acquired

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online transactions—to both purchase and sell prod- ucts online. The effective management of financial transactions is vital in online transactions for this poses the greatest risks to buyers, who may be taken advantage of by unscrupulous or fraudulent sellers who take money and then fail to deliver the expected product. Sellers also faced problems. When eBay first started, sellers usually demanded money orders or bank cashiers’ checks as secure forms of payment from buyers, or insisted that ordinary checks had to be cleared through their accounts before mailing the product to customers. This increased the length of time and effort involved in a transaction for sellers and buyers and led to lost sales—customers don’t like to wait a long time to receive their purchases.

By the early-2000s, online companies like PayPal and Billpoint had emerged that offered secure online electronic payment services that greatly facilitated online commerce. To work efficiently, these ser- vices require sellers and buyers to register and enter a valid bank account number, and usually a credit card number, to authenticate the sellers’ and buy- ers’ identities and their ability to pay for the items purchased. Now payment became instantaneous; the money was taken directly from the buyer’s bank ac- count or paid for by credit card. Buyers could now purchase on credit, while sellers could immediately send off the product to the buyer. When buyers paid sellers, the online payment company collected a 3% commission, which was taken from the seller’s proceeds—a very profitable source of revenue.

eBay recognized this was highly profitable value-chain activity because by becoming involved in online payment services it would increase its share of the fees involved in eBay transactions. But, eBay also realized that ownership of a secure online pay- ment system would reinforce its attempts to increase the reputation of both buyers and sellers to encour- age the growth of online sales by preventing fraud. Major synergies between selling and payment ac- tivities were possible. Since it was late to enter this business and would take a long time to develop its own payment service from scratch, eBay acquired the online payment service Billpoint and worked to get eBay buyers and sellers to register with Billpoint. However, eBay found itself running up against a brick wall; just as eBay had gained the first-mover advantage in the auction business, so PayPal had gained it in the online payment business. Millions of eBay users were already signed up with PayPal. After

Drop-Off Store describes, photographs, and lists the item on eBay and then handles all the payment and shipping activities involved in the auction pro- cess. The store owner receives a commission, often 15% or more of the final selling price (not including eBay’s commission) for providing this service. These stores have proved highly profitable for their own- ers and thousands have sprung up across the United States and the world (a search request on eBay’s site allows buyers to identify the closest eBay Drop-Off Store). The advantage for eBay is that this drop-off service gives it access to the millions of people who have no experience in posting photographs online, organizing payment, or opening an eBay account and learning how to list an item, and so eBay gains from increased listing fees.

Increased Advertising To promote the millions of products it has for sale on its site, eBay increased its use of advertising—on television, newspapers, and on popular Websites—to expand its user base in the 2000s. Its goal was to make eBay the preferred place to shop online by demonstrating two things: first, the incredible diver- sity of products available for purchase on its site, and second, the fact that its products generally cost less than buyers would pay in B&M stores—or even on other online stores. New and used DVDs, books, de- signer clothing, electronics and computers are some of the multitude of products that can be obtained at a steep discount on eBay. Thus, while the range of the products eBay sells provides it with a differentia- tion advantage, the low prices that buyers can often obtain gives it a low-price advantage too—provided buyers are prepared to wait a few days to receive their newly purchased products.

PayPal Payment Service Meg Whitman was also working to find ways to make transactions easier for eBay buyers and sellers to increase the ease, security, and volume of online sales. One way to do this was to get involved in an ex- tremely profitable part of any company’s value chain activity—the payment system involved in manag- ing the financial transactions necessary to complete

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in the sale of new and used fixed-price consumer products such as books, movies, video games, DVDs, and so on that are offered at a fixed price and sold on a first-come-first-served basis, not by auction. eBay’s “Buy It Now” feature is similar, although sellers are allowed to set a lower start price than the buy-it-now price, and the selling process can develop into an auc- tion if bidders start to compete for the product. In the 2000s, the popularity of fixed-price online retail- ing led to a significant expansion in eBay’s activities in this segment of the retail market. In 2006, eBay opened its new eBay Express site, which was designed to work like a standard Internet shopping site to con- sumers with U.S. addresses. Select eBay items are mir- rored on eBay Express, where buyers use a shopping cart to purchase products from multiple sellers. A UK version of eBay Express is also in development.

In 2005, eBay acquired Shopping.com, an online price-comparison shopping site, for $635 million. With millions of products, thousands of merchants, and millions of reviews from the Epinions commu- nity, Shopping.com empowers consumers to make informed choices and, as a result, encourages more buyers to purchase products. Information provided by Shopping.com also facilitates eBay sellers’ pric- ing knowledge about their online competitors and helps them price their products competitively so that they can sell them more quickly. The site also allows customers to purchase products from various eBay retail formats.

In the 2000s, online local classifieds have become an increasingly popular way for people to sell their unwanted products, especially because there are usu- ally no fees associated with them. Local classifieds are very popular for bulky products like furniture, ap- pliances, exercise equipment, and so on, where high transportation costs represent a significant percentage of the purchase price. In 2004, to ensure its foothold in this online retail segment, eBay bought a 25% stake in the popular free online classifieds Website Craigslist by buying the stock of one of Craigslist’s founders.

These free local classified services have been hurting newspapers whose classified sales have sharply decreased. It remains to be seen in the fu- ture whether these classified services will remain free or whether they will also be charging fees. Clearly, eBay would like to charge a fee if it owned a con- trolling stake in Craigslist. Perhaps preparing for the future when money will be made from online clas- sifieds, in 2004, eBay acquired Marktplaats, a Dutch

failing to make Billpoint the market leader, in 2002 eBay acquired PayPal for $1.5 billion in stock—a great return for PayPal’s stockholders. Then, to re- duce costs, eBay switched all Billpoint customers to PayPal and shut down Billpoint. This purchase has been very profitable for eBay, for it now owns the world’s leading online payment system. The PayPal acquisition has paid for itself many times over, as discussed below.

More Retail Formats eBay also began to make many acquisitions to facili- tate its entry into new kinds of specialized retail and auction formats to increase its market reach—and its revenues and profits. In 1999, it acquired the well- known auction house Butterfield & Butterfield to facilitate its entry into the auctioning of high-priced antiques and collectibles and compete with upper- end auction houses such as Sotheby’s and Christie’s. However, eBay’s managers discovered that a lot more involvement was needed to correctly identify, price, list, and then auction rare, high-priced antiques, and it exited the upper-end auction niche in 2002 when it sold Butterfield & Butterfield to Bonhams, an up- scale auction house that wanted to develop a much bigger online presence.

To further its expansion into the highly profitable motor vehicle segment of the market, in 2003 eBay acquired CARad.com, an auction management ser- vice for car dealers, to strengthen eBay Motors. Now eBay controls the auctions in which vehicle dealers bid on cars that they then resell to individual buyers, often on eBay Motors. In another move to enter a new retail market in 2004, eBay acquired Rent.com for $415 million. This online site offers a completely free rental and roommate search service; it offers to pay users who have signed a new lease at a prop- erty found on its Website $100 when they inform Rent.com. Once again, the “sellers” of the rentals on its Websites are charged the fees; the online room- mate search is free. Rent.com has millions of up- to- date rental listings, with thousands added every day; listings include a property’s address and phone num- ber, a detailed description, photos, floor plans, and so on, which makes it easier for prospective renters to research and select a rental.

In 2000, eBay acquired Half.com for $318 million. Half.com is an online retail platform that specializes

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sellers to integrate Skype into their storefronts and to find new ways to include it in the regular transaction process just as it was doing with its PayPal service.

eBay ProStores Another strategy eBay has used to grow its revenues was to create a new online retail consulting service called ProStores in 2005 that allows potential sell- ers to utilize eBay’s functional competencies in online retailing to create their own online storefront using eBay’s software—for a fee of course. ProStores offers sellers a fully featured Web store that can be custom- ized specifically for each online seller and that is then maintained and hosted by eBay. Sellers using the Pro- Stores service might be specialist B&M stores search- ing for a quick and easy way to establish an online presence, or any entrepreneur who wishes to start an online store. The difference between eBay ProStores and regular eBay Stores is that ProStores sites are ac- cessed through a URL unique to each seller and are not required to carry eBay branding. ProStores sell- ers are responsible for driving their own store traffic. While items on ProStores sites sell at fixed prices only, they can be simultaneously listed on the eBay market- place in either the auction or fixed-price formats.

ProStores provides all software needed to build a storefront and then create the listing, promotion, and payment systems needed to make it work. ProStores uses templates and wizards that allow users to quickly and easily build an attractive, feature-rich store with no technical or design skills whatsoever. In return, eBay charges two basic fees to all sellers who purchase a ProStores Web store: (1) a monthly subscription fee and (2) a monthly successful transaction fee calcu- lated as a percentage of the sales price of items sold in the store. The subscription fee ranges from $6.95 to $249.95, depending on the size of the store. The suc- cessful transaction fee varies between 1.5 and 2.5%.

eBay Express Finally, reacting to growing buyer demand for a discounted, fixed-price retail format, in 2006, eBay established eBay Express, where a vast inventory of brand-new, brand-name, and hard-to-find prod- ucts are offered at fixed prices by top eBay sellers. Buyers are able to obtain the products they want

competitor that had achieved an 80% market share in the Netherlands by focusing on small fixed-price ads, not auctions. Then, in 2005, eBay acquired Gumtree, a network of UK local city classifieds sites; the Spanish classifieds site, Loquo; and the German language classifieds site, Opus Forum. In 2005 eBay launched Kijiji, a local classifieds site it made avail- able in nearly a dozen countries to try to dominate this growing retailing market.

The Skype Acquisition Perhaps going furthest away from its core business, in 2005, eBay acquired Skype, the dominant Voice- Over-Internet-Provider (VOIP) telephone company, for $2.6 billion. Meg Whitman’s rationale for this expensive purchase was that Skype would provide eBay with the ability to perform an important ser- vice for its users, specifically, to give them a quick, inexpensive way to communicate and exchange the information required to complete online transac- tions. Skype’s software allows users to make free calls from their computers over the Internet to anyone, anywhere in the world. Skype boasts supe- rior call quality and the ability to allow users not just to make phone calls but also to send instant messages, transfer big files, chat, and make video conference calls. It is a full-scale online communi- cations company.

According to Whitman, Skype would help eBay sellers build their online businesses. Using Skype, buyers can contact sellers anytime on their Skype phone number. Sellers can also call regular phone numbers anywhere in the world using SkypeOut at very low rates, and with a SkypeIn phone number, buyers can call a regular telephone number wherever the seller is in the world. Also, in the case of large sellers, Skype allows continuous contact between all the members of the store with SkypeIn numbers and Skype Voicemail. For buyers, Skype allows them to get all the product information they need to buy with confidence and to get answers immediately, without waiting for e-mail.

Many analysts believed it was questionable whether eBay needed to buy a VOIP company given that so many alternative methods of instant communication were offered by so many online com- panies as AOL, MSN, Yahoo!, Google, and so on. Nevertheless, eBay quickly developed strategies to get

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and any other Internet Website willing to share ad- vertising revenues with Google. In fact, because eBay is one of the world’s biggest buyers of Web search terms, it is one of Google’s largest customers. eBay manages a portfolio of 15 million keywords on different search sites, such as Google, Yahoo!, and AOL. These searches are aimed at attracting bidders to one of eBay’s retail formats, which is why eBay, or one of its subsidiaries, often comes up first on a search inquiry.

All the large Internet companies realized they had underestimated the enormous potential revenues to be earned from Internet advertising and were anxious to get a bigger share of the pie and copy Google’s approach. eBay, which had not placed ads on its pages in the past to allow its users to focus on the products for sale, now began to have banner ads, pop-ups, and the other obtrusive and annoying ways of advertising developed by software advertis- ing engineers. By 2007, it had placed several ads on each page in its desperate hurry to increase revenues. eBay became concerned Google would start to drain away even more of its revenues and customers, and it searched for ways to counter Google’s threat. How- ever, analysts noted that eBay could not abandon its “friendly” relationship with Google because Google is the most popular search engine on which eBay promotes its retail storefronts.

Third, in another controversial move, in the spring of 2006, eBay decided to sharply increase the fees it charged its fixed-cost storefronts to advertise on its site. By 2006, sales of fixed-price products, which carried smaller margins than auction products, had grown to over 80% of total retail sales. In charging higher fees, eBay risked alienating large fixed-cost sellers, which would be forced to pass on these in- creases to customers, and of alienating customers who now could choose a popular shopping com- parison tool like eBay, MSN, or Google’s shopping- specific Websites, all of which attempt to locate the lowest-priced products. They could also go and shop at Amazon.com. Analysts questioned if this strategy would backfire—and it did as discussed below.

A 2007 Turnaround? In 2007, eBay announced some impressive finan- cial results that provided a lift to its stock price that had fallen from $60 in 2005 to a low of $25

with no bidding and no waiting; they can fill their shopping carts from multiple eBay merchants and pay for everything, including shipping, in a single, secure payment using PayPal. eBay is touting that every transaction is safe, secure, and fully covered by free buyer protection from PayPal. eBay Express was eBay’s first major move to react to the grow- ing threat it was facing from Amazon.com, whose rapid growth was based on the growing popularity among online customers for fixed-price retailing. As discussed below, eBay was too late to enter fixed- price retailing because Amazon.com had now gained the first mover advantage and this has resulted in growing problems, as discussed next.

New Problems for eBay Despite adopting all these new strategies to strengthen its business model, in the 12 months end- ing August 2006, eBay’s stock declined 30% from its lofty height, while the stock market had risen about 8%. Why? The first major problem facing eBay was that while the number of its global users was increasing, it was increasing at a decreasing rate— even after all its promotional and advertising efforts and its emphasis on introducing new site features, functionality, retail formats and international expan- sion. Similarly, although the number of items listed on eBay’s retail platforms was increasing (by 45% in 2004 and 33% in 2005), growth was also slowing. In fact, in eBay’s U.S. retail segment, net transaction revenues increased only 31% in 2005 and 30% in 2004, compared to 43% in 2003, while gross mer- chandise volume increased 19% in 2005 and 27% in 2004, compared to 41% in 2003. eBay’s revenue growth was slowing, and it seemed clear to investors that despite all its new strategies and entry into on- line payment and communications activities would not be able to sustain its future growth—and so jus- tify its lofty stock price.

A second major problem was its failure to rec- ognize the potential of online advertising revenues. By 2006, it was clear that leading Internet compa- nies like Yahoo!, Microsoft, and eBay were all facing a major threat from Google, which was perfecting its incredibly lucrative online search and advertising model. Google was now the “new eBay” in terms of stock appreciation because of the way it was able to implant its advertising search software into its own

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also proposed to develop a much clearer way of com- bining fixed-price listings, which are appropriate for new current-model products, and auctions, which are the best way to find prices for unique, older and used merchandise. In 2008, buyers could purchase fixed-price goods on the main eBay site, as well as on its eBay Express site and Shopping.com site. In the future, Donahoe wants all these different options to be presented on a single page of search results from eBay’s main site. This was an ambitious goal as the changes eBay’s software designers had been making over time were often not well received by buyers or sellers, who had not liked the changes eBay had been making to its search engine. However, eBay was now increasingly under attack from Google and Amazon .com, that had been developing much more advanced search engines and were attracting more customers as a result.

Donahoe also noted that an increasing percent- age of eBay’s revenues and profits were coming from its PayPal operations and that one of his ma- jor priorities would be to promote the use and scale of PayPal’s financial operations. On the other hand, he also noted that the Skype acquisition was not in- creasing the profitability of eBay’s value-chain opera- tions, and that he would look at the pros and cons of divesting it to free up working capital to be invested in eBay’s Marketplaces retail channels.

Donahoe also announced that eBay would be creating a new fee structure for sellers that would reduce the initial cost of listing an item, including the cost of putting photographs on the listing, and shifting the burden to an increased percentage of the final sale price. He claimed that, as Amazon.com was doing, sellers prefer this model that only charges a fee when a sale is made because it involves less risk to them. However, as he said: “There definitely will be those that are concerned or upset about these changes, our clear belief is what’s good for buyers is good for sellers, and is good for eBay.” Little did he know what was in store for eBay.

eBay’s Seller’s Revolt As noted earlier, since its founding, eBay has sought to cultivate good relationships with the millions of sellers that advertise their goods on its Website. But, at the same time, to increase its revenues and profits it steadily increased the fees it charges sellers to list

in 2006. Shares of eBay jumped by 8% in February 2007 when eBay reported a fourth-quarter profit that climbed 24% as sales rose more than expected, helped by a surge in its PayPal electronic payments business and higher prices for the items eBay sells online. Net income for the fourth quarter rose to $346 million, or $0.25 a share, from $279 million, or $0.20, a year earlier. Revenue from eBay’s PayPal payments business rose 37% to $417 million, or 1/4 of the company’s total, while sales in its online mar- ketplace business rose 24%. These results suggested that eBay’s decision to raise its charges to list items in eBay stores to some of its highest-volume sellers had paid off, the quality of the listing had improved, and more of these sellers had been encouraged to use the higher fee-paying auction method. eBay’s stock price climbed to $40 by October 2007, and that once again seemed to suggest to investors that its competi- tive advantage was secure, even in the face of chal- lenges from Google and Amazon.com. However, the turnaround was short-lived.

A New CEO and New Problems and Strategies When eBay reported results in the next two quar- ters, however, it was clear that all was not well as its core auction business experienced sequential de- clines in listings. It was becoming clear that the com- pany’s growth was still slowing despite all of Meg Whitman’s efforts to expand its sales and retail chan- nels, payment services, and communication through Skype. When the company’s stock had dropped back to $26 by March 2008, Whitman decided to resign and a new CEO, John Donahoe, who had been presi- dent of eBay Marketplaces and its retail channels, was named to succeed her.

In one of his first press conferences as CEO, Donahoe announced that eBay’s biggest problem was that it was lagging behind in its attempts to de- velop an advanced search engine that would let users find the products they want: “Today our buyers tell us that we know you have unmatched selection, but we can’t always find what we want and find values as fast as we want,” Donahoe said. Donahoe’s new goal for eBay’s retail channels was to use its massive data- base on seller and buyer transactions to provide the most relevant search experience possible, Donahoe

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did smooth over the bad feeling between sellers and eBay, but the old “community relationship” it had enjoyed with sellers largely disappeared.

Improving Retail Channels and Product Search Clearly, Donahoe would not be able to significantly increase eBay’s revenues by increasing fees to sellers in the future, so his focus now was on expanding and improving its retail channels and product search capabilities to increase revenues. In 2007, eBay had acquired StubHub, the world’s largest online ticket marketplace, and Donahoe worked to increase its market share and profits, once again by increasing fees, but also by improving its search software ca- pabilities. eBay has also launched its Kijiji classified sites in 200 U.S. cities during 2007, but had not had the success it expected. In 2010, eBay relaunched its Kijiji classifieds site as eBayClassifieds.com with major software enhancements that it claimed would create industry-leading standards in trust and safety, customer service and user experience. In 2008, eBay Marketplaces introduced gift cards to capitalize on the growing popularity of “private” credit cards.

In 2009, eBay introduced “Daily Deals” to com- pete with Groupon and Living Social, backed by Amazon.com. This new online coupon retail channel connects buyers with sellers faster than ever, and its popularity has exploded. In 2011, eBay launched a new home page design that offers more deals and personalization—especially for fixed-price goods the latest step in Donahoe’s attempts to improve its search engine capabilities. Also, in 2011, it acquired local product search company, Milo.com, to enhance its daily deal channel offerings.

New Moves with PayPal Over the last several years, PayPal was contribut- ing more and more to eBay’s profits as the number of its active users, compared to eBay users, and the volume and value of PayPal’s transactions increased (See Exhibit 1).

eBay has been working hard to make PayPal a financial powerhouse, and a leading conduit through which buyers and sellers can transact internationally,

and promote their products on its sites, to use its PayPal payment service, and so on. This had caused some grumbling and problems with sellers in the past because it reduced their profit margins. How- ever, eBay had been increasing its advertising and de- veloping new retail channels to attract millions more buyers to its Websites so sellers would receive better prices and this would offset their higher costs. As a result, sellers tolerated eBay’s fee structure.

This all changed in February 2008 when Donohue’s new fee structure took effect. For its small-scale sell- ers that already had thin profit margins the fee hikes that increased back-end commissions on completed sales and payments were painful. In addition, in the future, eBay announced it would block sellers from leaving negative feedback about buyers— feedback such as buyers who didn’t pay for the goods they pur- chased or took too long to do so. Donohue’s claimed this change was to improve the buyer’s experience because many buyers had complained that if they left negative feedback for a seller—the seller would then leave negative feedback for the buyer!

Together, however, these changes resulted in a blaze of conflict between eBay and its millions of sellers who thought they were being harmed by these changes, that they had lost their prestige and stand- ing at eBay, and their bad feelings resulted in a re- volt. Blogs and forums across the Internet were filled with messages expressing feelings that eBay had abandoned its smaller sellers and was pushing them out of business in favor of high-volume “powersell- ers” who contributed more to eBay’s profits. eBay and Donohue received millions of hostile e-mails and sellers threatened they would move their business elsewhere, such as onto Amazon.com. Sellers even organized a 1-week boycott of eBay during which they would list no items with the company to ex- press their hostility. Many sellers did shut down their eBay online storefronts and moved to Amazon.com, which claimed in 2009 that for the first time its net- work of retail sites had overtaken eBay in monthly unique viewers or “hits.” One informal survey found that while over 50% of buyers thought Amazon.com was an excellent sales channel, only 23% regarded Bay as being excellent.

Realizing his changes had backfired, Donohue reversed course in 2009 and eliminated several of eBay’s fee increases and revamped its feedback sys- tem so that buyers and sellers can now respond to one another’s comments in a fairer way. These moves

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other companies could link in directly to the PayPal system and customize their payment approach. For example, in 2010

Facebook users became able to use PayPal to pay for Facebook Ads through the company’s on- line advertising tool and for gaming services such as Zynga’s Cityville and Farmville. In 2011, PayPal launched a new service that lets digital-game play- ers pay for digital goods without leaving the content site—and it has already processed $3.4 billion in digital-goods payments.

Given the growing importance of secure mobile payments in the 2010s as Apple and Google also be- gan offering their own mobile online payments sys- tem, in 2011 eBay acquired privately-held Zong Inc. for $240 million to strengthen PayPal’s position in the fast-growing mobile payments and digital goods market. Zong allows consumers to pay for purchases from their mobile phones (or direct-carrier billing) on the Internet and offers a secure connection to more than 250 mobile operators in 45 countries. PayPal President Scott Thompson said that eBay ex- pects that “Zong will strengthen PayPal’s value by helping us reach the more than 4 billion people who have mobile phones, giving them more choice and security when they pay.”

The Skype Divestiture Meg Whitman’s strategy that Skype, by providing easy and free global communication, would speed information flow between sellers and buyers and drive eBay’s global sales and revenues was not realized—most eBay users stayed with their own e-mail or SMS providers. Consequently, in 2009 an- nounced that it would sell about 70% of Skype to a group of private investors for $2.75 billion, which it bought for about $3.1 billion in 2005. While this

something that often involves high fees for buyers and sellers. PayPal also issues eBay credit cards and it has become another important means to reassure buyers that sellers are honest and reputable. During the last decade complaints about fraud on eBay have received increasing publicity as the scams practiced by unethical sellers have been revealed. PayPal al- lows eBay to offers buyers who use PayPal to pay for their products free product insurance protection in the event that their purchases are either fraudu- lent or misrepresented. It also reassures sellers that they can trust buyers. Through PayPal, eBay can police sellers and buyers and suspend their accounts if necessary to increase the reliability and quality of its performance. Today, the eBay Buyer Protection program offered through PayPal is the most com- prehensive online consumer protection provided by a global retailer.

eBay has also been working to expand PayPal’s appeal in many other ways to make it the leading online payment company. In 2005, PayPal launched its Merchant Services division that allows sellers of all sizes to easily and securely accept payments across the Internet. In 2006, PayPal launched a mobile ap- plication that allows PayPal users to send money via their mobile phones. By 2008, 8% of all e-commerce worldwide was transacted via PayPal. In 2009, PayPal acquired Israel’s Fraud Sciences Ltd. to en- hance its security and fraud management systems. Also in 2009, eBay launched its iPhone application, giving millions of buyers mobile access to eBay so that they could buy their items and then pay for them online. To allow its customers more credit facilities, eBay also acquired “Bill Me Later,” a leading online- oriented payments brand and began to offer Bill Me Later as an option to customers during checkout.

In 2009, PayPal also opened its platform, PayPal X to become the first major global payments com- pany that was open to third-party development so

2006 2007 2008 2009 2010

Number of Active Global eBay Users (in millions) 82 85 88 90 94

Number of Active Global PayPal Users (in millions) 49 57 70 81 94

Total PayPal Payment Volume (in billions) $366 $486 $606 $726 $926

Exhibit 1 Changes in eBay and PayPal Users and PayPal Payments 2006–2010

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and shipping of inventory of the merchants who sell their products on its Websites. Merchants who use Amazon.com’s value-chain services benefit enor- mously from its huge supply chain and the econo- mies of scale that come with it, such as not having to handle inventory, and fast and often free shipping. In the past, eBay appeared to have a stronger business model than Amazon.com’s because, unlike Amazon .com, it did not have to bear the costs of warehouses, inventory, and shipping. It provided the marketplace for buyers and sellers to meet, and then, of course, also provided the profitable PayPal payment service that has allowed it to take a greater percentage of the revenues from online transactions on its Website. However, Amazon.com, has shown that by using IT to manage the huge supply chain infrastructure of warehouses necessary to control transactions along the value chain it can provide a better experience for merchants and customers—driving merchants to sell through Amazon.com instead of eBay. Recall, that in the late-1990s Amazon.com tried to take on eBay in auctions and failed. Now eBay is playing catch-up to Amazon.com in the fixed-price product market and is establishing its own physical value chain. Will this work? In 2011, more and more of eBay’s profits were coming from expanding its PayPal financial services and analysts worried that this was not a good strat- egy to increase the profitability of its business model.

seemed to be a poor return on eBay’s investment, it received a pleasant surprise in 2011 when Microsoft announced that it was acquiring Skype for $8.5 billion; that gave eBay a quick $1.4 billion profit on its remaining 30% stake.

A 2011 Turnaround? After all these strategic changes to its business model, by October 2010, Donahoe’s turnaround plan for eBay was showing signs of success; 2009 revenues were $8.7 million, or 14% higher than before Donahoe took over in 2008, and in 2010, revenues were $9.5 billion while profit had also increased fu- eled by the Skype sale, growth in PayPal and growth in revenues from increased sales from its online retail channels.” CEO John Donahoe announced that he was pleased with the progress that buyers and sell- ers were noticing, but also that there was still a lot of work to do. eBay’s biggest challenge is still how to manage the threats posed by Amazon.com and Google, which have also been changing their busi- ness models to outcompete eBay.

One strategy eBay announced in July 2011 was that it was going to start rolling out a fulfillment service for its merchants, similar to Amazon.com’s Marketplace service, and this will handle the storage

Endnotes

www.ebay.com, press releases 1997–2011. eBay Annual and 10K Reports, 1997–2011. Belbin, David, The eBay Book: Essential Tips for Buying

and Selling on eBay.co.uk, (London: Harriman House Publishing, 2004).

Cihlar, Christopher, The Grilled Cheese Madonna and 99 Other of the Weirdest, Wackiest, Most Famous eBay Auctions Ever, (New York: Random House, 2006).

Cohen, Adam, The Perfect Store: Inside eBay, (Boston: Little, Brown & Company, 2002)

Jackson, Eric M., The PayPal Wars: Battles with eBay, the Media, the Mafia, and the Rest of Planet Earth, (Los Angeles: World Ahead Publishing, 2004).

Nissanoff, Daniel, FutureShop: How the New Auction Cul- ture Will Revolutionize the Way We Buy, Sell and Get the Things We Really Want, London: The Penguin Press, 2006).

Spencer, Christopher Matthew, The eBay Entrepreneur, New York: Kaplan Publishing 2006).

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CASE 23 Is Yahoo!’s Business Model Working in 2011?

In 2006, Yahoo! was the world’s most-visited in- teractive Web portal or entryway into the World Wide Web (WWW). It averaged over 144 million page views per day, earned $2 billion on revenues of $6.4 billion in 2006, and its stock price was around $30 (down from its all time high of $100 before the 2000 dot.com bust led its stock price to plunge in value to $4.40!). By 2010, Yahoo! was still the third most-visited Web portal, despite that both Google and Facebook surpassed it in their numbers of daily page views. Moreover, its share of the search engine market had dramatically plummeted from over 30% to around 12% while Google search in- creased its share to a whopping 65%. The result of these changes was that in 2011, Yahoo!’s stock price averaged around only $15—it had lost over half its value in the last 5 years. What went wrong? Why had Yahoo!’s business model been performing so poorly; why were its strategies not working in the rapidly evolving Internet content provider industry?

Yahoo!’s Beginnings The Yahoo! portal has its origins in the Website directory created as a hobby by its two founders, David Filo and Jerry Yang. Filo and Yang, two Ph.D. candidates in electrical engineering at Stanford Uni- versity. They wanted a quick and easy way to re- member and revisit the Websites they had identified as the best and most useful from the hundreds of thousands of sites that were quickly appearing on the WWW in the early-1990s. They soon realized that as the list of their favorite Websites grew lon- ger and longer, the list began to lose its usefulness, as they had to wade through a longer and longer list of URLs (Website addresses) to find the specific

site they wanted. So to reduce their search time Filo and Yang decided to divide their list of Websites into smaller and more manageable categories according to each one’s specific content or subject matter, such as sports, business, politics, or culture. In 1994, they published their Website directory online calling it “Jerry’s Guide to the WWW” for their friends to use. Soon, hundreds—then thousands—of people located and clicked on their Website because it saved them time and effort to identify the most useful sites— their Website went viral.

As they continued to develop their directory, Filo and Yang found that each of the directory’s subject categories were also quickly becoming large and un- wieldy to search, so they further divided them into subcategories. Now, their directory organized Web- sites into a hierarchy, rather than a searchable index of pages, so they renamed their directory “Yahoo!” supposedly short for “Yet Another Hierarchical Of- ficious Oracle,” and the Yahoo! search engine was born. However, Filo and Yang insisted they selected the name because they liked the word’s general mean- ing as originated by Jonathan Swift in Gulliver’s Travels as someone or something that is “rude, unso- phisticated, and uncouth”; their goals was, after all, to continuously improve the site over time. As their directory grew, they realized they could not possibly identify all the best Websites that were appearing in the WWW, so they recruited human volunteers to help them improve, expand, and refine their direc- tory and make it a more useful, laborsaving search device.

By 1994, hundreds of thousands of users were visiting Yahoo! every day; it had quickly become the primary search portal of choice for people surfing the Web to help them find the sites that provided the most useful, interesting and entertaining content.

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (YAHOO), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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clicked on an ad, this “click impression” became a charge to the advertiser’s account, and the greater the number of impressions the greater the advertising fees. As their fledgling company grew and the num- ber of user visits soared, Filo and Yang realized they needed to find new sources of funding to develop a sophisticated IT infrastructure to support their por- tal’s growth. Searching for backing from venture cap- italists, they soon struck a deal with Sequoia Capital, a Silicon Valley firm that had supported Apple and Oracle among other high-tech companies. Using the $2 million seed capital to build their company’s IT systems, their portal continued to soar in popularity, and in 1996, this success led to Yahoo!’s initial pub- lic stock offering that raised $338 million by selling 2.6 million shares at $13 each, to allow it to fund future growth.

Sequoia Capital understood the problems facing new startups and entrepreneurs and insisted that Filo and Yang, who had no business background, should hire experienced executives to develop Yahoo!’s business model. Sequoia’s partners had learned that the skills needed to be a successful manager often diverge from those necessary to develop successful business strategies, especially if entrepreneurs are driven by their technical or scientific background and do not understand the realities of industry com- petition. Filo and Yang hired Tim Koogle, an expe- rienced ex-Motorola executive with an engineering background to be Yahoo!’s new CEO. Filo and Yang became joint co-chairmen of Yahoo! with the title of “Chief Yahoo!”.

Developing Yahoo!’s Business Model Koogle started to build Yahoo!’s business model by focusing on recruiting marketing experts and increasing the company’s advertising function to strengthen Yahoo!’s core competences and increase ad revenues to fund the company’s further growth. At the same time, Koogle decided revenue growth should be driven by increasing the number of site users, and so the need to continuously improve Yahoo!’s search engine—and find new ways to at- tract visitors—was vital.

Filo and Yang took responsibility for improving the search engine but now hired many experts such

By 1995, Yahoo! recorded over a million “hits” or user visits per day as word kept spreading about the utility of their search engine. The increasing size of their search engine had outgrown the limited host- ing capacity of their Stanford University account so they arranged to borrow server capacity from nearby Netscape, which had developed the first Web browser. Yang and Filo decided to put their graduate studies on hold and turn their attention and skills to work on building Yahoo! into a business.

When they created their directory, Filo and Yang had no idea they had a potential gold mine at their fingertips. They enjoyed surfing the Web and were interested in making it easier for ordinary people to do so as well. But, by 1994, it became clear that they could make major money from their directory if they allowed companies to advertise their products on the site in order to attract more sales. Of course, all along, the Internet had been rapidly expanding, and Filo and Yang realized they had to move quickly to capitalize on Yahoo!’s popularity—in any market there are always several other entrepreneurs who are pursuing a similar idea, and the race is on to become the first to successfully develop a new product and make it a success. Although their search engine was the first of its kind to be up and running, they knew it could be imitated. Indeed, competitive Web- crawling search engine companies like AltaVista that used mathematical algorithms to detect the most relevant Websites had already emerged. At this time, Yahoo!’s advantage was that it was a human-powered search engine where real people did the legwork for ordi- nary Internet surfers, and listed sites handpicked for their usefulness. The new mathematical algo- rithms being developed at this time could not match Yahoo!’s ability to select relevant results for specific user inquiries—however, technology quickly im- proved, and Filo and Yang’s human-powered search engine was already on the way to becoming a dino- saur because of the incredible growth of the Internet and WWW that would occur in the next decade.

Nevertheless, as visits to Yahoo!’s hits continued to increase, so did requests by companies to adver- tise on its Web portal, and its advertising revenues rapidly increased, which paid for the rocketing costs of hosting their online directory on computer serv- ers. With a hot new business on their hands, Yang and Filo’s business model was to generate revenues by renting advertising space on the rapidly expand- ing Web pages of their search engine. When a user

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tals Viaweb and Yoyodyne to create its new retail- shopping platform, Yahoo! Stores. Its new online services would enable new and existing businesses to quickly create and manage secure online stores to market and sell their products. After launching their store, these merchants were also included in searches on Yahoo! Shopping, one of the increasingly popu- lar shopping portals that provided potential custom- ers with price comparisons of the products in which they are interested, and so helped to determine the online store from which they would purchase.

To build brand awareness and make it the por- tal of choice for all kinds of Internet-based services Yahoo! spent heavily on advertising, using radio and television ads targeted at mainstream America. To make its portal more useful, Koogle pioneered Yahoo!’s strategy of expanding the range of content and services of the Internet communication services it provided to its users to make the portal more useful to them. Over the next decade, Yahoo! con- tinuously developed its technology and made many (expensive) acquisitions that allowed users to access services such as e-mail, instant and text messaging, news, stock alerts, personals, and job placement ser- vices. Moreover, it made these services available over a rapidly expanding array of digital and computing devices or channels from desktop PCs to wireless laptops, and eventually to mobile computing devices such as PalmPilots and smartphones.

Yahoo! also began to work with media and en- tertainment content providers to help them build and improve their own online content and ability to work on Yahoo!’s digital platform. This increased the value of Yahoo!’s portal to users who could ac- cess any content or merchants they needed through Yahoo!. Its goal was to become the portal of choice— the place where Internet users would routinely visit to enjoy and complete online transactions.

At the same time, these moves made Yahoo! increasingly valuable to companies anxious to ad- vertise on the Internet to grow their business. Each specific new online service Yahoo! offered allowed advertisers to better target their advertising mes- sage to specific demographic groups, for example, sports fans, teens, game players, or investors. On- line brokers such as E*Trade and Ameritrade started to heavily advertise on Yahoo!’s popular financial pages; similarly, sports magazines, eBay, and Block- buster focused on the best way to spend their ad dollars on its shopping and news pages. Targeted

as Srinija Srinivasan or “Ontological Yahoo!” as she became known in the company’s early days because of her crucial role in refining and developing the clas- sification system that was the hallmark of Yahoo!’s search engine. She helped Filo and Yang hire hun- dreds more software engineers to broaden and in- crease the reach and usefulness of Yahoo!’s search engine, and to manage its fast-growing IT infrastruc- ture that was being continuously upgraded to handle the tens of millions of daily user requests the com- pany was now receiving. By 1996, Yahoo! listed over 200,000 individual Websites in over 20,000 different categories. Hundreds of companies had signed up with Yahoo! to advertise their products on its portal to reach its millions of users.

Another strategy Koogle developed was to take Yahoo!’s business model and replicate it around the world—to increase global advertising revenue. By the end of 1996, there were 18 Yahoo! portals us- ing 12 languages operating outside the United States. In each country, Yahoo!’s portal and Web directory was customized to the tastes and needs of local users. However, there was considerable overlap between countries in terms of popular global news, poli- tics, media, and entertainment Websites, which also helped Yahoo! to find new attractive Websites and strengthen its U.S. search engine. This, of course, led to the development of new Web pages that helped increasing its advertising revenues.

Yahoo!’s success with its growing global Internet search operations convinced Koogle to craft a new vision and business model for Yahoo!. The company would no longer operate only as a search engine, but would now develop new media and entertainment services to allow it become the dominant global communication, media entertainment, and retail company. Yahoo! would become a portal that could be used to enable anyone to connect with anything or anybody on the Internet.

In the vision its top executives crafted, Yahoo! would not only continue to generate increasing rev- enues from the sale of advertising space on its search engine pages, it would also earn significant revenues from engaging in e-commerce transactions— buying and selling between Internet users—and take a per- centage of the value of each transaction executed using its portal as its fee. Of course, other com- panies such as eBay and Amazon.com were also quickly developing this kind of Website service. In 1998, Yahoo! acquired the Internet shopping por-

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financial Web page and track their portfolio’s value over time. The financial Webpage also provided links to message boards where individual investors can jointly discuss a company’s prospects. The abil- ity to create a high level of customization created major switching costs for customers. Once users cre- ated their portfolios, personal pages, shopping lists, and other profiles, they would be much less likely to want to repeat this process by signing up at another Web portal—unless it offered some other “killer ap- plication,” or compelling content, which of course is what Google and Facebook have been able to offer in the 2000s.

Yahoo! worked hard to remain the Web por- tal of choice by continuing to introduce additional kinds of online services as soon new startup Internet companies had showed their services were popular among online users. It developed a strategy of ac- quiring the leading Internet company in a particular online area, for example, online dating, to extend its portfolio of services, and keep its leadership as an online portal, thereby increasing its value to its users. In 1999, for example, it made three important acquisitions, RocketMail, an e-mail service provider that became the basis for Yahoo! Mail; GeoCities that provided a free Web-hosting service to regis- tered users, which allowed them to publish their own personal homepages (containing material of their own choice) and to share it with friends and any other interested parties. Lastly, it bought Broad- cast.com, an early leader in online streaming digital audio and video programming that allowed Yahoo! to broadcast audio and video content on all its chan- nels to users. Yahoo!’s goal was to make its services even more valuable to its users—and thus to its ad- vertisers as well—so that these acquisitions would result in increasing advertising revenues. Then, in 2000, Yahoo! acquired eGroups, a free social group/ mailing list hosting service that allowed registered users to set up any kind of online group of their choice, and use it as a forum to attract other Inter- net users that shared their interests; soon hundreds of thousands of specialized groups had been estab- lished. Yahoo! integrated eGroups into its successful Yahoo! Groups service to develop and strengthen its services, and today it has millions of registered groups of users and is a popular mailing list service for all kinds of social networking purposes. Yahoo! paid billions to acquire these companies, however, because this was the time of the dot.com bubble;

advertising increased the rate at which a user clicks on ads, which translated into more completed on- line transactions, therefore increasing the yield (or return) of online advertising to merchants. (This is something Google understood much better than Yahoo! and the reason why Google is the leader in online advertising today.)

The result of Koogle’s new business model and strategies was spectacular. By the end of 1998, the company had 50 million unique users, up from 26 million in the prior year; 35 million of these were now registered Yahoo! users who had created e-mail, gaming, and other kinds of accounts with the com- pany. Moreover, 3,800 companies were advertising on Yahoo!’s pages up from 2,600 in 1997, and 700 in 1996. By 1999, 5000 merchants were selling prod- ucts on the Yahoo! Shopping page up from 3,500 in 1998, and the company’s revenues had grown from $21.5 million in 1996 to $203 million in 1998!

Building a Stronger Business Model: More Content and Channels To keep Yahoo!’s profits growing, it was necessary to drive an increasing number of users to its portal, and Koogle’s new strategies revolved around making Yahoo! a “megabrand” by “becoming the most use- ful and well-known Web portal on the Internet.” His entire focus was to create compelling news, media, shopping, and entertainment content by adding ad- ditional Yahoo! channels, which had more services and features to increase its value to users, and en- courage them to become regular registered users. The ability to attract and retain customers is a ma- jor metric used by investors to evaluate a company’s value, not only Internet content providers but also cable TV providers, wireless phone providers, and so on. Yahoo!’s goal was to lock in users and increase their switching costs of turning to a new portal.

To facilitate this process, Yahoo! provided fea- tures that made it possible for users to customize Yahoo!’s Web pages and services to better meet their specific needs. For example, Yahoo!’s registered us- ers could customize its popular news service to show the specific news sections they were the most inter- ested in, such as technology or entertainment, or users could input their personal portfolios into its

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Big Problems Face Yahoo! Just 2 years later, however, Yahoo!’s stock had plum- meted to just $9 a share, which valued the company at less than $10 billion. Why? Because the dot.com bust sent thousands of Internet companies into bankruptcy and caused an across-the-board plunge in their stock prices. However, Yahoo! was still re- garded as a dot.com powerhouse and many analysts put some of the blame for the fall in its stock price (eBay’s did not fall greatly) on managerial mistakes at the top of the company—in particular on the way Yahoo!’s business model had developed over time.

CEO Tim Koogle had staked Yahoo!’s continuing success on its ability to develop an increasing range of compelling Web content and services to drive in- creased visits to its portal and generate more adver- tising and e-commerce revenues. The problem with this business model was that it made Yahoo!’s profit- ability (and stock price) totally dependent upon how fast advertising revenues increased—or how fast they fell. The dot.com bust and the economic reces- sion that followed in the early-2000s led to a huge fall in the amount large and small companies were willing to spend on Internet advertising. As its adver- tising revenues plunged, Yahoo!’s stock price plum- meted, and its investors’ hopes of increasing revenue growth disappeared. Moreover, it turned out that Koogle had spend far too much money—billions too much—to pay for acquisitions such as GeoCities and eGroups (especially given that these companies prof- its were also highly dependent on Internet advertis- ing!). Had these companies remained independent, they would now be valued at a fraction of the price Yahoo! paid for them.

Advances in Internet and Digital Technologies At the same time, Internet and digital technologies were continually advancing and improving, and that lowered the value of the acquired companies’ distinctive competencies, and therefore their com- petitive advantage in providing a specific online service—the primary reason why Yahoo! acquired them. Technological advances had made it easier for entrepreneurs to start new dot.coms that could provide similar kinds of specialized Internet services

afterwards the value of these acquisitions plunged— as did Yahoo!’s stock.

In addition to the services just mentioned, Yahoo! also now provided services such as Yahoo! Messen- ger, an instant messaging client that allowed for on- line chat; Yahoo! Games, a successful game-playing service; and various specialized online retail sites, including an online auction service it had started to compete with highly-profitable eBay. Its original search engine had, by this time, become just one of the many services it provided. As it turned out, Koogle’s (and Filo and Yang’s) failure to realize the central importance of Internet searching was a ma- jor factor that led to Yahoo!’s later problems—just as this same error hurt Microsoft, AOL, and all the other major search portals. Google was the excep- tion, as it was focusing its efforts on search capabili- ties, although its reasons were not obvious until the early-2000s.

Nevertheless, as Koogle hoped, as the range of services Yahoo! offered expanded, its popularity in- creased as it became a “one-stop shop” that could cater to most kinds of services that Internet users’ needed—information, entertainment, and retail, for example. Its expanding business model seemed to be working. Most of its services were provided free to Yahoo! users because the advertising revenues it earned from the ads on the millions of Web pages on its portal were the primary source of revenues in its profitable business model. In addition, it earned some revenues from the fees it charged sellers and buyers on its shopping and specialized retail sites. Also, Yahoo! charged for specialized services such as its personals dating service, a streaming stock quotes service, a job hunting service, and various premium e-mail and Web storage options that provided users with more kinds of value-added solutions. This also helped to increase revenues and earnings.

The success of its strategy of bundling online ser- vices to attract ever-greater numbers of users became clear as Yahoo!’s user base exploded. By the end of the 1990s, 15 million people a day were visiting Yahoo! and it had become the most visited portal on the WWW. Its business model, based on the idea that the more services it offered, the greater the num- ber of Internet users it would attract, (and the higher would be the advertising fees it could charge compa- nies) seemed to be working. In 2000, Yahoo!’s stock price reached the astronomical height of $237, its market value was $220 billion!

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Yahoo!’s search engine technology because it had be- come a portal providing so many different kinds of information services.

The Web Portal Industry To appreciate the problems Yahoo! was now fac- ing, it is necessary to understand how the incredible growth in the 1990s of the Internet and WWW, and rapid advances in Internet hardware and software, changed the function of Web portals dramatically over the 2000s.

Internet Service Provider Portals The first commercial portals were entry or access portals called Internet Service Providers (ISPs) that provided people with a way to log on to the Internet. For example, companies such as CompuServe, MSN, and AOL offered customers e-mail service and access to the WWW for time-related fees. Slow dial-up con- nections meant high monthly fees, and early on, ISPs charged users for each individual e-mail they sent! Moreover, once on the WWW, users were hampered by the fact that there was no Internet Web browser available to help them easily find and navigate to the thousands (and then millions) of Web pages and Websites that were emerging. Yahoo!’s directory, and then Netscape’s Internet browser (introduced in 1994), changed all this. So did the growth in the number of search engines, including early leaders such as AltaVista, Inktomi, and Infoseek, that were all available to help users surf the Web. Typically, a user would connect to the Web through an access portal, and then go to their specific search engine of choice to identify Websites of interest, which they could then bookmark as favorites using Netscape’s Web browser.

Product Bundling Portals When Yahoo! became the leading search engine, this began the second phase of portal development, the product bundling or aggregation phase. Dot.coms such as Yahoo!, AOL, MSN, and hundreds of other now defunct Web portals were competing to

that Yahoo! offered—but which also had a new twist or killer application that was better than Google’s. Thus in the 2000s, competitors like Monster.com, MySpace, and YouTube emerged offering digital services that proved so attractive they also became leading Web portals in providing a particular kind of online application: job hunting, social networking, and online video, respectively. These portals became major threats to Yahoo! because they siphoned off its users, and reduced its advertising revenues, which at that time were mainly based on the number of users visiting a Website. Now, Yahoo! lacked the re- sources to buy these portals, it had spent its cash and its stock price was low.

Search Engine’s Become More Powerful: The Growing Threat from Google On the search engine front as well, the search in- formation service that had been the key to Yahoo!’s rise and its original distinctive competence was also experiencing a new threat. Yahoo! was experiencing increased competition because of the growing popu- larity of Google, a small, relatively unknown search engine company in 2000. By the early-2000s, how- ever, it became obvious to Web watchers that Google was pioneering advances in WWW search technol- ogy that was making Yahoo!’s hierarchical directory classification obsolete! Yahoo!, like other major Web portals such as Microsoft’s MSN and AOL had failed to realize how the search function would increase so much in importance as the breadth and depth of information on the WWW increased. It had become increasingly difficult for Internet users to locate the specific information they needed. The search engine that can find the specific information users want in the fastest time is the one that wins the search en- gine war, and Google’s proprietary technology was attracting more and more users by word of mouth— just as Yahoo!’s directory had grown in popularity so fast in the 1990s. Yahoo! had been providing more and more kinds of online services but in the process had forgotten—or lost—the reason for its origi- nal success. Perhaps a professional manager at the helm was not such a good idea in the first place. Or, perhaps Filo and Yang were simply enjoying their newfound wealth and had not worked to improve

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connections, and users continued to gravitate to por- tals such as Yahoo!, eBay, Amazon.com, MySpace, YouTube, and other similar sites.

Customized Portals In fact, the next major development in Web portals arrived when some Web portals started to special- ize in developing “deeper” relationships with their users. Their goal was to offer their users an increas- ingly customized online experience that set out to help users make better or more informed choices when buying goods or services. Internet book-selling Amazon.com was one of the first portals to pioneer the development of the personalized or custom- ized shopping experience. Amazon.com’s software focused upon providing more information to users by, for example, allowing people who had bought books to provide detailed feedback to users about a particular book—and subsequently all kinds of products that it sold. Similarly, one of Amazon.com’s central goals became to track its users around its site to help them find other products that they might be attracted to. Amazon.com’s database recorded each user’s buying preferences to help them make better buying decisions, and in the 2000s, its tracking tech- nology became so invasive it developed software to track its users as they surfed the Web on other sites to find new products to offer them. Not surprisingly, many of its users thought this was an invasion of their privacy, but in the last decade these new track- ing technologies have proliferated, and few ordinary Internet users today are aware of how much infor- mation is being collected about them by tracking companies that can sell this information to advertis- ing companies.

All the major portals began to realize the impor- tance of offering users a customized online experi- ence, to increase their switching costs, and to keep them loyal, repeat users so their purchases and use could be tracked. Yahoo!, for example, uses “bea- cons” that allow it to follow its users around the WWW unless they choose to turn off this feature to increase their privacy. All the major portals began to make the “My” personal preferences choices on their portals a more important part of their service such as “MyAOL and MyYahoo! in order to be able to increasingly target advertising toward specific customer groups and make their portals easier to

attract Internet users and become the main portal of choice—to obtain advertising revenues. Now dif- ferences in the business models of different portals became increasingly clear, for example, portals like Yahoo! focused on offering users the widest possible selection of free Internet services to create switching costs and develop brand loyalty. Others, like AOL and MSN, adopted the fee-paying model, in which users paid to access the Web through a dial-up con- nection their portals provided, then they could use the range of services they offered free or for a charge for a premium service, like personals.

Competition between these combined access/ aggregation portals increased as they strived to at- tract the tens of millions of new Internet users who were coming online at this time. The bigger their user base, the higher the potential fees and advertising revenues they could collect, so the price of Internet service quickly fell. By the mid-1990s, AOL made a major decision to offer its users unlimited Internet connection time for $19.95 a month. In the U.S., this attracted millions of new customers, and AOL be- came the leading access and aggregation portal with over 30 million users at its height, followed by MSN, and many other smaller ISPs.

The competitive problem these ISP/aggregated service portals like AOL faced from the beginning was that once their users were online, they would search out the “best of breed” Web portal that could provide them with the particular kind of informa- tion service they most wanted. So, millions of AOL subscribers, for example, used the portal to get on- line, but then used the myriad of services available on Yahoo! and other portals. The business model used by AOL, MSN, and others was to improve their content to keep subscribers on their portals in order to obtain the vital advertising and e-commerce rev- enues that Yahoo! was enjoying.

The problem soon facing the ISP/aggregation portals was that new companies started to offer lower-priced Internet access service, and, especially, that developing broadband technology had started to rapidly grow in popularity because of the speed it offered in using and downloading the WWW ser- vices or content that users wanted. This worked in favor of free portals like Yahoo! that did not gener- ate revenues from getting users online. But, it began to hurt fee-based portals such as AOL and MSN that soon experienced falling revenues as new and existing Internet users chose faster broadband ISP

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targeted advertising revenues. In addition, its online games, such as CityVille, provided by Zynga, allow it to generate revenues from the fees it can charge game providers, retail providers, and others.

Many analysts argued that when Yahoo!’s stock price was at its peak, it should have purchased other e-commerce companies that were generating revenue by other means than advertising—such as eBay—so that it could have broadened the source of its rev- enues and reduced its dependency on advertising revenues. If advertising revenues decreased, Yahoo!’s profitability and stock price would plunge. In the early-2000s, Yahoo!’s stock price plummeted as the dot.com bust led to a huge fall in advertising rev- enues, and investors began to realize the weaknesses associated with its business model.

Yahoo!’s disastrous performance convinced its board of directors that new leadership was needed, and Tim Koogle was replaced as CEO by Terry Semel, an experienced Hollywood media ex- ecutive who had once controlled Warner Brothers. To change Yahoo!’s business model, especially as it could no longer afford to acquire specialized Web portals, Semel adopted new strategies to generate in- creased online revenues.

First and foremost, Yahoo! needed to improve its search engine technology, a major portal attrac- tion, to generate more users and advertising rev- enues. As time went on, and the success of Google’s business model became increasingly obvious, Yahoo! focused upon improving its search soft- ware to beat Google at its own game and develop the ability to offer high-quality targeted advertis- ing. Also, Semel decided to pursue a new content- driven strategy, and Yahoo! internally developed new kinds of services, and acquired small special- ist Internet companies that could provide it with the new competencies it needed to compete in new emerging online information and media market segments. For example, Yahoo! acquired HotJobs, a leading Internet job hunting and placement com- pany, and it began to expand its global news and media services operations.

Recognizing the growing importance of digital communications media to generate advertising rev- enues, it established a new Media Group function to develop advanced imaging and video news content to take advantage of increasing broadband Internet access. Yahoo! launched its own video search engine service in 2005, and revamped the Yahoo! Music

use by, for example, offering easy online payment checkout services.

However, it became increasingly apparent that the “best of breed” or leading category Web por- tals were quickly developing a first-mover advan- tage and strong brand loyalty. Amazon.com’s stock price had also plunged after the dot.com bust, but it still pursued its business model to develop the online software that would attract the most cus- tomers and allow it to become the leader in Internet retailing. It succeeded, and was able to withstand the challenge from the thousands of other shop- ping portals that had sprung up in the 2000s, but Amazon.com also crushed the shopping channels of leading portals such as Yahoo! and AOL. Simi- larly, Yahoo!’s online auction service, despite that it was free to its registered users, could not compete with online auction leader eBay because eBay had gained the first-mover advantage, and its popular- ity allowed it to offer buyers and sellers a much larger market (and therefore a much better selec- tion and higher prices).

Yahoo! Problems Increase throughout the 2000s In the 2000s, it became clear that the two biggest sources of revenue and profit for Web portals were those gained from e-commerce, for example, from online retail and auction sales, which has been the source of Amazon.com’s success in the 2010s; and to the generation of and sale of online advertising revenues. In the search engine segment of the market, the search engine company that could quickly pro- vide online customers with the specific information necessary for them to make the best purchase possi- ble, attracted the most advertisers, and could charge higher advertising rates. Google’s strategy to con- tinuously increase its competencies to provide fast, relevant information has, of course, been the busi- ness model behind its huge success, and the failure of most other search engine companies, including Yahoo! and MSN. However, customized portals like Facebook that provide specialist services such as so- cial networking, could also earn high advertising and e-commerce revenues. Facebook’s software platform and huge user base has allowed it to collect detailed information about its users that it can sell to generate

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New Problems with a Content- Driven Strategy By the summer of 2006, things were not so rosy, and major questions were surfacing about how Yahoo!’s content-driven strategy could continue to drive its revenues in the future as competition, especially as Google’s and Facebook’s popularity increased. Yahoo!’s stock fell 25% in the last half of 2006, and analysts worried that these popular search engine and social networking portals were stealing away its us- ers, and that advertising revenues and user fees would fall in the future. For example, Google was now offer- ing an ever-increasing number of free online services such as e-mail, chat, storage, and word processing software to compete with MSN as well as Yahoo!

In an internal e-mail leaked to the media, one of Yahoo!’s top managers expressed concern that many of its new investments in content and services were too expensive, unlikely to generate much profit, and it would not be able to keep up with agile new spe- cialist portals; Google was becoming an Internet Gi- ant. In the “Peanut Butter” memo, senior executive Brad Garlinghouse described Yahoo! as a company in search of a successful business model and strategies: “I’ve heard our strategy described as spreading peanut butter across the myriad opportunities that continue to evolve in the online world. The result: a thin layer of investment spread across everything we do and thus we focus on nothing in particular. I hate peanut butter. We all should.” He had good reasons for his concern because the new specialist portals were more popular than Yahoo!’s own instant messaging and e-mail service, and, especially, in online imaging and video that had become increasingly important to In- ternet users. For example, Google drew further ahead of Yahoo! after its purchase of YouTube in 2006.

Nevertheless, Yahoo! still had impressive con- tent covering sports, entertainment and finance, in particular. Also, it had embarked upon a major push to enhance the mobile delivery of all its services to better meet the needs of people on the go as the number of people using mobile-computing devices such as smartphones soared through the end of the 2000s, and is still growing in 2011. By 2008, for ex- ample, mobile video was a killer application, and to compete with Google, Yahoo! had heavily invested to upgrade this service—but eventually Yahoo! was forced to shut down its video service to cut costs.

download service; it also acquired Flickr, a leading photograph hosting and sharing site. All these strate- gies were designed to become a part of its new so- cial networking strategy in order to compete with MySpace, YouTube, and Facebook. In fact, Yahoo! lost its battle to acquire YouTube to Google in 2006, and, of course, the fast growth of Facebook de- stroyed its chances to develop a popular social net- working site, as Facebook overpowered MySpace, which had been purchased by News Corp. The fast- changing fortunes of Web portals is shown by the change in MySpace’s fortunes; in 2005 it was valued at $3 billion, but its owner New Corp. was happy to divest it in 2011 for $100 million.

Semel continued to try to make new acquisitions to revitalize the appeal of Yahoo!’s hundreds of dif- ferent online content and media services to create a more customized, social network-like appeal to its users. Yahoo! launched a personalized blogging and social networking service Yahoo! 360°, re- vamped its MyWeb personal Web hosting service, created a new PhotoMail service, and purchased online social event calendar company Upcoming .org to compete with Google’s new online calendar service. Continuing its push to strengthen its social networking services. Yahoo! acquired blo.gs, a ser- vice based on RSS feed aggregation and del.icio.us, which allows registered users to create a scrapbook or notebook of information they wish to keep from the Websites they visit, similar to Google’s note- book service.

Semel’s content-driven strategy was to make Yahoo!’s media and entertainment services so use- ful and attractive to online customers that they would be willing to pay for them—in the form of once-and-for-all or monthly fees for services. For example, monthly fees for personal ads in its dat- ing site, or ads to sell or rent merchandise like cars or homes, and fees that provided premium services in areas such as e-mail, data storage, photo shar- ing, e- commerce, message boards, and similar ser- vices. Also, it followed Amazon.com’s initiative and worked to provide online software to generate fees from small businesses that wished to link to its Web portal and use Yahoo!’s specialist services to create, host, and manage their retail stores. Through these moves, Yahoo! kept its position as the most popular portal; its revenue more than tripled from 2003 to 2006 to over $6 billion, and its stock price recovered somewhat in the first half of 2006.

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by the peanut butter memo. The new streamlined organizational structure grouped Yahoo!’s services into three primary product divisions, one focused upon satisfying the needs of its Website users, one upon finding better ways to service the needs of its advertisers, and one upon developing new technology. Semel hoped the reorganization would make Yahoo! more proficient at delivering online services and ads to capture the attention of online users. In 2007, Yahoo! rolled out its new targeted advertising system and announced that it expected major improvements in advertising revenues by the summer. Revenue per search query may grow by 10% or more in the second half of the year, and Semel said, “We believe this will deliver more relevant text ads to users, which in turn should create more high-quality leads. By the time we get to 2008 and beyond, this is a very, very, significant amount of additional profit and I’m pleased with the tangible progress we have made. I’m convinced we’re on the right path.” Yahoo!’s stock increased by over 10% as investors bet that this would be a turnaround moment in Yahoo!’s battle with Google.

Jerry Yang Takes Over as CEO Semel and Yahoo! Investors were wrong. The num- ber of users, including registered Yahoo! users, of Google’s advanced search engine and other services, and the rapid development of popular specialized portals such as YouTube, and social networking Websites like Facebook, continued to siphon off mil- lions of visits to Yahoo!’s Website. At the same time, the number of Yahoo! employees needed to pro- vide the new advanced media services it was trying to offer soared, and so did its R&D costs; its cost structure increased. Also, at the same time, Micro- soft recognized it had been slow to develop its search competencies and it began to pour billions into de- veloping an advanced search engine called “Bing” that emerged at the end of the 2000s.

Investors lost confidence in Semel, who was forced out in 2008, and Yahoo!’s new CEO was now one of its original founders Jerry Yang. Yang spent the next 8 months streamlining Yahoo!’s business model, prioritizing the importance of its vast array of online services, and improving its search and ad- vertising competences, while reducing its workforce to cut costs. But the Google Juggernaut was roaring ahead, and the value of Yahoo!’s stock continued

The problem for Yahoo! was that its cost structure was increasing and it had lost its first-mover advan- tage to its new rivals—not a good position in the fast-changing online world.

The Search Engine Dilemma A discussed earlier, for online digital media compa- nies it had become essential to improve their search engine capabilities. Only Google had understood the crucial strategic relationship between providing us- ers with fast, accurate search results, and the search engine provider that gives the ability to generate increasing advertising revenues. Google’s business model was based upon providing better search ca- pabilities and then providing an increasing number of free online services to attract more users and de- velop brand loyalty. To achieve significant revenue and profit growth, Semel recognized that Yahoo! also had to increase the capabilities of its search en- gine and generate the high volume of user visits that lead to increased revenues from online advertising and facilitating e-commerce transactions. Semel be- gan to look for acquisitions to strengthen and im- prove Yahoo!’s search engine, and it bought several search companies such as Inktomi and Overture to improve its search competences. However, Google was unbeatable; its share of the search engine mar- ket was double that of Yahoo!’s—49% compared to Yahoo!’s 24% in 2006—and Microsoft’s own search engine also plunged in popularity.

To meet Google’s challenge, Semel combined the distinctive competencies of Inktomi and Overture, with its own in-house technology, to develop an im- proved search engine that would allow Yahoo! to of- fer a much more targeted online advertising program to compete with Google’s—Project Panama. This huge, expensive project soon fell behind schedule, the company failed to launch it according to schedule, and Yahoo!’s stock price continued to plunge as it played catch up to Google and the other specialized Web portals. In fact, in 2005, Yahoo! and Google were neck-and-neck and each had about 18% of to- tal online advertising revenues. By the end of 2006, Google’s revenue had grown to 25% and Yahoo!’s had dropped to less than 14%.

In 2007, Semel reorganized Yahoo!’s management structure to allow it to better implement its business model and compete with its rivals—a shakeup sparked

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Yahoo! to gain more control over its business units and reduce operating costs was to centralize functions that had previously been performed by Yahoo!’s different business units, such as product development and marketing activities. For example, all the company’s online publishing and advertising functions were centralized and put under the control of a single executive. Yahoo!’s European, Asian, and emerging markets divisions were combined and cen- tralized under the control of another top executive. Bartz was astonished to find that Yahoo!’s talented programmers and engineers, who worked in differ- ent business units, didn’t talk to each other, and she brought them all under the centralized control of a new executive in charge of product development, Chief Technology Officer Ari Balogh.

Bartz’ cost-cutting efforts helped Yahoo! satisfy investors when, in the Spring of 2009, she an- nounced plans to cut 5% more of Yahoo! staff, on top of 1,600 job cuts that had been made in Decem- ber 2008. However, the way she would grow its reve- nues was not clear, especially as she assumed control when the financial crisis and recession had begun in 2009, and online advertising revenues plunged. Bartz said brand marketers put the brakes on ad spending, especially on display ads; the pictorial banners that were Yahoo!’s chief source of business and revenues fell 13% in 2009. Also, Yahoo!’s search engine adver- tising business fell 3% after having made progress in the last few years—Google kept powering ahead. Nevertheless, she had reduced operating expenses by 4% and had not cut employees in key functions such as product development and marketing. Yahoo!’s stock price rose 5% in the middle of 2009.

Although Yang had refused to sell the company he founded, Bartz made it clear that the company was still for sale—at the right price. Microsoft, however, was no longer interested in a takeover as the power of specialized portals such as Facebook, YouTube, and Amazon.com had by now become apparent—being a generalist and offering all things to all users was no longer possible. Nevertheless, the possibility of a ma- jor strategic alliance between the companies, so both could enjoy cost savings from economies of scale and scope in combining their search engine and online- targeted advertising functions, still existed. Essentially, Microsoft sought to obtain many of the advantages it had sought to achieve from acquiring Yahoo! by forming a strategic alliance. Now, Yahoo!’s position was considerably weaker as Bartz had to find ways to

to fall, so much so that in late-2008, Microsoft an- nounced that it wanted to acquire Yahoo! for $40 bil- lion, a huge premium over its stock price, before the bid and Yahoo!’s stock soared in value. Microsoft’s logic was that its new search engine technology was now mature enough to replace Yahoo!’s and that in combining their search engines and online advertis- ing functions, the merger would reap billions of dol- lars in cost savings. Furthermore, the merger would allow it to combine its MSN online service with Yahoo!’s so its registered customer base would soar, as would the number of users of its new combined Web portal. $40 billion was a lot of money, however.

After the bid, CEO Yang announced that Micro- soft’s offer to buy Yahoo! was a “galvanizing” event for his beleaguered company. However, he also made it clear that he was not interested in the takeover bid, and that he would meet with its board of di- rectors to defend against what he expected would turn into a hostile bid. The battle raged for months during which Yang said he was holding out for a higher offer than the current bid that substantially undervalued Yahoo!’s assets. However, many ana- lysts claimed that Yang was dreaming, and that the company’s founder was not the right person to be in charge of making such an important decision.

Yang was supported by the board, and contin- ued to reject repeated buyout and search-ad deal offers from Microsoft throughout 2008; eventu- ally Microsoft announced it was withdrawing its bid for the company—upon which the value of the company’s stock plunged and irate stockholders de- manded that Yang be replaced. During this crucial year, Yang had been distracted by the takeover bid from streamlining the company’s business model, so its performance had continued to fall! An exhausted Yang, whose resistance to the merger had personally cost him billions of dollars, decided that his future as CEO looked bleak and he handed over the reins to former Autodesk CEO Carol Bartz who became Yahoo! CEO in January 2009.

Bartz Reorganizes Yahoo! Bartz has a long history of success in managing on- line companies and she moved quickly to find ways to reduce Yahoo!’s cost structure and simplify its operations to maintain its strong online brand iden- tity. Bartz decided that the best way to restructure

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profit, while Google’s 29,000 employees had generated $33 billion in revenues and $9 billion in profit. Why?

First, Yahoo! had not obtained the potential ben- efits it had expected to receive from its deal with Microsoft; although it was guaranteed a minimum payment of $450 million per year, the alliance had not generated a major increase in the number of vis- its to its search engine. However, Bartz said she ex- pected revenues to substantially increase by the end of 2011 as the Bing search engine used by Yahoo! was increasing in popularity.

Second, Yahoo!’s targeted display advertising business had not performed as well as expected and profits had significantly fallen. However, Bartz an- nounced that the costs of upgrading Yahoo!’s adver- tising platform and making it consistent across its global Websites was the main reason for this. With its new systems in place, Yahoo! would be able to de- liver targeted advertising faster across all its different online services globally, and to provide companies with more effective advertising. Also, Yahoo! could now deliver its content and ads on all kinds of mo- bile computing devices, not just desktops, and Bartz stressed Yahoo!’s leading position in the U.S. and abroad in important content channels such as news and finance. However, Yahoo! has faced increasing competition from Facebook and Google, and inves- tors worried if it could recover revenue in this highly lucrative market segment.

Yahoo!’s stock fell after this report, especially be- cause it also announced lower revenue guidelines for the rest of 2011. But, its stock also took a major hit in June 2011 when it was announced that Alibaba, a huge Chinese Web portal, in which Yahoo! owns a 40% stake, had spun off its Alipay online payment service into a new company—without securing agree- ment from Yahoo!. Alibaba is worth many billions to Yahoo!, so this seemed to wipe off billions more of its market value and its stock plunged again. In August 2011, Bartz announced that Yahoo! would receive between $2 and $6 billion if and when the Alipay service was eventually spun off in an initial public offering, but this further reduced the value of its Alibaba investment and damaged Bartz’ position. In August 2011, Yahoo!’s market value was about $18 billion, and 2/3 of that value was made up of its Asian assets valued at $9 billion, its $3 billion in cash; what was left was Yahoo!’s global online assets, now valued at around $6 billion. Microsoft had offered to pay $40 billion for its assets just a few years ago!

reduce costs given that Yahoo!’s revenues were stag- nant or declining in many areas. She needed to keep up the company’s stock price, in part, to still make it an attractive acquisition despite the fact that its mar- ket value had now plunged below $30 billion—over $10 billion less than Microsoft had offered for the company. In addition, Bartz announced that when the economy turned around, Yahoo!’s strategy for restor- ing growth would capitalize upon its online brand name and large size, and focus on “creating kick-ass products” to drive its growth.

The Agreement with Microsoft In 2009, Yahoo! and Microsoft announced they had formed a strategic alliance that would benefit both companies in their battle with Google and Facebook. Yahoo! agreed to outsource its back-end search func- tions such as Web crawling, indexing and ranking to Microsoft to save money and use its Bing search engine to enhance its competitive position. In ex- change, Yahoo! agreed to pay Microsoft a commis- sion for paid search ads sold on Yahoo! and Yahoo! partner sites. Yahoo! estimated that this alliance would boost its annual operating income by about $500 million and reduce costs by about $200 mil- lion. Nevertheless, Bartz noted that “Search is a very valuable business for Yahoo!; we need to retain some stake in search to help it target display ads better. Search is important to our users and search is impor- tant to our advertisers.”

At the same time, Bartz continued to prune Yahoo!’s unprofitable online services to reduce costs and focus its efforts upon the fastest growing, most profitable ad display markets. Yahoo! also an- nounced continuing job cuts throughout 2009 and 2010 to reduce its workforce to under 14,000 and bring costs back under control.

Yahoo! in 2011 In June 2011, Yahoo! announced some disappoint- ing results, in the most recent quarter its revenues had dropped by 23% compared to a year ago while Google announced that its revenues had increased by 32%. In the past year, Yahoo!’s 14,000 employees had generated $5.6 billion in revenues and $1.2 billion in

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company. Yahoo! was in disarray in October 2011 as no new strategic leadership had emerged to or- chestrate the company’s turnaround and a stunned Bartz tweeted through her iPad that “Yahoo has. . . . me over.” It seems that Yahoo!’s dysfunctional board is desperately trying to find a buyer for the company in order to provide stockholders with the most value for their investment.

In October, Microsoft, Google, and private investment funds had all been suggested as po- tential buyers for the company at a price around $20 billion—half of Microsoft’s original offer. The company was still for sale—but the billion dollar question is at what price? The longer it takes to find a new buyer the less valuable Yahoo! is likely to be in the future—unless it can find some vision- ary CEO that can provide the company with a new vision and mission.

Thus, in August 2011, Yahoo! analysts could not decide if Yahoo! was undervalued because its online properties still offered the possibility of generating substantial revenue from search and advertising. Or, if its value might decline further in the future be- cause it now had given up its online search expertise to Microsoft? It could not counter the strategies of Google and Facebook, and there was still no pipeline of innovative products to attract new users. Bartz’ turnaround plan for Yahoo! had kept the company profitable because it had reduced costs, but what was its future vision and mission?

Yahoo! Fires Bartz In September 2011, Yahoo!’s board of directors de- cided to fire Bartz—over the phone—claiming she had not found the right strategies to turn around the

Endnotes

www.yahoo.com, 1990–2011. Yahoo! 10K Reports, 1990–2011.

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CASE 24 CBS Broadcasting established Viacom as an inde- pendent company in 1970 to comply with regula- tions set forth by the U.S. Federal Communications Commission (FCC) barring television networks from owning cable TV systems, or from syndicating their own programs in the United States. The increasing spread of cable television and the continuing pos- sibility of conflicts of interest between television networks and cable television companies made the spinoff necessary, and Viacom formally separated from CBS in 1971, when Viacom’s stock was distrib- uted to CBS shareholders.

Viacom quickly became one of the largest cable operators in the United States, with over 90,000 ca- ble subscribers. It also owned the syndication rights to a large number of popular, previously run CBS television series that it made available for syndica- tion to cable TV stations. In 1976, to take advantage of Viacom’s experience in syndicating programming to cable TV stations, its managers decided to estab- lish the Showtime movie network to directly compete with HBO, the leading outlet for films on cable tele- vision. In 1977, Viacom earned $5.5 million on sales of $58.5 million. Most of its earnings represented revenues from the syndication of its television series, but they also reflected growth of its own cable TV systems, which at this time had about 350,000 sub- scribers. Recognizing that both producing and syn- dicating television programming could earn greater profits, Viacom’s managers decided to produce their own television programs in the late-1970s and early- 1980s. Their efforts produced only mixed results, however, no hit series resulted from their work, and the Big Three television networks of ABC, NBC, and CBS continued to dominate the airwaves.

During the early-1980s, the push to expand the cable television side of its business was Viacom’s

managers’ priority, and it rapidly grew its subscriber base. Viacom’s managers, however, believed that its core cable operations were not a strong enough en- gine for future growth. Cable TV prices were regu- lated at this time, so cable companies had limited ability to increase prices, but its managers believed that real profit growth would come from provid- ing the content of cable programming—television programs—not from just cable television service. Given that Viacom had failed to make its own success- ful new TV programs, its managers sought to acquire companies that made entertainment programs—the content. In 1981, Viacom started in a small way by buying a stake in Cable Health Network, a new advertiser-supported television network. Then, in September 1985, in a stroke of fortune, it made the acquisition that would totally change the company’s future. Viacom purchased the MTV Networks from a competitor, Warner Bros., that desperately needed cash to invest in its own cable TV system to keep it viable. As it turned out, Warner Bros. had sold the jewel in its crown.

The MTV Networks included MTV, a new pop- ular music video channel geared toward the 14–24 age groups; Nickelodeon, a channel geared toward children; and VH-1, a music video channel geared toward an older 25–44 age audience. MTV was the most popular property in the MTV Network. Its quick pace and flashy graphics attracted young television viewers who were a major target for large advertising companies, and the popularity of a TV station’s programming determines how much a broadcast network can charge for advertising— which is why Super Bowl ads cost millions. MTV was performing well, but Nickelodeon had been less successful and had not achieved much of a fol- lowing among young TV viewers, which limited its

Viacom is Successful in 2011

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (VIA), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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Viacom Speeds Up Redstone bought Viacom because he believed that cable TV programming would become the main channel to deliver customers with entertainment content in the future. Redstone believed Viacom’s MTV and Nickelodeon networks were its “crown jewels,” they provided half the company’s revenues and profits, which came both from subscribers (the cable companies that bought the programming) and from advertisers (who advertised on these channels). To strengthen these networks and build their brand name, Redstone hired a more aggressive advertising and sales management team, and against the expec- tations of industry analysts MTV and Nickelodeon experienced continuing growth and profitability. In 1989, for example, the MTV Networks won 15% of all dollars spent on TV cable advertising. Also, MTV was rapidly expanding throughout the world— broadcasting to Western Europe, Japan, Australia, large portions of Latin America, and eventually to countries in Asia.

Viacom in the 1990s The problem facing Redstone and Biondi was how to position Viacom for profitable growth in the 1990s. Both executives felt that developing and expanding Viacom’s strengths in developing entertainment con- tent was the key to its future success, although this is a very expensive process. They believed that the mes- sage or content that is sent is what really mattered, not the distribution channel carrying it. As Biondi put it, “In the end, a pipe is just a pipe. The cus- tomer doesn’t care how the information is obtained; all that matters is “the message.” To build its enter- tainment programming strengths, Biondi worked hard to expand the success of Viacom’s MTV chan- nels. His goal was to promote the MTV networks as global brands that were perceived as having some- thing unique to offer. Since MTV’s viewers domi- nate the record-buying audience, Biondi sought to negotiate exclusive contracts that gave MTV the first crack at playing most major record companies’ mu- sic videos—thus making it unique. At the same time, MTV went from being a purely music video channel to a channel that championed new kinds of innova- tive programming to appeal to a younger audiences,

advertising revenues. Viacom’s managers moved quickly to revamp Nickelodeon and give it the slick, flashy look of MTV. They developed unique programming to appeal to children—programming a very different aesthetic than The Mickey Mouse Show, which competitors like the Disney Channel offered. In the next few years, Nickelodeon went from being the least popular children’s cable TV channel to being the most popular! Viacom’s man- agers were confident that they had the foundation of a new content programming strategy to comple- ment its cable TV interests to increase the company’s profit growth.

Enter Sumner Redstone Viacom’s hopes were shattered when its Showtime channel lost 300,000 subscribers by 1986 because of intense competition from HBO, which, under its CEO Frank Biondi, had become the dominant sub- scriber movie channel. Viacom’s cash flow plunged, it reported a loss in 1986, and, weakened by the $2 billion debt incurred to fund its growth, it became a takeover target.

After a 6-month battle to acquire the company Sumner M. Redstone bought Viacom for $3.4 bil- lion in 1986. Redstone was the owner of National Amusements Inc. that owned and operated 675 movie theatres. Redstone had built NAI from 50 drive-in movie theaters to a modern theater chain and is credited with pioneering the multiplex movie theater concept. However, running a chain of movie theaters is very different from running a debt-laden media company like Viacom. Many analysts believed Redstone had overpaid for Viacom—but he saw a great potential for growth.

Aside from its cable television systems and syn- dication rights, which now included the popular TV series The Cosby Show, Redstone recognized the po- tential of its MTV and Nickelodeon channels. Also, Viacom had acquired 5 television and 8 radio sta- tions in major markets that were also valuable prop- erties. Redstone quickly moved to solve Viacom’s problems and with his “hands-on,” directive man- agement style, he fired Viacom’s top managers and searched for more capable managers who would be loyal to him. To turn Showtime around, he hired Frank Biondi, who had made HBO the major pay movie channel, as CEO of Viacom.

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Internet service providers (ISPs), radio stations, and others, were allowed to enter each other’s markets. These changes led to industry consolidation and the emergence of new giants such as Time Warner, News Corp., Comcast, and Disney, companies that were now all competing to offer the best selection of entertainment content or programming “soft- ware” as well as the best way to distribute this con- tent through channels such as cable, wireless, or the Internet, the “hardware” side of the business.

Viacom’s business model was based on the prem- ise that to prosper in the fast-changing entertain- ment industry, a company needed to be the provider of the entertainment to all the different distribution channels. In other words, the most successful en- tertainment companies would be those that could offer programming suitable for any channel, and be the primary software providers—not the hard- ware providers that provided the infrastructure to bring entertainment into peoples’ homes. With its well-known channels such as MTV, Nickelodeon, Showtime, and its syndicated programming, Viacom should base its strategy on forming alliances with the companies that provided the “hardware” chan- nels into peoples’ homes. Viacom’s revenues would come both from the fees it charged to the hardware providers for its entertainment channels and most importantly, from the huge revenues it would obtain from selling advertising spots on its many popular TV shows, revenues that are determined by the size of the viewing audience. However, the issue was how to obtain high-quality programming at a price lower than the revenues to be earned from advertising and distributing its programs to maximize profits in an industry in which the value of entertainment and media companies was rocketing as stock prices increased.

The Paramount and Blockbuster Acquisitions Viacom’s new mission was to become an entertain- ment software-driven company with the goal to drive its entertainment content through every distri- bution channel possible, and to every world region to maximize revenues and profits. To achieve this mission, Viacom needed to acquire companies that could produce unique entertainment programming

such as Beavis and Butthead, and Road Stories, that were interspersed with music videos.

In developing its programming strategy, how- ever, Viacom’s interest was not in promoting certain specific programs or stars—all of which may have short-lived popularity of fame—but in building its networks as unique brands. For example, on the MTV channel, the goal was to attract viewers be- cause of what the channel as a whole personified— an appeal to youth. Soon, MTV reached 250 million households in 74 countries. Viacom began to perform much better: in 1992 it made profits of $48 million on sales of $1.86 billion, and in 1993 it made profits of $70 million on sales of $2 billion. While the develop- ment of innovative programming was one reason for Viacom’s return to profitability, a second reason was Redstone’s emphasis on keeping costs under control. Redstone is well known for his frugal way of doing business. He runs Viacom in a cost-conscious man- ner and this is evident throughout the organization. For example, costs soared in Hollywood studios and television networks as movie stars, writers, and pro- duction companies demanded ever increasing prices for their services. At Viacom, Redstone demanded that its own programming should be made by us- ing low-cost, homegrown talent. An example of this is in the production of its MTV shows—most of its homegrown hosts are paid little compared to em- ployees at well-known networks that are often paid millions of dollars per year.

Changes in the Media and Entertainment Industry Although focused on building Viacom’s program- ming strengths, Redstone and Biondi realized the entertainment industry was rapidly changing and that it was not at all clear how entertainment pro- gramming would be delivered, that is, through which distribution channels, in the future. In the 1990s, the U.S. cable television industry was in a state of flux as emerging technologies such as wireless satellite TV and Internet broadband threatened to bypass traditional cable systems—making Viacom’s invest- ment in wired cable much less valuable. Also, pres- sures were building to deregulate the industry so that by the end of the 1990s, companies in different industries—cable companies, telephone companies,

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Internet, could pose to the sale and rental of movies and games in the future was looking for a buyer for Blockbuster. Redstone also knew that Blockbuster’s future was in doubt because of the development of new digital entertainment distribution technologies, but now Redstone was in a war with Diller to ac- quire Paramount, and offers for the company soared. In January 1994, Viacom announced an $8.4 bil- lion merger with Blockbuster; it also announced a higher bid for Paramount of $105 a share—a huge premium price—but this bid allowed Viacom to ac- quire Paramount in July 1994. Redstone hailed the new Viacom as an “entertainment colossus” and “a massive global media company.”

Explosive Growth In a few short years, Redstone had gone from con- trolling several hundred movie theaters to controlling the properties and franchises of three Fortune 500 companies—Viacom, Blockbuster, and Paramount. By engineering the 3-way merger of Viacom, Para- mount, and Blockbuster Entertainment, Redstone created one of the three largest global media em- pires (the others were Disney/Capital Cities ABC, and AOL Time Warner) each with annual revenues in excess of $10 billion. This was a large jump from the $2 billion revenue that Viacom had generated just before its new acquisitions. It was clear that Redstone and Biondi faced several major challenges to manage Viacom’s new entertainment empire to allow it to achieve profitable growth.

Engineering Synergies To justify the expensive purchase of Paramount and Blockbuster, it was essential that CEO Biondi engineer synergies between Viacom’s different enter- tainment properties, each of which was now orga- nized as a separate business division. Efforts began immediately, Paramount executives were instructed to evaluate the potential of new shows developed by MTV and Nickelodeon to sell to television net- works. Viacom launched a new TV channel, the United Paramount Network (UPN) in 1995 to take advantage of its new programming resources across its entertainment divisions. For example, MTV ex- ecutives were instructed to quickly begin developing programming for UPN.

content for worldwide distribution. In particular, Viacom needed an entertainment company that had an established film/TV studio and library that could round out Viacom’s current programming portfolio by supplying old feature films and TV shows to its television channels. Paramount Pictures provided an opportunity for this when it became an acquisition target in 1993.

Paramount’s many businesses included enter- tainment including the production, financing, and distribution of motion pictures, television program- ming, the operation of movie theaters, indepen- dent television stations, regional theme parks, and Madison Square Garden. Paramount also owned a large library of movies. Redstone and Biondi began to picture the extensive synergies that a merger with Paramount would provide Viacom in the future. As Redstone told reporters, “This merger is not about two plus two equaling four, but six, or eight, or ten.” Together Viacom and Paramount would be a much more efficient and profitable organization because, for example, Paramount could make films that fea- tured MTV characters like Beavis and Butthead and new cable TV channels supported by Paramount’s library of 1,800 films and 6,100 television pro- grams. In 1993, after behind-the-scene talks between Redstone and Paramount executives, Paramount announced an $8.2 billion merger with Viacom. However, a bidding war for Paramount started when Barry Diller, CEO of QVC Network Inc., another large entertainment company, announced a hostile bid for Paramount. On September 20, 1993, QVC announced an $80 per share or $9.5 billion bid for Paramount, and the battle between Viacom and QVC for ownership of Paramount Communications Inc. had begun.

This unwelcome bid from QVS was a major problem for Redstone because Viacom still had a substantial debt due to the original 1987 acquisi- tion of Viacom, and the expenses incurred to rap- idly develop its own TV programming. Redstone could not afford to counter QVS’s bid unless he obtained other sources of financing and cash flow. At the same time, Blockbuster Video’s energetic CEO, Wayne Huizinga, who had made it the larg- est chain of video stores in the nation, was also on the market. Blockbuster was cash rich because of its rapid growth, but Huizinga recognized the growing threat that digital electronic entertainment chan- nels, such as pay-per-view, wireless cable, and the

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with Capital Cities/ABC; and News Corp. that had established the Fox channel and owned the 20th Century Fox was also buying new entertainment channels—especially online digital channels. As a re- sult, the industry was now composed of four major players: Disney, AOL Time Warner, News Corp., and Viacom, which was the fourth biggest company.

A major threat by the mid-1990s was that the number of entertainment distribution channels was exploding as government regulations prevented broadcast networks from owning TV programming companies and so on were phased out. Viacom’s strat- egy to develop a full line of movie and TV entertain- ment programming had also spurred changes in the competitive dynamics of the entertainment and me- dia industry as many new small independent movie and TV studios, such as Pixar and DreamWorks, were established to provide attractive new program- ming that could be sold to movie distributors and cable TV providers.

The industry was also experiencing rapid glo- balization as U.S. movies, news, and TV shows were now being shown around the world. A major chal- lenge facing Viacom was to obtain access to the global marketplace to increase revenues and profits, for example, there was a potential market of over a billion viewers in India and China. As one example of Viacom’s global strategy in 1995, Viacom won a cable television license to launch its Nickelodeon and VH-1 channels in Germany, Europe’s biggest and potentially most lucrative media market, to complement the MTV pop music network that had operated in Europe since 1987. However, all this global expansion was expensive and Viacom’s cost structure increased, which resulted in lower profits.

New technology challenges also confronted Viacom and the media industry because advances in digital technology, including streaming audio and video over the Internet began to offer online compa- nies viable new channels to distribute entertainment content. Just as the dominance of the Big Three net- works had been eroded by the growth of companies like Viacom with its new programming networks, so now new channels to distribute content to con- sumers were now threatening major entertainment companies. Moreover, digital piracy had become a major threat to these companies, as Websites such as Napster and LimeWire were developed to exchange digital music and movie files. This was also a major threat to revenues and profits and by the 2000s

In another attempt to create synergies, Paramount executives were instructed to make their moviemak- ing skills available to the MTV Network, and to help it make inexpensive movies that could be distributed through Paramount. One result of this was a “Beavis and Butthead” movie produced by Paramount that proved very successful when it was launched in the- atres in 1996. To keep costs low, Redstone’s strategy was to boost the output of movies at Paramount, while at the same time keeping its budget under con- trol and forcing its managers to find ways to make low-budget successful movies—not an easy task. Redstone and Biondi also searched for synergies between Blockbuster and Viacom’s other divisions, hoping that Blockbuster could link its retail stores with Viacom’s cable networks and Paramount’s ex- tensive film library. Perhaps Blockbuster could sell copies of Paramount’s vast library of movies to encourage people to create their own DVD collec- tions. Also, the release of a new Paramount movie on DVD could be timed to coincide with a major advertising campaign in Blockbuster stores to pro- mote the launch. Finally, the launch of new movies could be timed to accompany a major advertising blitz on the MTV channel—something that hap- pened when Paramount released Mission Impossible in 1996. Redstone claimed that: “Viacom through its new combination of assets is poised to participate in, and in many ways define, the entertainment and information explosion about to engulf the globe.” As events turned out, however, few potential synergies emerged between Viacom’s various divisions to help boost revenues and profits.

Media and Entertainment Industry Challenges The fast-changing entertainment and media in- dustry created many challenges for Redstone and Biondi especially because the major U.S. entertain- ment companies were all rapidly expanding and the industry was consolidating. Seven major studios dominated movie production and the “Big Three” networks—ABC, CBS, and NBC—had for years dominated the production of TV programming for the mass audience. The growing strength of Viacom spurred industry consolidation; in 1995 AOL Time Warner announced that it would merge with Turner Broadcasting; Disney announced that it would merge

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Video, that were creating a price war in some mar- kets, while pay-per-view and on demand televi- sion was spreading rapidly in large urban markets. Blockbuster’s revenues were flat; its costs were in- creasing and the hoped-for growth in cash flow to service Viacom’s debts did not occur.

Redstone fell out with the top management teams of Paramount and Blockbuster that he thought were doing a poor job; he forced the resignations of key executives and went in search of new leadership tal- ent. Then, in 1996, he announced that he was fir- ing his second-in-command Frank Biondi because Biondi did not have the “hands-on skills” needed to manage the kinds of problems that Viacom was fac- ing. Redstone felt that Biondi’s decentralized man- agement style was out of place in a company actively searching for synergies and cost reductions. In place of Biondi he promoted his two lieutenants, Philippe Dauman and Tom Dooley, to orchestrate Viacom’s strategy despite that they had little direct experience with the entertainment business.

Viacom’s New Moves In 1996, Redstone hired William Fields, a senior Walmart manager who had extensive experience using IT to run efficient retail operations, to be Blockbuster’s new CEO. Redstone hoped he could find a way to transform the Blockbuster Video stores into broader based entertainment-software stores because video cassettes were being replaced by DVDs, and new wireless cable, DSL telephone, and direct broadcasting technologies, such as the DISH network, were rapidly expanding.

However, it was too late; in early-1996 Viacom’s stock price plunged from $55 to $35 as investors fled the stock because of problems at Blockbuster and Paramount. By summer of that year, after a string of flops, Redstone announced plans to cut back the number of movies Paramount would make and to reduce its production costs as he searched for a new strategy. Chief among Viacom’s problems was its huge debt that had to be pruned by selling its assets. Also, Viacom had to find ways to reduce rising op- erating costs as well new ways to leverage resources and competences across divisions to increase reve- nues and build cash flow. Flat revenues and soon-to- be losses at Blockbuster and Paramount were pulling down the performance of the whole corporation.

digital piracy resulted in major entertainment com- panies losing billions in potential revenues—even new movie releases were often available illegally on- line for download just days after being introduced in movie theaters.

Major Problems for Viacom Soon after Redstone’s expensive decision to buy Paramount, its new movie Forrest Gump became a surprise hit that generated over $250 million for Viacom and silenced analysts who argued that he had spent far too much to purchase the movie studio. Viacom’s managers began to feel like Forrest Gump with his philosophy that: “Life is like a box of chocolates: You never know what you’re going to get.” It seemed that Redstone and Viacom had been in the right place at the right time and had made a profitable acquisition. Just as Redstone had sensed the potential of MTV, he had also sensed the po- tential of Paramount and Blockbuster. By the end of 1995, however, the selection of chocolates in Viacom’s box had gone downhill as many of the hoped-for synergies were not obtained. Before the merger, Redstone claimed that Blockbuster would be valuable to Viacom as a distributor of its cre- ative programming—but few benefits of this kind were achieved. Analysts argued that Paramount had to cooperate more closely with Viacom’s cable TV channels and Blockbuster to achieve synergies.

Most importantly, both the Paramount and Blockbuster divisions’ performance had proved dis- appointing. The Gump smash hit was followed by a string of expensive failures that lost hundreds of mil- lions, and Redstone began to realize that making hit movies is a highly risky business—past successes are no indication of future success. Paramount’s share of box office revenues dropped by 5% during 1995, but the marketing and production costs to make its movies were rapidly increasing. Paramount’s poor performance hurt Viacom’s cash flow and ability to pay its huge debts.

Viacom’s situation was made worse because Blockbuster was also not performing well. Redstone bought Blockbuster at the peak of its success—when its revenues were doubling every year and its free cash flow was a valuable asset. But after the acqui- sition, Blockbuster ran into increased competition from new rival video chains, such as Hollywood

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cross-divisional synergies, create new programming content, and enhance its revenue and earnings.

Both Redstone and Karmazin understood that the most important source of profits from owning an entertainment empire was to achieve economies of scale and scope that arise when a company is able to offer large companies the opportunity to advertise their products across multiple channels that attract different kinds of viewers. In other words, a poten- tial advertiser could produce one or more themed commercials to run across all of Viacom’s different TV networks as well as its movies, theme parks, and other channels. Redstone noted that Disney merged with the Capital/ABC networks to provide it with important new distribution and advertising channels for the Disney franchise.

Since the majority of Viacom’s future revenue stream would come from the success of its advertis- ing, Redstone established a new unit, Viacom Plus, to provide a centralized advertising service to manage relationships with large companies and handle ad- vertising for all of Viacom’s divisions. For example, in 2001, Procter & Gamble (P&G) and Viacom Plus negotiated a new cross-channel deal whereby P&G would pay $300 million for advertising spread across 9 of Viacom’s major divisions. This deal worked out so well for P&G it paid $350 million in 2002 for advertising spread across 14 of Viacom’s divisions. P&G could obtain a much better deal than if it ne- gotiated with each Viacom channel separately and Viacom Plus had reduced the costs of managing the vital advertising process across the company. Other companies followed P&G’s lead to “scatter” their advertising dollars across Viacom’s different chan- nels and reach different demographic groups includ- ing children who watched Nickelodeon, teens who tuned into MTV, and different groups of adults who watched its different network programming. The future of the Viacom advertising platform looked bright indeed, perhaps it could provide the platform for giving the company the synergies it needed to boost revenues and profits.

The CBS Acquisition To capitalize on advertising synergies, a new op- portunity arose in 1999 when CBS was in trouble because of falling ratings, and its managers were interested in merging with another entertainment

Blockbuster was now a growing liability, and Field’s efforts were not bearing quick results.

In fact, Blockbuster’s revenues were falling, and in 1997, Fields left and Redstone brought in a new CEO, John Antioco, and they streamlined Blockbuster’s operations. (See the Blockbuster case for detailed information on its new strategy.) They also introduced the radical idea of video-rental rev- enue sharing with the movie studios, and within a few years, Blockbuster’s revenue stream was increas- ing again.

On the revenue side, there were signs that some potential synergies were emerging. Paramount did produce successful Beavis and Butthead movies. Viacom’s global presence was widening as its TV studios developed new and customized channels to meet the demands of customers in different countries around the world. In 1997, growing demand for its entertainment content led Viacom to buy the rest of Spelling Entertainment, with its Star Trek franchise, to help its struggling UPN network that was failing (it became part of CBS in 2006). Redstone integrated Spelling Entertainment into Paramount’s TV opera- tions to obtain economies of scale and scope in the production of new television programming—such as new Star Trek programming that has proved to be highly profitable.

Although Redstone was focused on creating long-term benefits from his entertainment empire, the poor performance of Viacom’s stock was a con- tinual embarrassment to him because he had not been able to realize the potential of Viacom’s en- tertainment assets. However, Blockbuster enjoyed increasing revenues in 1999 because of its revenue sharing agreement, and this gave Redstone the op- portunity he needed to dispose of this risky asset. Viacom announced that Blockbuster stock would be listed separately from Viacom’s so its performance could be evaluated separately. Approximately 18% of Blockbuster’s stock was sold at $16 to $18 a share, and this raised over $250 million that was used to pay off Viacom’s debt.

Also in 1999, Redstone hired the experienced me- dia and entertainment manager, and former head of CBS, Mel Karmazin, as Viacom’s CEO to help solve its ongoing problems. Karmazin had made his repu- tation by selecting hit TV programming, and for his hands-on ability to find ways to leverage resources to increase profitability. He set to work to restructure Viacom’s different entertainment assets to engineer

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leverage its news, sports, and other programming across many more of Viacom’s channels. Viacom’s TV studios also formed a unit called MTV Films to produce movies for Paramount. Some of its low- budget movies made a profit including The Rugrats and Beavis and Butthead Do America.

In yet another move to make it the number 1 advertising platform in the world for advertisers with programming that appealed to every demo- graphic category, in 2001, Viacom acquired Black Entertainment Television (BET) for $3 billion. The BET network reaches 63.4 million U.S. households, and its other channels, like BET on Jazz and BET International, reach 30 countries in Europe and 36 in Africa. Continuing its strategy of leveraging value from its properties, BET began to seek ways to inte- grate its activities with other Viacom properties, both by customizing various Viacom TV programming for BET’s channels, and vice versa, such as its popu- lar shows and also news and sports programming.

Karmazin instructed all of Viacom’s networks to follow MTV’s lead and develop a global strategy to locally produce content in each country in which they were broadcasting in order to increase the com- pany’s global viewing audience. MTV, for example, has a presence in most of the world’s major markets; it reaches a billion households and generates crucial revenues for Viacom today. And, while it broadcasts its U.S. programming in countries abroad, it had also produced successful shows in countries abroad that are customized to local tastes; these have proved so popular that they have been successfully transferred to the United States and other countries.

Viacom’s stock climbed in 2002 despite the huge fall in advertising revenues caused by the 2000 re- cession that caused the earnings of its broadcast networks to drop by 20%. Nevertheless, analysts believed that Viacom was the best-positioned media company to benefit from the upswing in advertising that was expected in the 2000s because of its combi- nation of large-scale operations and leading brands. Reeling from the downturn in advertising revenues, Redstone and Karmazin continued to seek ways to counter future threats to the Viacom empire particu- larly because the threat from digital and broadband technology was directly impacting its Blockbuster unit, and would in the future, threaten Viacom’s dis- tribution channels.

Indeed, many analysts reported that Mel Karmazin and Redstone had locked heads on many

company. Redstone decided that CBS’s entertainment assets would give Viacom access to a much larger number of channels to reach the greatest number of viewers and listeners (CBS-owned Infinity Radio Broadcasting) of any media enterprise, spanning all ages and demographics from “cradle to cane.” This would allow Viacom to become the premier outlet for large companies around the world because it could offer them the opportunity to achieve huge econo- mies of scale and scope when spending their adver- tising dollars. Advertising content could be driven and promoted across all media segments, includ- ing broadcast and cable television, radio, outdoor advertising and new digital media. Also, channels such as MTV, MTV2, VH-1, and CMT could now be broadcast over Trinity’s radio stations and over the Internet, and CBS’s high-quality content, such as its news and sports programming, could be broad- cast over all Viacom’s properties. After the merger, Viacom’s bigger empire would also give it more bar- gaining power with programming suppliers (to re- duce programming costs) and allow it to maximize the effectiveness of its advertising salesforce across all its divisions. Perhaps Viacom’s problem was that it was simply not big enough to generate higher rev- enues and profits?

In 2000, Viacom and CBS Corp. began the pro- cess of merging the operations of the two companies to create the largest global media company, because they believed that “biggest is the best.” The range of Viacom’s properties was now staggering in its scope, especially because CBS had acquired radio station owner Infinity Broadcasting and King World produc- tions that syndicated such programs as Jeopardy and the Oprah Winfrey Show. Karmazin now gave his full attention to structuring and managing Viacom’s new assets to realize the gains from sharing and le- veraging the competencies of its divisions across all its entertainment operations—not an easy thing to do given all the uncertainties involved in managing their different business models and a rapidly chang- ing industry environment.

However, it began to appear that the CBS acqui- sition had given Viacom the critical mass it needed to achieve advertising synergies and cost savings. Karmazin integrated Paramount’s and CBS’ televi- sion groups, and the new division consisted of 35 television stations reaching 18 of the top 20 U.S. television markets. CBS would now function as a lo- cal as well as a national broadcaster, and it could

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channels—preferring to watch their favorite cable channels or to surf the Web. Slowly but steadily, the growing use of the Internet and new online digital media properties were taking away advertising rev- enues and Viacom was slow to realize the dangers the Internet posed as a major alternative entertain- ment channel. Competition began to increase as new Websites that offered specialist services, such as www .rottentomatoes.com (a movie review Website owned by News Corp.), video Websites such as YouTube, and a host of illegal Websites that offered free down- loading of video content, had emerged. Viacom’s revenues fell, but perhaps this was a temporary phenomenon because Redstone and Karmazin an- nounced they expected major increases in revenues and profits in the future.

Problems at CBS Another major problem for Viacom was that its ac- quisition of CBS was not generating the hoped for cost savings or synergies that drive revenue growth. When a company buys different kinds of media properties and channels, it also enters new industries and faces different sets of competitive opportuni- ties and threats! Investors became increasingly wary of Viacom’s stock because they no longer believed Redstone or Karmazin could manage its new assets— and they found it much more difficult to evaluate the real value of each of its many media properties and channels, especially its Blockbuster division.

Spinning off Blockbuster into a separate com- pany would eliminate this source of uncertainty; in 2004, when Blockbuster’s stock was trading at a re- cent new high of $20, Viacom announced it would divest its remaining shareholding in Blockbuster. By making the deal attractive to Viacom stockholders, Redstone was finally able to divest the unit which became an independent company headed by its CEO John Antioco. (See the Blockbuster case for what has happened since.)

Viacom’s Failing Business Model: Bye Bye CBS Viacom had failed to realize the importance of build- ing strong online entertainment assets when they were cheap, and it now lagged behind major competitors

occasions about emerging strategic issues having to do with digital and programming content. Karmazin was especially critical of Redstone’s expensive ac- quisitions that increased debt, but had not yet real- ized the benefits that had been expected. Karmazin also argued that Viacom needed to increase its on- line presence as quickly as possible. However, in 2002, the increased revenues and profits resulting from the CBS and BET acquisitions suggested that Redstone’s “growth-by-acquisition” strategy was working. Karmazin joked that their management styles were complementary, and that he was in no rush to assume leadership of Viacom, especially since the 79-year-old Redstone was “good for an- other 30–40 years—at least!” Redstone, however, joked that when Karmazin’s contract expired in 2003, Karmazin “might want to retire.” Karmazin’s response? “Never, never, never.”

New Problems for Viacom In the early-2000s, Viacom made no significant ac- quisitions, Redstone felt his company has all the right pieces of entertainment property in place and the company still had a huge debt load. Redstone be- lieved the primary strategic problem facing Karmazin was to manage Viacom’s assets to realize the huge potential stream of advertising revenues and prof- its locked up in its entertainment assets. Operating revenues from its entertainment division, which in- cluded Paramount Pictures and theme parks, rose by 46% in 2003, and its operating income was up 15% to $66 million as a result of higher movie ticket sales and stronger sales of DVDs. Its Viacom Plus unit continued to aggressively market its “one-stop- shopping approach across all marketing channels,” and as the economy picked up in 2003, advertising revenues rebounded. In 2004, Viacom announced its overall revenues were up 11% and half the increase was due to increased advertising revenues.

The Growing Use of the Internet While national advertising revenues on Viacom’s many cable channels rebounded, however, local ad- vertising revenues from its TV stations, including the CBS network, and from its radio stations were fall- ing and hurting the company’s performance; fewer and fewer people were watching or listening to local

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revenues upon which most entertainment companies depended. By the 2000s, the cookie-cutter business model, whereby a media giant could simply add new media properties to its existing ones to increase prof- itability, had been shown to be a failure—at least in terms of generating consistent increases in a com- pany’s stock price.

As noted above, Redstone’s focus upon fixing the ongoing problems with his media empire also de- layed his recognition of the growing importance of the Internet as an entertainment distribution channel and the threat of competition from (illegal) digital video downloading and streaming media. In the mid- 2000s, Viacom moved to acquire some small Internet media properties such as Neopets, a virtual pet Website, and Xfire, iFilm, Quizilla.com, Harmonix Music Systems, and Atom Entertainment, that served niche markets. However, these acquisitions didn’t have the reach of News Corp.’s acquisition of the social networking company MySpace, which was valued at $3 billion (although it had been bought for only a few hundred million in 2004). Viacom was much slower than its rivals to react to the changes in digital and Internet technologies taking place, and its stock price continued to suffer. The entertainment company with the best digital strategy in the 2000s had been News Corp.

As the “unknown” names of its Internet acquisi- tions suggest, Viacom was failing in its attempt to develop a strong, coherent Internet strategy. This strategic failure hurt its stock price, which had risen to $45 after the 2005 split, but now plunged to $35 in 2006. Redstone, as usual, responded by firing Viacom’s CEO, blaming him for the com- pany’s poor performance, and appointed Philippe Dauman as the new CEO of Viacom. Dauman had been one of Redstone’s top strategists for decades, and a top Viacom executive from 1994 to 2000— he was now in charge of maximizing the value from Viacom’s assets.

In his first public statement, Dauman claimed he had free reign to develop a new business model, and that he wasn’t simply a pawn for Redstone to use and then discard. If Redstone attempted to micromanage or meddle in operational issues Dauman said, “I can push back.” He also indicated he would work to cre- ate a new business model based on “creative excel- lence” and focus on strategic movie, TV channel and Internet internal ventures and acquisitions. Dauman claimed Viacom still had an enormous potential for

like Disney and News Corp. At the same time, de- spite having spent 5 years developing strategies to realize the value from the 2000 CBS acquisition, it was clear that Redstone and Karmazin had failed. Adding TV and radio stations and a host of other media assets to Viacom’s TV channel and movie pro- gramming empire had increased the strategic prob- lems associated with managing its empire of media assets. Redstone learned the hard way that the dif- ferent divisions of a company grow at different rates, and the performance of the weakest division pulls down the performance of the whole company—and Viacom’s growth was slowing fast. Its CBS assets, like Blockbuster had before, could not meet Viacom’s aggressive growth targets. Redstone was frustrated once again that Viacom’s underperforming assets were dragging down its stock price, which by 2004, was almost half of its 2000 stock price! Karmazin had warned Redstone about this, and the personal relationship between Redstone and Karmazin now deteriorated fast. Redstone fired Karmazin (who was the CEO of SiriusXM Radio in 2011).

In 2005, to improve Viacom’s future growth, Redstone announced that he would split the $60 bil- lion conglomerate into two smaller, separately traded companies. CBS would be allocated Viacom’s slow and steady growth properties and channels, such as CBS TV programming and TV and radio stations, Showtime, outdoor advertising, and so on. The future Viacom would be made up of high potential growth properties and channels such as MTV, Nickelodeon, BET Networks, and Paramount Studios—essentially the company’s focus after it divested Viacom, and before it merged with CBS. CBS was also allocated slow-growth Paramount Parks, which it later sold to amusement park operator Cedar Fair in 2006. The split took effect at the beginning of 2006 and effec- tively retracted the Viacom/CBS merger.

The New Viacom Business Model After a decade of growth by acquisition, Viacom, like other media conglomerates, such as Sony, Disney, and Time Warner, began to reconfigure its business model. These companies were now being pushed hard by new Internet technologies and changing customer viewing habits that had altered the chan- nels on which they could hope to obtain maxi- mum advertising revenues—still the main source of

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RateMyProfessors.com in 2007, and acquired the global franchise for Teenage Mutant Ninja Turtles in 2009. He did however, form several strategic al- liances to increase the value of Viacom’s assets such as several joint ventures with Indian companies to expand its presence in a country with almost a bil- lion viewers, and with U.S. media companies to find better ways to make use of their resources. He also sold some of its little-known online assets such as Harmonix Music Systems and Famous Music to Sony to exit the music business.

His new focus was upon finding ways to use Viacom’s assets in creative ways. For example, he cre- ated a new specialty movie division called Paramount Vantage, and Paramount decided to take control of distributing its own movies in the 15 major markets outside the United States. Also, a major rebranding of its TV networks took place as the company de- veloped increasing numbers of TV channels to fur- ther segment its network viewing audience to directly target specific customer groups. For example, its Nickelodeon network now includes channels such as Nickelodeon, Nick at Night, Nick.com, Nick Jr., Teen Nick, Nickelodeon Kids, Nick Toons, Nickelodeon Virtual Worlds, and Family Games! The costs of such increased differentiation and market segmentation has been spurred by the development of digital tech- nologies that dramatically reduce the costs involved in creating new channels. At the same time, differ- entiation provides a way to attract advertisers, who wish to focus on a specific market segment and are willing to pay for it. It has made the same kinds of changes to its global MTV networks that today al- low for increasing customization of programming, both between and within countries, and new ideas are quickly transferred around the world and have resulted in several hit new shows.

Most importantly, Dauman recruited a top man- agement team of media experts to develop hit new shows for its networks, shows that could be made at relatively low costs, such as reality programming. In the last 5 years, Viacom has excelled at creating new shows that have resulted in major increases in its advertising revenues and profits. At the same time, Dauman has been vigilant to protect the value of Viacom’s digital content, and in 2009, it sued Google because it claimed its YouTube channel was allow- ing the streaming of thousands of its TV shows and movies. It lost the suit, but Google has been forced to more closely monitor the content being uploaded

achieving internal “organic growth,” meaning that it could innovate new entertainment products inter- nally and increase the value from its first-class set of entertainment properties and channels. He noted that BET and Comedy Central had a huge future potential and that even established brands such as MTV and Nickelodeon could be developed to offer a much wider range of programming to attract dif- ferent kinds of customers. As a result, Viacom would be able to increase its advertising revenues by offer- ing large companies the opportunity to reach the mass audience, and targeted marketing toward spe- cific customer groups, which was becoming increas- ingly important in the 2000s. Once again, a division similar to Viacom’s centralized marketing division, which had been closed down, was reactivated to fo- cus on increasing advertising revenues. If this failed, then further divestitures seemed likely because the new Viacom had to realize the value from its assets in order to pay down its huge debt.

In late-2006, Viacom reported a 16% fall in third- quarter profit as weakness at the box office from un- profitable movies offset strength in cable and higher advertising revenues. Viacom’s recovering share price plunged; as usual, Redstone fired someone, this time its chief financial officer, and he said that Viacom would now “move rapidly to the forefront of emerging digital markets, keeping us on the path to outstanding long-term financial performance and free cash flow generation.” Clearly, even managing a smaller, more focused media company to achieve profitable growth is a difficult task—especially when each of its different divisions face complex problems and agile competitors.

Dauman’s Creates a Successful Business Model for Viacom In 2007, CEO Dauman faced difficult choices in de- ciding upon the right corporate and business strate- gies to pursue to create a profitable future business model for the company. Having an 83-year-old owner in charge was probably not the best thing for Dauman, or for Viacom’s shareholders, apart from Redstone himself, of course. Dauman set to work after observing the reasons for the failures and fir- ings of its several last CEOs. Since 2007, Dauman has made few acquisitions, although it bought

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media network portfolio was the major contributor to its strong advertising growth. In a press release, Dauman said: “Our media networks are creating hit after hit, sought after by both audiences and adver- tisers, and Paramount Pictures is putting together a truly unprecedented year of box office success.” Viacom said revenue from its media or TV networks division that includes MTV, Nickelodeon and other channels grew 16%; revenues from its Paramount film division increased by 13%, thanks to gains in DVD sales and TV license revenue. At the same time, global advertising revenue grew by 14%, which was more than in the previous quarter—a sign that the global advertising market was improving.

In addition, Viacom’s efforts to secure more rev- enues from the cable and wireless TV providers, and online digital providers that want to show its entertainment content, also increased by 19%. This includes revenues from Viacom’s older TV shows such as “SpongeBob SquarePants,” and especially from new shows such as “Jersey Shore” and Comedy Central’s “The Sarah Silverman Show.” Its agree- ment with Hulu and Netflix significantly boosted revenues. Its blockbuster film Transformers: Dark of the Moon was released too late to contribute to its reported profits, so it expects a continuing improve- ment in revenues through 2011.

In 2011, it seemed that Dauman had been able to realize the value in Viacom’s assets, and had been able to develop new potential sources of revenue. He had also kept the company’s cost structure under control while pursuing new low-cost digital avenues to ex- pand its revenues. How well has Viacom performed compared to its competitors over the last 5 years? In August 2011, while its stock price had increased by 150%, Disney’s had increased by 20%, while News Corp. had fallen by 16%, and Time Warner’s had fallen by 38%. Under Dauman, Viacom finally ap- pears to be managing its entertainment assets and channels to add value to the company; if its good per- formance continues, it will be able to reduce its debt and develop new entertainment content that will pro- vide new sources of revenue and profit for the future.

onto YouTube. In addition, realizing it was too late to establish its own online entertainment distribu- tion channels, Dauman has been increasingly work- ing to form strategic alliances with distribution companies such as Netflix and Hulu and license the rights to show its programming content in re- turn for a share of the revenues. Given that once the programming has been made and shown on its own networks, where it receives advertising revenues to cover the costs of production and make a profit, al- most all the revenues it makes from online streaming agreements translate into profits. This is also true of streaming its Paramount movies through other dis- tribution channels, where it can at least obtain some revenue by attracting customers that dislike illegal downloading, and are willing to pay a modest fee to obtain Viacom’s content in a safe and legal man- ner. Every dollar Viacom obtains from licensing its content results in 90% profit because the costs of making its content available to Internet distributors are extremely low.

Viacom in 2011 How well has Dauman’s new business strategy suc- ceeded? Perhaps the best way to evaluate this is to look at Viacom’s financial results released in August 2011, and the new business model behind the com- pany. Viacom announced that its third-quarter earn- ings grew 37% because its portfolio of entertainment properties resulted in growing advertising sales and higher fees from cable TV companies that wish to show its programming, and by online companies, such as Netflix, that want to stream its content. The media company earned $574 million, or $0.97 per share, up 37% from $420 million (or $0.69 per share) a year earlier.

Advertising and programming revenues grew because of the success of its new movies, TV net- works and its new TV shows such as “Jersey Shore” and “16 and Pregnant.” CEO Dauman said the “breadth of hit programming found across Viacom’s

Endnotes

www.amazon.com, 1997–2011. Amazon.com, Annual and 10K Reports, 1997–2011.

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CASE 25

Green Can Be Green! On June 24, 2009, US-based technology giant General Electric Company (GE), surpassed its target of investing US$5 billion in research and develop- ment in its environmental initiative, Ecomagination. GE had earlier set 2010 as the target for achiev- ing this goal but reached it a year ahead of sched- ule.3 The company planned to invest an additional US$10 billion in R&D by 2015. It was also on its way to achieving the US$20 billion mark in revenues from Ecomagination products, having generated US$18 billion in 2009, an increase of 6%. GE ex- pected the Ecomagination revenue to grow at twice the rate of the total company revenue by 2015, which would give Ecomagination an even larger share of the total company sales. According to Steve M. Fludder (Fludder), vice president, Ecomagination, “We have grown Ecomagination revenue and research and de- velopment every year, even in challenging economic times. Given our success, we are committing to do more. The vision of a cleaner, affordable, secure, and globally accessible energy infrastructure inspires and motivates us.”4

Established in 1892, GE is a diversified conglom- erate with products and services ranging from air- craft engines and power generation to business and consumer financial services, healthcare, and television programming. Started in 2005, Ecomagination em- bodied GE’s commitment to building innovative clean energy technologies and meeting customers’ demands for more energy-efficient products and bringing re- liable growth for the company. The main objectives

of this green initiative were to reduce greenhouse gas (GHG) emissions, increase energy efficiency of GE operations, improve water use, double the investment in R&D for cleaner technologies, and keep the public informed about its Ecomagination efforts.

Through Ecomagination, GE developed prod- ucts and services with lower environmental impact, such as energy-efficient engines, appliances, locomo- tives, and wind turbines. According to some analysts, Ecomagination was a business opportunity for GE to increase revenues by introducing energy-efficient products to customers.

However, some critics felt that Ecomagination was just a business savvy move by the company, aimed at resurrecting its image as an environment friendly company. Behind the façade of environmental sus- tainability and green technologies was GE’s corpo- rate goal of increasing profits, they alleged. Critics felt that the initiative was over-hyped and that GE was pursuing profits in the name of clean technolo- gies. According to Kavita Prakash Mani, vice presi- dent of SustainAbility,5 “GE has invested billions of dollars in Ecomagination, but it hasn’t really changed the rest of its business. It’s made out to be bigger than it actually is.”6 Executives from GE, however, main- tained that Ecomagination was not a brand building exercise; it was a good business opportunity for GE to make money while at the same time contributing to environmental sustainability. “It’s not an advertis- ing ploy or marketing gimmick. GE wants to do this because it is right, but also we plan to make money while we do so,”7 said Peter O’Toole (O’Toole), di- rector of public relations at GE.

Ecomagination: Driving Sustainable Growth for GE

This case was written by Syeda Maseeha Qumer, under the direction of Debapratim Purkayastha, IBS Center for Management Research. It was compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.

“GE should be commended for a bold approach to climate issues. However, the company has a long way to go before it can legitimately claim to be an environmentally progressive company.”1

—Jeff Jones, Communications Director, Environmental Advocates of New York,2 in 2009.

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About Ge GE was formed in 1892 by the merger of the Edison General Electric Company (EGEC) and the Thomas- Houston Electric Company8 (TEC). By the 1950s, GE had grown into a large industrial conglomer- ate with interests in diverse businesses. In the late 1960s, GE had 46 Strategic Business Units (SBUs) within the company and also diversified into other new businesses like computers, nuclear power, and aircraft engines. In 1977, GE’s earnings crossed the US$1 billion mark.

In 1981, an important phase began in GE’s history when Jack Welch (Welch) was appointed as CEO. One of Welch’s core strategies was the Number One Number Two strategy.9 In 1995, GE’s market value exceeded US$100 billion. In 1996, GE completed 100 years on the Dow Jones Industrial Average,10 the only company remaining from the original list of 12 stocks, first published on May 26, 1896.

In mid-2001, Jeffrey R. Immelt (Immelt) suc- ceeded Welch as the Chairman and CEO of GE. Within days of his taking over, the September 11, 2001 terrorist attacks occurred. As a result, GE too was affected by the changes in the business environ- ment. Immelt then brought in several changes at the company in order to win investor confidence. The company was listed on the Dow Jones Sustainability Index in late 2004.11 In the fiscal year ended December 2005, GE posted revenues of more than US$149 billion.

In 2009, Forbes ranked GE as the world’s largest company with over 300,000 employees in its various business units. At the end of 2009, GE had six core business units and was the big- gest manufacturer of power plants, jet engines, locomotives, and medical equipment worldwide12 (Refer Exhibit I). GE Global Research consisted of more than 3,000 employees working in four state-of-the-art facilities at Niskayuna (New York), Bangalore (India), Shanghai (China), and Munich (Germany). In 2009, despite the tough economic climate, GE reported earnings of US$11.2 billion (Refer Exhibit II and III). In 2010, GE was ranked among Fortune’s ‘Most Admired Companies in the World’ for the 5th consecutive year. In the second quarter ended June 2010, the company’s revenues fell by 4% to US$37.4 billion. Industrial sales were US$24.4 billion, down 6% compared to corre- sponding period of the previous year.

Winds of Change at Ge According to some analysts, GE had not been known over the years as a particularly environment- friendly company. In fact, it was considered for a long time as one of the biggest corporate polluters in the US. Though the company delivered outstand- ing returns to shareholders, it lagged behind on the social responsibility front. GE was criticized on several occasions for its lack of social responsibil- ity. However, the company chose to ignore its critics and gave precedence to profitability and financial goals rather than social and environmental objec- tives, added experts.

During the 1980s and 1990s, GE stonewalled and delayed most of its environmental initiatives, and this led to significant negative equity among many in the environmental community. One of the biggest environmental controversies involving GE was related to the pollution of the Hudson and Housatonic rivers in the US. In the early-1980s, GE was indicted for dumping several million of pounds of polychlorinated biphenyls (PCBs)13 into stretches of the two rivers from its factories located along their banks. In 1977, after the US Congress passed the Clean Water Act,14 the US Environment Protection Agency (EPA)15 banned the production of PCB. Since most of GE’s PCB dumping had been done before 1972, when the substance was not banned by law, the company argued that it was not responsible for the sediments already present in the rivers. But envi- ronmentalists argued that the dangerous nature of PCBs had been well known even before the law had been passed, and that GE had acted irresponsibly in dumping the chemicals in the rivers.

Between 1991 and 1996, EPA charged GE with 23 violations when toxic releases from its plants went unreported. In March 1992, the Nuclear Regulatory Commission (NRC)16 slapped a fine of US$20,000 on GE for violating regulations at its fuel fabrica- tion plant in Wilmington, North Carolina. It was reported that workers at the plant had accidentally moved about 320 pounds of uranium to a waste treatment tank, which could have led to a nuclear accident. Later, the NRC found that the mistake had been made because of lax safety controls at the plant. Again in March 1998, GE was fined US$92,000 for violations of environmental reporting requirements for toxic releases at its silicone manufacturing plant in Waterford, New York.

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Though GE gave more significance to profitabil- ity than to social responsibility, the business environ- ment prevailing in the early-2000s made companies look beyond financial goals. Sustainability became critical for business success as climate change, water scarcity, and poverty were seen as profound chal- lenges for the global economy. During this time, the Kyoto Protocol17 was a much discussed subject, and at global forums like the G818 and WTO19 meetings, environmental sustainability became a hot topic. Moreover, as consumers and investors became more environmentally conscious than before, it became more important for companies to consider environ- mental sustainability in their operations.

In 2001, when Immelt succeeded Welch, the com- pany started to focus more on addressing environ- mental challenges. Immelt felt that sustainability was a profitable business opportunity rather than a cost and hence seized on the idea of greening GE’s technol- ogy and turning it into a corporate-wide strategy for growth. He felt that with creativity and imagination, it was possible to solve some of the world’s most diffi- cult environmental problems and make money while doing it. Immelt’s new slogan was “green is green,” meaning that green business equaled green money.

Immelt wanted GE to support climate change and invest in creating new markets for cleaner fuels and technologies as they offered opportunities for product innovation. He consulted executives from other companies who had launched environmental programs such as DuPont20 Chairman and CEO, Charles Holliday Jr. They advised him to solve the company’s earlier environmental problems and then go ahead with green product ideas.

In 2002, a large team of executives from GE at- tended a training session on CSR at Crotonville. As part of the training, the executives visited several companies that dealt with social and environmen- tal issues such as IBM,21 Eli Lilly,22 BP,23 and Nike.24 They also interacted with regulators, activists, and investors, who had an interest in CSR. During the course of their training, the executives found that though GE was well known for its management quality and operations, it ranked low on the so- cial responsibility aspect. They felt that for GE to maintain its position in the global economy, imme- diate steps had to be taken to build its image as an environmentally-friendly company.

In 2002, Christine Todd Whitman, the then EPA Administrator, issued a ruling related to the Hudson

river clean-up that gave GE two options—to agree to an out of court settlement, or pay fines of up to US$2 billion.25 In 2005, GE entered into an agree- ment with the EPA and the US Department of Justice to carry out a two stage clean-up of the Hudson River at an estimated cost of around US$750 million.26

In the early 2000s, GE launched several global ini- tiatives in order to make the company more socially re- sponsible. For instance, it started conducting audits on its suppliers to ensure that they were complying with globally accepted labor, environmental, health, and safety standards in their operations. In 2002, Immelt appointed Bob Corcoran, a long-time GE employee, as the company’s first vice president for corporate citizen- ship. Immelt also restructured GE’s business portfolio to include more companies operating in emerging in- dustries and acquired companies such as Enron Wind Corp.,27 Ionics Inc.,28 Osmonics Inc.,29 and AstroPower Inc.30 The company began to invest in new technolo- gies. For instance, in 2004, GE invested in a new coal technology called Integrated Gasification Combined- Cycle (IGCC), which filtered out GHG and pollutants when coal was burned for energy.31

As part of the green drive, Immelt began delegating preliminary tasks to various teams within the company like researching greenhouse legislation, formulating metrics, conducting customer surveys, prototyping new products, formulating cross- company guidelines, etc. The company’s marketing team identified a B2B32 mar- ket opportunity for green products and outlined the monetary benefits of these products to its customers.

In late 2004, a senior-level brainstorming session at GE set the stage for the companywide environ- mental initiative, Ecomagination. The initiative was initially greeted with skepticism by a majority of the senior level management as they felt that it would require huge investments. Senior executives posed questions such as “Do we want to attract attention?” and “Will this create problems around the Hudson River [issue]?” during internal discussions. Instead of stepping back, Immelt drew on the trust and support he had earned from his team and went ahead with the proposal. Since GE comprised many businesses, con- vincing the heads of each business unit was one of the toughest parts of the execution process. According to O’Toole, “Ecomagination had to enable our busi- ness leaders to work better with their customers. It couldn’t be an ‘unfunded mandate’ from corporate. So there had to be give-and-take with our top leaders to ensure we were helping our customers.”33

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growth strategy. It is a business strategy based on the idea that by investing in technologies to help cus- tomers solve these big megatrends that we’re seeing, to help them grow sustainably in this world—where there is more regulation, more scarcity, higher energy costs—that we can grow sustainably as well.”38

As part of the initiative, GE committed itself to doubling its annual research investment in cleaner technologies, from US$700 million in 2004 to US$1.5 billion in 2010.39 During the same period, GE aimed to double its revenue from Ecomagination products and services to US$20 billion annually and expected more than half of its product revenue to come from such products by 2015. GE set a target to reduce GHG emissions from its factory operations by 1% by 2012 from a 2004 baseline and to improve energy efficiency by 30% by the end of 2012.40

GE promoted Ecomagination widely through ad- vertisements and other promotion campaigns, as part of its ‘keeping the public informed’ objective. It launched an integrated advertising campaign in the television, print, and online media to make consumers aware of the company’s energy-efficient products available in the market. Besides advertisements, GE also launched an exclusive Website and several short online films. In October 2005, GE partnered with Dow Jones to launch a US$50,000 prize competition called “ECOnomics: The Environmental Business Plan Challenge” which invited entrepreneurs, executives, and students to sub- mit eco-friendly business ideas. In September 2006, GE in association with MtvU41 rolled out the “MtvU GE Ecomagination Challenge” wherein college students across the US were asked to submit innovative ideas for projects that would make their institutions more environmentally responsible. In 2008, GE launched a comprehensive campaign to promote its Smart Grid technology. According to Jeff Renaud, Director of GE’s Ecomagination program, “Looking at GE’s over- all advertising and digital media efforts, it’s clear that Ecomagination is a core element . . . We also believe that Ecomagination has had and will continue to have a positive impact on GE’s overall brand value.”42

ecomagination at Work One of the vital components of GE’s Ecomagination program was to build strategic partnerships with cor- porations and governments around the world, univer- sities, and research institutions to solve energy needs.

Some environmentalists too supported the initia- tive as it addressed environmental challenges such as global warming and climate change. According to Eileen Claussen, president of the Pew Center for Climate Change,34 “We are still quite politically po- larized on the issue of climate change in this country. The fact that a company that size wants to take a very public position to talk about their products in terms of climate change and then, most important of all, to say they want to be part of the policy dialogue, which is very difficult in the United States at this mo- ment, is an act of courage.”35

The Launch of ecomagination On May 9, 2005, Immelt announced the launch of the US$ 150 billion environmental initiative. According to GE’s Ecomagination Website, Ecomagination is “a business initiative to help meet customers’ demand for cleaner and more energy-efficient products and to drive reliable growth for GE.”36 Commenting on the initia- tive, Immelt said, “It’s no longer a zero-sum game— things that are good for the environment are also good for business. We are launching Ecomagination not be- cause it is trendy or moral, but because it will acceler- ate our growth and make us more competitive.”37

The name ‘Ecomagination’, which was derived from GE’s “Imagination at Work” slogan, addressed chal- lenges such as the need for cleaner and more efficient sources of energy, reduced emissions, and new sources of clean water. Through Ecomagination, GE aimed to focus on its energy, technology, manufacturing, and in- frastructure capabilities to develop new sustainable so- lutions and invest in technologies such as solar energy, hybrid locomotives, wind power generation, fuel cells, lower emission aircraft engines, efficient lighting, and water purification technologies and appliances.

Through Ecomagination, GE planned to invest in technologies such as biomimicry, nanotechnology, and other emerging clean technologies. Experts were of the view that at a time when most other compa- nies were cutting back on R&D funding for projects that lacked clear market application with custom- ers, GE, through the initiative, had created options to develop radical technologies which would take longer to develop but deliver results with large pay- offs. According to Lorraine Bolsinger (Bolsinger), president and CEO of GE Aviation Systems LLC, “Ecomagination is for us, above everything else, a

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areas in these regions. In Africa, GE partnered with the Algerian government and the Algerian Energy Company to build the continent’s largest desalina- tion plant at Hamma.

GE also collaborated with end users and external partners to identify energy-saving lighting projects. In 2007, Wal-Mart50 fitted refrigerated display cases with GE’s light emitting diodes (LEDs) to reduce en- ergy consumption in more than 500 of its retail stores. The same year, oil giant BP also formed a global alli- ance with GE to develop about 15 hydrogen power projects in order to cut GHG emissions from elec- tricity generation.51 Besides big companies, GE also partnered with non-profit organizations such as the World Resources Institute52 and the Pew Center on Global Climate Change to check GHG emissions. According to Beth Comstock (Comstock), Chief Marketing Officer of GE, “Ecomagination has been strengthened by input from a variety of partners . . . When you’re teamed with a partner who shares a common vision and commitment and complemen- tary capabilities, a new kind of energy is created.”53

As part of the Ecomagination initiative, GE rolled out several energy efficient and renewable energy tech- nologies at its facilities too, including products such as solar panels and advanced lighting systems which it manufactured itself. Within the company, GE began engaging employees to see where energy savings could be achieved. It implemented initiatives such as turning off the lights when a factory was idle, installing LED lights on factory floors, recycling water at nuclear fa- cilities, etc. GE installed solar panels on many build- ings, including its headquarters, and energy efficient light bulbs in many of its factories. “Leading by exam- ple is the essence of Ecomagination. If we are propos- ing that customers and enterprises around the world use GE solutions to reduce their emissions, then we should do the same,”54 said Fludder.

To reduce energy usage and GHG reductions, GE made use of the “Energy Treasure Hunts”55 devel- oped by Toyota.56 GE carried out regular treasure hunt sessions from 2005 to identify energy-efficiency savings at a specific manufacturing site. For instance, at its, locomotive operations in Erie, Pennsylvania, GE switched to natural-gas fired power from oil, saving money and cutting emissions in the manu- facture of locomotive engines. As of July 2010, GE had conducted 200 internal treasure hunts, which helped the company save more than US$130 million annually and contributed to reductions in excess of 250,000 metric tons of CO

2 .57

In 2005, GE Energy Financial Services entered into a partnership with AES Corporation43 to develop a ven- ture called Greenhouse Gas Services44 in the US. The goal of the partnership was to offset the equivalent of an annual production volume of 10 million metric tons (MMT) of carbon dioxide gas by 2010 through the reduction of methane emissions from landfill gas, coal mines, and agricultural waste. In 2008, Greenhouse Gas Services joined with Google, Inc.45 to codevelop a GHG reduction project46 at a landfill in Caldwell County, North Carolina.

According to GE’s 2005 Ecomagination Report, in 2004 and 2005, the company had undertaken nearly 500 global energy conservation projects which had led to substantial energy cost savings and a reduction of more than 250,000 tons of GHG emissions, equivalent to keeping nearly 50,000 cars off the road.47 Between 2005 and 2009, GE financed and invested in 247 megawatts of solar projects, including one of the world’s largest, the 11-megawatt Serpa solar plant in Portugal. The com- pany focused not only on individual projects but also in- vested capital in other companies that were developing solar power around the world. For instance, GE Oil & Gas Ecomagination technology played a vital role in the development of Asia’s natural gas pipeline infrastruc- ture to supply gas from Uzbekistan and Kazakhstan to China for meeting China’s rising energy demands.

In May 2006, GE launched Ecomagination in China followed by its launch in Australia five months later. According to GE, China Ecomagination products brought significant growth to GE’s business in China. In the first three quarters of 2009, GE’s Ecomagination revenues in China reached US$656 million, an in- crease of 50% compared to the previous year. In 2009, GE signed 20 memorandums of under stand- ing (MOUs) with central and local government bod- ies and 10 MOUs with state-owned-enterprises and Chinese universities to develop energy-efficient solu- tions in areas such as biogas solutions, wind power, clean coal technology, industrial emissions reduction, aircraft engines, locomotives, etc.48

In February 2007, GE Aviation signed an MOU with Air India,49 to make Air India’s operations more sustainable by providing the airline’s fleet with fuel- efficient engines. By using these engines, the airline was expected to save US$150 million over the next 15 years while establishing itself as an environmen- tally friendly service. In 2007, to combat severe po- table water shortages in countries in Southeast Asia, Africa, and Latin America, GE provided solar energy modules and water filtration technologies to rural

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well as environmental performance, support growth of new technologies, and drive a more sustainable form of development. Talking about the product ver- ification process, Bolsinger said, “If we got this great green technology, but it’s totally unaffordable, we say no, that’s not ready to be an ecoproduct. It has to be better, in terms of operating performance for the customer—to give them some economic return— as well as the environmental piece of it.”63

As part of the EPR process, GE analyzed the environmental attributes of its products relative to benchmarks such as competitors’ products, regula- tory standards, and historical performance. It ensured that all Ecomagination products met the required criteria and that the product marketing was clear and substantiated. To provide independent, quantita- tive environmental analysis and verification of GE’s product claims, GE partnered with GreenOrder.64 The firm verified the product information and ad- vised GE on the associated marketing claims of the products. For this purpose, GreenOrder developed a scorecard system for evaluating Ecomagination products and technologies. For each product, an ex- tensive scorecard was created quantifying the prod- uct’s environmental attributes, impact, and benefits relative to comparable products. The scorecards were then used to create product marketing claims. “This process is flexible enough to cover incredibly diverse industries, since Ecomagination creates, com- pares, measures, and launches products as small as a light bulb or as big as a jet engine,”65 said Comstock.

As of June 2010, GE was marketing 90 Ecomagi- nation certified products ranging from compact fluo- rescent lighting, smart grid components, and wind turbines, to smart appliances, aircraft engines, and water treatment technologies (Refer to Exhibit IV). Products developed under the Ecomagination um- brella were not limited to GE’s manufacturing busi- nesses alone but was also extended to the company’s financial business. Once a product became a part of the Ecomagination portfolio it was reviewed regu- larly to ensure that performance claims were based on the latest relevant information and reflected any changes to the product itself or its market. R&D funding for Ecomagination products was provided by GE’s four Global Research Centers and some ma- jor businesses of the company.

Between 2002 and 2005, GE invested more than US$350 million to develop high efficiency appliance products and to meet the ENERGY STAR66 quali- fication for as many of its Consumer & Industrial

In 2007, GE Transportation partnered with Union Pacific,58 to launch hybrid locomotives capable of re- cycling thermal energy as stored power in on-board batteries. The energy stored in the batteries could re- duce fuel consumption and emissions by as much as 10% compared to ordinary freight locomotives. In the automotive sector, GE Energy Financial Services59 in- vested in the battery company, A123 Systems Inc.,60 to develop the next generation of battery technology for hybrid and plug-in hybrid electrics. For instance, GE made an investment to help A123Systems roll out bat- teries for Norwegian electric car manufacturer Think Global.61 Besides providing capital, GE, through GE Global Research, offered system design expertise and supported A123’s power product development for electric grid applications, and designed battery system components for A123’s automotive programs.

In May 2007, GE’s media arm, NBC Universal62 (NBCU), announced its “Green is Universal” initia- tive to bring about environmental awareness and ed- ucate consumers about environmental sustainability. NBCU aimed to reduce its GHG emissions at least 1% by 2012. As part of this effort, NBCU aired en- vironmentally themed content through its on-air net- works and online platforms during its Green Week (in November) and Earth Week (in April). In November 2009, NBCU’s “Make Green Count” campaign was launched. This campaign encouraged audiences to make one small green change to their daily lives such as turning the lights off or walking to work.

ecomagination Products To ensure that Ecomagination products and services improved environmental performance, GE employed a rigorous review and qualification procedure known as the Ecomagination Product Review (EPR) process to assess which products and services should be included in the Ecomagination portfolio. The EPR process was carried out by the Ecomagination team comprising environmental health and safety counsel product marketing teams from the GE business units and corporate legal counsel. The evaluation process was audited by a third party. Product characteristics considered during the EPR process included environ- mental factors such as energy consumption, GHG emissions, and water usage, in addition to the finan- cial benefits of the product to customers.

For products to be included in the Ecomagination portfolio they had to be better in terms of operating as

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categories—Renewable Energy, Grid Efficiency, and EcoBuildings/Homes. Each of the five innovation challenge award winners would receive US$100,000 in cash and bag a partnership deal with GE to develop and distribute the technology.

Results According to analysts, Ecomagination was a turn- ing point for the company, which had been grappling with the problem of an inconsistent green image. Since its launch in 2005, the initiative paid off in a big way as it helped GE to evolve as a sustainable enterprise and contributed to the rise in its brand value, they said. Talking about the success of the program, Immelt said, “Ecomagination is one of the most successful cross-company business initiatives in our recent history. It is a clear amplifier of our strong reputation for innovation and execution, harness- ing the strength of every GE business to maximize returns for GE investors while minimizing our own energy use and greenhouse gas emissions.”75

In 2005, revenues from the sale of Ecomagination products and services reached US$10.1 billion com- pared to US$6.2 billion in 2004.76 Orders and com- mitments doubled to about US$17 billion. In 2006, revenues from the Ecomagination portfolio of prod- ucts and services surged past US$12 billion, up 20% from 2005, while the order backlog increased to US$50 billion.77 In 2007, Ecomagination revenues crossed US$14 billion, an increase of 15% from 2006.78 For the first time, GE’s investment in cleaner technology R&D crossed US$1 billion in 2007. In 2008, GE’s revenues from Ecomagination grew by 21% to US$17 billion.79 The company increased its investment in R&D of clean tech solutions by 27% to US$ 1.4 billion, up from US$750 million in 2005. In 2008, GE reduced GHG intensity by 41%, sur- passing its goal of reducing it by 30%.

In the year 2009, which marked the fifth anniver- sary of the Ecomagination program, revenues from Ecomagination products and services grew by 6% to cross US$18 billion despite the global economic recession.80 In 2009, GE invested US$1.5 billion on Ecomagination R&D. In 2009 GE’s GHG emis- sions were 22% below its 2004 baseline and water consumption reduced by 30% compared to a 2006 baseline, surpassing the original goal of 20% by 2012. According to GE statistics, since the inception

products as possible. In 2005, GE invested more than US$60 million to develop 164 new ENERGY STAR qualified appliances. Again in 2007, the company in- vested approximately US$47 million to create 215 new ENERGY STAR qualified appliance models. In recognition of GE’s commitment to developing high- efficiency appliance products, the US Department of Energy and the EPA awarded GE the ENERGY STAR Partner of the Year “Sustained Excellence” award for three consecutive years (2006–2008).67

In May 2007, GE launched 11 new Ecomagination products and services including a hybrid locomo- tive68 and a carbon offset company. In July 2007, GE Money69 launched the first-ever US credit card with a reward program known as GE Money Earth Rewards.70 The program offered cardholders an easy way to offset their carbon impact and reduce carbon emissions by contributing up to 1% of their net spend to buy carbon offsets. On May 24, 2007, the GE and Masco Contractor Services71 (MCS) Environments for Living division announced the Ecomagination Homebuilder Program to help resi- dential developers and builders design homes which were are not only comfortable, but also more efficient in their energy consumption and indoor water con- sumption. Homes built under this program resulted in at least 20% saving in household energy, water consumption, and emissions compared to industry accepted new homes. In 2008, for the first time, GE Healthcare products joined the Ecomagination port- folio. These products not only provided outstanding clinical performance, but also offered significant sav- ings. In 2010, GE launched two new products in the Ecomagination portfolio—the WattStation electric vehicle charger72 and the Nucleus,73 a real-time home energy monitor.

On July 13, 2010, GE launched a US$200 million global innovation challenge called the GE Ecomagination Challenge: Powering the Grid to create and adopt more efficient and economically sustainable electric grid technologies. The challenge invited technologists, entrepreneurs, and startups to design innovative business models, technologies, and processes that would bring clean, usable energy to the market through renewable energy, power grid efficiency, and eco homes. Co-funded by four ven- ture capital firms,74 the challenge aimed to leverage on GE’s technical expertise and bring new ideas to market quickly. Until September 30, 2010, par- ticipants could submit proposals in three general

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going to make, break, or save GE,”84 said William Rothschild, a Consultant at Rothschild Strategies Unlimited.85

According to some experts, Ecomagination prod- ucts and technologies focused on large scale, cen- tralized solutions and were mostly capital-intensive applications based on existing business models. Little attention was paid to small-scale standalone applica- tions that might address distinct market needs and customers, they said. Industry observers felt that Ecomagination products mostly served the needs of customers at the top of the economic pyramid86 and ignored the requirements of customers at the base of the pyramid who lacked reliable and affordable solutions related to energy, transportation, water, materials, and financial services.

Commenting on the criticism related to the initia- tive, Bolsinger said, “I think the skepticism piece was never a big deal for me because (Ecomagination) was never based on “we’re doing this for philanthropy” or “we’re doing this to make the world safe.” We’re glad to be doing that as a result of making money. It’s a different lens that informs your decisions about where to spend money and what resources you’re going to invest.”87

Looking Ahead According to GE, Ecomagination was not a short- term proposition and the company planned to make it a part of its identity and market the brand aggres- sively to the world. GE planned to increase revenues from Ecomagination products and services to at least US$25 billion by the end of 2010.88 GE com- mitted itself to reducing its GHG emissions by 1% by 2012 and to improving energy efficiency by 30% by the end of 2012 compared to the 2004 baseline. GE aimed to achieve its commitment to double an- nual investment in clean tech R&D to US$ 1.5 bil- lion by 2010.89 It also planned to invest an additional US$10 billion in Ecomagination R&D by 2015, par- ticularly in the development of low-carbon products.

The company committed itself to ensuring that by 2015, Ecomagination revenue would grow at twice the rate of total company revenue and planned to improve the energy intensity of its operations by 50% and re- duce its absolute GHG emissions by 25%, both against the 2004 baseline.90 The company also altered its goal of reducing freshwater consumption by 20% by 2012

of Ecomagination, the company had invested a total of US$5 billion in its R&D investment and gener- ated a total of US$70 billion in revenues through the end of 2009.81 “Ecomagination is one of our most successful cross-company business initiatives. If counted separately, 2009 Ecomagination revenues would equal that of a Fortune 130 company and Ecomagination revenue growth equals almost two times the company average,”82 said Immelt.

The Other View Despite the positive aspects of this green initiative, some experts felt that GE could not call itself an eco- friendly company because of its history of pollution, particularly the dumping of PCBs in the Hudson River and the delay in cleaning it up. Some ana- lysts charged that despite making tall claims about its products being environmental friendly, GE con- tinued to sell coal-fired steam turbines and was in- volved in oil and gas extraction.

Some analysts accused GE of greenwashing as they felt that the Ecomagination initiative was meant to divert people’s attention from the compa- ny’s negligent stance toward environmental matters. Ecomagination was an attempt to cover up GE’s poor environmental image and its continuing obses- sion with profit at the expense of the environment, they charged. According to Chris Ballantyn, director of the Hudson River Program, “Actions speak louder than words. When you scratch beneath the public relations surface, I’m afraid they have unfinished business in terms of environmental protection.”83

Moreover, GE’s annual US$1 million invest- ment in marketing Ecomagination was criticized as an expensive branding exercise which amounted to greenwashing. Some experts were of the view that Ecomagination did not address all of the company’s environmental problems and was risky as compa- nies were generally reluctant to play up their prod- ucts’ environmental benefits fearing that their green claims would not able to match the company’s over- all environmental footprint. They observed that sus- tainability as a corporate strategy worked only if it was made a company-wide initiative. If it remained restricted to a few products, its impact would be limited. “Even at $20 billion, Ecomagination is only about 10 percent of GE. It’s a very creative way to drive and differentiate the company, but it’s not

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from the 2006 baseline to 25% by 2015. As part of its public awareness, GE planned to increase its interac- tions with the public and revamp its Website to enable people to put forward their questions and queries.

In the future, under the Ecomagination pro- gram, GE planned to build a massive battery plant in New York and a US$2 billion wind project in Oregon and to launch a series of high-end energy-efficient front-load washers and dryers. In June 2010, GE Energy Financial Services entered into an agreement with a Spanish renewable energy company Abengoa,91 to develop the largest cogeneration92 power plant in Mexico. The companies were to invest US$180 mil- lion in the project expected to be commercially op- erational by 2012. The 300 megawatt plant was to supply electricity and steam over the next 20 years and help the Mexican government meet its energy effi- ciency targets by reducing GHG emissions by 50% in comparison with 2002 by 2050. GE identified China and South Korea as countries where the company ex- pected green technology to thrive in the future.93

GE said while it would continue to invest in prod- ucts like energy efficient turbines, green locomotives, and sodium batteries in the future, it would also focus on bringing more intelligence and networking to its existing product categories. For instance, it planned to roll out software applications for monitoring flight paths, take-offs, and landings for airplanes in order to reduce the time that planes had to spend circling airports. This would help cut fuel consumption. “It is a cost savings to the airlines and it is a huge comfort factor for customers. These are the kind of IT-enabled solutions we will invest in,”94 said Fludder.

According to industry observers, Ecomagination was a good platform for GE to make investments in new technologies while making money at the same time. They felt that the initiative had huge scope for expansion in the future as more green technolo- gies would be able to address new problems, cre- ate new markets, and reach underserved customers. While there were some discordant notes as well, the company said it was committed to taking this initiative forward. According to Comstock, “With Ecomagination, we’ve learned that sustainability is as much a change-management challenge as it is a busi- ness or scientific challenge . . . Change happens when others see opportunity—and change their behavior, join in, and make it their own. Ecomagination’s mantra is no longer just GE’s. And that’s just fine with us.”95

Energy

• Digital Energy

• Electrical Distribution

• Energy

• Oil & Gas

• Sensing & Inspection

• Water & Process Technologies

Technology Infrastructure

• Aviation

• Healthcare

• Transportation

GE Capital

• Commercial Lending & Leasing

• Consumer Financing

• Energy Financial Services

• GE Capital Aviation Services

• Real Estate Financing

• Worldwide GE Capital Locations

NBC Universal

• Cable

• Film

• Networks

• Parks & Resorts

GE Home & Business Solutions

• Appliances

• Consumer Electronics

• Intelligent Platforms

• Lighting

Exhibit I GE-Business Groups

Source: http://www.ge.com/products_services/directory/ by_business.html

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2009 2008 2007

Revenues

Sales of goods 65,068 69,100 60, 670

Sales of services 38,709 43,669 38,856

Other income 1,006 1,586 3,019

GECS earnings from continuing operations — — —

GECS revenues from services 52,000 68,160 69,943

Total Revenues 156,783 182,515 172,488

Costs and expenses

Cost of goods sold 50,580 54,602 47,309

Cost of services sold 25,341 29,170 25,816

Interest and other financial charges 18,769 26,209 23,762

Investment contracts, insurance losses and insurance annuity benefits 3,017 3,213 3,469

Provision for losses on financing receivables 10,928 7,518 4,431

Other costs and expenses 37,804 42,021 40,173

Total costs and expenses 146,439 162,733 144,960

Earnings (loss) from continuing operations before income taxes 10,344 19,782 27,528

Benefit (provision) for income taxes 1,090 (1,052) (4,155)

Earnings from continuing operations 11,434 18,730 23,373

Loss from discontinued operations, net of taxes (193) (679) (249)

Net earnings 11,241 18,051 23,124

Less net earnings (loss) attributable to non controlling interests 216 641 916

Net earnings attributable to the Company 11,025 17,410 22,208

Preferred stock dividends declared (300) (75) —

Net earnings attributable to GE common shareowners 10,725 17,335 22,208

Amounts attributable to the Company:

Earnings from continuing operations 11,218 18,089 22,457

Loss from discontinued operations, net of taxes (193) (679) (249)

Net earnings attributable to the Company 11,025 17,410 22,208

Per-share amounts—net earnings

Diluted earnings per share 1.01 1.72 2.17

Basic earnings per share 1.01 1.72 2.18

Dividends declared per common share 0.61 1.24 1.15

Exhibit II General Electric Company-Consolidated Statement of Earnings For the years ended December 31 Dollar amounts and share amounts in millions; per-share amounts in dollars

Source: GE 2009 Annual Report

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Rank Company Revenues (US$ millions) Profits (US$ millions)

1 Wal-Mart Stores 408,214.0 14,335.0

2 Exxon Mobil 284,650.0 19,280.0

3 Chevron 163,527.0 10,483.0

4 General Electric 156,779.0 11,025.0

5 Bank of America Corp. 150,450.0 6,276.0

6 ConocoPhillips 139,515.0 4,858.0

7 AT&T 123,018.0 12,535.0

8 Ford Motor 118,308.0 2,717.0

9 J.P. Morgan Chase & Co. 115,632.0 11,728.0

10 Hewlett-Packard 114,552.0 7,660.0

Exhibit III Top 10 in Fortune’s Ranking of America’s Largest Corporations (2010)

Adapted from http://money. cnn.com/magazines/fortune/fortune500/2010/full_list/

Total Products Investment in R&D Greenhouse Gas (GHG) emissions Revenues

2005 GE has increased its Ecomagination pipeline by 75% over the last year—from 17 products to 30.

GE invested US$700 million in cleaner technologies in 2005.

GHG emissions from operations remained relatively flat in 2005 compared to 2004, while GHG intensity was reduced by 10% and energy intensity was reduced by 11%.

GE’s revenues from Ecomagination products and services reached US$10.1 billion. Orders and commitments nearly doubled to US$17 billion. Revenues for 2005 were at US$10.1 billion; orders went up 93% from 2004, nearly doubling to US$17 billion.

2006 GE has increased its Ecomagination pipeline by 50% over the last year—from 30 products to 45.

GE invested US$900 million in cleaner technologies in 2006.

GHG emissions in 2006 from operations have been reduced by about 4% from the 2004 baseline. GHG and energy intensity have been reduced by 21% and 22% respectively compared to 2004.

In 2006—GE’s revenues grew from US$10 billion in 2005 to US$12 billion, delivering a 20% increase in revenue. 2006 revenues at US$12 billion; orders and commitments have increased to US$50 billion.

Exhibit IV Ecomagination Statistics

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10. “GE Ecomagination Revenue Grows 21% to $17B,” www.environmentalleader.com, May 27, 2009.

11. GE 2009 Annual Report. 12. GE 2009 Ecomagination Report. 13. Lisa Roner, “GE: Runaway Ecomagination is

Not Enough,” www.climatechangecorp.com, June 4, 2008.

14. “GE’s5Ecomagination’ Business Grows to $14 billion; Revenue Target Raised to $25 billion as Orders Top $70 billion,” www.domain-b.com, May 29, 2008.

15. “GE’s5ecomagination’ business grows to $14 billion; revenue target raised to $25 billion as orders top $70 billion news,” www.domain-b.com, May 28, 2008.

16. Martin LaMonica, “GE to Lower Water Use, Raise Ecomagination Target,” http://news.cnet.com, May 28, 2008.

17. Douglas MacMillan, “The Analysis: In Immelt We Trust,” www.businessweek.com, March 4, 2008.

18. GE 2008 Ecomagination Report.

References:

1. Ariel Schwartz, “GE Boosts Ecomagination Initiative with an Extra $10 Billion,” www.fastcompany.com, June 25, 2010.

2. Candace Lombardi, “GE to Invest $10 billion in Ecomagi- nation Initiative,” http://news.cnet.com, June 24, 2010.

3. “Ecomagination at 5: Unleashing Action & Measure- ment,” www.gereports.com, June 24, 2010.

4. “GE Surpassed $5 Billion in Research & Develop- ment Investment in Ecomagination Technology,” www .genewscenter.com, June 24, 2010.

5. Michael Kaneloss, “GE Looks to Smart Grids for Airports, Railroads in Ecomagination 2.0,” www . greentechmedia.com, June 24, 2010.

6. “GE’s Ecomagination Business in China Records 50% Growth,” www.reliableplant.com, 2010.

7. Caylena Cahill, “Problems in Green Marketing,” fuse. ithaca.edu, December 2009.

8. James Murray, “GE Talks up Ecomagination Success,” www.businessgreen.com, May 28, 2009.

9. “GE’s Ecomagination Team Unveils its Annual Score- card,” www.gereports.com, May 27, 2009.

Total Products Investment in R&D Greenhouse Gas (GHG) emissions Revenues

2007 GE increased the number of Ecomagination- certified products by 38 percent over last year—from 45 to 62 products.

It invested US$1.1 billion in cleaner technology research and development.

It reduced its greenhouse gas (GHG) emissions by about 8% in 2007 from the 2004 baseline, while reducing GHG and energy intensity by 34% and 33% respectively.

It increased its revenues from Ecomagination products with US$14 billion in revenues from Ecomagination products and services in 2007.

2008 GE increased its Ecomagination portfolio—from 17 products in 2005 to more than 80 products today.

GE invested US$1.4 billion in cleaner technology research and development in 2008, up from US$750 million in 2005.

GHG emissions from operations reduced by about 13% from the 2004 baseline. GHG and energy intensity reduced by 41% and 37%, respectively, compared to 2004.

GE reported US$17 billion in revenues from Ecomagination products and services in 2008, an increase of 21% over the previous year.

2009 Products grew to 90. It invested US$1.5 billion in cleaner technologies, achieving its 2010 goal one year ahead of schedule.

Reduced greenhouse gas emissions from operations approximately 22% from the 2004 baseline. GHG and energy intensity reduced by 39% and 34% respectively.

Revenues grew by 6% to US$18 billion.

Compiled from various sources

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15 EPA is an agency of the US federal government respon- sible for protecting human health and safeguarding the natural environment.

16 Formed in 1975, NRC is a US government agency responsible for overseeing the civilian use of nuclear materials in the US.

17 The Kyoto Protocol is an agreement made under the UN Framework Convention on Climate Change concern- ing issues related to global warming. The countries that ratify the protocol commit themselves to reducing their emissions of carbon dioxide and five other greenhouse gases, or to engage in emissions trading if they main- tain or increase emissions of these gases. The treaty was negotiated in December 1997 and came into force on February 16, 2005. As of July 2010, there were 192 sig- natories to the treaty.

18 The G8 or the Group of Eight is an annual political sum- mit meeting of the heads of government of eight of the most powerful countries in the world. The members are: Canada, France, Germany, Italy, Japan, Russia, the UK, and the US.

19 Headquartered in Geneva, Switzerland, the WTO (World Trade Organization) is an international, multi- lateral organization, which sets the rules for the global trading system and resolves disputes between its mem- ber states.

20 Founded in 1802, DuPont is a science-based prod- ucts and services company operating in 80 countries worldwide.

21 IBM Corporation is a multinational computer, tech- nology, and IT consulting company headquartered in Armonk, New York.

22 Headquartered in Indianapolis, Eli Lilly and Company is a global pharmaceutical company.

23 Headquartered in London, UK, BP Plc is one of the lar- gest oil and gas companies in the world with operations in over 100 countries.

Endnotes

1 Caylena Cahill, “Problems in Green Marketing,” www .fuse.ithaca.edu, December 2009.

2 Environmental Advocates of New York is a watchdog group on environmental issues affecting New York.

3 “GE Surpassed $5 Billion in Research & Develop- ment Investment in Ecomagination Technology,” www .genewscenter.com, June 24, 2010.

4 Ibid. 5 SustainAbility is an independent think tank and strategy

consultancy. 6 Lucy Aitken, “Wiping out ‘Greenwash’,” www.guardian

.co.uk, November 19, 2007. 7 Ron Irwin, “GE Imagines a Greener Future,” www

.brandchannel.com, July 11, 2005. 8 The Thomas-Houston Electric Company was founded

in 1879. It was a competitor to EGEC until the merger of the two companies.

9 As per the ‘Number One Number Two’ strategy GE had to be either the number one or number two player in every segment it operated. If any business failed to meet this criterion, it was shut down or sold off.

10 The Dow Jones Industrial Average (DJIA) is the average value of 30 large, industrial stocks. These market aver- ages help investors know how companies traded on the stock market are performing in general.

11 Launched in 1999, the Dow Jones Sustainability Indexes are a group of indexes which track the financial perfor- mance of companies that fulfill criteria for environmen- tal, social, and financial sustainability.

12 Amanda Griscom Little, “GE’s Green Gamble,” Vanity Fair, July 12, 2006.

13 PCBs are chemical compounds with low water solubil- ity and environmental degradability, and studies have shown that people exposed to them could suffer several adverse effects.

14 Established in 1972, The Clean Water Act is a primary federal law in the US governing water pollution.

19. Lucy Aitken, “Wiping out 5Greenwash,” www .guardian.co.uk, November 19, 2007.

20. Martin LaMonica, “Stirring GE’s Ecomagination,” http://news.cnet.com, October 26, 2007.

21. “GE’s Jeff Renaud Discusses Ecomagination and Transparency,” www.environmentalleader.com, August 22, 2007.

22. Mary Milliken, “GE “Green” Ecomagination Unit Gaining Ground: CEO,” http://uk.reuters.com, May 24, 2007.

23. GE 2007 Ecomagination Report. 24. Amanda Griscom Little, “GE’s Green Gamble,” Vanity

Fair, July 12, 2006. 25. GE 2006 Ecomagination Report. 26. Elizabeth M. Whelan, “Public Health Absurdities,” The

Washington Times, December 30, 2005.

27. Brett Clark, “General Electric’s Ecomagination: New Veneer, Same Propaganda,” http://mrzine.monthlyreview .org, August 2, 2005.

28. Ron Irwin, “GE Imagines a Greener Future,” www .brandchannel.com, July 11, 2005.

29. Greg Schneider, “GE Determined to Show More_ Ecomagination,” www.washingtonpost.com, May 10, 2005.

30. “Global Environmental Challenges,” www.ge.com, May 9, 2005.

31. Joel Makeower, “Ecomagination: Inside GE’s Power Play,” www.worldchanging.com, May 8, 2005.

32. GE 2005 Ecomagination Report. 33. www.ecomagination.com 34. www.ge.com. 35. www.hoovers.com

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24 Nike, Inc is a leading US-based sportswear and equip- ment manufacturer and supplier.

25 Ibid 26 Elizabeth M. Whelan, “Public Health Absurdities,” The

Washington Times, December 30, 2005. 27 Enron Wind Corp was a global supplier of wind turbine

generators. 28 Ionics, Inc provided water and water treatment equip-

ment through the use of proprietary separation technol- ogies and systems.

29 Osmonics, Inc designed, manufactured, and marketed a wide range of products used in the filtration, separation, and processing of fluids.

30 AstroPower Inc was one of the biggest manufacturers of solar energy equipment in the US.

31 Ibid 32 The Business-to-Business (B2B) market involves transac-

tions between businesses, such as between a manufacturer and a wholesaler, or between a wholesaler and a retailer.

33 Douglas MacMillan, “The Analysis: In Immelt We Trust,” www.businessweek.com, March 4, 2008.

34 Established in 1998, The Pew Center on Global Climate Change is a nonprofit, independent organization dedi- cated to providing credible information and solutions related to global climate change.

35 Greg Schneider, “GE Determined to Show More ‘Eco- magination’,” www.washingtonpost.com, May 10, 2005.

36 www.ge.com/in/company/factsheet_in.html. 37 “Global Environmental Challenges,” www.ge.com, May

9, 2005. 38 Martin LaMonica, “Stirring GE’s Ecomagination,”

http://news.cnet.com, October 26, 2007. 39 GE 2005 Ecomagination Report. 40 “GE’s ‘Ecomagination’ Business Grows to $14 billion;

Revenue Target Raised to $25 billion as Orders Top $70 billion,” www.domain-b.com, May 29, 2008.

41 MtvU is MTV Networks’ 24-hour television network just for college students in the US. It is broadcast to more than 750 college campuses and 700 college com- munities in the US.

42 “GE’s Jeff Renaud Discusses Ecomagination and Transpar- ency,” www.environmentalleader.com, August 22, 2007.

43 Headquartered in Arlington, Virginia, AES Corporation is a global power company involved in generation and distribution of electric power.

44 Greenhouse Gas Services builds a portfolio of projects that reduce, avoid, or destroy gases that directly contrib- ute to global warming.

45 Google Inc. is a global technology company that pro- vides a Web-based search engine through its Website. The company offers a wide range of search options, including Web, image, groups, directory, and news searches.

46 Through the project, Greenhouse Gas Services would capture and destroy methane gas emitted from the land- fill to generate about an estimated 110,000 tons of car- bon credits over a ten-year timeframe. Google would use a percentage of the credits to achieve carbon neutrality.

47 Ibid 48 “GE’s Ecomagination Business in China Records 50%

Growth” www.reliableplant.com, 2010. 49 Air India is the state owned domestic airline of India. 50 Wal-Mart Stores, Inc. is a US based chain of large retail

discount department stores. 51 Mary Milliken, “GE “Green” Ecomagination Unit

Gaining Ground: CEO,” http://uk.reuters.com, May 24, 2007.

52 Based in Washington, The World Resources Institute (WRI) is an environmental think tank which protects the earth and improves people’s lives.

53 “Ecomagination at 5: Unleashing Action & Measure- ment,” www.gereports.com, June 24, 2010.

54 “GE’s Ecomagination Team Unveils its Annual Score- card,” www.gereports.com, May 27, 2009.

55 The Energy Treasure Hunt process created by Toyota Motor Manufacturing North America identifies projects that drive energy efficiency.

56 Headquartered in Japan, Toyota Motor Corporation is one of the largest automakers in the world.

57 GE 2009 Ecomagination Report 58 Union Pacific Corporation is one of the leading trans-

portation companies and the operator of one of the larg- est railroads in North America.

59 GE Energy Financial Services, a division of GE, pro- vides financial and technological investment in energy infrastructure projects around the world. In renewable energy, GE Energy Financial Services is growing its port- folio of more than US$4 billion in assets in wind, solar, biomass, hydro, and geothermal power.

60 Founded in 2001, A123Systems develops and manufac- tures advanced lithium-ion batteries and battery systems for the transportation, electric grid services, and por- table power markets.

61 Founded in 1991, Think Global is a Norwegian elec- tric car company which manufactures cars under the TH!NK brand.

62 NBC Universal is one of the world’s leading media and entertainment companies involved in the development, production, and marketing of entertainment, news, and information.

63 Ibid 64 Established in 2000, GreenOrder is a US-based sustain-

ability strategy consulting firm. 65 Ibid 66 ENERGY STAR, a joint program of the U.S. Environ-

mental Protection Agency and the US Department of Energy, is an international standard for energy efficient consumer products. It was created in 1992 as a US government program and was subsequently adopted by Australia, Canada, Japan, New Zealand, Taiwan, and the European Union.

67 The Sustained Excellence award recognizes GE’s achieve- ment in developing high-performance household appli- ance and lighting products, which help reduce energy spending and protect the environment.

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77 GE 2006 Ecomagination Report. 78 Ibid 79 GE 2008 Ecomagination Report. 80 Ibid 81 Candace Lombardi, “GE to Invest $10 billion in Ecomag-

ination Initiative,” http://news.cnet.com, June 24, 2010. 82 Ibid 83 Ibid 84 Lisa Roner, “GE: Runaway Ecomagination is Not

Enough,” www.climatechangecorp.com, June 4, 2008. 85 Rothschild Strategies Unlimited, is a US-based consult-

ing firm specializing in strategy development, review and human resources.

86 An economic pyramid depicts the distribution of wealth among the world’s population. The bottom rung of the economic pyramid comprises low income group people whereas high earners are placed at the top of the pyramid.

87 Martin LaMonica, “Stirring GE’s Ecomagination,” http://news.cnet.com, October 26, 2007.

88 Ibid 89 Ibid 90 Ibid 91 Abengoa SA is a technology company that applies inno-

vative solutions to sustainable development in the infra- structures, environment, and energy sectors.

92 Cogeneration involves simultaneous production of elec- tricity and heat using a single fuel source such as natural gas. This can result in higher thermal efficiency and can reduce carbon dioxide emissions substantially.

93 Ibid 94 Michael Kaneloss, “GE Looks to Smart Grids for

Airports, Railroads in Ecomagination 2.0,” www . greentechmedia.com, June 24, 2010.

95 Ibid

68 GE engineers designed a hybrid diesel electric locomo- tive that captures the energy dissipated during braking and stores it in a series of batteries which can be used by the crew on demand. The electric locomotive reduces fuel consumption by as much as 15% and emissions by about 50% compared to normal freight locomotives.

69 Headquartered in London, GE Money is part of GE Capital operating division of GE.

70 Under the GE Money Earth Rewards program, cardhold- ers were able to automatically contribute up to 1% of their purchases to buy carbon offsets. The credit card rewards accrued over the course of the year and could be redeemed for emissions credit on each Earth Day (April 22).

71 Based in Florida, Masco Contractor Services provides products and installation services for residential and commercial builders.

72 Named the GE WattStation, the electric-vehicle charg- ing station was designed to charge an electric vehicle in four to six hours. The charging station, as tall as a bar stool. featured a sleek silver column equipped with a retractable cord. The electric vehicle charger not only significantly decreased the time needed for charging, but its smart grid technology let utilities manage the impact on local and regional grids.

73 Nucleus is an in-home energy consumption track- ing device that communicates with GE appliances and allows consumers to track their energy usage through a display or Website.

74 The venture capital firms included Emerald Technology Ventures, Foundation Capital, Kleiner Perkins Caufield & Byer and RockPort Capital.

75 Martin LaMonica, “GE to Lower Water Use, Raise Eco- magination Target,” http://news.cnet.com, May 28, 2008.

76 Ibid

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CASE 26 CEMEX’s Acquisition Strategy—The Acquisition of Rinker Group

Introduction On January 27, 2010, Mexico-based cement company CEMEX S.A.B de C.V (CEMEX) anno- unced that its net sales for the fourth quarter ended December 31, 2009, had dropped by 17% to US$ 3.42 billion. Moreover, the company reported that its annual net sales in fiscal 2009 had dropped by 28% to US$ 14.5 billion as compared to the net sales reported in fiscal 2008. In 2009, the company reported a fall of 35% in its earnings before interest, depreciation, taxes, and amortization (EBIDTA) to US$ 2.7 billion. CEMEX had been facing problems like lower net sales and high debt since mid-2007 since its acquisition of Australia-based major cement company, the Rinker Group (Rinker).

As of early 2010, CEMEX was the largest cement company in the world in terms of production capac- ity. It was one of the companies based in an emerging nation like Mexico that had grown to become one of the top multinational companies in the global ce- ment industry. Most of CEMEX’s expansion in the domestic market as well as abroad came through ac- quisitions. Over the decades, it had developed strong expertise in successfully integrating acquired compa- nies and reaping significant benefits. The company also relied on technology to optimize its operational efficiency, which placed it among the most profitable cement companies in the world.

CEMEX, which was known for its post-merger integration skills, also managed its cash flows well and used the free cash flows to amortize and eventu- ally pay off the debt it had incurred for an acquisi- tion. However, in mid-2007, CEMEX completed its largest acquisition ever by paying US$ 14.2 billion for acquiring Rinker. CEMEX financed the Rinker acquisition completely through a debt from a syndi- cate of banks. It estimated that Rinker’s operations would result in strong cash flows and that, along with its own cash flows, it would be able to success- fully service the huge debt burden. The company had set ambitious targets of achieving within 24 months leverage ratios similar to the ones that had existed prior to Rinker’s acquisition. However, the US, which after acquisition was CEMEX’s largest market, faced an economic slowdown due to the subprime crisis3 that emerged in late 2007.

CEMEX, which derived a major portion of its revenues from the US, had to deal with low demand for its products since late 2007. The huge debt it had incurred for Rinker’s acquisition added to the company’s woes. The deficit in its anticipated free cash flows forced it to refinance its debts, sell assets, and take several cost-cutting measures like job cuts. The subprime crisis affected many of the financial institutions including commercial banks and invest- ment banks which resulted in cautious lending from banks. CEMEX’s debt credit rating was downgraded

This case was written by A. Harish, under the direction of Vivek Gupta, IBS Center for Management Research. It was compiled from published sources and is intended to be used as a basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation.

“The lessons CEMEX has learned in the crisis means it has a lighter, more flexible, and dynamic operat- ing base that will allow its eventual recovery . . . multiplying its profitability not only in the United States but in the majority of its subsidiaries.”1

—Carlos Hermosillo, Analyst, Vector Brokerage, in January 2010.

“CEMEX is in a much stronger financial position to regain our financial flexibility and, eventually, our investment-grade capital structure.”2

—Lorenzo Zambrano, Chief Executive Officer, CEMEX, in August 2009.

C337

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Zambrano, was made the Chairman and CEO of Cementos Mexicanos. With a strong academic back- ground6 and experience in working with Cementos Mexicanos since 1968, Zambrano embarked on an aggressive expansion plan. He also focused on im- proving operational efficiency and customer satisfac- tion. Till the mid-1980s, the practice in the cement industry in Mexico was to provide its customers with an expected delivery time which usually ranged between 3 and 5 hours. Cementos Mexicanos also followed the same practice before Zambrano be- came Chairman and CEO.

CEMEX did not have an Information Tech nology (IT) department and scheduling delivery trucks and plant operations was done manually. This was op- erationally inefficient. Zambrano created an IT de- partment which observed customer interaction and delivery methods implemented at several companies like FedEx, Exxon and City of Houston’s 911 emer- gency system. In 1989, CEMEX implemented a satel- lite communication system called CEMEXnet which connected all the plants of CEMEX via satellite. A central office was opened to coordinate operational activities at several plants. This helped the plants to have information relating to supply and demand.

In 1988, Cementos Mexicanos was renamed as CEMEX S.A.B de C.V. During the late 1980s, CEMEX acquired several small cement plants in Mexico including Cementos Anahuac7 in 1987 and Cementos Tolteca8, its biggest domestic competitor, in 1989. By the year 1990, CEMEX had acquired a 65% market share in Mexico and was one of the ten largest companies in the world. In 1992, CEMEX expanded internationally by acquiring Valenciana and Sanson, Spain’s two largest cement companies, for US$ 1.84 billion. CEMEX’s investors expressed concerns on the rapid pace at which it was going ahead with its expansion plans and the amount of debt the company had taken for funding these acqui- sitions. To address these concerns, CEMEX paid off a large portion of its debts by selling the nonstrategic assets of the Spanish companies it had acquired.

In 1994, CEMEX acquired a 60% equity stake in Vencemos, Venezuela’s largest cement manufac- turer at that time, for US$ 550 million. Its other acquisitions during the year included Cemento Bayano in Panama and Balcones in the US. In 1995, CEMEX acquired Cementos Nacionales, a leading cement company in the Dominican Republic. In 1996, CEMEX emerged as the third largest cement company in the world after acquiring Colombia’s

by several credit rating agencies, which dented its credibility. With low credibility, CEMEX’s cost of capital increased as it had to pay higher interest on the debt raised by the company.

By early 2010, analysts were predicting that the US markets would recover from the economic cri- sis and that the construction activity in the country would pick up. They also said that the stimulus pack- ages announced by the US government in 2008 and 2009 would be used for infrastructure projects which would also add to the demand for building materials. CEMEX Vice president for Finance and Legal, Hector Medina, said, “While we are seeing a bottoming out in some of our markets as evidenced by some leading indicators, we expect first quarter 2010 to continue to be weak and that most of the expected growth in EBITDA will occur in the second half of the year.”4

Background Note CEMEX had its roots in a cement company called Cementos Hidalgo which was founded way back to 1906 in Monterrey, Northern Mexico. Cementos Hidalgo had a production capacity of 5,000 metric tons (MT) of cement per annum. In 1920, Lorenzo Zambrano established Cementos Portland Monter- rey with a production capacity of 20,000 MT of ce- ment per annum near Monterrey. In 1931, Cementos Hidalgo and Cementos Portland Monterrey merged to form Cementos Mexicanos. By 1959, Cementos Mexicanos had expanded its production capacity to produce over 230,420 MT of gray cement and 14,692 tons of white cement. Till the late 1960s, the company operated as a local company in Monterrey. In the late 1960s, the company started expanding to other parts of the country like Southern and Central Mexico through acquisitions and also by opening new plants.

In 1976, Cementos Mexicanos went public and got its shares listed on the Mexico stock exchange. It also became the largest cement producer in the same year after acquiring three plants of Cementos Guadalajara. By the mid-1980s, Cementos Mexica- nos’ annual cement production capacity had crossed 15 million MT. The mid-1980s, however, brought a major challenge for Cementos Mexicanos, which had been thriving in Mexico since its inception. Mexico started relaxing its protectionist policies and allowed multinational companies to operate in the country.

In 1985, Lorenzo Zambrano (Zambrano)5, grandson of Cementos Mexicanos founder Lorenzo

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CEMEX’s operations, taking its total annual cement production capacity to 97 million MT. CEMEX ended the year 2006 with revenues of US$ 18.2 billion and a net profit of US$ 2.3 billion (Refer to Exhibit I, II and III for Financial Statements of CEMEX).

CEMEX had a three-point acquisition strategy— the acquired company must provide risk adjusted returns in excess of the company’s weighted aver- age cost of capital, it must enhance the company’s geographical presence, and it must contribute to CEMEX’s capital structure12.

The Acquisition Integration Process CEMEX had learnt in the course of its business that implementing the technical and management stan- dards it followed in its existing plants was not suffi- cient to ensure the smooth integration of an acquired company. The company realized that it had to learn the processes already implemented in the acquired company, compare it with the corresponding pro- cesses it followed, and retain the better of the two. CEMEX then made efforts to implement the best practices learned from the acquired company across its worldwide operations. This acquisition integra- tion process was later named as the ‘CEMEX Way.’

The ‘CEMEX Way’ was an internal benchmark- ing process which resulted in a core set of best busi- ness practices based on which CEMEX conducted business across the globe. It was driven by five guide- lines developed by the company (Refer to Table I for CEMEX Way Guidelines).

After acquiring a target company, CEMEX deployed multinational standardization teams

Cementos Diamante9 and Samper. In 1997, CEMEX started its Asian operations by acquiring Rizal Ce- ment in the Philippines. In 1999, CEMEX’s acqui- sitions included APO Cements in the Philippines, Assiut Cement Company in Egypt, and Dementos del Pacifico of Costa Rica. In 1999, CEMEX’s shares were listed on the New York Stock Exchange.

In 2000, CEMEX became North America’s larg- est cement company by acquiring Houston-based Southdown10, then the second largest cement pro- ducer in the US, for US$ 2.63 billion. This was the largest acquisition made by CEMEX till that time. In the same year, CEMEX launched the CEMEX Way, an initiative to identify, incorporate, and execute standardized best practices in different functional areas like logistics, finance, human resources, and planning throughout the organization.

In 2001, CEMEX acquired the Saraburi Cement Company in Thailand. In the same year, it launched an online customer service initiative where custom- ers could place orders, purchase products, and ac- cess other services and information electronically. As most of CEMEX’s growth came from acquisitions, the company had developed strong post-merger inte- gration (PMI) expertise. After completing an acqui- sition, it usually deployed a post-merger integration team that analyzed the operations of the acquired company to identify the areas where costs could be cut, reduce headcount, and upgrade technical and management systems to fall in-line with what were being followed at CEMEX. This expertise helped CEMEX in turning around several ailing companies it had acquired by cutting down on costs and im- proving operational efficiency.

In the early 2000s, CEMEX concentrated on expanding its presence in developing markets like the Philippines, Indonesia, and Thailand. The com- pany’s profitability was higher than its major inter- national rivals—Holcim and Lafarge—because of its concentration on developing nations where profit margins were higher. Developing nations also of- fered CEMEX’s businesses a longer term growth po- tential. In 2003, CEMEX launched a company-wide procurement process and global sourcing office to consolidate its international sourcing operations and realize the benefits of economies of scale.

In 2005, CEMEX acquired the UK-based RMC Group11 for US$ 5.8 billion. The acquisition made the company a worldwide leader in the ready-mix con- crete market and increased its exposure to the Euro- pean markets significantly. It also doubled the size of

Efficiently manage the global knowledge base

Identify and disseminate the best practices

Standardize business processes

Implement key information and Internet-based technologies

Foster innovation

Table I CEMEX Way Guidelines

Source: www.cemex.com.

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comprising experts from various functional areas like Finance, HR, and IT. The work was overseen by an executive at the Vice-president level. The PMI team studied the processes of the acquired company. Typi- cally, 20% of the processes of an acquired company were retained. The remaining 80% processes were stored in a centralized database, and were compared with internal and external processes. If deemed to be superior to the existing processes, they were then implemented in all other plants. According to indus- try experts, around 70% of the processes followed in CEMEX operations were actually adopted from the acquired companies.

The teams for each PMI operation were selected on an ad hoc basis. Functional level managers, typi- cally middle level managers, were selected from different plants of CEMEX. These managers were re- sponsible for understanding the existing processes of the acquired company and identifying those processes which were superior to the processes that were being followed at CEMEX. Since these managers had gained expertise of working on a particular process at CE- MEX, they taught the managers at the acquired com- pany about the processes at CEMEX. Also, they were experienced in the functional departments of CEMEX,

and so were able to judge better whether the corre- sponding processes in the acquired company would be able to positively contribute to CEMEX’s operations.

Acquisition of Rinker On October 30, 2006, CEMEX made an offer to buy all issued and outstanding shares of Rinker for US$ 12.8 billion. The offer was at a 27% premium over Rinker’s share closing price as on October 27, 2006, and at a 26.2% premium over Rinker’s three-month volume weighted average price.13 CEMEX expected to derive annual cost synergies of US$ 130 million from the second year after completing the acquisition.

Rinker had generated approximately 50% of its revenues from the commercial and civil construction sector in the fiscal 2005. Its product portfolio was diver- sified and included aggregates, concrete, cement pipes, cement, gypsum wallboard supply, concrete block, and asphalt. The acquisition of Rinker significantly en- hanced the position of CEMEX in the ready-mix and aggregates sector though the impact on cement pro- duction capacity was not much (Refer to Table II for Global Cement Industry Rankings in 2005).

Cement (In million metric tons) Ready-Mix (In million

cubic meters) Aggregates (In million

metric tons)

Company Capacity Company Sales Volume Company Sales Volume

Holcim 183 CEMEX1Rinker 97 CEMEX+Rinker 284

Lafarge 155 CEMEX 76 CRH 253

CEMEX+Rinker 97 Holcim 40 Lafarge 240

CEMEX 94 Lafarge 39 Hanson 240

Heidelberg 86 Heidelberg 28 Vulcan 236

Italcementi 64 Italcementi 21 Martin Marietta 184

Anhui Conch 62 Rinker 21 CEMEX 175

Taiheiyo 46 Hanson 20 Holcim 174

Buzzi 34 CRH 19 Rinker 118

Eurocement 31 Tarmac 8 Colas 101

Rinker 3 Vicat / Cimpor 7 Heidelberg 98

Others ~1,750 Others ~2,900 Others ~18,000

Table II Global Cement Industry Rankings (2005)

Source: www.cemex.com.

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Rinker was the market leader in some of the key markets in the US like Florida, Arizona, and had a wide presence in Australia. It was one of the top three companies in the ready mix business, among the top five in aggregates14 in the US, and among the top three in building materials in Australia. Rinker had huge reserves of aggregates, around 3.6 billion MT, in the US and Australia which were estimated to last for 30 years of production in the US and 43 years of production in Australia.

Rinker provided CEMEX with an opportunity to diversify geographically and increase its presence in Australia. In the fiscal 2005, CEMEX generated the highest amount of EBIDTA from its Mexican operations followed by the US. Rinker’s acquisition brought down CEMEX’s significant reliance on the Mexican markets. However, the acquisition in- creased CEMEX’s reliance on the US markets (Refer to Figure I for Geographical Contribution of CE- MEX and CEMEX 1 Rinker EBIDTA in 2005).

CEMEX announced that the markets in the US where Rinker held most of its assets and operations were complementary to its operations in the US and would enhance its position in the country. The com- pany expected that the demand for building mate- rials in the US would be robust in the long term. In addition to geographical diversification, Rinker’s acquisition also offered it an opportunity to change the product- wise contribution to the CEMEX’s EBIDTA (Refer to Figure II for Product Wise contri- bution to CEMEX and CEMEX+ Rinker EBIDTA in 2005).

Following the announcement of acquisition by CEMEX, Rinker’s share price increased and traded over CEMEX’s bid price of A$ 17,15 implying that CEMEX had to increase its bid in order to get shareholders’ approval for the acquisition (Refer to Exhibit IV for Rinker’s Stock Price Chart). Rinker’s board rejected CEMEX’s initial bid.

After failing to convince Rinker’s board and shareholders to approve the deal, CEMEX increased its offer to A$ 19.41 in April 2007. Rinker’s board approved the deal. The upward revision saw the total acquisition bid of CEMEX amounting to US$ 14.2 billion after adjusting for the exchange rate fluctuations between the Australian and the US dollar during the intervening period. (Refer to Exhibits V and VI for Rinker’s Financial Statements).

In order to convince Rinker’s retail shareholders in Australia, CEMEX took the help of Georgeson, one of Australia’s leading proxy solicitation and shareholder communications firms. With the help of Georgeson, in April 2007, CEMEX conducted a three-phase canvassing campaign, where it contacted Rinker’s shareholders in Australia to deliver key messages and to motivate them by communicating the benefits of accepting its offer within a given time frame (Refer to Table III for the reasons communi- cated to Rinker’s shareholders to accept the offer).

On April 05, 2007, CEMEX also got approval from the Department of Justice (DoJ) in the US for Rinker’s acquisition after agreeing to sell 39 ready mix concrete, concrete block, and aggregate facili- ties in the country. The DoJ required CEMEX to

Figure II Product Wise Contribution to CEMEX and CEMEX 1 Rinker EBIDT A (2005)

Adapted from data available in www.cemex.com

Cement Concrete OthersAggregate

72%

15%

CEMEX

57% 19%

14%

10%

CEMEX + Rinker

Mexico US Europe

33%

27%

25%

10%

2% 4%

CEMEX

24%

41%

18%

CEMEX + Rinker

Figure I Geographical Contribution of CEMEX and CEMEX 1 Rinker EBIDTA (2005)

Adapted from data available in www.cemex.com

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According to the company sources, if a share- holder did not elect an option before the deadline, then CEMEX would pay them using Option 1, in case the shareholder’s registered address with Rinker was in Australia, and Option 3, if the shareholder’s registered address with Rinker was outside Australia.

By the end of December 2007, CEMEX reported that its PMI team had been able to complete the core postmerger integration process at Rinker. The company said it had identified the best practices and would capitalize US$ 400 million resulting from syn- ergies in fiscal 2008 and 2009, US$ 270 million above what it had estimated before completing the acquisi- tion. Typically, CEMEX relied on the free cash flows to pay off the debts it had raised for any acquisition. In the case of Rinker’s acquisition, CEMEX expected to generate enough free cash flows right from the first year to pay off its annual debt obligations.

Post-Acquisition Problems In January 2008, CEMEX announced its financial re- sults for the financial year ended December 31, 2007. The company reported net sales of US$ 21.7 bil- lion, 19% higher than the net sales reported in fis- cal 2006. Its net profit rose to US$ 2.9 billion from US$ 2.37 billion. The results included Rinker’s sales and net profit for the six months ended December 31, 2007. CEMEX ended the fiscal 2007 with a debt of

1. All Rinker directors recommended that you accept CEMEX’s offer and have decided to accept the offer in respect of their own Rinker’s shares.

2. Rinker’s major shareholder, Perpetual, who held approximately 10% of Rinker has accepted CEMEX’s offer.

3. You will receive a 45% premium and full value for your Rinker’s shares.

4. You will receive the announced Rinker dividend of A$ 0.25 regardless of when you accept the offer.

5. CEMEX’s offer is within the independent expert’s valuation range.

6. There is no reason to delay your acceptance, the offer had been declared final and cannot legally be increased.

7. If CEMEX acquired over 50% but less than 100% of Rinker and you do not accept, then you will become a minority shareholder in Rinker. Changes under CEMEX management may include a lowering of Rinker’s dividend payout ratio.

8. If the CEMEX Offer does not succeed, Rinker’s share price is likely to fall.

Table III Reasons Communicated to Rinker’s Shareholders to Accept the Offer

Source: www.sec.gov

Table IV CEMEX Payment Options

Option 1: US$ 15.85 for each of their Rinker shares converted into and paid in A$.

Option 2: A$ 19.50 per share for their first 2,000 Rinker shares (or for all of their shares if they held 2,000 Rinker shares or less) and US$ 15.85 for each of their remaining shares (if any) converted into and paid in A$.

Option 3: US$ 15.85 for each of their Rinker shares paid in US$.

Option 4: A$ 19.50 per share for their first 2,000 Rinker shares (or for all of their shares if they held 2,000 Rinker shares or less) and US$ 15.85 for each of their remaining shares (if any) paid in US$.

Source: www.ato.gov.au

sell some of its plants in Tampa, St. Petersburg, Fort Walton Beach, Panama City, Pensacola, Jacksonville, Orlando, Fort Myers, and Naples where the com- petition would significantly reduce after CEMEX’s acquisition of Rinker. Later, in December 2007, CEMEX sold some of these assets.

On July 10, 2007, CEMEX announced that it had acquired a 90% equity stake in Rinker and would compulsorily acquire the rest of the shares. Under Australian law, a company could compulsorily ac- quire the remaining shares once it had acquired a minimum of 90% equity stake. CEMEX offered Rinker’s remaining shareholders four payment op- tions from which they had to select one and confirm it by July 16, 2007 (Refer to Table IV for CEMEX Payment Options).

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US$ 19.9 billion16 as against a debt of US$ 5.81 bil- lion at the end of fiscal 2006. Its net-debt-to-EBIDTA ratio went up to 3.6 by the end of 2007, from 1.4 at the end of fiscal 2006. CEMEX’s interest coverage ratio fell to 5.7 at the end of fiscal 2007 from 8.4 at the end of fiscal 2006 mainly due to the additional debt it had raised for financing Rinker’s acquisition. CEMEX said that its target was to bring down the net-debt-EBIDTA ratio to 2.7 and to maintain its in- terest coverage ratio at above 4.5 by mid-2009. How- ever, CEMEX failed to achieve these financial targets due to a significant fall in cement demand in its major markets including the US in fiscal 2008 and 2009 (Re- fer to Exhibit VII for Note on Cement Industry in US) and the huge debt burden post Rinker’s acquisition.

Fall In Cement Demand In late 2007, the subprime crisis in the US resulted in a significant slowdown in the growth of residential mort- gage markets in the US. Prices in the real-estate sector started falling sharply. The demand for housing prop- erties began to decline. The crisis eventually spread to other sectors as a number of financial institutions

who reported significant losses, tightened their lending norms. The construction industry which was highly capital-intensive and relied heavily on external fund- ing for executing projects was adversely impacted. The demand for residential and commercial properties plunged deeply in the US beginning late 2007. One of the industries that was adversely affected by the slow- down in the residential and commercial real estate in- dustry was the building materials industry.

CEMEX was one of the major players in the build- ing materials industry in the US which saw its net sales and sales volumes falling sharply in the fiscal 2007 and 2008. The crisis which originated in the US spread to other major world economies and resulted in a global economic slowdown in 2008 (Refer to Table V and Table VI for Country Wise Volume Growth of CEMEX Products in fiscal 2007 and 2008).

Huge Debt Burden CEMEX had financed Rinker’s acquisition by raising short-term and long-term debts from a syndicate of banks including the Royal Bank of Scotland, HSBC, Banco Santander, BNP Paribas, and Citibank. The

Product/Country Cement Ready Mix Aggregates

Mexico 4 8 NA

US (8) 13 75

Spain (5) (4) N

United Kingdom 12 (2) 2

Germany (6) NA NA

France NA 5 2

South/Central America and Caribbean 8 NA NA

Africa and Middle East 8 NA NA

Asia and Australia 7 NA NA

Australia NA 5 7

Philippines 12 NA NA

Table V Country Wise Volume Growth (%) of CEMEX Products (2007)

Source: CEMEX Annual Report 2007. *NA- not available in the annual reports.

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debt instruments involved had maturities starting from 2009 till 2011.

In late 2006 and 2007, CEMEX issued several debt instruments the proceeds of which were pre- dominantly targeted at paying off its existing debts as well as the debt it had incurred for acquiring Rinker (Refer to Table VII for CEMEX’s debt issu- ances in late 2006 and 2007).

In 2008, CEMEX could not raise new capital from the financial markets as they had witnessed a significant downturn. In February 2008, CEMEX

decided to sell assets worth around US$ 2 billion to reduce some of its debt load. However, analysts opined that CEMEX needed to sell around US$ 2.7 billion worth of assets in order to meet its debt obligations. A Mexico-based analyst said, “CEMEX is likely to need to sell more than they say. The debt issue is a big challenge.”17

In March 2008, CEMEX sold its 9.5% equity stake in Mexican telecom company Axtel for US$ 257 million. By mid-2008, another of CEMEX’s key markets, Spain, started facing an economic

Product/Country Cement Ready Mix Aggregates

Mexico (4) (6)

US (14) (13) (3)

Spain (30) (26)

United Kingdom (16) (21) (11)

Germany 4 NA

France NA 0 (5)

South/Central America and Caribbean (13) NA NA

Africa and Middle East 8 NA NA

Asia and Australia (1) NA NA

Australia NA 6 5

Philippines (2) NA NA

Table VI Country Wise Volume Growth (%) of CEMEX Products (2008)

Source: CEMEX Annual Report 2008. *NA- not available in the annual report.

Table VII CEMEX Debt Issuances (2006–2007)

Nominal Amount (In Million) Issue Date Repurchase Option Interest Rate (%)

€ 730 May 2007 Tenth Anniversary 6.3

US$ 730 February 2007 Eighth Anniversary 6.6

US$ 750 December 2006 Fifth Anniversary 6.2

US$ 900 December 2006 Tenth Anniversary 6.7

Source: CEMEX Annual Report, 2007.

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slowdown, due to the impact of the recession on American and European countries. Economists also predicted that the slowdown in the US would im- pact Mexico, its #2 trade partner. In July 2008, CE- MEX sold its subsidiaries in Austria and Hungary to Austria-based construction company, Strabag, for around € 310 million (Refer to Exhibit VIII for CE- MEX Contractual Obligations for year 2008).

In October 2008, the credit rating agency Standard & Poor’s18 (S&P) lowered its credit rating on the long-term corporate credit and senior unsecured debt ratings of CEMEX to ‘BBB-’ from BBB and said that its outlook on the company was negative. Juan Pablo Becerra, Analyst at S&P, said, “The rating ac- tions reflect our expectations that CEMEX’s financial performance for the rest of 2008 and into 2009 will fall short of our previous expectations, given the weak- ening of economic growth prospects in its principal markets and around the globe. In addition, CEMEX faces important debt maturities (US$ 5.7 billion) at the end of 2009 (particularly in December when US$ 3.7 billion related to its acquisition of Rinker Group Limited are due), which pose a significant challenge to the company in light of current market conditions. The negative outlook reflects the risk of further deterioration in the company’s financial con- dition due to the weakness in the global economy. In particular, a downgrade is likely if CEMEX fails to improve its FFO-to-total net adjusted debt ratio to a low 20% by 2010 and if it is unable to refinance its 2009 maturities well in advance.”19 Soon after the ratings were lowered, CEMEX decided to cut 6000 jobs worldwide as a cost-cutting measure. In the same month, Fitch Ratings,20 another credit rating agency, downgraded the credit rating of CEMEX to below investment grade standard.

In November 2008, CEMEX announced that it had sold its operations in Canary Islands to a Span- ish Investment holding company, Cimpor Inversio- nes, for US$ 211 million. On December 11, 2008, CEMEX reported that it had been successful in refi- nancing US$ 72 million debt mostly due in Decem- ber 2008 and January 2009. These debt obligations would now be due in September 2011. However, the amount refinanced was just 17% of the total US$ 418 million debt CEMEX had actually planned to refinance. Failure to refinance this debt completely led to CEMEX’s stock price falling by 19% on the same day to close at US$ 8.3 (Refer to Exhibit IX for CEMEX Stock Price Chart).

CEMEX reported net sales of US$ 21.7 billion in the fiscal 2008, which was almost flat compared to the corresponding figures of fiscal 2007. CEMEX’s cost of sales as a percent of total sales increased from 66.6% to 68.3%. The company reported a 5% drop in EBIDTA at US$ 4.5 billion as compared to 2007. Its interest coverage ratio in fiscal 2008 came down to 4.9 from 5.7 in fiscal 2007. The Mexican peso which depreciated vis-à-vis the US dollar in 2008 resulted in foreign exchange losses of US$ 386 million (Refer to Exhibit X for Mexican Peso VS American Dollar C hart). CEMEX lost US$ 1.35 billion on financial instruments like currency swaps of which most was attributed to the depreciation of the peso against the US dollar. The company reported a free cash flow of US$ 2.6 billion in 2008 (Refer to Exhibit XI for CEMEX Cash Flow Statement of 2008) of which US$ 1.56 billion went into capital expenditure for capacity expansion and the rest for reducing debt. CEMEX had a net debt of US$ 17.91 billion and its net-debt-to-EBDITA rose to 4 in 2008.

In January 2009, CEMEX announced that it would close down the operations of its Davenport plant and lay off 125 employees to align its opera- tions with weakened demand. S&P had downgraded CEMEX’s rating to BB+, a notch below investment grade status BBB-. On March 05, 2009, CEMEX an- nounced that it would delay its proposed plan to sell bonds to raise US$ 500 million that was to fund its repayment of the US$ 4.24 billion of debt that was maturing between the second quarter and fourth quarter of fiscal 2009. CEMEX decided to delay the US$ 500 million bond sale as not enough investors showed an interest in subscribing to the issue despite its extensive road shows in London and New York. Following its failure to raise capital, credit rating agencies downgraded the rating on CEMEX again. S&P downgraded CEMEX’s rating by 5 notches to B- from BB+.

In April 2009, CEMEX announced very disap- pointing results for the first quarter of 2009. The company reported a 99.36% drop in its net profits to US$ 3 million as compared to US$ 470 million in the corresponding quarter in 2008. During the same period, its revenues fell by 32% to US$ 3.7 billion. CEMEX’s free cash flows, which were important for repaying its debt, fell by 76% in the same period to US$ 118 million. CEMEX’s management assured the investors that it was progressing well in the debt restructuring talks with its lenders. It said that the

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in demand for its products in its major markets. The fresh refinancing terms limited the company’s ability to invest in expansion projects or to go in for new acquisitions.

In its effort to raise capital, in September 2009, CEMEX issued 1.3 billion Ordinary Participatory Notes (OPOs) in the form of American Deposi- tory Shares (ADS). Each ADS comprised 10 OPOs. Each ADS was priced at US$ 12.5 and OPOs were priced at MXP 16.64825.22 Of the issued 1.3 billion, 325 million CPOs were sold in Mexico and the rest in other countries in the form of ADS. CEMEX raised US$ 1.8 billion from this issue.

In December 2009, CEMEX also raised US$ 1.25 billion through the issue of notes maturing in seven years and carried an annual coupon rate of 9.5% and € 350 million in eight year notes carrying an annual coupon rate of 9.625%. Financial analysts expressed concern over CEMEX’s strategy to raise capital by issuing fresh bonds to repay a portion of its earlier debts. According to Gonzalo Fernandez of Santander brokerage, “We are still somewhat con- cerned that CEMEX continues refinancing banking debt with bonds, and that it is not effectively reduc- ing debt.”23

Industry analysts remained skeptical about CEMEX’s ability to significantly improve its finan- cial performance in the near future. They opined that after Rinker’s acquisition, CEMEX could not gener- ate enough free cash flows to repay the debt like it had done in the case of earlier acquisitions.

In early 2010, CEMEX’s problems continued. On January 26, 2010, the company announced dis- appointing results for the fiscal year 2009. The com- pany generated revenues of US$ 14.5 billion, about 28% lower as compared to fiscal 2008. During the same period, the company’s EBIDTA decreased by 35% to US$ 2.7 billion. The free cash flows after maintenance capital expenditure was also down by 53% to US$ 1.2 billion.

Industry analysts opined that CEMEX needed to expand its operations in major cement consum- ing markets like China and India. However, un- til it had repaid a significant part of the debt, the company’s creditors would not allow CEMEX to expand its operations in these countries. More- over, analysts pointed out that after selling several assets globally, CEMEX’s reliance on the US mar- kets had further increased Hence, the company’s future success relied heavily on the economic re- covery in the US.

depreciation of the peso against the US dollar and weak sales in its major markets like the US and Spain were the main reasons for its poor financial perfor- mance. CEMEX received a large chunk of its revenues in Mexican pesos whereas most of its debt was in US dollars. The peso’s depreciation against the US dollar exacerbated its debt obligations. CEMEX said that it had stopped most of its capital-intensive expansion projects to save cash for repaying its debt.

In June 2009, CEMEX announced that it would be selling the Australian operations of Rinker to its rival Holcim for US$ 1.6 billion. According to in- dustry analysts, the price at which CEMEX sold the Australian operations was almost half of what it had paid for acquiring them from Rinker in 2007. They opined that the poor demand for cement in CEMEX’s major markets coupled with huge debt liabilities had forced it to exit one of the lucrative markets for cement production.

Future Tense? In July 2009, CEMEX lowered its free cash flow forecasts for the fiscal year 2009 to US$ 1.6 billion as against the previous forecast of US$ 2.05 billion. This led to worries among the company’s share- holders and lenders. In August 2009, CEMEX announced that all its creditors had agreed to support its proposal for refinancing a debt of US$ 15 billion maturing over the next two years. According to the new plan, the debt that was to mature between 2009 and 2011 would have ex- tended maturities till 2014.

However, in spite of refinancing approvals from the lenders, credit rating agencies did not upgrade the rating of CEMEX to investment grade as there were uncertainties in the economic scenario. Also, they were not certain about CEMEX’s ability to gen- erate sufficient cash flows in the years through 2014 to repay its debt obligations. Juan Pablo Becerra, Credit Analyst at S&P, said, “For an improvement in the rating, we would have to see a more stable macroeconomic environment, a refinancing not just of 2009 debt but also of that in 2010 and 2011 and a cut in company debt levels.”21

According to financial experts, the cost of refi- nancing would add to CEMEX’s annual interest burden, estimated to be an additional US$ 2 billion. Moreover, they opined that CEMEX may require ad- ditional refinancing in future, given the uncertainty

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2004 2005 2006 2007 2008

Net Sales 8,149.36 15,320.96 18,249.36 21,672.99 21,688.53

Cost of Sales (4,586.35) (9,271.20) (11,648.47) (14,441.03) (14,822.86)

Gross Profit 3,563.01 6,049.76 6,600.89 7,231.96 6,865.68

Selling, General and Administrative Expenses (1,711.33) (3,563.10) (3,655.06) (4,260.50) (4,379.01)

Operating Income 1,851.68 2,486.66 2,945.83 2,971.46 2,486.67

Other Expenses, Net (513.50) (316.43) (49.86) (300.52) (1,916.96)

Operating Income After Other Expenses, Net 1,338.18 2,170.23 2,895.97 2,670.94 569.71

Financial Expenses (372.23) (526.17) (493.91) (806.64) (911.65)

Financial Income 23.42 39.26 45.71 78.96 51.63

Exchange Gain (Loss), Net (23.56) (78.82) 20.30 (22.24) (385.91)

Monetary Position Gain (Loss) 385.87 418.83 409.44 630.92 37.24

Gain (Loss) on Financial Instruments 119.84 386.20 (13.68) 218.56 (1,353.05)

Total Comprehensive Financing Cost (Income) 133.34 239.31 (32.14) 99.56 (2,561.75)

Net income Before Income Taxes 1,501.15 2,408.48 2,879.51 2,770.50 (1,992.04)

Income Tax (183.45) (330.26) (497.30) (439.20) 2,101.24

Net income Before Participation of Uncons. Subs

1,288.07 2,079.28 2,366.52 2,331.30 109.20

Participation in Unconsolidated Subsidiaries 40.06 87.35 121.69 136.20 97.90

Consolidated Net Income 1,328.13 2,166.63 2,488.21 2,467.50 207.10

Net Income Attributable to Minority Interest 20.93 55.04 110.28 76.67 3.98

Majority Interest Net Income 1,307.20 2,111.59 2,377.93 2,390.83 203.13

Earnings per ADS (NYSE:CX) 3.93 6.10 3.31 3.22 0.27

EBITDA* 2,538.26 3,557.10 4,137.68 4,586.11 4,343.11

Free Cash Flow* 1,478.00 2,013.00 1,943.00 1,144.00 1,040.00

Exhibit I CEMEX—Income Statements (2004–08) (In US$ millions)

Source: www.cemex.com.

Exhibit II CEMEX Quarterly Income Statements (2009) (In US$ Millions)

1Q 2Q 3Q 4Q

Net Sales 3,660.12 4,188.11 4,217.08 3,443.80

Cost of Sales (2,614.98) (2,906.51) (2,897.06) (2,532.49) (continued)

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1Q 2Q 3Q 4Q

Gross Profit 1,045.14 1,281.60 1,320.02 911.31

Selling, General and Administrative Expenses (719.48) (870.62) (909.02) (813.00)

Operating Income 325.66 410.98 411.01 98.31

Other Expenses, Net (37.87) (100.55) (61.85) (219.84)

Operating Income After Other Expenses, Net 287.79 310.43 349.16 (121.53)

Financial Expenses (205.08) (210.47) (275.08) (315.94)

Financial Income 7.14 5.84 10.82 8.69

Exchange Gain (Loss), Net (138.22) 80.75 15.99 50.18

Monetary Position Gain (Loss) 5.28 7.53 9.98 7.96

Gain (Loss) on Financial Instruments (138.72) (5.01) (23.02) 20.72

Total Comprehensive Financing Cost (Income) (469.60) (121.35) (261.30) (228.40)

Net income Before Income Taxes (181.81) 189.08 87.85 (349.93)

Income Tax 189.78 (4.41) 25.56 613.20

Net income Before Participation of Uncons. Subs 7.96 184.67 113.42 263.28

Participation in Unconsolidated Subsidiaries (2.19) 7.34 20.37 1.78

Consolidated Net Income 5.78 192.01 133.79 (213.15)

Net Income Attributable to Minority Interest 2.98 5.45 12.84 (3.70)

Majority Interest Net Income 2.79 186.56 120.95 (209.45)

Earnings per ADS (2) 0.00 0.24 0.14 (0.22)

EBITDA* 712.22 811.59 805.56 473.69

Exhibit II (continued)

Source: www.cemex.com.

Exhibit III CEMEX Balance Sheets (2006–08) (In Mexican Pesos millions)

Balance Sheet 2008 2007 2006

Assets

Current Assets

Cash and investments 13,604 8,670 18,494

Trade receivables less allowance for doubtful accounts 18,276 20,719 16,525

Other accounts receivable 9,945 9,830 9,206

Inventories,net 22,358 19,631 13,974

Other current assets 4,012 2,394 2,255

Total current assets 68,195 61,244 60,454

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Exhibit III (continued)

Balance Sheet 2008 2007 2006

Non-current Assets

Investment in associates 14,200 10,220 8,712

Other investments and non-current accounts receivable 24,633 11,339 9,966

Property, machinery and equipment, net 281,858 262,189 201,425

Goodwill, intangible assets and deferred charges, net 234,736 197,322 70,526

Total non-current assets 555,427 481,070 290,629

Total assets 623,622 542,314 351,083

Liabilities and stockholders’ equity

Current liabilities

Short-term debt including current maturities of long-term debt 95,270 36,257 14,657

other financial obligations 3,462

Trade payables 22,543 23,660 20,110

Other accounts payable and accrued expenses 31,462 23,471 17,203

Total current liabilities 152,737 83,388 51,970

Non-current Liabilities

Long-term debt 162,824 180,654 73,674

other financial obligations 1,823 0 0

Employee benefits 6,788 7,650 7,484

Deferred income tax liability 38,439 50,307 30,119

other non-current liabilities 23,744 16,162 14,725

Total non-current liabilities 233,618 254,773 126,002

Total liabilities 386,355 338,161 177,972

Shareholder’s Equity

Majority interest:

Common Stock 4,117 4,115 4,113

Additional Paid-in capital 70,171 63,379 56,982

Other equity reserves 28,730 (104,574) (91,244)

Retained earnings 85,396 174,140 152,921

Net income 2,278 26,108 27,855

Total majority interest 190,692 163,168 150,627

Minority interest and perpetual debentures 46,575 40,985 22,484

Total stockholders’ equity 237,267 204,153 173,111

Total liabilities and stockholder’s equity 623,622 542,314 351,083

Source: CEMEX Annual Reports 2007–08.

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Rinker Stock Price Chart (April 2006 – October 2006) 24.00

P ri

ce (

A S

)

P rice

(U S

$ )

18.48

16.94

15.40

13.86

12.32

10.78

9.24

7.70

22.00

20.00

18.00

16.00

14.00

12.00

10.00 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06

Rinker Share Price (AS) Rinker Share Price (US$)

Value Range

Exhibit IV Rinker Stock Price Chart (April 2006—October 2006)

Source: www.sec.gov.

Year ended March 31 2007 2006

Trading revenue 5,337.30 5108.40

Cost of sales (2,744.00) (2,666.30)

Warehouse and distribution costs (1,058.60) (1,015.20)

Selling, general and administrative costs

-general (366.30) (373.80)

-takeover defence costs (14.50)

Share of profits from investments accounted for using the equity method 25.30 32.60

Other income 44.50 68.40

Other expenses (5.80) (8.50)

Profit before finance and income tax expense 1,217.90 1,145.60

Interest Income 15.90 21.7

Finance Costs (57.30) (41.8)

Profit before income tax 1,176.50 1,125.50

Income tax (390.10) (381.9)

Net profit 786.40 743.6

Exhibit V Income Statements of Rinker (2006–07) (In US$ millions)

Source: Rinker Annual Report 2007.

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Year ended March 31 2007 2006

Current Assets

Cash and cash equivalents 185.9 289.1

Receivables 671.4 672.3

Inventories 373.7 330.9

Other current assets 23.1 20.7

Current Assets 1,254.10 1,313.00

Non-current assets

Receivables 22.3 45.2

Inventories 9.8 8.6

Investments accounted for using the equity method 148 132.9

Other financial assets 40.3 32.6

Property, plant and equipment 2,233.10 1,963.40

Intangibles, including goodwill 937.1 901.7

Other non-current assets 59.6 59.8

Non-current assets 3,450.20 3,144.20

Total Assets 4,704.30 4,457.20

Current liabilities

Payables 511.8 542.2

Borrowings 9.4 5.4

Income tax liabilities 49.1 62.4

Provisions 77.4 76.2

Current liabilities 647.7 686.2

Non-current Liabilities

Payables 88.8 94.1

Borrowings 1,092.30 645.2

Net deferred income tax liabilities 218 205.8

Provisions 144.5 138.6

Non-current Liabilities 1,543.60 1,083.70

Total Liabilities 2,191.30 1,769.90

Net Assets 2,513.00 2,687.30

Equity

Contributed equity(a) 636 1,138.70

Shares held in trust 252.3 244.2

Reserves 286.5 182.4

Retained profits 1,632.70 1,401.30

Equity attributable to members of Rinker Group Limited 2,502.90 2,678.20

Minority interests 10.1 9.1

Total equity 2,513.00 2,687.30

Exhibit VI Balance Sheets of Rinker (2006–2007)

Source: Rinker Annual Report 2007.

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Cement has been one of the most commonly used construction materials in the world. The construction boom in the US in early 2000s through mid-2006 fueled the demand for cement from both the domestic cement producers as well as imports from foreign cement producers. In response to the increasing demand, several cement companies in the US invested in the latest technology to improve the efficiency of their plants as well as increasing their production capacities significantly. The cement production touched a record high of 99.319 million MT in 2005. The production contracted marginally for the years 2006 and 2007 before contracting by 25% from the peak to reach 75 million MT in 2009. The annual production of 75 million MT was the lowest in the US since the mid-1990s (Refer to Table A for Cement Production, Trade and Consumption in the US between 1995 and 2009).

The share of cement imports in the US domestic consumption peaked in 2006 when it hit 25.2%. That share had come down drastically to 11.90% by 2009. In absolute terms, the cement imports in the US fell from the peak of 32.141 million MT in 2006 to 10 million MT in 2009. However, the exports increased from 0.723 million MT per annum in 2006 to 0.9 million MT in 2009 as many global companies including CEMEX diverted their local production to other countries.

Despite a significant reduction in production volumes in 2008 and 2009, the average production volumes remained at around 91.13 million MT per annum over the five-year period ending 2009. The average figure was about the same as compared to the average production volume of 91.35 million MT per annum over the five-year period ending 2004. However, the average annual cement industry revenue was recorded at around US$ 10.2 billion per annum over the five years ending 2009 as compared to US$ 9.2 billion per annum over the five years ending 2004. The higher realization was due to the uptrend in the average prices of cement and related products since the mid-2000s. The cement industry’s EBITDA also decreased from 54.5% of revenue in 2006 to 46% of revenue in 2009.

Year Production Imports Exports Aggregate Consumption

1995 76.906 10.969 0.759 86.003

1996 79.266 11.565 0.803 90.355

1997 82.582 14.523 0.791 96.018

1998 83.931 19.878 0.743 103.457

1999 85.952 24.578 0.694 108.862

2000 87.846 24.561 0.738 110.470

2001 88.900 23.694 0.746 112.810

2002 89.732 22.198 0.834 110.020

2003 92.843 21.015 0.837 114.091

2004 97.434 25.396 0.749 121.981

2005 99.319 30.403 0.766 128.276

2006 98.167 32.141 0.723 127.595

2007 95.464 21.496 0.885 116.695

2008 87.700 11.000 0.950 98.610

2009 75.000 10.000 0.900 84.000

Table A Cement Production, Trade, and Consumption in*US (In million MT except year)

Adapted from data available with US Geological Survey, January 2010.

Exhibit VII A Note on Cement Industry in the US (2005–2009)

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Housing starts, which represented new construction activity in the housing sector in the US, reflected the demand for cement from the housing sector. The starts fell to 550,000 in 2009 from a cyclical peak of 2,068,300 in 2005. On an average, around 21 MT of cement was consumed to construct a single family house with an average size of 2,500 square feet. In the year 2009, the cement consumption in the US fell to 84 million MT while the domestic production was at 75 million MT. In the same year, the industry reported revenue of US$ 8.25 billion, a fall of 14.8 percent as compared to 2008 revenues (Refer to Table B for Cement Industry Revenue in US between 1995 and 2009).

Though the new construction activity and prices in the housing sector declined because of the subprime crisis, construction activity in the nonhousing sector helped the cement industry to a certain extent. The nonhousing sector, including industrial buildings, bridges, roads, and other infrastructure projects, was provided financial support by the US administration through various stimulus packages to revive the sagging economy.

Though the years 2008 and 2009 had been tough for the cement industry, analysts expected the future for the industry in the US to be better. They estimated that the cement industry would record a strong cyclical growth in revenues at an average annual growth rate of 4.5% over the next five years till 2014. They expected the average annual production to be around 80.8 million MT during this period. Some analysts expected that domestic companies would resume running their facilities at full capacity to improve their productivity and combat low cost imports from the Asian countries. The cement imports were expected to rebound to 22.5 million MT by 2014.

A significant 77.5% market share in the US cement industry was controlled by the top five players. As of 2009, CEMEX was the leading player with a 25% market share followed by Holcim Inc (17.5%), HeidelbergCement AG (15%), Lafarge North America (15%), and Texas Industries Inc (5%).

Exhibit VII (continued)

Year Industry Revenue (In US$ Million) Growth (%)

1995 7,230.10 8.9

1996 7,727.80 6.9

1997 8,533.40 10.4

1998 9,024.10 5.8

1999 8,955.20 –0.8

2000 8,927.40 –0.3

2001 9,215.40 3.2

2002 9,862.70 7

2003 9,113.50 –7.6

2004 9,930.80 9

2005 10,756.60 8.3

2006 11,522.00 7.1

2007 11,000.00 –4.5

2008 10,000.00 –9.1

2009 8,525.00 –14.8

Table B Cement Industry Revenue in the US (1995–2009)

Adapted from data available with US Geological Survey, January 2010.

Compiled from various sources.

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Maturing Less than

1 year 1–3 years 3–5 years More than

5 years 2008 Total

2007 Total

Long-term debt 4,161 8,565 1,396 1,876 15,998 18,100

Capital Lease Obligation 14 10 3 — 27 51

Total debt 4,175 8,575 1,393 1,876 16,025 18,151

Operating Leases 214 339 228 179 960 841

Interest Payments on Debt 357 566 213 136 1,272 2,624

Interest rate derivatives 9 53 5 25 92 407

Pension plans and other benefits 164 309 311 825 1,609 1,925

Inactive derivative financial instruments

252 30 95 8 385 —

Total Contractual obligations 71,050 135,641 30,929 41,893 279,513 261,513

Exhibit VIII CEMEX–Contractual Obligations as of December 31, 2008 (In US$ Million)

Source: CEMEX Annual Report 2008.

2000 2002

Cemex Stock Price Chart

2004 2006 2008

Exhibit IX CEMEX Stock Price Chart

Source: www.reuters.com.

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15.986

15.168

14.350

13.532

12.714

11.897

11.079

10.261

9.443 Feb 2007

Feb 2009

Feb 2008

Mexican Peso Vs US$ Chart

Aug 2007

Aug 2008

Aug 2009

Exhibit X Mexican Peso vs US$ Chart

Source: www. forexdirectory. net *X-axis5 US$ value in Mexican Pesos Y-axis5 Time Period

2008

Operating Activities

Consolidated Net income 2,278

Non-Cash Items:

Depreciation and amortization of assets 20,864

Impairment of assets 21,125

Equity in income of associates (1,098)

Other expenses, net (4,727)

Comprehensive financing result 28,725

Income taxes paid in cash (23,562)

Change in working capital, excluding financial expenses and income taxes 1,243

Net cash flows provided by operating activities before comprehensive financing results and income taxes

44,848

Financial expenses paid in cash (9,951)

Income taxes paid in cash (3,625)

Net cash flows provided by operating activities before comprehensive financing results and income taxes

31,272

Exhibit XI CEMEX Cash Flow Statement (2008) (In US$ millions)

(continued)

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Suggested Readings and References:

Endnotes

1. J. C. Collins and J. I. Porras, Built to Last (Harper Busi- ness, New York, 1994).

2. M. Conlin, “Too Much Doodle?” Forbes, October 19, 1998, 54–56.

3. M.Dickson, “Back to the Future,” Financial Times, 1994, May 30, 7.

4. J. Hallinan, “3M’s Next Chief Plans to Fortify Results with Discipline He Learned at GE Unit,” Wall Street Journal, December 6, 2000, B17.

5. E. Von Hippel et al., “Creating Breakthroughs at 3M,” Harvard Business Review, September-October 1999.

6. R. Mullin, “Analysts Rate 3M’s New Culture,” Chemical Week, September 26, 2001, 39–40.

7. 3M. A Century of Innovation, the 3M Story. 3M, 2002. Available at www.3m.com/about3m/century/index.jhtml.

8. 3M Investor Meeting, September 30, 2003, archived at www.corporate-ir.net/ireye/ir_site.zhtml?ticker=MMM& script=2100

9. T. Studt. “3M–Where Innovation Rules,” R&D Maga- zine, April 2003, Vol 45, 20–24.

10. De’Ann Weimer, “3M: The Heat is on the Boss,” Busi- ness Week, March 15, 1999, 82–83.

11. J. Useem. “(Tape) + (Light bulb) 5 ?”, Fortune, August 12, 2002, 127–131.

12. M. Gunther, M. Adamo, and B. Feldman, “3M’s Innova- tion Revival,” Fortune, September 27, 2010, 73–76.

1 M.Dickson, “Back to the Future,” Financial Times, May 30, 1994, 7. www.3m.com/profile/looking/mcknight.jhtml.

2 www.3m.com/about3M/pioneers/drew2.jhtml 3 www.3m.com/about3M/innovation/scotchgard50/

index.jhtml 4 3M. A Century of Innovation, the 3M Story. 3M, 2002.

Available at http://www.3m.com/about3m/century/index .jhtml

5 3M. A Century of Innovation, the 3M Story. 3M, 2002, page 33. Available at http://www.3m.com/about3m/cen- tury/index.jhtml

6 T. Studt, “3M–Where Innovation Rules,” R&D Maga- zine, April 2003, Vol 45, 20–24.

7 3M. A Century of Innovation, the 3M Story. 3M, 2002, page 78. Available at http://www.3m.com/about3m/cen- tury/index.jhtml

30%. By 2010, after 5 years of Buckley’s leadership, the percentage was back up to 30%. According to many in the company, Buckley had been a champion of researchers at 3M, devoting much of his personal time to empowering researchers, and urging them to restore the luster of 3M.

Buckley had stressed the need for 3M to more ag- gressively pursue growth opportunities. He wanted the company to use its differentiated brands and technology to continue to develop core businesses and extend those core businesses into adjacent ar- eas. In addition, like McNerney, Buckley wanted the company to focus R&D resources on emerging busi- ness opportunities, and he, too, seemed to be pre- pared to play a more proactive role in this process. Areas of focus included filtration systems, track and trace information technology, energy and mineral extraction, and food safety. 3M has made a number of acquisitions since 2005 to achieve scale and ac- quire technology and other assets in these areas. In addition, it increased its own investment in technolo- gies related to these growth opportunities, particu- larly nanotechnology.

Buckley had made selective divestures of busi- nesses not seen as core. Most notably, in November 2006, 3M reached an agreement to sell its pharma-

ceutical business for $2.1 billion. 3M took this step after deciding that a combination of slow growth, and high regulatory and technological risk, made the sector an unattractive one that would dampen the company’s growth rate.

Finally, Buckley was committed to continuing in- ternationalization at 3M. 3M doubled its capital in- vestment in the fast growing markets of China, India, Brazil, Russia, and Poland between 2005 and 2010. All of these markets have been expanding 2–3 times as fast as the United States’ market.

Judged by the company’s financial results, the McNerney and Buckley eras did seem to improve 3M’s financial performance. The first decade of the 21st century was a difficult one, marked by sluggish growth in the United States, and in 2008–2009, a steep recession triggered by a global financial crisis. 3M weathered this storm better than most, bounc- ing out of the recession in 2010 with strong revenue and income growth, helped in large part by its new products and exposure to fast growing international markets. For the decade, revenues expanded from $16 billion in 2001 to $26.66 billion in 2010, earn- ings per share expanded from $1.79 to $5.63, and ROIC increased from the mid-teens in the 1990s to the mid-20s for most of the decade.

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8 3M. A Century of Innovation, the 3M Story. 3M, 2002, page 78. Available at http://www.3m.com/about3m/ century/index.jhtml

9 3M. A Century of Innovation, the 3M Story. 3M, 2002, page 42. Available at http://www.3m.com/about3m/ century/index.jhtml

10 E. Von Hippel et al., “Creating Breakthroughs at 3M,” Harvard Business Review, September–October 1999.

11 From 3M Website at www.3m.com/about3M/history/ mcknight.jhtml

12 3M. A Century of Innovation, the 3M Story. 3M, 2002,143–144. Available at http://www.3m.com/ about3m/century/index.jhtml

13 M. Conlin, “Too Much Doodle?”, Forbes, October 19, 1998, 54–56.

14 De’Ann Weimer, “3M: The Heat is on the Boss,” Busi- ness Week, March 15, 1999, 82–83.

15 J. Hallinan, “3M’s Next Chief Plans to Fortify Results with Discipline He Learned at GE Unit,” Wall Street Journal, December 6, 2000, B17.

16 J. Useem. “(Tape) + (Light bulb) 5 ?”, Fortune, August 12, 2002, 127–131.

17 R. Mullin, “Analysts Rate 3M’s New Culture,” Chemical Week, September 26, 2001, 39–40.

18 3M Investor Meeting, September 30, 2003, archived at http://phx.corporate-ir.net/phoenix.zhtml?c=80574&p= irol-irhome

19 Tim Studt, “3M—Where Innovation Rules,” R&D Mag- azine, April 2003, 22.

20 3M Investor Meeting, September 30, 2003, archived at http://phx.corporate-ir.net/phoenix.zhtml?c=80574&p= irol-irhome

21 Adapted from presentation by Jay Inlenfeld, 3M Inves- tor Meeting, September 30, 2003, archived at http:// phx.corporate-ir.net/phoenix.zhtml?c=80574&p= irol-irhome

22 Ibid. 23 Tim Studt, “3M—Where Innovation Rules,” R&D Mag-

azine, April 2003, 21. 24 Material here drawn from George Buckley’s presenta-

tion to Prudential’s investor conference on “Inside our Best Ideas,” September 28, 2006. This and other relevant presentations are archived at http://phx.corporate-ir.net/ phoenix.zhtml?c=80574&p=irol-irhome

25 J. Sprague, “MMM: Searching for Growth with New CEO Leading,” Citigroup Global Markets, May 2, 2006.

26 M. Gunther, M. Adamo, and B. Feldman, “3M’s Innova- tion Revival,” Fortune, September 27, 2010, 74.

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CASE 28

In 2011, Antonio Perez, CEO of the Eastman Kodak Co., was reflecting upon his company’s current situa- tion. Since he had become CEO in 2005 and launched his strategy to make Kodak a leader in the consumer and business imaging markets, progress had been slow. His efforts to cut costs while heavily investing to develop new digital products had resulted in Ko- dak losing money in most of the previous years, and Kodak had already cut its profit estimates for 2011.

After spending billions of dollars to create the dig- ital competencies necessary to give Kodak a competi- tive advantage, and after cutting tens of thousands of jobs, the company’s future was still in doubt. Could Kodak survive given the fact its digital rivals were continually introducing new and improved products that made its own look out of date? Was Kodak’s new digital business model really working? And, did it have the digital products in place to rebuild its profitability and fulfill its “You press the button, we do the rest” promise? Or, after 10 years of declining sales and profits was the company on the verge of bankruptcy in the face of intense global competition on all product fronts?

Kodak’s History Eastman Kodak Co. was incorporated in New Jersey on October 24, 1901, as successor to the Eastman Dry Plate Co., a business originally established by George Eastman in September 1880. The Dry Plate Co. had been formed to develop a dry photographic plate that was more portable and easier to use than other plates in the rapidly developing photography field. To mass produce the dry plates uniformly, Eastman patented

a plate-coating machine and began to commercially manufacture the plates. Eastman’s continuing interest in the infant photographic industry led to his devel- opment in 1884 of silver halide paper-based photo- graphic roll film. Eastman capped this invention with his introduction of the first portable camera in 1888. This camera used his own patented film, which was developed using his own proprietary method. Thus, Eastman had gained control of all the stages of the photographic process. His breakthroughs made pos- sible the development of photography as a mass lei- sure activity. The popularity of the “recorded images” business was immediate, and sales boomed. Eastman’s inventions revolutionized the photographic industry, and his company was uniquely placed to lead the world in the development of photographic technology.

From the beginning, Kodak focused on 4 pri- mary objectives to guide the growth of its business: (1) mass production to lower production costs; (2) maintaining the lead in technological develop- ments; (3) extensive product advertising; and (4) the development of a multinational business to exploit the world market. Although common now, those goals were revolutionary at the time. In due course, Kodak’s yellow boxes could be found in every coun- try in the world. Preeminent in world markets, Kodak operated research, manufacturing, and dis- tribution networks throughout Europe and the rest of the world. Kodak’s leadership in the development of advanced color film for simple, easy-to-use cam- eras and in quality film processing was maintained by constant research and development in its many research laboratories. Its huge volume of production allowed it to obtain economies of scale. Kodak was also its own supplier of the plastics and chemicals

The Rise and Fall of Eastman Kodak: Will It Survive Beyond 2012?

Copyright © 2011 by Gareth R. Jones. This case was prepared by Gareth R. Jones as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted by permission of Gareth R. Jones. All rights reserved. For the most recent financial results of the company discussed in this case, go to http://finance.yahoo.com, input the company’s stock symbol (EK), and download the latest company report from its homepage.

Gareth R. Jones Texas A&M University

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than in one single country, and this also gave Kodak a cost disadvantage. Thus, the combination of Fu- ji’s efficient production and Kodak’s own manage- ment style allowed the Japanese to become the cost leaders—to charge lower prices and still maintain profit margins.

Another blow on the camera front came when Kodak lost its patent suit with Polaroid Corp. Ko- dak had abandoned the instant photography busi- ness in the 1940s, when it turned down Edwin Land’s offer to develop his instant photography process. Polaroid developed it, and instant photog- raphy was wildly successful, capturing a significant share of the photographic market. In response, Kodak set out in the 1960s to develop its own in- stant camera to compete with Polaroid’s. Accord- ing to testimony in the patent trial, Kodak spent $94 million perfecting its system, only to scrub it when Polaroid introduced the new SX-70 camera in 1972. Kodak then rushed to produce a com- peting instant camera, hoping to capitalize on the $6.5 billion in sales of instant cameras. However, a federal judge ordered Kodak out of the instant pho- tography business for violating 7 of Polaroid’s pat- ents in its rush to produce an instant camera. The cost to Kodak for closing its instant photography operation and exchanging the 16.5 million cameras sold to consumers was over $800 million. By 1985, Kodak reported that it had exited the industry at a cost of $494 million; however, in 1991 Kodak also agreed to pay Polaroid $925 million to settle out of court a suit that Polaroid had brought against Kodak for patent infringement.

On its third product front, photographic process- ing, Kodak also experienced problems. It faced stiff competition from foreign manufacturers of photo- graphic paper and from new competitors in the film- processing market. Increasingly, film processors were turning to cheaper sources of paper to reduce the costs of film processing. Once again, the Japanese had de- veloped cheaper sources of paper and were eroding Kodak’s market share. At the same time, many new independent film-processing companies had emerged and were printing film at far lower rates than Kodak’s own official developers. These independent laborato- ries had opened to serve the needs of drugstores and supermarkets, and many of them offered 24-hour ser- vice. They used the less expensive paper to maintain their cost advantage and were willing to accept lower profit margins in return for a higher volume of sales.

needed to produce film, and it made most of the component parts for its cameras.

Kodak became one of the most profitable Ameri- can corporations, and its return on shareholders’ eq- uity averaged 18% for many years. To maintain its competitive advantage, it continued to heavily invest in research and development in silver halide pho- tography, principally remaining in the photographic business. In this business, as the company used its resources to expand sales and become a global busi- ness, the name Kodak became a household word sig- nifying unmatched quality. By 1990, approximately 40% of Kodak’s revenues came from sales outside the United States.

Starting in the early 1970s, however, and es- pecially in the 1980s, Kodak ran into major prob- lems, reflected in the drop in return on equity. Its preeminence was being increasingly threatened as the photographic industry and industry competi- tion changed. Major innovations were taking place within the photography business, and new methods of recording images and memories beyond silver halide technology, most noticeably digital imaging, were emerging.

Increasing Competition In the 1970s, Kodak began to face an uncertain en- vironment in all its product markets. First, the color film and paper market from which Kodak made 75% of its profits experienced growing competition from Japanese companies, led by FujiFilm. Fuji invested in huge, low-cost manufacturing plants, using the lat- est technology to mass-produce film in large volume. Fuji’s low production costs and aggressive, competi- tive price cutting squeezed Kodak’s profit margin. Finding no apparent differences in quality, and ob- taining more vivid colors with the Japanese product, consumers began to switch to the cheaper Japanese film, and this shift drastically reduced Kodak’s mar- ket share.

Besides greater industry competition, another liability for Kodak was that it had done little in- ternally to improve productivity to counteract ris- ing costs. Supremacy in the marketplace had made Kodak complacent, and it had been slow to in- troduce productivity and quality improvements. Furthermore, Kodak (unlike Fuji in Japan) produced film in many different countries in the world rather

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As a result, Kodak lost markets for its chemical and paper products—products that had contributed signifi- cantly to its revenues and profits. The photographic in- dustry surrounding Kodak had dramatically changed. Competition had increased in all product areas, and Kodak, while still the largest producer, faced increas- ing threats to its profitability as it was forced to reduce prices to match the competition.

The Emergence of Digital Imaging Another major problem that Kodak had to con- front was not because of increased competition in its existing product markets, but because of the emergence of new industries that provided alterna- tive means of producing and recording images. The introduction of videotape recorders, and later video cameras, gave consumers an alternative way to use their dollars to produce images, particularly mov- ing images. Video basically destroyed the old, film- based home movie business upon which Kodak had a virtual monopoly. After Sony’s introduction of the Betamax machine in 1975 the video industry grew into a multibillion-dollar business. VCRs and first 16mm camera, and the compact 8mm video cam- eras became increasingly hot-selling items as their prices fell with the growth in demand and the stan- dardization of technology. Then, the later introduc- tion of laser disks, compact disks, and, in the 1990s, DVDs were also significant developments. The vast amount of data that can be recorded on these disks gave them a great advantage in reproducing images through electronic means.

It was increasingly apparent that the entire nature of the imaging and recording process was changing from chemical methods to electronic, digital meth- ods of reproduction. Kodak’s managers should have perceived this transformation to digital-based methods as a disruptive technology because its tech- nical preeminence was based on silver halide pho- tography. However, as is always the case with such technologies, the real threat lies in the future. These changes in the competitive environment caused enormous difficulties for Kodak. Between 1972 and 1982, profit margins from sales declined from 16% to 10%. Kodak’s glossy image lost its luster. It was in this declining situation that Colby Chandler took over as chairman in July 1983.

Kodak’s New Strategy Chandler saw the need for dramatic changes in Kodak’s businesses and quickly pioneered 4 changes in strategy: (1) he strove to increase Kodak’s control of its existing chemical-based imaging businesses; (2) he aimed to make Kodak the leader in electronic imaging; (3) he spearheaded attempts by Kodak to diversify into new businesses to increase profitabil- ity; and (4) he began on major efforts to reduce costs and improve productivity. To achieve the first 3 ob- jectives, he began a huge program of acquisitions, realizing that Kodak did not have the time to venture new activities internally. Because Kodak was cash rich (it was one of the richest global companies) and had low debt, financing these acquisitions was easy.

For the next 6 years, Chandler acquired busi- nesses in 4 main areas. By 1989, Kodak had been restructured into 4 main operating groups: imag- ing, information systems, health, and chemicals. At its annual meeting in 1988, Chandler announced that with the recent acquisition of Sterling Drug for $5 billion, the company had achieved its objective: “With a sharp focus on these 4 sectors, we are serv- ing diversified markets from a unified base of science and manufacturing technology. The logical synergy of the Kodak growth strategy means that we are neither diversified as a conglomerate nor a company with a 1-product family.”

The way these operating groups developed under Chandler’s leadership is described in the following text.

The Imaging Group Imaging comprised Kodak’s original businesses, in- cluding consumer products, motion picture and au- diovisual products, photo finishing, and consumer electronics. The unit was charged with strengthening Kodak’s position in its existing businesses. Kodak’s strategy in its photographic imaging business has been to fill gaps in its product line by introducing new products either made by Kodak or bought from Japanese manufacturers and sold under the Kodak name. For example, to maintain market share in the camera business, Kodak introduced a new line of disk cameras to replace the Instamatic lines. Kodak also bought a minority stake and entered into a joint venture with Chinon of Japan to produce a range of 35mm automatic film cameras that would be sold

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under the Kodak name. This arrangement would capitalize upon Kodak’s strong brand image and give Kodak a presence in this market to maintain its cam- era and film sales. Kodak sold 500,000 cameras and gained 15% of the declining film camera market. In addition, Kodak invested heavily in developing new and advanced film such as a new range of “DX” coded film to match the new 35mm camera market that possesses the vivid color qualities of Fuji’s film. Kodak had not developed vivid film color earlier because of its belief that consumers wanted “real- istic” color—its managers were still fixated on im- proving core declining film business.

Kodak also made major moves to solidify its hold on the film-processing market. It attempted to stem the inflow of foreign low-cost photographic paper by gaining control over the processing market. In 1986, it acquired Fox Photo Inc. for $96 million and became the largest national wholesale photograph finisher. In 1987, it acquired the American Photographic Group, and in 1989, it solidified its hold on the photo finishing market by forming a joint venture, Qualex, with the photofinishing operations of Fuqua industries. These acquisitions provided Kodak with a large, captive customer for its chemical and paper products as well as control over the photofinishing market. Also, in 1986 Kodak introduced new improved 1-hour film- processing labs to compete with other photographic developers. To accompany the new labs, Kodak popu- larized the Kodak “Color Watch” system that requires these labs to use only Kodak paper and chemicals. Kodak’s strategy was to stem the flow of business to 1-hour mini-labs and also establish the industry stan- dard for quality processing—it succeeded but the pace of change to the digital world was accelerating and by the end of the 1980s, given the soaring popularity of digital PCs Kodak’s managers should have recognized they were on the wrong track.

Kodak’s rapidly declining profitability forced it to engage in a massive internal cost-cutting effort to improve the efficiency of the photographic products group. Beginning in 1984, it introduced more and more stringent efficiency targets aimed at reduc- ing waste while increasing productivity. In 1986, it established a baseline for measuring the total cost of waste incurred in the manufacture of film and pa- per throughout its worldwide operations. By 1987, it had cut that waste by 15%, and by 1989, it an- nounced total cost savings worth $500 million an- nually. This was peanuts given the rapidly changing

competitive situation—Kodak’s managers did not want to shrink their large, bureaucratic company that had become conservative and paternalistic over time. As a result, Kodak’s profits dropped dramati- cally in 1989 as all film makers woke up to the new competitive reality and Polaroid and Fuji also ag- gressively tried to capture market share by engaging in price cutting and increasing advertising to raise market share. The result was even further major declines in profitability. These rising expenditures offset most of the benefits of Kodak’s cost-cutting effort, and there was little prospect of increasing profitability because Kodak’s core photographic im- aging business was in decline—Kodak already had 80% of the market, it was tied to the fortunes of one industry. In addition, the increasing use and grow- ing applications of digital imaging techniques, led to Chandler’s second strategic thrust: an immediate policy of acquisition and diversification into new industries, including the electronic imaging business with the stated goal of being first in film and digital imaging. He thought the two could still co-exist. He could not understand that digital imaging was a dis- ruptive technology.

The Information Systems Group In 1988, Sony introduced a digital electronic camera that could take still pictures and then transmit them back to a television screen. This was an obvious sig- nal that the threat to Kodak from new digital imag- ing techniques was going to accelerate. However, at that time, the pictures taken with video film could not match the quality achieved with chemical repro- duction. Technology will always advance, and the introduction of CDs was also a sign that new form of digital storage media were on the horizon—the silver halide film media was already out of date as declining sales showed. For Kodak to survive in the imaging business, its managers woke up to the fact that it required expertise in a broad range of new technologies to satisfy customers’ recording and im- aging needs—they began to see the threat posed by the disruptive technology. Kodak’s managers saw in all its film markets different types of digital products were emerging as strong competitors. For example, electronic imaging had become important in the medical sciences and in all business, technical, and research applications driven by introduction of ever more powerful servers and PCs.

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However, Kodak’s managers did not choose to focus on imaging products and markets close to “photographs”—for example Kodak could have bought Sony or Apple. Instead, they began to target any kind of imaging applications in communications, computer science, and similar applications, that they believed would be important in digital imaging mar- kets of the future. Because Kodak had no expertise in digital imaging, its managers decided to acquire companies they perceived did have these skills and then market these companies’ products under its own famous brand name. For example, a Kodak electronic publishing system for business documents, and a Kodak imaging record keeping system.

Kodak began its disastrous strategy of acquisi- tions and joint ventures that wasted much of its huge retained earnings in new imagining technologies that its managers hoped, somehow, would increase its future profitability. In the new information systems group, acquisitions included Atex Inc., Eikonix Corp., and Disconix Inc. Atex made newspaper and maga- zine electronic publishing and text-editing systems to newspapers and magazines worldwide as well as to government agencies and law firms. Eikonix Corp. was a leader in the design, development, and pro- duction of precision digital imaging systems. Further growth within the information systems group came with the development of the Ektaprint line of copier- duplicators that did achieve some success in the com- petitive high-volume segment of the copier market. In 1988, Kodak announced another major move into the copier service business when it purchased IBM’s copier service business and that it would market copi- ers manufactured by IBM as well as its own Ektaprint copiers. But these copiers were not based on digital imaging—they were still ink-based even though they used digital technology. With these moves, Kodak extended its activities into the electronic areas of ar- tificial intelligence, computer systems, consumer elec- tronics, peripherals, telecommunications, and test and measuring equipment. Kodak was hoping to gain a strong foothold in these new businesses to make up for losses in its traditional business—but it was still not trying to streamline and shrink its core business to reduce its cost structure fast enough, and these ac- quisitions raised its cost structure.

In addition, top managers now terrified by how far Kodak was behind, decided to purchase imaging companies that made products as diverse as computer workstations and floppy disks! Kodak aggressively

acquired any IT companies that might fill in its prod- uct lines and obtain technical expertise in digital tech- nology, and help it in its core imaging business. After taking more than a decade to make its first 4 acqui- sitions, Kodak completed 7 acquisitions in 1985 and more than 10 in 1986. Among the 1985 acquisitions was Verbatim Corp., a major producer of floppy disks. This acquisition made Kodak one of the 3 big produc- ers in the floppy disk industry—an industry in which it had no expertise.

In entering office information systems, Kodak entered new markets where it faced strong competi- tion from established companies such as IBM, Apple, and Sun Microsystems. The Verbatim acquisition brought Kodak into direct competition with 3M. Entering the copier market brought Kodak into di- rect competition with Japanese firms such as Canon, which was the leader in marketing advanced, new low-cost copiers—and Canon still is today.

In brief, Kodak was entering new businesses where it had little expertise, where it was unfamil- iar with the competitive forces, and where there was already strong competition. Soon, Kodak was forced to retreat from many of these markets. In 1990, it announced that it would sell Verbatim to Mitsubi- shi. (Mitsubishi was immediately criticized by Japa- nese investors for buying a company with an old, outdated product line!) Kodak was forced to with- draw from many other areas of business simply by selling assets, closing operations, and taking a write- off such as its non-digital videocassette operations. The fast-declining performance of its information systems group, which Kodak attributed to increased competition and delays in bringing out new prod- ucts, reduced earnings from operations from a profit of $311 million in 1988 to a loss of $360 million in 1989. This was a major wake up call to investors who now realized that Kodak’s top managers had no viable business model for the company and were simply wasting its capital.

The Health Group Kodak’s interest in health products emerged from its involvement in the design and production of film for medical and dental X-rays. The growth of digital imaging in medical sciences seemed another oppor- tunity for Kodak to apply its “skills” in new mar- kets, and it began to develop such products as Kodak Ektachem—clinical blood analyzers. It developed

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other products—Ektascan laser imaging films, print- ers, and accessories—for improving the display, stor- age, processing, and retrieval of diagnostic images. This seemed more related to its core business imag- ing mission.

However, Kodak did not confine its interests in medical and health markets to imaging-based prod- ucts. In 1984, it established within the health group a life sciences division to develop and commercialize new products deriving from Kodak’s distinctive competen- cies in its still profitable chemical division. Kodak had about 500,000 chemical formulations upon which it could base new products, top managers decided that they could use these resources to enter newly develop- ing biotechnology markets and grow its “life sciences” division that soon engaged in joint ventures with ma- jor biotechnology companies such as Amgen and Im- munex. However, these advances into biotechnology proved highly expensive, and again Kodak had no expertise in this complex industry! Soon, even its own managers realized this, and in 1988 Kodak quietly ex- ited the industry. What remained of the life sciences di- vision was then folded into the health group in 1988, when Chandler completed Kodak’s biggest, and most useless acquisition, the purchase of Sterling Drug, for more than $5 billion.

The Sterling acquisition once again had no rel- evance to Kodak’s business model. Sterling Drug was a global maker of prescription drugs, over-the- counter medicines, and consumer products with fa- miliar brand names such as Bayer Aspirin, Phillips’ Milk of Magnesia, and Panadol. Chandler thought this merger would allow Kodak to become a major player in the pharmaceuticals industry. With this ac- quisition, Kodak’s health group became pharmaceu- tically oriented, and its mission was to develop a full pipeline of major prescription drugs and a world- class portfolio of over-the-counter medicines— something that is an enormously complex, uncertain, and expensive process. Analysts immediately ques- tioned the acquisition because, once again, Chandler was taking Kodak into a new industry where com- petition was intense and was consolidating because of the massive costs of drug development. Some analysts claimed that the acquisition was aimed at deterring a possible takeover of Kodak—because it was still cash rich and its capital was being wasted! The acquisition of Sterling also resulted in a major decline in profits in 1989; this was growth without profitability.

The Chemical Division Established almost a hundred years ago to be the high-quality supplier of raw materials for Kodak’s film and processing businesses, the Eastman Chemi- cal division was responsible for developing many of the chemicals and plastics that made Kodak the leader in silver-halide filmmaking. The chemical di- vision was also a major supplier of chemicals, fibers, and plastics to thousands of customers worldwide, and Kodak had benefited from the profits from its plastic material and resins unit because of the suc- cess of Kodak PET (polyethylene terephthalate), to- day the major polymer used in soft-drink bottles.

However, in its chemical division, Kodak also ran into the same kinds of problems experienced by its other operating groups. There is intense competition in the plastics industry, not only from U.S. firms like DuPont, but also from large Japanese and European. In specialty plastics and PET, for example, increased competition forced Kodak to reduce prices by 5% and this also led to the plunge in its earnings in 1989. The chemical division, however, had excellent resources and competencies—but not now that they were still controlled by a declining film giant.

Kodak’s Failing Business Model Results in Massive Cost Cutting With the huge profit reversal in 1989 after all the years of acquisition and “internal development,” analysts were questioning the existence of the “logi- cal synergy,” or economies of scope that Chandler claimed for Kodak’s new acquisitions. Certainly, Kodak had new sources of revenue—but was this profitable growth? Was Kodak positioned to compete successfully in the future? What were the synergies that Chandler was talking about? And wasn’t any in- crease in profit due to its attempts to reduce costs?

Indeed, as Chandler made his acquisitions, he also realized the increasing need to change Kodak’s management style and organizational structure to reduce costs and allow it to respond more quickly to changes in the competitive environment. Because of its dominance in the industry, in the past, Kodak had not worried about outside competition. As a result, the organizational culture at Kodak empha- sized traditional, conservative values rather than

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entrepreneurial values. Kodak was often described as a conservative, plodding monolith because all decision making had been centralized at the top of the organization among a clique of senior manag- ers. Furthermore, the company had been operating along functional lines. Research, production, and sales and marketing had operated separately in dif- ferent units at corporate headquarters and dispersed to many different global locations. Kodak’s different product groups also operated separately. The result of these factors was a lack of communication and slow, inflexible decision making that led to delays in making new product decisions. When the com- pany attempted to transfer resources between prod- uct groups, conflict often resulted, and the separate functional operations also led to poor product group relations, for managers protected their own turf at the expense of corporate goals. Moreover, there was a lack of attention to the bottom line, and manage- ment failed to institute measures to control waste.

Another factor encouraging Kodak’s conservative orientation was its promotion policy. Seniority and loyalty to “Mother Kodak” counted nearly as much as ability when it came to promotions. Only 12 presi- dents had led the company since its beginnings in the 1880s. Long after George Eastman’s suicide in 1932, the company followed his cautious ways: “If George didn’t do it, his successors didn’t either.”

Kodak’s technical orientation also contributed to its problems. Traditionally, its engineers and scien- tists had dominated decision making, and market- ing had been neglected. The engineers and scientists were perfectionists who spent enormous amounts of time developing, analyzing, testing, assessing, and re- testing new products. Little time, however, was spent determining whether the products satisfied consumer needs. As a result of this technical orientation, man- agement passed up the invention of xerography, leav- ing the new technology to be developed by a small Rochester, New York, firm named Haloid Co.—later Xerox. Similarly, Kodak had passed up the instant camera business.

With its monopoly in the photographic film and paper industry gone, Kodak was in trouble. Chandler had to alter Kodak’s management orientation. He began with some radical changes in the company’s culture and structure. Forced to cut costs, Chandler began a massive downsizing of the work force to eliminate the fat that had accumulated during Kodak’s prosperous past. Kodak’s policy of lifetime

employment was swept out the door when declining profitability led to continuing employee layoffs and cost reductions. Between 1985 and 1990, Kodak laid off over 100,000 of its former 136,000 employees, less that 10% of its workforce and a tiny percent- age that would do nothing to prevent its declining performance. Kodak was now a company that had come unstuck, it could not recognize that it had lost its competitive advantage and that all its new strate- gies were just accelerating its decline. It was burning money but its top managers did not want to dam- age the company or its employees, it was obviously a dinosaur.

Every move top managers made failed. Kodak at- tempted to create a structure and culture to encour- age internal venturing. It formed a “venture board” to help underwrite projects imitating 3M and created an “office of submitted ideas” to screen projects. Ko- dak’s attempts at new venturing were unsuccessful, of the 14 ventures that Kodak created 6 were shut down, 3 were sold, and 4 were merged into other divisions. One reason was Kodak’s management style, which also affected its new businesses. Kodak’s top managers never gave operating executives real authority or abandoned the centralized, conserva- tive approach of the past. Kodak also reorganized its worldwide facilities to increase productivity and lower costs, For example, Kodak streamlined Euro- pean production by closing duplicate manufacturing facilities and centralizing production and marketing operations, and in doing so thousands more employ- ees were laid off.

George Fisher Tries to Change Kodak Chandler retired as CEO in 1989, and was replaced by his COO, Kay Whitmore, another Kodak veteran. As Kodak’s performance continued to plunge, Whit- more hired new top managers from outside Kodak to help restructure the company. When they proposed selling off Kodak’s new acquisitions and laying off tens of thousands more employees to reduce costs Whitmore resisted; he too was entrenched in the old Kodak culture. Kodak’s board of directors ousted Whitmore as CEO, and in 1993, George Fisher left his job as CEO of Motorola to become Kodak’s new CEO. At Motorola, he had been credited with lead- ing that company into the digital age.

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Fisher’s strategy was to reverse Chandler’s diver- sification into any industry outside digital imaging and to strengthen its competencies in this industry. Given that Kodak had spent so much money on mak- ing useless acquisitions, and the company was now burdened with huge debt from its acquisitions and because of falling profits, Fisher’s solution was dra- matic. Strategizing about Kodak’s 4 business groups Fisher decided that the over-the-counter drugs com- ponent of the health products group was reducing Kodak’s profitability and he decided to divest it and use the proceeds to pay off debt. Soon, all that was left of this group was the health imaging business. Fisher also decided that the chemicals division, de- spite its expertise in the invention and manufacture of chemicals, no longer fit with his new digital strat- egy. Kodak would now buy its chemicals in the open market, and in 1995 he spun the chemicals division off and gave each Kodak shareholder a share in the new company. This was a very profitable move for shareholders who kept their shares in Eastman Chemicals—its price has soared.

The information systems group with its diverse businesses was a more difficult challenge; the new businesses that would promote Kodak’s new digital strategy should be kept, and the businesses which would not should be sold off. Fisher decided that Kodak should focus on building its strengths in doc- ument imaging and on photocopiers, business imag- ing, and inkjet printers, and exit all its business that did not fit this theme.

After 2 years, Fisher had reduced Kodak’s debt by $7 billion and boosted Kodak’s stock price. Fisher still had to confront the problems inside Kodak’s core photographic imaging group, and here the so- lution was neither easy nor quick. Kodak was still plagued by high operating costs that were over 27% of annual revenue, and Fisher knew he needed to reduce these costs by half to compete effectively in the digital world. Kodak’s workforce had shrunk by 40,000 to only 95,000 by 1993, and the only means to quickly slash costs was to implement more layoffs and close down its operations. However, Kodak’s top managers fought him all the way because they wanted to keep their power, arguing that it was better to find ways to raise revenue than layoff a loyal workforce to reduce costs.

Kodak put off the need to take the hard steps necessary to reduce operating costs by billions. At the same time, top managers were urging Fisher to

invest billions of its declining capital in R&D to build competences in digital imaging. Kodak still had no particular competency in making either digi- tal cameras or the software necessary to allow them to operate efficiently. Over the next 5 years, Kodak spent over 4 billion dollars on digital projects, but new digital products were slow to emerge and its competitors were drawing ahead because they had the first-mover advantage. Also, in the 1990s con- sumers were slow to embrace digital photography because early cameras were expensive, bulky, and complicated to use, and printing digital photographs was also expensive. By 1997, Kodak’s digital busi- ness was still losing over $100 million a year and Japanese companies were coming out with the first compact easy to use digital cameras. To make things worse, Kodak’s share of the film market was falling as a price war broke out to protect market share and it revenues continued to plunge.

To speed product development, Fisher reorga- nized Kodak’s product divisions into 14 autono- mous business units based on serving the needs of distinct groups of customers, such as those for its health products or commercial products. The idea was to decentralize decision making and put man- agers closer to their major customers and so escap- ing Kodak’s suffocating centralized style of decision making. Fisher also changed the top managers in charge of the film and camera units but he did not bring in many outsiders to spearhead the new digital efforts—Kodak’s top managers prevented him from doing this. However, the creation of these 14 busi- ness units also meant that operating costs soared because each unit had its own complement of func- tions; thus sales forces and so on were duplicated.

The bottom line was that Fisher was making little progress, was in a weak position, and was pres- sured by powerful top managers backed by Kodak’s directors. The result was that Daniel A. Carp, a Kodak veteran, was named Kodak’s president and COO meaning that he was Fisher’s heir apparent as Kodak’s CEO. Carp had spearheaded the global con- solidation of its operations and its entry into major new international markets such as China. He was widely credited with having had a major impact on Kodak’s attempts to fight Fuji on a global level and help it to maintain its market share. Henceforth, Ko- dak’s digital and applied imaging, business imaging, and equipment manufacturing—almost all its ma- jor operating groups—would now report to Carp.

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However, Kodak’s revenues and profits continued to decline throughout the 1990s and into the 2000s as it steadily lost market share in its core film business to Fuji and new cheap generic film makers, so prices and profits plunged and so did its market share— down over 25% in the last decade to 66% of the U.S. market meaning the loss of billions in annual reve- nues. Meanwhile, the quality of the pictures taken by digital cameras was advancing rapidly as as newer models touted higher resolutions (more pixels). The price of basic digital cameras was falling rapidly be- cause of huge economies of scale in global produc- tion by companies such as Sony and Canon. Finally, the digital photography market was taking off, but could Kodak meet the challenge?

The answer was no. Kodak had effectively taken control of Japanese camera manufacturer Chinon to make its advanced digital cameras and scan- ners and Kodak continued to introduce low-priced digital cameras—but it was just one more company in a highly competitive market now dominated by Sony and Canon. Kodak also bought online com- panies that offered digital processing services over the Internet, and began offering Kodak branded digital picture-maker kiosks in stores where cus- tomers could edit and print out their digital images. Although Kodak was making some progress in its digital mission; its digital cameras, digital kiosks, and online photofinishing operations were being in- creasingly used by customers, it was being left behind by agile competitors. In 1999, Carp replaced Fisher as CEO to head Kodak’s fight to develop the digital skills that would lead to innovative new products in all its major businesses. In 1999, its health imag- ing group announced the fastest digital image man- agement system for echocardiography labs. It also entered the digital radiography market with 3 state- of-the-art digital systems for capturing X-ray images. Its document imaging group announced several new electronic document management systems. It also teamed up with inkjet maker Lexmark to intro- duce the stand-alone Kodak Personal Picture Maker by Lexmark, which could print color photos from both compact flash cards and smart media. Its com- mercial and government systems group announced advanced new high-powered digital cameras for uses such as in space and in the military.

With these developments, Kodak’s net earnings increased between 1998 and 2000, and its stock price rose. However, one reason for the increase in

profits was that the devastating price war with Fuji ended in 1999 as both companies realized it simply reduced both their profits. The main reason was simply the fact that the stock market soared in the late-1990s and Kodak’s stock price increased with it—for no good reason. Kodak was still not intro- ducing the new digital imaging products it needed to drive its future profitability. Also, Carp made no major efforts to reduce costs in its film products divi- sion, which had powerful managers backing Carp to become CEO to make sure he did nothing threaten their interests. It was the same old story, a rising cost structure and declining revenues and profits.

Kodak in the 2000s Rapidly advancing digital technology and the emer- gence of ever more powerful, easy to use digital im- aging devices began to increasingly punish Kodak in the 2000s. In the consumer imaging group, for example, Kodak launched a new camera, the Ea- syShare, in 2001. Over 4 million digital cameras were sold in 2000 and over 6 million in 2001. How- ever, given the huge R&D costs to develop its new products, and intense competition from Japanese companies like Sony and Canon, Kodak could not make any money from its digital cameras because profit margins were razor thin. Moreover, every time it sold a digital camera, it reduced demand for its high-margin film products that really had been the source of its incredible profitability in the past. Kodak was being forced to cannibalize a profitable product (film) for an unprofitable one (digital imag- ing). Kodak was now a dinosaur in the new digital world and its stock collapsed in 2000 and 2001, falling from $80 to $60 to around $30, as investors now saw the writing on the wall as its profitability plunged.

Carp argued that Kodak would make more money in the future from sales of the highly prof- itable photographic paper necessary to print these images and from its photofinishing operations. However, consumers were not printing out many of the photographs they took, preferring to save most in digital form and display them on their PCs and then on the rapidly emerging digital photo frames market that made film-based photograph albums obsolete. Revenues would not increase from sales of film or paper. Similarly, the photofinishing market

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was declining and its own Qualex and Fox photo finishing chains were forced into bankruptcy.

Kodak was also doing poorly in the important health imaging market where its state-of-the-art imaging products were expected to boost its profit- ability. However, competition increased when health care providers demanded lower prices from imaging suppliers and Kodak was forced to slash its prices to win contracts with other large health care providers. Competition was so intense that in 2001, sales of laser printers and health-related imagining products, which make up Kodak’s second biggest business fell 7% and profit fell 30% causing Kodak’s stock price to plunge. Also, in 2001 Carp announced another major reorganization of Kodak’s businesses to give it a sharper focus on its products and customers, Ko- dak announced that it would create 4 distinct prod- uct groups: the film group, which now contained all its silver halide activities; consumer digital imaging; health imaging, and its commercial imaging group, which continued to develop its business imaging and printing applications. Nevertheless, revenues plunged from $19 billion in 2001 to only $13 billion by 2002 and its profits disappeared.

Analysts wondered if Carp was doing any bet- ter than Fisher and if real change was taking place. Now Carp was forced to cut jobs, and by 2003 its workforce was down to 78,000—still far too high a number given its declining performance. Carp was still trying to avoid the massive downsizing that was still needed to take place to make Kodak a viable company because its entrenched, inbred, and unre- sponsive top managers frustrated real efforts to re- duce costs and streamline operations. Despite all the advances it had made in developing its digital skills, Kodak’s high operating costs combined with its de- clining revenues were driving the company further down the road to bankruptcy. Would layoffs or reor- ganization be enough to turn Kodak’s performance around at this point?

2002 proved to be a turning point in the photo- graphic imaging business as sales of digital cameras and other products began to soar at a far faster pace than had been expected. The result for Kodak’s film business was disastrous because sales of Kodak film started to fall sharply as did demand for its paper— people printed only a small fraction of the pictures they took. From 2003–2005 this trend accelerated, as it has ever since. Digital cameras became the camera of choice of photographers worldwide and Kodak’s

film and paper revenues sunk. Kodak had become unprofitable, which was somewhat ironic given that Kodak’s line of EasyShare digital cameras had be- come one of the best-selling cameras, and Kodak was the number 2 global seller with about 18% of the market. However, profit margins on digital products were razor thin because of intense competition from companies such as Canon, Olympus, and Nikon. Profits earned in digital imaging were not enough to offset the plunging profits in its core film and paper making divisions.

The Decline and Fall of Kodak’s Core Film Business In 2004, Carp announced Kodak’s cash-cow film business was in “irreversible decline” and that Kodak would stop investing in its core film business and pour all its resources into developing new digital products, such as new digital cameras and accesso- ries to improve its competitive position and profit margins. It bought the remaining 44% of Chinon, its Japanese division that designed and made its digi- tal cameras to protect its competency in digital im- aging. Kodak began a major push to develop new state-of-the-art digital cameras and also to develop new skills in inkjet printing to create digital photo printing systems so its users could directly print from its cameras—and achieve economies of scope. Also, Carp announced Kodak would invest to grow its digital health imaging business that had gained market share and it would launch a new initiative to make advanced digital products for the commercial printing industry.

Analysts and investors reacted badly to this news. Xerox had tried to enter the digital printer business years before with no success against HP, the market leader. Moreover, they wondered how new revenues from digital products could ever make up for the loss of Kodak’s film and paper revenues. Carp also announced that to fund this new strategy, Kodak would reduce its hefty dividend by 72% from $1.80 to $0.50 a share that would immediately raise $1.3 billion to invest in digital products. Investors had no faith in Carp’s new plan, and Kodak’s stock plunged to $22, its lowest price in decades. Kodak’s top management came under intense criticism for not reducing its cost structure, and Kodak’s stock

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price continued to fall as it became clear its new strategy would do little to raise its falling revenues— this might be the beginning of Kodak’s end.

In 2004, Carp finally announced what the company should have done 10 years before. Kodak would cut its workforce by over 20% by 2007; another 15,000 employees would lose their jobs saving a billion dol- lars a year in operating costs. Jobs would be lost in film manufacturing at the support and corporate levels and from global downsizing as Kodak reduced its to- tal facilities worldwide by 1/3 and continued to close its out-of-date photofinishing labs that served retailers. This news sent Kodak’s share price up by 20% to over $30. But, it was now too late for Kodak to build the competencies that might have offered it a chance to rebuild its presence as a digital imaging company— there were too many agile competitors and digital technology was changing too fast for the company to respond—at least under Carp’s leadership.

Antonio Perez Takes Control of Kodak It had become clear that Carp could and would not radically restructure Kodak’s operations and bring it back to profitability. Kodak’s board of directors decided to hire Antonio Perez, a former HP print- ing executive, as its new president and COO, to take charge of the reorganization effort. Perez now made the hard choices about which divisions Kodak would close, and announced the termination of thousands of more managers and employees. Carp resigned and Perez’ restructuring efforts were rewarded by his ap- pointment as Kodak’s new CEO. He was now in charge of implementing the downsized, streamlined company’s new digital imaging strategy. Perez an- nounced a major 3-year restructuring plan in 2004 to try to make Kodak a leader in digital imaging.

With regard to costs, Perez announced that Kodak needed “to install a new, lower-cost busi- ness model consistent with the realities of a digital business. The reality of digital businesses is thinner margins—we must continue to move to the business model appropriate for that reality.” His main ob- jectives were to reduce operating facilities by 33%, divest redundant operations, and reduce its work- force by another 20%. In 2004, Kodak ended all its traditional camera and film activities except for advanced 35mm film, it allowed Vivitar to make

film cameras using its name, but in 2007 that agree- ment ended. Kodak also implemented SAP’s ERP system to link all segments of its value-chain activi- ties together and to its suppliers to reduce costs after benchmarking its competitors showed it had a much higher cost of goods sold. Using ERP, Kodak’s goal was to reduce costs from 19% to 14% by 2007 and, therefore, increase profit margins.

From 2004–2007 Perez laid off 25,000 more employees, shut down and sold operating units, and moved to a more centralized structure. All 4 heads of Kodak’s main operating groups report directly to Perez. In 2006, Kodak also signed a deal with Flex- tronics, a Singapore-based outsourcing company, to make its cameras and inkjet printers that allowed it to close its own manufacturing operations. The costs of this transformation were huge. Kodak lost $900 million in 2004, $1.1 billion in 2005, and $1.6 billion in 2006. Because of its transformation, and the high costs involved in terminating employees while investing in new digital technology its 2006 ROIC was a negative 20% compared to its main dig- ital rival, Canon, that enjoyed a positive 14% ROIC!

Kodak’s Increasing Problems, 2007 Kodak’s revenues and profits were falling fast, but in its 3 primary digital business groups—consumer imaging, business graphics, and health imaging— Perez continued his push to develop innovative new products. The goals was to reduce costs in its declin- ing film division that still enjoyed much higher profit margins than its digital business groups! Kodak had to increase profit margins in all its digital divisions if it was to survive.

The Medical Imaging Group By 2006, the costs of research and marketing digi- tal products in its consumer and commercial units was putting intense pressure on the company’s resources—and Kodak still had to invest large amounts of capital to develop a lasting competitive advantage in its medical imaging unit. Here, too, in the 2000s, Kodak had made many strategic ac- quisitions to strengthen its competitive advantage in several areas of medical imaging such as digital mammography and advanced X-rays. It had devel- oped one of the top 5 medical imaging groups in the world. However, in May 2006, Kodak put its

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medical imaging unit up for sale. It realized that this unit required too much future investment if it was to succeed—and its consumer and commercial groups were not providing the profits necessary to fund this investment. In addition, although the medical unit accounted for nearly 1/5 of Kodak’s overall sales in 2005, its operating profit plunged 21% as profit margins fell because of increased competition from major rivals such as GE. In 2007, Kodak announced that it had sold its medical imaging unit to the Onex Corp., Canada’s biggest buyout firm, for $2.35 bil- lion. By selling its health imaging unit, Kodak cut an- other 27,000 jobs, and its global workforce was now under 50,000 from a peak of 145,300 in 1988. Once again Perez said, “We now plan to focus our atten- tion on the significant digital growth opportunities within our businesses in consumer and professional imaging and graphic communications.”

Developments in the Consumer Imaging Group In the consumer group, improving its digital imag- ing products and services was still the heart of Perez’ business model for Kodak; he was determined to make Kodak the leader in digital processing and printing. Perez focused on developing improved digi- tal cameras, inkjet printers, and photofinishing soft- ware and services.

Advanced Digital Cameras Perez pushed designers to continuously innovate new and improved models several times a year to increase profit margins and keep its lead over competitors. It was the market leader in the United States by 2005 in digital camera sales, and total sales and revenues increased sharply. However, by 2006, Kodak’s pros- pects deteriorated as the growth in sales of its digital cameras came to a standstill because of increasing price competition. Now, many new companies like Samsung were making digital cameras that had become a commodity product and profit margins plunged for all digital camera makers. Nevertheless, in 2006, the company brought out new digital cam- eras products such as its first dual-lens camera, and cameras with Wi-Fi that could connect wirelessly to PCs to download and print photographs, and it used these innovations to once again raise prices. Kodak also entered the growing digital photo-frame market

in 2007 introducing 4 new EasyShare-branded mod- els in sizes from 8 to 11, some of which included multiple memory card slots and even Wi-Fi capabil- ity to connect with Kodak’s cameras.

Since 2007, however, Kodak has been forced to cut the prices of its digital cameras to compete with Canon and Sony, U.S. customers had lost faith that its EasyShare models offered the best value and so Kodak’s profits from the sales of its cameras con- tinued to decline. At the same time, increasing digi- tal camera sales led to a major decline in sales of its film products. In 1999, Kodak announced that it was ending production of its consumer film products and its “yellow boxes” disappeared from sight as it sought to cut costs. In sum, its camera business of- fered little prospect of being able to raise its future profitability.

New Inkjet Printers A major change in strategy occurred when Perez launched an advertising campaign to promote its new Kodak EasyShare all-in-one inkjet printers. This new line of color digital printers used an advanced Kodak ink that would provide brighter pictures that would keep their clarity for decades. Apparently Perez, who had been in charge of HP’s printer busi- ness before he left Kodak had all along made the development of digital printers a major part of his turnaround strategy—despite that profit margins were shrinking on these products as well. However, Perez’ printer strategy was based upon charging a higher price for the printer than competitors like HP and Lexmark, but a much lower price for the ink cartridge to attract a bigger market share—a ra- zor and razor blades strategy. Black ink cartridges would cost $9.99 and color $14.99, which will aver- age out to about $0.10 per print—far lower than the $0.20–$0.25 per print using a HP printer. Perez believed this would attract the large market seg- ment that still wanted to print out large numbers of photographs, and so would make this product a multibillion revenue generator in the future, Perez announced he expected inkjet printing to result in double digit increases in profit within 3 years.

Kodak’s new printers did attract a lot of cus- tomers who were alienated by the high costs of ink cartridges, however, as online photo processing and storage solutions became more and more popular, and new mobile devices made it increasingly easy

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to access photos from the net—on iPods, iPads, and smartphones in general, users had less and less incentive to burden themselves with paper-based photo albums. Nevertheless, its new printers did help increase revenues and profits although they never achieved the gains Perez anticipated. In 2009, it announced its new line of ESP all-in-one digital printers that still used all its EasyShare technology to help users print and share their photographs. Kodak’s new printers were popular and helped to increase revenues and profits. For example, in 2010–2011, sales increased by over 40% but this was still not enough to make up for declines in rev- enues elsewhere in digital imaging.

Digital Photofinishing Another part of Perez’ con- sumer strategy was to invest in developing both on- line, and physical “digital kiosks,” channels to allow customers to download, process, print, and store their photographs using its EasyShare software. Kodak’s EasyShare Internet service would allow customers to download their images to its online Website, Kodak Gallery, and receive back both printed photographs and the images on a CD.

In a major effort to develop an empire of digi- tal processing kiosks, Kodak began to rapidly in- stall them in stores, pharmacies, and other outlets as fast as possible, especially because they used its inks and paper. It configured these kiosks to give customers total control over which pictures to de- velop at what quantity, quality, and size. Kodak and Walmart signed an alliance to put 2,000 kiosks into 1,000 Walmart stores, and by 2006, Kodak had over 65,000 kiosks. However, this was an expensive busi- ness to operate and profit margins were razor thin as competition increased.

These moves proved popular because it was easy to use and photofinishing revenues increased as it built a base of 30 million customers. But profit margins were slim because competition increased and many other free online programs were being introduced, such as Goggle’s Picasa. Between July 2010 and July 2011, profits dropped from $36 mil- lion to $2 million and did nothing to help Kodak’s bottom line.

Kodak also made major attempts to penetrate the mobile imaging market because of the huge growth in the use of cameras in mobile phones in the 2000s. The Kodak Mobile Imaging Service offered camera phone users several options to view, order,

and share prints of all the digital photos on their phones. Users could upload and store pictures from their cameras in their personal Kodak gallery ac- counts; then after editing using Kodak’s free EasyS- hare software, they could send their favorite photos back to their mobile phones or wirelessly link to its picture Kiosks to arrange to print the best photo- graphs. Kodak also joined up with social media sites like Facebook and Picasa (now linked to Google+), to easily download photos to members of their so- cial community’s pages. It has, of course, also devel- oped applications for the Apple iOS, BlackBerry OS and Android OS mobile operating systems to make it easy for users to connect their Kodak EasyShare pictures to the kind of mobile computing device they are using. Kodak benefits from revenues re- ceived when mobile customers take advantage of its processing and printing services while they upload and share photographs. For example, any user can request a paper copy, or enlargement of a particular photograph or a series of photos contained in an album. Kodak Kiosks also allows users to upload pictures wirelessly through Bluetooth; customers can beam photos directly to the kiosk from mobile device to get Kodak prints and more. One problem, however, was that increasing sales of powerful cam- eras in smartphones led to a major decline in the number of customers who intended to upgrade to a more advanced digital camera—smartphones were cannibalizing sales of digital cameras. In addition, this has not proved to be an important source of additional revenues, its greater market share has not translated into higher profits. By 2010, there was intense competition in all areas of the digital imag- ing and information markets, including PCs, smart- phones, MP3 Players and gaming consoles, as more and more people were online and became used to the Web as the place to process and store their docu- ments in different forms—written, graphic, photo- graphic, video, music or movies. Although Kodak had achieved a presence in the consumer digital imaging and storage market segment, it still could not generate the profits needed to offset its losses resulting from the rapid decline of its cash-cow film business—and in its other business areas.

In fact, in July 2011, it announced major de- creases in profits and sales across many of its prod- uct groups. Sales of cameras were down by 8%; revenues from its photofinishing operations were down 14%; sales of ink and inkjet printers had

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increased by over 40%, a bright spot, but neverthe- less overall sales had decreased by 10% compared to the previous year and the group had lost $92 million.

The Graphic Communications Group Although its consumer digital business was its most visible business group, by 2007 Perez, had recog- nized that its graphic communications group that had dealt with business customers also offered an opportunity to grow revenues and profits—if it could develop distinctive competencies. Profit margins are much higher in commercial imaging and packaging because the users of these products are companies with large budgets. The 5 primary customer groups served by this division are commercial printers, in- plant printers, data centers, digital service providers, and packaging companies. For each of these seg- ments, Kodak developed a suite of digital products and services that offered customers a single end-to- end solution to deliver the products and services they needed to compete in their business. Kodak was able to develop this end-to-end solution because of its ac- quisition of specialist digital printing companies such as KPG, CREO, Versamark, and Express. From each acquisition, Kodak gained access to more products and more customers along with more services and solutions to offer them. Perez claimed that no other competitor could offer the same breadth of products and solutions that it could offer. Kodak’s product line included image scanners and document manage- ment systems, and the industry’s leading portfolio of digital proofing solutions and state-of-the-art color packaging solutions that can be customized to the needs of different customers—whether they need cardboard boxes, or rigid or flexible cardboard or plastic packaging.

Following his decision to make Kodak a major competitor in consumer inkjet printing, because of his HP printing background, Perez also decided to make it a major player in commercial printing as well—bringing into direct competition with HP, Xe- rox, and Canon by 2009. Kodak had developed an award-winning wide-format inkjet printing process including the most robust toner-based platforms for 4-color and monochrome printing. Kodak also claimed to have the leading continuous inkjet tech- nology for high-speed, high-volume printing, as well as imprinting capabilities that could be combined with traditional offset printing for those customers

still in the process of making the transition to digital printing.

At the same time, he decided to invest resources to improve Kodak’s packaging solutions to utilize its expertise in color processing and he made pack- ing another avenue to increase revenues and profits. Kodak then announced in July 2011 that second- quarter sales from this group were $685 million, similar to the previous year; however, this group also lost $45 (compared $17 million in the same quarter a year ago) because of the enormous development and marketing costs necessary to support growth in its commercial inkjet operations.

Will Kodak Survive? In January 2009, Kodak posted a $137 million loss and announced plans to cut 4,500 jobs that de- creased its workforce to about 18,000, and in June 2009, it announced it would retire its Kodachrome film—the main source of its incredible past financial success. In fact, its losses have been increasing in the last 5 years, but the extent of these losses had been disguised because of the way the company had sold many of its assets to reduce its losses and engaged in patent battles. For example, in 2007, it sold its Light Management Film Group to Rohm & Hass, and in 209 it sold its Organic Light-Emitting Diode (OLED) business unit to LG Electronics, both were advanced LED flatscreen technologies that it could no longer afford to invest in—but brought in a few hundred million dollars.

Then, to find new sources of revenue to offset losses, Kodak launched a series of lawsuits against other electronic companies, claiming that they had infringed on the huge library of digital patents that it had generated over the years. In 2008, Kodak se- lected its first targets, Samsung and LEG, which it claimed had used its technology in the cameras in their mobile phones. A U.S. judge decided in 2009 that these companies had infringed on its patents, but they decided not to appeal. Kodak announced it would settle out of court and develop cross-license agreements with these companies and it is estimated that Kodak received over $900 million from these settlements.

Emboldened by its success, Kodak decided to take on Apple and Research In Motion (RIM) in March 2010. The Kodak complaint, filed with the U.S. International Trade Commission (ITC) claimed

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that Apple’s iPhone and RIM’s camera-enabled BlackBerrys infringed upon a Kodak patent that cov- ered technology related to a method for previewing images. At the end of March, the ITC ruled in favor of Kodak; it seemed to have won its patent dispute with Apple and RIM, a victory that might provide it with $1 billion in new licensing revenue. Overnight Kodak’s stock soared by 25%. Then, Apple filed a countersuit, and in April 2011, Kodak sold it Mi- crofilm Unit to raise the millions needed to fund its lawsuits. In June 2011, the ITC, under a new judge issued a mixed ruling and announced the final de- cision would not be made until August 2011—and Kodak’s stock plunged 25%. Then, in August 2011 Kodak’s stock price soared by 25% after it seemed that it would get protection for its patents. However, in late 2011 its stock plunged again as the value of its patent portfolio became unclear and investors once again fled.

Perez continued to claim he would use the proceeds from intellectual property licensing to continue to invest in the company’s now core growth businesses— inkjet printing, packaging and software and services—in order to counter falling revenue from camera film. However, since 2007, Kodak’s stock had steadily plunged from $24 to around $1.25 in November 2011. It seemed that Perez’ strategies have done little or nothing to turnaround Kodak, which had a mar- ket value of only around $300 million in November 2011. Some analysts claimed the only reason the com- pany had not been acquired for this low price was that it had $2.6 billion in unfunded pension obliga- tions because of its huge layoffs over the last decade. Given that Kodak announced it would have to incur more debt—unless it could sell its portfolio of patents profitably—by November 2011 many analysts won- dered how the company would survive beyond 2012— and what would finally push it into bankruptcy.

Endnotes

www.kodak.com, Annual reports, 1980–2011. www.kodak.com, 10K reports, 1980–2011.

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CASE 29 Boeing Commercial Aircraft in 2011

Introduction The first decade of the 20th century was one of ups and downs for Boeing Commercial Airplane, the commercial aircraft division of the world’s largest aerospace company. In the late-1990s and early-2000s, Boeing had struggled with a number of ethics scandals and production problems that had tarnished the reputation of the company and led to sub-par financial performance. To make ma- ters worse, its global rival, Airbus, had been gaining market share. Between 2001 and 2005, the Euro- pean company regularly garnered more new orders than Boeing.

The tide started to turn Boeing’s way in 2003, when it formally launched its next generation jet, the 787. Built largely out of carbon-fiber composites, the wide-bodied 787 was billed as the most fuel-efficient large jetliner in the world. The 787 was forecasted to consume 20% less fuel than Boeing’s older wide- bodied jet, the 767. By 2006, the 787 was logging significant orders. This, together with strong interest in Boeing’s best-selling narrow bodied jet, the 737, helped the company to recapture the lead in new commercial jet aircraft orders. Moreover, in 2006 Boeing’s rival, Airbus, was struggling with significant production problems and weak orders for its new aircraft, the A380 super-jumbo. Airbus was also late to market with a rival for the 787, the wide-bodied Airbus A350, which would also be built largely out of carbon-fiber. While the 787 was scheduled to en- ter service in 2008, the A350 would not appear until 2012, giving Boeing a significant lead.

Over the next few years, Boeing encountered a number of production problems and technical design issues with the 787 that resulted in the in- troduction of the 787 being delayed 5 times. The 787 is now scheduled to enter service in late-2011,

more than 3 years later than planned. Despite this, Boeing has a very healthy backlog for the 787, with 827 jets ordered as of mid-2011, compared to 567 for the rival A350. Airbus has also encoun- tered some production problems of its own with the A350, and delivery of that aircraft model has now slipped into 2013.

Looking forward, Boeing now has some im- portant decisions to make regarding its venerable narrow-bodied 737 aircraft family, which accounts for some 60% of Boeing’s total aircraft deliveries. The main competitor for the 737 has long been Air- bus’ A320. In late-2010, Airbus announced that it would build a new version of the A320, designed to use advanced engines from Pratt & Whitney, and es- timated to be 10–15% more efficient than existing engines. Know as the A320NEO (NEO stands for “new engine option”), by August 2011, the aircraft had garnered an impressive 1,029 orders. Airbus’ success here forced Boeing’s hand. Boeing, too, has stated that they will offer a version of the 737 using new engines (this will require some redesign of the 737, driving up Boeing’s R&D costs). However, the company still must decide whether to totally rede- sign the 737, taking advantage of knowledge gained during the process of developing the 787, to build an all-new 737 out of composites that would also be designed with more efficient engines.

To complicate matters, for the first time in a generation there are several new entrants on the horizon. The Canadian regional jet manu- facturer, Bombardier, is starting to gain orders for the 110–130 seat narrow bodied CSeries jet, which would place it in direct competition with the smallest of the 737 and A320 families. In ad- dition, the Commercial Aircraft Corporation of China (Comac) has announced that it will build a 170–190 seat narrow-bodied jet.

Charles W.L. Hill University of Washington

C389

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(EADS), formed by a merger between French, German and Spanish interests, acquired 80% of the shares in EADS, and BAE Systems, a British com- pany, took a 20% stake.

Development and Production The economics of development and production in the industry are characterized by a number of facts. First, the R&D and tooling costs associated with developing a new airliner are very high. Boe- ing spent some $5 billion to develop the 777. Its lat- est aircraft, the 787, was initially expected to cost $8 billion to develop, but delays have increased that to at least $12 billion. Development costs for Airbus’ A380 super-jumbo reportedly exceeded $15 billion.

Second, given the high upfront costs, in order to break even a company must capture a significant share of projected world demand. The breakeven point for the Airbus super-jumbo, for example, is estimated to be between 250 and 270 aircraft. Esti- mates of the total potential market for this aircraft vary widely. Boeing has suggested that the total world market will be for no more than 320 aircraft over the next 20 years—Airbus believes that there will be demand for some 1,250 aircraft of this size. It may take 5–10 years of production before Airbus breaks even on the A380–on top of years of negative cash flow during development.3

Third, there are significant learning effects in air- craft production.4 On average, unit costs fall by about 20% each time cumulative output of a specific model is doubled. The phenomenon occurs because managers and shop floor workers learn over time how to assem- ble a particular model of plane more efficiently, reduc- ing assembly time, boosting productivity, and lowering the marginal costs of producing subsequent aircraft.

Fourth, the assembly of aircraft is an enormously complex process. Modern planes have over 1 million component parts that have to be designed to fit with each other, and then produced and brought together at the right time in order to assemble the engine. At several times in the history of the industry, problems with the supply of critical components have held up production schedules and resulted in losses. In 1997, Boeing took a charge of $1.6 billion against earn- ings when it had to halt the production of its 737 and 747 models due to a lack of component parts. In 2008, Boeing had to delay production of the 787 due to a shortage of fasteners.

The Competitive Environment By the 2000s, the market for large commercial jet aircraft was dominated by just two companies, Boeing and Airbus. A third player in the industry, McDonnell Douglas, had been historically signifi- cant, but had lost share during the 1980s and 1990s. In 1997, Boeing acquired McDonnell Douglas, pri- marily for its strong military business, because in the mid-1990s Airbus has been gaining orders at Boeing’s expense. By the mid-2000s, Boeing and Airbus were splitting the market.

Both Boeing and Airbus have a full range of air- craft. Boeing offers 5 aircraft “families” that range in size from 100 to over 500 seats. They are the narrow bodied 737 and the wide bodied 747, 767, 777 and 787 families. Each family comes in various forms. For example, there are currently 4 main variants of the 737 aircraft. They vary in size from 110 to 215 seats, and in range from 2,000 to over 5,000 miles. List prices vary from $47 million for the smallest member of the 737 family, the 737–600, to $282 million for the larg- est Boeing aircraft, the 747–8. The newest member of the Boeing family, the 787, lists for between $138 mil- lion and $188 million depending upon the model.1

Similarly, Airbus offers 5 “families,” the narrow bodied A320 family, and the wide bodied A300/310, A330/340, A350 and A380 families. These aircraft vary in size from 100 to 550 seats. The range of list prices is similar to Boeing’s. The A380 super-jumbo lists for between $282 million to $302 million, while the smaller A320 lists for between $62 million and $66.5 million.2 Both companies also offer freighter versions of their wide bodied aircraft.

Airbus was a relatively recent entrant into the market. Airbus began its life as a consortium be- tween a French company and Germany company in 1970. Later, a British and Spanish company joined the consortium. Initially, few people gave Airbus much chance for success, but the consortium gained ground by innovating. It was the first aircraft maker to build planes that “flew by wire,” made extensive use of composites, had only two flight crew members (most had three), and used a common cockpit layout across models. It also gained sales by being the first company to offer a wide bodied twin-engine jet, the A300, that was positioned between smaller single aisle planes like the 737 and large aircraft such as the Boeing 747.

In 2001, Airbus became a fully integrated com- pany. The European Defense and Space Company

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Finally, all new aircraft are now designed digi- tally, and assembled virtually before a single compo- nent is produced. Boeing was the first to do this with its 777 in the early-1990s, and with its new version of the 737 in the late-1990s.

Customers Demand for commercial jet aircraft is very volatile and tends to reflect the financial health of the com- mercial airline industry, which is prone to boom and bust cycles (see Exhibits 1, 2 and 3). The airline industry has long been characterized by excess ca- pacity, intense price competition, and a perception

Historically, airline manufacturers tried to man- age the supply process through vertical integration, by making many of the component parts that went into an aircraft (engines were long the exception to this). Over the last two decades, however, there has been a trend to contract out production of compo- nents and even entire sub-assemblies to indepen- dent suppliers. On the 777, for example, Boeing outsourced about 65% of the aircraft production, by value, excluding the engines.5 While helping to reduce costs, contracting out has placed enormous onus on airline manufacturers to work closely with its suppliers to coordinate the entire production process.

1600

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0

$ b

il li o

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Exhibit 1 Commercial Aircraft Orders 1990–2010

Exhibit 2 World Airline Industry Revenues

Source: Boeing and Airbus Websites http://www.boeing.com/ http://www.airbus.com/

Source: IATA Data.

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the recession that was ushered in by the 2008–2009 global financial crisis. High fuel prices during much of the decade made matters worse (prices for jet fuel more than doubled between 2004 and 2006—see Exhibit 4). The bill for jet fuel represented over 25% of the industry’s total operating costs in 2006, com- pared to less than 10% in 2001.7

During the 2001–2005 period, losses were par- ticularly severe among the big six airlines in the world’s largest market, the United States (American Airlines, United, Delta, Continental, US Airways and Northwest). Three of these airlines (United, Delta and Northwest) were forced to seek Chapter 11

among the travelling public that airline travel is a commodity. After a moderate boom during the 1990s, the airline industry went through a nasty downturn during 2001–2005. The downturn started in early-2001 due to a slowdown in business travel after the boom of the 1990s. It was compounded by a dramatic slump in airline travel after the terrorist attacks on the United States in September of 2001. Between 2001 and 2005, the entire global airline in- dustry lost some $40 billion, more money than it had made since its inception.6

The industry recovered in 2006 and 2007, only to rack up big losses again in 2008 and 2009 due to

–5

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Exhibit 3 World Airline Industry Net Profit ($ billions) 2001–2010

Exhibit 4 Jet Fuel Prices July 2001–June 2011

Source: IATA Data.

Source: www.iata.org

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by their superior in flight service. In good times, the network carriers can recoup their costs by charging higher prices than the discount airlines, particularly for business travelers, who pay more to book late, and to fly business or first class. In the competitive environment of the 2000s, however, this was no longer the case. Between 2000 and 2010, the price of an average round trip domestic ticket in the U.S. increased from $317 to $338, an increase of 6.7% over the decade, while the consumer price index in- creased 26.6% (i.e. in real terms prices fell).9

Due to the effect of increased competition, the real yield that U.S. airlines got from passengers fell from $0.087 cents per mile in 1980 to 6.37 cents per mile in 1990, $0.0512 cents per mile in 2000, and $0.04 cents per mile in 2005 (these figures are expressed in constant 1978 cents).10 Real yields are also declining elsewhere. With real yields declining, the only way that airlines can become profitable is to reduce their operating costs.

Outside of the United States, competition has in- tensified as deregulation has allowed low cost air- lines to enter local markets and capture share from long established national airlines that have utilized the hub and spoke model. In Europe, for example, Ryanair and easyJet have adopted the business model of Southwest, and used it to grow aggressively.

By the mid-2000s, large airlines in the U.S. were starting to improve their operating efficiency, helped by growing traffic volumes, higher load factors and reductions in operating costs, particularly labor costs. Load factors refers to the percentage of a plane that is full on average, which hit a record 86% in mid-2006 in the United States, and 81% in interna- tional markets. Load factors have remained reason- ably high since then, moving between 75% and 85% on a monthly basis between 2006 and 2010.

Demand Projections Both Boeing and Airbus issue annual projects of likely future demand for commercial jet aircraft. These projections are based upon assumptions about future global economic growth, the resulting growth in demand for air travel, and the financial health of the world’s airlines.

In its 2011 report, Boeing assumed that the world economy would grow by 3.3% per annum over the next 20 years, which should generate growth in pas- senger traffic of 5.1% per annum, and growth in

bankruptcy protections. Despite that demand and profits plummeted at the big six airlines, some car- riers continued to make profits during 2001–2005, most notably the budget airline Southwest. In addi- tion, other newer budget airlines including AirTran and JetBlue (which was started in 2000), gained market share during this period. Indeed, between 2000 and 2003, the budget airlines in the United States expanded capacity by 44% even as the majors slashed their carrying capacity and parked unused planes in the desert. In 1998, the budget airlines held a 16% share of U.S. market; by mid-2004 their share had risen to 29%.8

The key to the success of the budget airlines is a strategy which gives them a 30–50% cost advan- tage over traditional airlines. The budget airlines all follow the same basic script–they purchase just one type of aircraft (some standardize on Boeing 737s, others on Airbus 320s). They hire nonunion labor and cross-train employees to perform multiple jobs (e.g. to help meet turnaround times, the pilots might help check tickets at the gate). As a result of flexible work rules, Southwest needs only 80 employees to support and fly an aircraft, compared to 115 at the big six airlines. The budget airlines also favor flying “point-to-point,” rather than through hubs, and of- ten use cheap secondary airports, rather than major hubs. They focus on large markets with lots of traffic (e.g. up and down the East coast). There are no frills on the flights, no in flight meals . and prices are set low to fill up seats.

In contrast, the operations of major airlines are based on the network or “hub and spoke” system. Under this system, the network airlines route their flights through major hubs. Often, a single airline will dominate a hub (for example, United dominates Chicago’s O’Hare airport). This system was devel- oped for good reason—it was a way of efficiently using airline capacity when there wasn’t enough de- mand to fill a plane flying point-to-point. By using a hub and spoke system, the major network airlines have been able to serve some 38,000 city pairs, some of which generate fewer than 50 passengers per day. But by focusing a few hundred city pairs where there is sufficient demand to fill their planes, and flying directly between them (point-to-point) the bud- get airlines seem to have found a way around this constraint. The network carriers also suffer from a higher cost structure due to their legacy of a union- ized workforce. In addition, their costs are higher

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robust demand for very large aircraft, and particu- larly its A380 offering.

Boeing has a different view of the future. The company has theorized that hubs will become in- creasingly congested, and that many travelers will seek to avoid them. Boeing thinks that passengers prefer frequent nonstop service between the cities they wish to visit. Boeing also sees growth in travel between city pairs as being large enough to support an increasing number of direct long-haul flights. The company notes that continued liberalization of regu- lations governing airline routes around the world will allow for the establishment of more direct flights between city pairs. As in the United States, the com- pany believes that long haul low-cost airlines that fo- cus on serving city pairs and avoid hubs will emerge.

In sum, Boeing believes that airline travelers will demand more frequent nonstop flights, not larger aircraft.13 To support this, the company has data showing that all of the growth in airline travel since 1995 has been met by the introduction of new non- stop flights between city pairs, and by an increased frequency of flights between city pairs, and not by an increase in airplane size. For example, Boeing notes that following the introduction of the 767, airlines introduced more flights between city pairs in North America and Europe, and more frequent departures. In 1984, 63% of all flights across the North Atlantic were in the 747. By 2004, the figure had declined to 13%, with smaller wide bodied aircraft such as the 767 and 777 dominating traffic. Following the intro- duction of the 777, which can fly nonstop across the Pacific, and is smaller than the 747, the same process occurred in the North Pacific. In 2006, there were 72 daily flights serving 26 city pairs in North America and Asia.

Boeing’s History14

William Boeing established the Boeing Company in 1916 in Seattle. In the early-1950s, Boeing took an enormous gamble when it decided to build a large jet aircraft that could be sold both to the military as a tanker, and to commercial airlines as a passen- ger plane. Known as the “Dash 80,” the plane had swept back wings and 4 jet engines. Boeing invested $16 million to develop the Dash 80, 2/3 of the com- pany’s entire profits during the post war years. The Dash 80 was the basis for 2 aircraft—the KC-135

cargo traffic of 5.6% per year. On this basis, Boeing forecast demand for some 33,500 new aircraft val- ued at more than $4 trillion over the next 20 years. Of this, some 15,370 aircraft will be replacement for aircraft retired from service, and the remaining air- craft will satisfy an expanded market. In 2030, Boe- ing estimates that the total global fleet of aircraft will be 39,530 up from 17,330 in 2005. Boeing believes that North America will account for 22% of all new orders, Asia Pacific for 34% and Europe for 23%. Passenger traffic is projected to grow at 7% per an- num in Asia, versus 2.3% in North America and 4% in Europe.11

Regarding the mix of orders, Boeing believes that 70% of all orders by units will be for narrow bodied aircraft such as the 737 and A320, 22% will be for wide-bodied twin aisle jets such as the 787 and 747, and 3% for large aircraft such as the 747 and A380.

The latest Airbus forecast covers 2010–2029. Over that period, Airbus forecasts world passenger traffic to grow by 4.8% per annum, and predicts demand for 25,850 new aircraft worth $3.2 tril- lion. (Note that Airbus excludes regional jets from its forecast, there are some 2,000 regional jet deliv- eries included in Boeing’s forecasts). Airbus believes that demand for very large aircraft will be robust, amounting to 1,740 large passenger aircraft and freighters in the 747 range and above, or 18% of the total value of aircraft delivered.12

The difference in the mix of orders projected by Boeing and Airbus reflect different views of how fu- ture demand will evolve. Airbus believes that hubs will continue to play an important role in airline travel, particularly international travel, and that very large jets will be required to transport people between hubs. Airbus bases this assumption partly on an analysis of data over the last 20 years, which shows that traffic between major airline hubs has grown faster than traffic between other city pairs. Airbus also assumes that urban concentrations will continue to grow. Airbus states that demand is simply a function of where people want to go, and most people want to travel between major ur- ban centers. The company notes, for example, that 90% of travelers from the United States to China go to 3 major cities. Fifty other cities make up the remaining 10%, and Airbus believes that very few of these cities will have demand large enough to justify a nonstop service from North America or Europe. Based on this assumption, Airbus sees

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sold nearly 1,430 747s, and was actively selling its latest version of the 747 family, the 747–8 which was scheduled to enter service in 2008.

By the mid-1970s Boeing was beyond the break even point on all of its models (707, 727, 737 and 747). The positive cash flow helped to fund invest- ment in two new aircraft, the narrow bodied 757 and the wide bodied 767. The 757 was designed as a replacement to the aging 727, while the 767 was a response to a similar aircraft from Airbus. These were the first Boeing aircraft to be designed with two person cockpits, rather than three. Indeed, the cockpit layout was identical, allowing crew to shift from one aircraft to the other. The 767 was also the first aircraft for which Boeing subcontracted a sig- nificant amount of work to a trio of three Japanese manufacturers—Mitsubishi, Kawasaki, and Fuji— who supplied about 15% of the airframe. Intro- duced in 1981, both aircraft were successful. Some 1049 757s were sold during the life of the program (which ended in 2003). By 2006, over 950 767s had been sold, and the program was still ongoing.

The next Boeing plane was the 777. A two-engine wide bodied aircraft with seating capacity of up to 400 and a range of almost 8,000 miles, the 777, was initiated in 1990. The 777 was seen as a response to Airbus’ successful A330 and A340 wide bodied aircraft. Development costs were estimated at some $5 billion. The 777 was the first wide bodied long- haul jet to have only two engines. It was also the first to be designed entirely on computer. To develop the 777, for the first time Boeing used cross- functional teams composed of engineering and production em- ployees. It also bought major suppliers and custom- ers into the development process. As with the 767, a significant amount of work was outsourced to foreign manufacturers including the Japanese trio of Mitsubishi, Kawasaki, and Fuji who supplied 20% of the 777 airframe. In total, some 60% of parts for the 777 were outsourced. The 777 proved to be an- other successful venture—by mid-2006, 850 777s had been ordered, far greater than the 200 or so re- quired to break even.

In December 1996, Boeing stunned the aerospace industry by announcing it would merge with long- time rival McDonnell Douglas in a deal estimated to be worth $13.3 billion. The merger was driven by Boeing’s desire to strengthen its presence in the defense and space side of the aerospace business, ar- eas in which McDonnell Douglas was traditionally

Air Force tanker and the Boeing 707. Introduced into service in 1957, the 707 was the world’s first commercially successful passenger jet aircraft. Boe- ing went on to sell some 856 Boeing 707s along with 820 KC-135s. The final 707, a freighter, rolled off the production line in 1994 (production of passen- ger planes ended in 1978). The closest rival to the 707 was the Douglas DC8, of which some 556 were ultimately sold.

The 707 was followed by a number of other suc- cessful jetliners including the 727 (which entered service in 1962), the 737 (which entered service in 1967), and the 747 (which entered service in 1970). The single aisle 737 went on to become the work- horse of many airlines. In the 2000s, a completely re- designed version of the 737 that could seat between 110 and 180 passengers was still selling strong. Cu- mulative sales of the 737 totaled 6,500 by mid-2006, making it by far the most popular commercial jet aircraft ever sold.

It was the 747 “jumbo jet,” however, that prob- ably best defined Boeing. In 1966, when Boeing’s board made the decision to develop the 747, they were widely viewed as betting the entire company on the jet. The 747 was born out of the desire of Pan Am, then America’s largest airline, for a 400 seat passenger aircraft that could fly 5,000 miles. Pan Am believed that the aircraft would be ideal for the growing volume of trans-continental traffic. How- ever, beyond Pan Am, which committed to pur- chasing 25 aircraft, demand was very uncertain. Moreover, the estimated $400 million in develop- ment and tooling costs placed a heavy burden on Boeing’s financial resources. To make a return on its investment, the company estimated it would need to sell close to 400 aircraft. To complicate matters fur- ther, Boeing’s principal competitors, Lockheed and McDonnell Douglas, were each developing 250 seat jumbo jets.

Boeing’s big bet turned out to be auspicious. Pan Am’s competitors feared being left behind, and by the end of 1970, almost 200 orders for the aircraft had been placed. Successive models of the 747 extended the range of the aircraft. The 747–400, introduced in 1989, had a range of 8,000 miles and a maximum seating capacity of 550 (although most configura- tions seated around 400 passengers). By this time, both Douglas and Lockheed had exited the market giving Boeing a lucrative monopoly in the very large commercial jet category. By 2005, the company had

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catch up with out of sequence work, and wait for backordered parts to arrive. Ultimately, the company had to take a $1.6 billion charge against earnings to account for higher costs and penalties paid to air- lines for the late delivery of jets. As a result, Boeing made very little money out of its mid-1990s order boom. The head of Boeing’s commercial aerospace business was fired, and the company committed it- self to a major acceleration of its attempt to overhaul its production system, elements of which dated back half a century.

Boeing in the 2000s In the 2000s, 3 things dominated the development of Boeing Commercial Aerospace. First, the company accelerated a decade-long project aimed at improv- ing the company’s production methods by adopting the lean production systems initially developed by Toyota and applying them to the manufacture of large jet aircraft. Second, the company considered, and then rejected, the idea of building a successor to the 747. Third, Boeing decided to develop a new wide bodied long haul jetliner, the 787.

Lean Production at Boeing Boeing’s attempt to revolutionize the way planes could be built began in the early-1990s. Beginning in 1990, the company started to send teams of ex- ecutives to Japan to study the production systems of Japan’s leading manufacturers, particularly Toyota. Toyota had pioneered a new way of assembling au- tomobiles, known as lean production (in contrast to conventional mass production).

Toyota’s lean production system was developed by one of the company’s engineers, Ohno Taiichi.16 After working at Toyota for 5 years and visiting Ford’s U.S. plants, Ohno became convinced that the mass production philosophy for making cars was flawed. He saw numerous problems, including 3 major drawbacks. First, long production runs cre- ated massive inventories, which had to be stored in large warehouses. This was expensive because of the cost of warehousing and because inventories tied up capital in unproductive uses. Second, if the initial machine settings were wrong, long production runs resulted in the production of a large number of de- fects (that is, waste). And third, the mass production

strong. On the commercial side of the aerospace business, Douglas had been losing market share since the 1970s. By 1996, Douglas accounted for less than 10% of production in the large commercial jet air- craft market and only 3% of new orders placed that year. The dearth of new orders meant the long-term outlook for Douglas’s commercial business was in- creasingly murky. With or without the merger, many analysts felt that it was only a matter of time before McDonnell Douglas would be forced to exit from the commercial jet aircraft business. In their view, the merger with Boeing merely accelerated that process.

The merger transformed Boeing into a broad- based aerospace business within which commercial aerospace accounted for 40–60% of total revenue, depending upon the stage of the commercial pro- duction cycle. In 2001, for example, the commercial aircraft group accounted for $35 billion in revenues out of a corporate total of $58 billion, or 60%. In 2005, with the delivery cycle at a low point (but the order cycle rebounding), the commercial airplane group accounted for $22.7 billion out of a total of $54.8 billion, or 41%. A wide range of military air- craft, weapons and defense systems, and space sys- tems comprised the balance of their revenue.

In the early-2000s, in a highly symbolic act, Boe- ing moved its corporate headquarters from Seattle to Chicago. The move was an attempt to put some distance between top corporate officers and the commercial aerospace business, the headquarters of which remained in Seattle. The move was also in- tended to signal to the investment community that Boeing was far more than its commercial businesses.

To some extent, the move to Chicago may have been driven by a number of production missteps in the late-1990s that occurred at a time when the com- pany should have been enjoying financial success. During the mid-1990s orders had boomed as Boeing cut prices in an aggressive move to gain share from Airbus. However, delivering these aircraft meant that Boeing had to more than double its production schedule between 1996 and 1997. As it attempted to do this, the company ran into some server produc- tion bottlenecks.15 The company scrambled to hire and train some 41,000 workers, recruiting many from suppliers, a move it came to regret when many of the suppliers could not meet Boeing’s demands, and shipments of parts were delayed. In the Fall of 1997, things got so bad that Boeing shut down its 747 and 737 production lines so that workers could

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stills that produced alcohol that they sold for money. The Japanese took this philosophy back home with them, and applied it to industrial machinery—which is where Boeing executives saw the concept in opera- tion in the 1990s. With the help of Japanese consul- tants, they decided to apply the moonshine creative philosophy at Boeing—to produce new “right-sized” machines with very little money that could be used to make money.

The moonshine teams were trained in lean pro- duction techniques, given a small budget, and then set loose. Initially, many of the moonshine teams focused on redesigning equipment to produce parts. Underlying this choice was a Boeing study, which showed that more than 80% of the parts manufac- tured for aircraft are less than 12 inches long, and yet the metal working machinery is huge, inflex- ible, and could only economically produce parts in large lots.17

Soon, empowered moonshine teams were design- ing their own equipment—small-scale machines with wheels on that could be moved around the plant, and that took up little space. One team replaced a large stamping machine that cost 6-figures and was used to produce L-shaped metal parts in batches of 1,000 with a miniature stamping machine powered by a small hydraulic motor that could be wheeled around the plant. With the small machine, that cost a couple of thousand dollars, parts could be produced very quickly in small lots, eliminating the need for inven- tory. They also made a sanding machine and a parts cleaner of equal size. Now the entire process—from stamping the raw material to the finished part—is completed in minutes (instead of hours or days) just by configuring these machines into a small cell and having them serviced by a single person. The small scale and quick turnaround now made it possible to produce these parts just-in-time, eliminating the need to produce and store inventory.18

Another example of a moonshine innovation concerns the process for loading seats onto a plane during assembly. Historically, this was a cumber- some process. After the seats would arrive at Boeing from a supplier, wheels were attached to each seat, and then the seats were delivered to the factory floor in a large container. An overhead crane lifted the container up to the level of the aircraft door. Then, the seats were unloaded and rolled into the aircraft, before being installed. The process was repeated un- til all of the seats had been loaded. For a single aisle

system was unable to accommodate consumer pref- erences for product diversity.

In looking for ways to make shorter production runs economical, Ohno developed a number of tech- niques designed to reduce setup times for produc- tion equipment, a major source of fixed costs. By using a system of levers and pulleys, he was able to reduce the time required to change dies on stamp- ing equipment from a full day in 1950 to 3 minutes by 1971. This advance made small production runs economical, which allowed Toyota to respond bet- ter to consumer demands for product diversity. Small production runs also eliminated the need to hold large inventories, thereby reducing warehous- ing costs. Furthermore, small product runs and the lack of inventory meant that defective parts were produced only in small numbers and entered the as- sembly process immediately. This reduced waste and made it easier to trace defects to their source and fix the problem. In sum, Ohno’s innovations enabled Toyota to produce a more diverse product range at a lower unit cost than was possible with conventional mass production.

Impressed with what Toyota had done, in the mid-1990s, Boeing started to experiment with ap- plying Toyota-like lean production methods to the production of aircraft. Production at Boeing was formerly focused upon producing parts in high vol- umes, and then storing them in warehouses until they were ready to be used in the assembly process. After visiting Toyota, engineers realized that Boe- ing was drowning in inventory. A huge amount of space and capital was tied up in things that didn’t add value. Moreover, expensive specialized machines often took up a lot of space, and were frequently idle for long stretches of time.

Like Ohno at Toyota, the company engineers started to think about how they could modify equip- ment and processes at Boeing to reduce waste. Boe- ing set aside space and time for teams of creative plant employees—design engineers, maintenance technicians, electricians, machinists and operators— to start experimenting with machinery. They called these teams “moonshiners.” The term “moonshine” was coined by Japanese executives who visited the United States after World War II. They were im- pressed by two things in the U.S.—supermarkets, and the stills built by people in the Appalachian hills. They noticed that people built these stills with no money. They would use salvaged parts to make small

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wasted bringing parts to a stall, and moving a plane from one stall to the next.

In 2001, Boeing introduced a moving assembly line into its Renton plant near Seattle, which manu- factures the 737. With a moving line, each aircraft is attached to a “sled” that rides a magnetic strip embedded in the factory floor, pulling the aircraft at a rate of 2 inches per minute, moving past a series of stations where tools and parts arrive at the mo- ment need, allowing workers to install the proper assemblies. The setup can eliminate wandering for tools and parts, as well as expensive tug pulls or crane lifts (only having tools delivered to worksta- tions, rather than having workers fetch them, was found to save 20–45 minutes on every shift). Preas- sembly tasks can be performed on feeder lines. For example, inboard and outboard flaps can be assem- bled on the wing before it will arrive for joining to the fuselage.22

Like a Toyota assembly line, the moving line can be stopped if a problem arises. Lights indicate the state of the line. A green light will indicate a normal work flow, the first sign of a stoppage brings a yellow warning light, and if the problem isn’t solved within 15 minutes, a purple light will indicate that the line has stopped. Each work area and feeder line has will require its own lights, so there is no doubt where the problem may occur.23

The cumulative effects of these process innova- tions have been significant. By 2005, assembly time for the 737 had been cut from 22 days to just 11 days. In addition, work in process inventory had been re- duced by 55% and stored inventory by 59%.24 By 2006, all of Boeing’s production lines, except for the 747, had shifted from static bays to a moving line. The 747 is scheduled to shift to moving line when Boeing starts production of the 747–8.

The Super-Jumbo Decisions In the early-1990s Boeing and Airbus started to con- template new aircraft to replace Boeing’s aging 747. The success of the 747 had given Boeing a monop- oly in the market for very large jet aircraft, making the plane one of the most profitable in the jet age, but the basic design dated back to the 1960s, and some believed there might be sufficient demand for a super-jumbo aircraft with as many as 900 seats.

Initially, the two companies considered estab- lishing a joint venture to share the costs and risks

plane this could take 12 hours. For a wide bodied jet, it would take much longer. A moonshine team adapted a hay elevator to perform the same job. It cost a lot less, delivered seats quickly through the passenger door, and took just 2 hours, while elimi- nating the need for cranes.19

Multiply the examples given here, and soon there would be a very significant impact on pro- duction costs. A drill machine was built for 5% of the cost of a full scale machine from Ingersoll- Rand; portable routers were built for 0.2% of the cost of a large fixed router; one process that took 2,000 minutes for a 100 part order (20 minutes per part because of setup, machining and transit) now takes 100 minutes (one minute per part); employ- ees building 737 floor beams reduced labor hours by 74%, increased inventory turns from 2 to 18 per year, and reduced manufacturing space by 50%; employees building the 777 tail cut lead time by 70% and reduced space and work in progress by 50%; production of parts for landing gear support used to take 32 moves from machine to machine, and required 10 months—production now takes 3 moves and 25 days.20

In general, Boeing found that it was able to pro- duce smaller lots of parts economically, often from machines that it built itself, which were smaller and cost less than the machines available from outside vendors. In turn, these innovations enabled Boeing to switch to just-in-time inventory systems and re- duce waste. Boeing was also able to save on space. By eliminating large production machinery at its Au- burn facility, replacing much of it with smaller more flexible machines, Boeing was able to free up 1.3 mil- lion square feet of space, and sold 7 buildings.21

In addition to moonshine teams, Boeing also adopted other process improvement methodolo- gies, using them when deemed appropriate. Six Sigma quality improvement processes are widely used within Boeing. The most wide reaching process change, however, was the decision to switch from a static assembly line to a moving line. In traditional aircraft manufacture, planes are docked in angled stalls. Ramps surround each plane, and workers go in and out to find parts and install them. Moving a plane to the next work station was a complex pro- cess. The aircraft had to be lowered from its work station, a powered cart was brought in, the aircraft was towed to the next station, and then it was lifted again. This could take two shifts. A lot of time was

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of EADS, Airbus’ parent company, approved devel- opment of the plane, which was now dubbed the A380. Development costs at this point were pegged at $12 billion, and the plane was forecasted to enter service in 2006 with Singapore Airlines. The A380 would have 2 passenger decks, more space per seat and wider aisles. It would carry 555 passengers in great comfort, something that passengers would ap- preciate on long transoceanic flights. According to Airbus, the plane would carry up to 35% more pas- sengers than the most popular 747–400 configura- tion, yet cost per seat would be 15–20% lower due to operating efficiencies. Concerns were raised about turnaround time at airport gates for such a large plane, but Airbus stated that dual boarding bridges and wider aisles meant that turnaround times would be no more than those for the 747–400.

Airbus also stated that the A380 was also de- signed to operate on exiting runways and within existing gates. However, London’s Heathrow airport found that it had to spend some $450 million to ac- commodate the A380, widening taxiways and build- ing a baggage reclaim area for the plane. Similarly, 18 U.S. airports had reportedly spent some $1 bil- lion just to accommodate the A380.26

The 787 While Airbus pushed forward with the A380, in March 2001, Boeing announced the development of a radically new aircraft. Dubbed the sonic cruiser, the plane would carry 250 passengers 9,000 miles and fly just below the speed of sound, cutting 1 hour of transatlantic flights and 3 hours of transpacific flights. To keep down operating costs, the sonic cruiser would be built out of low weight carbon- fiber “composites.” Although the announcement cre- ated considerable interest in the aviation community, in the wake of the recession that hit the airline in- dustry after September 11, 2001, both Boeing and the airlines became considerably less enthusiastic. In March 2002, the program was cancelled. Instead, Boeing said that it would develop a more conven- tional aircraft using composite technology. The plane was initially known as the 7E7 with the “E” standing for “Efficient” (the plane was renamed the 787 in early-2005).

In April 2004, the 7E7 program was formally launched with an order for 50 aircraft worth $6 billion from All Nippon Airlines of Japan. It

associated with a developing a super-jumbo aircraft, but Boeing withdrew in 1995 citing costs and un- certain demand prospects. Airbus subsequently con- cluded that Boeing was never serious about the joint venture, and the discussions were nothing more than a ploy to keep Airbus from developing its own plane.25

After Boeing withdrew, Airbus started to talk about offering a competitor to the 747 in 1995. The plane, then dubbed the A3XX, was to be a super- jumbo with capacity for over 500 passengers. Indeed, Airbus stated that some versions of the plane might carry as many as 900 passengers. Airbus initially es- timated that there would be demand for some 1,400 planes of this size over 20 years, and that develop- ment costs would total around $9 billion (estimates ultimately increased to some $15 billion). Boeing’s latest 747 offering—the 747–400—could carry around 416 passengers in 3 classes.

Boeing responded by drafting plans to develop new versions of the 747 family. The 747–500X and the 747–600X. The 747–600X was to have a new (larger) wing, a fuselage almost 50 feet longer than the 747–400, would carry 550 passengers in 3 classes and have a range of 7,700 miles. The smaller 747–500X would have carried 460 passengers in 3 classes and had a range of 8,700 miles.

After taking a close look at the market for a super-jumbo replacement to the 747, in early-1997 Boeing announced that it would not proceed with the program. The reasons given for this decision included the limited market and high development costs, which at the time, were estimated to be $7 bil- lion. There were also fears that the wider wing span of the new planes would mean that airports would have to redesign some of their gates to take the aircraft. Boeing, McDonnell Douglas (prior to the merger with Boeing) and the major manufacturers of jet engines all forecast demand for about 500–750 such aircraft over the next 20 years. Airbus alone forecasts demand has high as 1,400 aircraft. Boe- ing stated that the fragmentation of the market due to the rise of “point-to-point” flights across oceans would limit demand for a super-jumbo. Instead of focusing on the super-jumbo category, Boeing stated that it would develop new versions of the 767 and 777 aircraft that could fly up to 9,000 miles and carry as many as 400 passengers.

Airbus, however, continued to push forward with planes to develop the A3XX. In December 2000, with more than 50 orders in hand, the board

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787, and in 2005 some 232 orders. Another 85 or- ders were booked in the first 9 months of 2006 for a running total of 373–well beyond break even point.

In December 2004, Airbus announced that it would develop a new model, the A350, to compete directly with the 787. The planes were to be long haul twin-aisle jets, seating 200–300 passengers, and constructed of composites. The order flow, how- ever, was slow, with airlines complaining that the A350 did not match the Boeing 787 on operating efficiency, range or passenger comfort. Airbus went back to the drawing board and in mid-2006, it an- nounced a new version of the A350, the A350 XWB for “Extra Wide Body.” Airbus estimated that the A350 XWB would cost $10 billion to develop and enter service in 2012, several years behind the 787. The two-engine A350 XWB will carry between 250 and 375 passengers and fly up to 8,500 miles. The largest versions of the A350 XWB will be competing directly with the Boeing 777, not the 787. Like the 787, the A350 XWB it will be built primarily of com- posite materials. The “Extra Wide Body” is designed to enhance passenger comfort. To finance the A350 XWB, Airbus stated that it would seek launch aid from Germany, France, Spain and the UK, all coun- tries where major parts of Airbus are based.30

Trade Tensions It is impossible to discuss the global aerospace indus- try without touching on trade issues. Over the last 3 decades, both Boeing and Airbus have charged that their competitor benefited unfairly from government subsidies. Until 2001, Airbus functioned as a consor- tium of 4 European aircraft manufacturers: one Brit- ish (20.0% ownership stake), one French (37.9% ownership), one German (37.9% ownership), and one Spanish (4.2% ownership). In the 1980s and early-1990s, Boeing maintained that subsidies from these nations allow Airbus to set unrealistically low prices, to offer concessions and attractive financing terms to airlines, to write off development costs, and to use state-owned airlines to obtain orders. Accord- ing to a study by the United States Department of Commerce, Airbus received more than $13.5 billion in government subsidies between 1970 and 1990 ($25.9 billion if commercial interest rates are ap- plied). Most of these subsidies were in the form of loans at below-market interest rates and tax breaks.

was the largest launch order in Boeing’s history. The 7E7 was a twin-aisle wide bodied, two-engine plane designed to carry 200–300 passengers up to 8,500 miles, making the 7E7 well suited for long haul point-to-point flights. The range exceeded all but the longest range plane in the 777 family, and the 7E7 could fly 750 miles more than Airbus’ clos- est competitor, the mid-sized A330–200. With a fuse- lage built entirely out of composites, the aircraft was lighter and would use 20% less fuel than existing aircraft of comparable size.

The plane was also designed with passenger comfort in mind. The seats would be wider, as would the aisles, and the windows would be larger than in existing aircraft. The plane would be pressurized at 6,000 feet altitude, as opposed to 8,000 feet, which is standard industry practice. Airline cabin humidity was typically kept at 10% to avoid moisture buildup and corrosion—but composites don’t corrode, so hu- midity would be closer to 20–30%.27

Initial estimates suggested that the jet would cost some $7–8 billion to develop and enter service in 2008. Boeing decided to outsource more work for the 787 than on any other aircraft to date. Boeing would build some 35% of the plane’s fuselage and wing structure. The trio of Japanese companies that worked on the 767 and 777, Mitsubishi Heavy In- dustries, Kawasaki Heavy Industries, and Fuji Heavy Industries, would build another 35%, and some 26% would be built by Italian companies, particu- larly Alenia.28 For the first time, Boeing asked its ma- jor suppliers to bear some of the development costs for the aircraft.

The plane was to be assembled at Boeing’s wide bodied plant in Everett, Washington State. Large sub- assemblies were to be built by major suppliers, and then shipped to Everett for final assembly. The idea was to “snap together” the parts in Everett in 3 days, cutting down on total assembly time. To speed up transportation, Boeing would adopt air freight as its major transportation method for many components.

Airbus’ initial response was to dismiss Boeing’s claims of cost savings as inconsequential. They pointed out that even if the 787 used less fuel than the A330, that amount was equivalent to just 4% of total operating costs.29 However, even by Airbus’ cal- culations, as fuel prices were starting to accelerate, the magnitude of the savings rose. Moreover, Boeing quickly started to snag some significant orders for the 787. In 2004, Boeing booked 56 orders for the

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where the 787 is to be assembled, and more than $1 billion in loans from the Japanese government to 3 Japanese suppliers, who will build over 1/3 of the 787. Moreover, Airbus was quick to point out that a trade war would not benefit either side, and that Airbus purchased some $6 billion a year in supplies from companies in the United States.

In January 2005, both the U.S. and EU agreed to freeze direct subsidies to the 2 aircraft makers while talks continued. However, in May 2005, news reports suggested (and Airbus confirmed), that the jet maker had applied to 4 EU governments for launch aid for the A350, and that the British government would announce some $700 million in aid at the Paris Air Show in mid-2005. Simultaneously, the EU offered to cut launch aid for the A350 by 30%. Dissatisfied, the U.S. side decided that the talks were going nowhere, and on May 31 the United States formally filed a request with the World Trade Organization (WTO) for the establishment of a dispute resolution panel to resolve the issues. The EU quickly responded by filing a countersuit with the WTO claiming that U.S. aid to Boeing exceeded the terms set out in the 1992 agreement.31

In early-2011, the WTO ruled on the complaint by Boeing, and on Airbus’s counterclaim. The WTO stated that Airbus had indeed benefitted from some $15 billion in improper launch aid subsidies over the prior 40 years, and that this practice must stop. Boeing, however, had little time to celebrate. In a separate ruling, the WTO stated that Boeing, too, had benefited from improper subsidies, including $5.3 billion from the United States Government to develop the 787 (the WTO stated that most of these subsidies were in the form of payments from NASA to development space technology that subsequently had commercial applications. Both sides in the dis- pute are engaged in the process of appealing these rulings, which could drag out for years.32

The Next Chapter Huge financial bets have been placed on very dif- ferent visions of the future of airline travel— Airbus with the A380 and Boeing with the 787. By mid- 2011, Airbus had delivered 51 A380s and had a backlog of 236 on order. The rate of new orders had been slow, however; Boeing orders of 827 787s have had a backlog. Airbus also hedged its bets by

The subsidies financed research and development and provided attractive financing terms for Airbus’s customers. Airbus responded by pointing out that both Boeing had benefited for years from hidden US government subsidies, and particularly Pentagon R&D grants.

In 1992, the 2 sides appeared to reach an agree- ment that put to rest their long-standing trade dis- pute. The 1992 pact, which was negotiated by the European Union on behalf of the four member states, limited direct government subsidies to 33% of the total costs of developing a new aircraft and specified that and such subsidies had to be repaid with interest within 17 years. The agreement also limited indirect subsidies, such as government supported military research that has applications to commercial air- craft, to 3% of a country’s annual total commercial aerospace revenues, or 4% of commercial aircraft revenues of any single company on that country. Al- though Airbus officials stated that the controversy had now been resolved, Boeing officials argued that they would still be competing for years against sub- sidized products.

The trade dispute heated up again in 2004 when Airbus announced the first version of the A350 to compete against Boeing’s 787. What raised a red flag for the U.S. government was signs from Airbus that it would apply for $1.7 billion in launch aid to help fund the development of the A350. As far as the United States was concerned, this was too much. In late-2004, U.S. Trade Representative Robert Zoellick issued a statement formally renouncing the 1992 agreement and calling for an end to launch subsidies. According to Zoellick: “since its creation 35 years ago, some Europeans have justified subsidies to Air- bus as necessary to support an infant industry. If that rationalization were ever valid, its time has long passed. Airbus now sells more large civil aircraft than Boeing.” Zoellick went on to claim that Airbus has received some $3.7 billion in launch aid for the A380 plus another $2.8 billion in indirect subsidies includ- ing $1.7 billion in tax payer funded infrastructure improvements for a total of $6.5 billion.

Airbus shot back that Boeing, too, continued to enjoy lavish subsidies, and that the company had received some $12 billion from NASA to develop- ment technology, much of which has found its way into commercial jet aircraft. The Europeans also contended that Boeing would receive as much as $3.2 billion in tax breaks from Washington State,

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Aircraft plant for $580 million. Vought had been in a joint venture with the Italian company, Alenia Aero- nautical, to make fuselage parts for the 787. Vought had not been able to keep up with the demands of the program and Boeing’s acquisition has seen it as a move to exert more control over the production process, and inject capital into Vought.

In another development, Boeing quietly launched the 747–8 program in November 2005. This plane is a completely redesigned version of the 747 and incorporates many of the technological advances developed for the 787, including significant use of composites. It will be offered in both a freighter and intercontinental passenger configuration that will carry 467 passengers in a 3-seat configuration and have a range of 8,000 miles (the 747–400 can carry 416 passengers). The 747–8 will also use the fuel ef- ficient engines developed for the 787, and will have the same cockpit configuration as the 737, 777 and 787. Development costs are estimated to be around $4 billion. By July 2011, Boeing had orders for 78 747–8 freighters and 36 passenger planes. The first deliveries occurred in late-2011.

Looking forward, the primary issue confronting both Airbus and Boeing is what to do about their aging narrow bodies planes, the A320 and the 737 respectively? These aircraft are the workhorses of many airlines comprising some 70% of all units produced by the 2 manufacturers. Strong demand is expected for this category in the future. Boeing esti- mates that over the next 20 years, airlines will buy 23,000 single aisle jets worth some $1.95 trillion. Ideally, both Boeing and Airbus would probably pre- fer to wait for a few more years before bearing the R&D costs associated with new product develop- ment. The argument often made is that this will give time for new technologies to mature, and make for a better aircraft at the end of the day. However, events have conspired to force their hands.

First, new engine technologies developed by Pratt & Whitney reportedly increases fuel efficiency by 10–15%. Airlines want these new engines on their aircraft, but doing so requires some redesign of the A320 and 737. The wings of the 737 in particular, are too low slung to take the new engines, so Boeing would be required to do some major redesign work.

Second, there are several potential new entrants into the narrow body segment of the market. The Canadian regional jet manufacturer, Bombardier, is developing a 110–150 seat aircraft that makes

announcing the A350 XWB, and after a slow start the aircraft has amassed some 567 orders.

Both companies have had substantial produc- tion problems and faced significant delays. In mid- 2006, Airbus announced that deliveries for the A380 would be delayed by 6 months while the company dealt with “production issues” arising from prob- lems installing the wiring bundles in the A380. Esti- mates suggest that the delay would cost Airbus some $2.6 billion over 4 years.33 Within months, Airbus had revised the expected delay to 18 months, and stated that the number of A380s it now needed to sell in order to break even had increased from 250 to 420 aircraft. The company also stated that due to production problems, it would only be able to de- liver 84 A380 planes by 2010, compared to an origi- nal estimate of 420 (in fact it delivered only half of this amount).34

Boeing ran into a number of production and de- sign problems with the 787 that resulted in 5 de- lay announcements, pushing out the first deliveries more than 3 years. For the 787, Boeing outsourced an unprecedented amount of work to suppliers. This was seen at the time as a risky move, particularly given the amount of new technology incorporated into the 787. As it turns out, several suppliers had problems meeting Boeing’s quality specification, sup- plying substandard parts that had to be reworked or redesigned. The issues included a shortage of fasten- ers, a misalignment between the cockpit section and the fuselage, and microscopic wrinkles in the fuse- lage skin. In addition, Boeing found that it had to redesign parts of the section where the wing meets the fuselage. Boeing executives complained that their engineers were often fixing problems “that should not have come to us in the first place.”35

Some company sources suggest that Boeing erred by not managing its supplier relationships as well as it should have. In particular, there may have been a lack of ongoing communication between Boeing and key suppliers. Boeing tended to throw design specifications “over the wall” to suppliers, and then was surprised when they failed to comply fully with the company’s expectations. In addition, Boeing’s dependency on single suppliers for key components meant that a problem in any one of those suppli- ers could create a bottleneck that would hold up production.

In an attempt to fix some of the supply chain is- sues, in 2009, Boeing purchased a Vought Industries

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interest from airlines, racking up over 1,000 orders by August of 2011.

These developments have presented Boeing with a major strategic dilemma. Should they continue to evaluate what to do with the 737, perhaps waiting a few more years before making the heavy investment associated with redesign. This would allow them to design a high technology successor to the 737 that would incorporate many of the technologies devel- oped for the 787. Alternatively, should they jump into the fray now, and offer a redesigned version of the 737 that can utilize new engine technology?

In a sign of how Boeing’s hand may be forced, in July 2011, Boeing announced a large new order from American Airlines for 200 narrow-bodied aircraft. Boeing agreed to fit half of these aircraft with new engine technology, a requirement that will necessi- tate substantially higher R&D spending. At the same time, American Airlines announced that it would buy 260 A320 aircraft from Airbus, half of which will be A320NEOs. This will be the first order from American Airlines for Airbus since the 1980s.36

extensive use of composites to reduce weight. This will reduce operating costs by about 15% compared to the older 737 and A320 models. Known as the CSeries, as of June 2011, Bombardier had 133 firm orders for this aircraft plus options for an additional 129. The first CSeries aircraft are expected to enter service in 2013.

In addition, the Commercial Aircraft Corpora- tion of China (Comac) has announced that it will build a 170–190 seat narrow-bodied jet. Scheduled for introduction in 2016, this will compete with the larger 737 and A320 models. The European low cost airline, Ryanair, has entered into a co-development agreement with Comac and has talked about a 200+ plane order that could be as high as 400. Formerly, Ryanair had been a Boeing customer. Boeing must decide how to confront these growing threats.

Responding to these threats, Airbus in late- 2010 announced that it would introduce a rede- signed version of the A320 that utilizes the Pratt & Whitney engine. Known as the A320NEO (New Engine Option), the offering has garnered strong

Endnotes

1 Boeing Website. 2 Airbus Website. 3 J. Palmer, “Big Bird,” Barron’s, December 19, 2005, 25–29;

www.yeald.com/Yeald/a/33941/both_a380_and_787_ have_bright_futures.html

4 G.J. Steven,“The Learning Curve; From Aircraft to Space Craft,” Management Accounting, May 1999, 64–66.

5 D. Gates, “Boeing 7E7 Watch: Familiar Suppliers Make Short List,” Seattle Times.

6 The figures are from the International Airline Travelers Association (IATA).

7 IATA, “2006 Loss Forecast Drops to US$1.7 billion,” Press Release, August 31, 2006.

8 “Turbulent Skies: Low Cost Airlines,” The Econo- mist, July 10, 2004, 68–72; “Silver Linings, Darkening Clouds,” The Economist, March 27, 2004, 90–92.

9 Air Transport Association, The Economic Climb Out for U.S. Airlines, ATA Economics, August 3, 2011 (accessed on ATA Website).

10 Data from the Air Transport Association at www.air- lines.org.

11 Boeing, Current Market Outlook, 2011. Archived on Boeing’s Website.

12 Airbus’ Website. www.airbus.com/en/myairbus/global_ market_forcast.html.

13 Presentation by Randy Baseler, Vice President of Boe- ing Commercial Airplanes, given at the Farnborough Air show, July 2006. Archived at www.boeing.com/ nosearch/exec_pres/CMO.pdf.

14 This material is drawn from an earlier version of the Boe- ing case written by Charles W.L. Hill. See C.W.L. Hill, “The Boeing Corporation: Commercial Aircraft Opera- tions,” in C.W.L. Hill and G.R. Jones, Strategic Manage- ment, third edition (Boston: Houghton Mifflin, 1995). Much of Boeing’s history is described in R.J. Sterling, Legend and Legacy (St Martin’s Press, New York, 1992).

15 S. Browder, “A Fierce Downdraft at Boeing,” Business Week, January 26, 1988, 34.

16 M.A. Cusumano, The Japanese Automobile Industry (Cambridge, Mass.: Harvard University Press, 1989); Ohno Taiichi, Toyota Production System (Cambridge, Mass.: Productivity Press, (1990); J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

17 J. Gillie, “Lean Manufacturing Could Save Boeing’s Auburn Washington Plant,” Knight Ridder Tribune Business News, May 6, 2002, 1.

18 P.V. Arnold, “Boeing Knows Lean,” MRO Today, Febru- ary 2002.

19 Boeing, “Converted Farm Machine Improves Produc- tion Process,” Press Release, July 1, 2003.

20 P.V. Arnold, “Boeing Knows Lean,” MRO Today, February 2002. Also “Build in Lean: Manufacturing for the Future,” on Boeing’s Website www.boeing.com/ aboutus/environment/create_build.htm.; J.Gillie, “Lean Manufacturing Could Save Boeing’s Auburn, Washing- ton Plant,” Knight Ridder Tribune Business News, May 6, 2002, 1.

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30 D. Michaels and J.L. Lunsford, “Airbus Chief Reveals Plans for New Family of Jetliners,” Wall Street Journal, July 18, 2006, A3.

31 J. Reppert-Bismarck and W. Echikson, “EU Counter- sues over U.S. Aid to Boeing,” Wall Street Journal, June 1, 2005, A2; United States Trade Representative Press Release, “United States Takes Next Steps in Airbus WTO Litigation,” May 30, 2005.

32 N. Clark, “WTO Rules U.S. Subsidies for Boeing Unfair,” New York Times, March 31, 2011.

33 Anonymous, “Airbus Agonistes,” Wall Street Journal, September 6, 2006, A20.

34 Anonymous, “Forecast Dimmer for Profit on Airbus’ A380,” Seattle Times, October 20, 2006, Web Edition.

35 J. Weber, “Boeing to Rein in Dreamliner Outsourcing,” Bloomberg Business Week, January 16, 2009.

36 Staff Reporter, “American Airlines Orders 200 Boeing 737s, 260 More from Airbus,” Associated Press, July 19, 2011.

21 J. Gillie, “Lean Manufacturing Could Save Boeing’s Auburn Washington Plant,” Knight Ridder Tribune Business News, May 6, 2002, 1.

22 P.V. Arnold, “Boeing Knows Lean,” MRO Today, Febru- ary 2002.

23 M. Mecham, “The Lean, Green Line,” Aviation Week, July 19, 2004, 144–148.

24 Boeing, “Boeing Reduces 737 Airplane’s Final Assembly Time by 50 Percent,” Press Release, January 27, 2005.

25 The Economist, “A Phony War,” May 5, 2001, 56–57. 26 J.D. Boyd, “Building Room for Growth,” Traffic World,

August 7, 2006, 1. 27 W. Sweetman, “Boeing, Boeing, Gone,” Popular Science,

June 2004, 97. 28 Anonymous, “Who Will Supply the Parts?”, Seattle

Times, June 15, 2003. 29 W. Sweetman, “Boeing, Boeing, Gone,” Popular Science,

June 2004, 97.

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CASE 30 Case Study: Merck, the FDA, and the Vioxx Recall1

In 2006, the pharmaceutical giant Merck faced major challenges. Vioxx, the company’s once best- selling prescription painkiller, had been pulled off the market in September 2004 after Merck learned it increased the risk of heart attacks and strokes. When news of the recall broke, the company’s stock price had plunged thirty percent to $33 a share, its low- est point in eight years, where it had hovered since. Standard & Poor’s had downgraded the company’s outlook from “stable” to “negative.” In late 2004, the Justice Department had opened a criminal inves- tigation into whether the company had “caused fed- eral health programs to pay for the prescription drug when its use was not warranted.”2 The Securities and Exchange Commission was inquiring into whether Merck had misled investors. By late 2005, more than 6,000 lawsuits had been filed, alleging that Vioxx had caused death or disability. From many quarters, the company faced troubling questions about the development and marketing of Vioxx, new calls for regulatory reform, and concerns about its political influence on Capitol Hill. In the words of Senator Charles Grassley, chairman of a Congressional com- mittee investigating the Vioxx case, “a blockbuster drug [had become] a blockbuster disaster.”3

Merck, Inc.4

Merck, the company in the eye of this storm, was one of the world’s leading pharmaceutical firms. As shown in Exhibit 1, in 2005 the company ranked fourth in sales, after Pfizer, Johnson & Johnson, and Glaxo- SmithKline. In assets and market value, it ranked fifth. However, Merck ranked first in profits, earning $7.33 billion on $30.78 billion in sales (24 percent).

Merck had long enjoyed a reputation as one of the most ethical and socially responsible of the ma- jor drug companies. For an unprecedented seven

consecutive years (1987 to 1993), Fortune magazine had named Merck its “most admired” company. In 1987, Merck appeared on the cover of Time under the headline, “The Miracle Company.” It had consis- tently appeared on lists of best companies to work for and in the portfolios of social investment funds. The company’s philanthropy was legendary. In the 1940s, Merck had given its patent for streptomycin, a powerful antibiotic, to a university foundation. Merck was especially admired for its donation of Mectizan. Merck’s scientists had originally developed this drug for veterinary use, but later discovered that it was an effective cure for river blindness, a debili- tating parasitic disease afflicting some of the world’s poorest people. When the company realized that the victims of river blindness could not afford the drug, it decided to give it away for free, in perpetuity.5

In 1950, George W. Merck, the company’s long- time CEO, stated in a speech: “We try never to forget that medicine is for the people. It is not for the prof- its. The profits follow, and if we have remembered that, they never fail to appear. The better we have remembered that, the larger they have been.”6 This statement was often repeated in subsequent years as a touchstone of the company’s core values.

Merck was renowned for its research labs, which had a decades-long record of achievement, turning out one innovation after another, including drugs for tu- berculosis, cholesterol, hypertension, and AIDS. In the early 2000s, Merck spent around $3 billion annually on research. Some felt that the company’s culture had been shaped by its research agenda. Commented the author of a history of Merck, the company was “in- tense, driven, loyal, scientifically brilliant, collegial, and arrogant.”7 In 2006, although Merck had several medi- cines in the pipeline— including vaccines for rotavirus and cervical cancer, and drugs for insomnia, lymphoma, and the effects of stroke—some analysts worried that the pace of research had slowed significantly.

Anne Lawrence, San Jose State University

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sold to the public, its manufacturer had to carry out clinical trials to demonstrate both safety and effec- tiveness. Advisory panels of outside medical experts reviewed the results of these trials and recommended to the FDA’s Office of Drug Safety whether or not to approve a new drug.11 After a drug was on the market, the agency’s Office of New Drugs continued to monitor it for safety, in a process known as post- market surveillance. These two offices both reported to the same boss, the FDA’s director of the Center for Drug Evaluation and Research.

Once the FDA had approved a drug, physicians could prescribe it for any purpose, but the manufac- turer could market it only for uses for which it had been approved. Therefore, companies had an incen- tive to continue to study approved drugs to provide data that they were safe and effective for the treat- ment of other conditions.

In the 1980s, the drug industry and some patient advocates had criticized the FDA for being too slow to approve new medicines. Patients were concerned that they were not getting new medicines fast enough, and drug companies were concerned that they were losing sales revenue. Each month an average drug spent under review represented $41.7 million in lost revenue, according to one study.12

In 1992, Congress passed the Prescription Drug User Fee Act (PDUFA). This law, which was sup- ported by the industry, required pharmaceutical companies to pay “user fees” to the FDA to review

Estimating the company’s financial liability from the Vioxx lawsuits was difficult. Some 84 million people had taken the drug worldwide over a five-year period from 1999 to 2004. In testimony before Congress, Dr. David Graham, a staff scientist at the Food and Drug Administration (FDA), estimated that as many as 139,000 people in the United States had had heart at- tacks or strokes as a result of taking Vioxx, and about 55,000 of these had died.8 Merrill Lynch estimated the company’s liability for compensatory damages alone in the range of $4 to $18 billion.9 However, heart at- tacks and strokes were common, and they had multiple causes, including genetic predisposition, smoking, obe- sity, and a sedentary lifestyle. Determining the specific contribution of Vioxx to a particular cardiovascular event would be very difficult. The company vigorously maintained that it had done nothing wrong and vowed to defend every single case in court. By early 2006, only three cases had gone to trial, and the results had been a virtual draw—one decision for the plaintiff, one for Merck, and one hung jury.

Government Regulation of Prescription Drugs In the United States, prescription medicines—like Vioxx—were regulated by the Food and Drug Ad- ministration (FDA).10 Before a new drug could be

Company Sales ($bil) Profits ($bil) Assets ($bil) Market Value ($bil)

Pfizer 40.36 6.20 120.06 285.27

Johnson & Johnson 40.01 6.74 46.66 160.96

Merck 30.78 7.33 42.59 108.76

Novartis 26.77 5.40 46.92 116.43

Roche Group 25.18 2.48 45.77 95.38

GlaxoSmithKline 34.16 6.34 29.19 124.79

Aventis 21.66 2.29 31.06 62.98

Bristol-Myers Squibb 19.89 2.90 26.53 56.05

AstraZeneca 20.46 3.29 23.57 83.03

Abbott Labs 18.99 2.44 26.15 69.27

Source: Forbes 2000, available online at www.forbes.com. Listed in order of overall ranking in the Forbes 2000.

Exhibit 1 The World’s Top Pharmaceutical Companies, 2005

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“completely confident” that the FDA’s “final decisions adequately assess the safety of a drug.” Thirty-one percent were “somewhat confident” and 5 percent lacked “any confidence.” Two-thirds of those sur- veyed lacked confidence that the agency “adequately monitors the safety of prescription jobs once they are on the market.” And nearly one in five said they had “been pressured to approve or recommend ap- proval” for a drug “despite reservations about [its] safety, efficacy or quality.”16

After the FDA shortened the approval time, the percentage of drugs recalled following approval in- creased from 1.56% for 1993–1996 to 5.35% for 1997–2001.17 Vioxx was the ninth drug taken off the market in seven years.

Influence at the Top The pharmaceutical industry’s success in accelerat- ing the approval of new drugs reflected its strong presence in Washington. The major drug companies, their trade association PhRMA (Pharmaceutical Research and Manufacturers of America), and their executives consistently donated large sums of money to both political parties and, through their political action committees, to various candidates. The indus- try’s political contributions are shown in Exhibit 2.

proposed new medicines. Between 1993 and 2001, the FDA received around $825 million in such fees from drug makers seeking approval. (During this period, it also received $1.3 billion appropriated by Congress). This infusion of new revenue enabled the agency to hire 1,000 new employees and to shorten the approval time for new drugs from 27 months in 1993 to 14 months in 2001.13

Despite the benefits of PDUFA, some felt that industry-paid fees were a bad idea.

In an editorial published in December 2004, the Journal of the American Medical Association (JAMA) concluded: “It is unreasonable to expect that the same agency that was responsible for approval of drug li- censing and labeling would also be committed to ac- tively seek evidence to prove itself wrong (i.e., that the decision to approve the product was subsequently shown to be incorrect).” JAMA went on to recommend establishment of a separate agency to monitor drug safety.14 Dr. David Kessler, a former FDA Commis- sioner, rejected this idea, responding that “strengthen- ing post-marketing surveillance is certainly in order, but you don’t want competing agencies.”15

Some evidence suggested that the morale of FDA staff charged with evaluating the safety of new medicines had been hurt by relentless pressure to bring drugs to market quickly. In 2002, a survey of agency scientists found that only 13 percent were

Election Cycle Total

Contributions

Contributions from

Individuals Contributions

from PACs Soft Money

Contributions Percentage to Republicans

2006 $5,187,393 $1,753,159 $3,434,234 N/A 70%

2004 $18,181,045 $8,445,485 $9,735,560 N/A 66%

2002 $29,441,951 $3,332,040 $6,957,382 $19,152,529 74%

2000 $26,688,292 $5,660,457 $5,649,913 $15,377,922 69%

1998 $13,169,694 $2,673,845 $4,107,068 $6,388,781 64%

1996 $13,754,796 $3,413,516 $3,584,217 $6,757,063 66%

1994 $7,706,303 $1,935,150 $3,477,146 $2,294,007 56%

1992 $7,924,262 $2,389,370 $3,205,014 $2,329,878 56%

1990 $3,237,592 $771,621 $2,465,971 N/A 54%

Total $125,291,328 $30,374,643 $42,616,505 $52,300,180 67%

Source: Center for Responsive Politics, online at www.opensecrets.org

Exhibit 2 Pharmaceutical/Health Products Industry: Political Contributions 1990–2006

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The industry hired tens of thousands of sales representatives—often, attractive young men and women—to make the rounds of doctors’ offices to talk about new products and give out free samples.24 Drug companies also offered doctors gifts—from free meals to tickets to sporting events—to cultivate their good will. They also routinely sponsored continuing education events for physicians, often featuring re- ports on their own medicines, and supported doctors financially with opportunities to consult and to con- duct clinical trials.25 In 2003 Merck spent $422 mil- lion to market Vioxx to doctors and hospitals.26

During the early 2000s, when Vioxx and Pfizer’s Celebrex were competing head-to-head, sales rep- resentatives for the two firms were hard at work promoting their brand to doctors. Commented one rheumatologist of the competition between Merck and Pfizer at the time: “We were all aware that there was a great deal of marketing. Like a Coke-Pepsi war.”27 An internal Merck training manual for sales representatives, reported in The Wall Street Journal, was titled “Dodge Ball Vioxx.” It explained how to “dodge” doctors’ questions, such as “I am concerned about the cardiovascular effects of Vioxx.” Merck later said that this document had been taken out of context and that sales representatives “were not trained to avoid physician’s questions.”28

Direct-to-Consumer Advertising Although marketing to doctors and hospitals con- tinued to be important, in the late 1990s the focus shifted somewhat. In 1997, the FDA for the first time allowed drug companies to advertise directly to consumers. The industry immediately seized this opportunity, placing numerous ads for drugs—from Viagra to Nexium—on television and in magazines and newspapers. In 2004, the industry spent over $4 billion on such direct-to-consumer, or DTC, ad- vertising. For example, in one ad for Vioxx, Olym- pic figure skating champion Dorothy Hamill glided gracefully across an outdoor ice rink to the tune of “It’s a Beautiful Morning” by the sixties pop group The Rascals, telling viewers that she would “not let arthritis stop me.” In all, Merck spent more than $500 million advertising Vioxx.29

The industry’s media blitz for Vioxx and other drugs was highly effective. According to research by the Harvard School of Public Heath, each dollar spent on DTC advertising yielded $4.25 in sales.

Following the Congressional ban on soft money contributions in 2003, the industry shifted much of its contributions to so-called stealth PACs, nonprofit organizations which were permitted by law to take unlimited donations without revealing their source. These organizations could, in turn, make “substan- tial” political expenditures, providing political activ- ity was not their primary purpose.18

In addition, the industry maintained a large corps of lobbyists active in the nation’s capital. In 2003, for example, drug companies and their trade associa- tion spent $108 million on lobbying and hired 824 individual lobbyists, according to a report by Public Citizen.19 Merck spent $40.7 million on lobbying be- tween 1998 and 2004.20 One of the industry’s most effective techniques was to hire former elected of- ficials or members of their staffs. For example, Billy Tauzin, formerly a Republican member of Congress from Louisiana and head of the powerful Committee on Energy and Commerce, which oversaw the drug industry, became president of PhRMA at a reported annual salary of $2 million in 2004.21

Over the years, the industry’s representatives in Washington had established a highly successful re- cord of promoting its political agenda on a range of issues. In addition to faster drug approvals, these had more recently included a Medicare prescription drug benefit, patent protections, and restrictions on drug imports from Canada.

The Blockbuster Model In the 1990s, 80 percent of growth for the big phar- maceutical firms came from so-called blockbuster drugs.22 Blockbusters have been defined by Fortune magazine as “medicines that serve vast swaths of the population and garner billions of dollars in annual revenue.”23 The ideal blockbuster, from the compa- nies’ view, was a medicine that could control chronic but usually nonfatal conditions that afflicted large numbers of people with health insurance. These might include, for example, daily maintenance drugs for high blood pressure or cholesterol, allergies, arthritis pain, or heartburn. Drugs that could actu- ally cure a condition—and thus would not need to be taken for long periods—or were intended to treat diseases, like malaria or tuberculosis, that affected mainly the world’s poor, were often less profitable.

Historically, drug companies focused most of their marketing efforts on prescribing physicians.

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searchers learned that there were really two kinds of COX enzyme. COX-1, it was found, performed several beneficial functions, including protecting the stomach lining. COX-2, on the other hand, con- tributed to pain and inflammation. Existing anti- inflammatory drugs suppressed both forms of the enzyme, which is why drugs like ibuprofen (Advil) relieved pain, but also caused stomach irritation in some users.

A number of drug companies, including Merck, were intrigued by the possibility of developing a medicine that would block just the COX-2, leaving the stomach-protective COX-1 intact. Such a drug would offer distinctive benefits to some patients, such as arthritis sufferers who were at risk for ulcers (bleeding sores in the intestinal tract).33 As many as 16,500 people died each year in the United States from this condition.34

In May 1999, after several years of research and testing by Merck scientists, the FDA approved Vioxx for the treatment of osteoarthritis, acute pain in adults, and menstrual symptoms. The drug was later approved for rheumatoid arthritis. Although Merck, like other drug companies, never revealed what it spent to develop specific new medicines, estimates of the cost to develop a major new drug ran as high as $800 million.35

Vioxx quickly became exactly what Merck had hoped: a blockbuster. At its peak in 2001, Vioxx gen- erated $2.1 billion in sales in the United States alone, contributing almost 10 percent of Merck’s total sales revenue worldwide, as shown in Exhibit 3.

The drug companies defended DTC ads, saying they informed consumers of newly available thera- pies and encouraged people to seek medical treat- ment. In the age of the Internet, commented David Jones, an advertising executive whose firm included several major drug companies, “consumers are be- coming much more empowered to make their own health care decisions.”30

However, others criticized DTC advertising, say- ing that it put pressure on doctors to prescribe drugs that might not be best for the patient. “When a pa- tient comes in and wants something, there is a de- sire to serve them,” said David Wofsy, president of the American College of Rheumatology. “There is a desire on the part of physicians, as there is on any- one else who provides service, to keep the customer happy.”31 Even some industry executives expressed reservations. Said Hank McKinnell, CEO of Pfizer, “I’m beginning to think that direct-to-consumer ads are part of the problem. By having them on televi- sion without a very strong message that the doctor needs to determine safety, we’ve left this impression that all drugs are safe. In fact, no drug is safe.”32

The Rise of Vioxx Vioxx, the drug at the center of Merck’s legal woes, was a known as “a selective COX-2 inhibitor.” Scientists had long understood that an enzyme called cyclo-oxygenase, or COX for short, was associated with pain and inflammation. In the early 1990s, re-

*Withdrawn from the market in September 2004.

Sources: Columns 1 and 2: IMS Health (www.imshealth.com); Column 3: Merck Annual Reports (www.merck.com).

Exhibit 3 Vioxx Sales in the United States, 1999–2004

U.S. Prescriptions Dispensed

U.S. Sales

U.S. Sales of Vioxx as % of Total Merck Sales

1999 4,845,000 $372,697,000 2.2%

2000 20,630,000 $1,526,382,000 7.6%

2001 25,406,000 $2,084,736,000 9.8%

2002 22,044,000 $1,837,680,000 8.6%

2003 19,959,000 $1,813,391,000 8.1%

2004* 13,994,000 $1,342,236,000 5.9%

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between the agency and the company over their wording.39

Kaiser/Permanente: In August 2004, Dr. David Graham, a scientist at the FDA, reported the results of a study of the records of 1.4 million patients en- rolled in the Kaiser health maintenance organization in California. He found that patients on high doses of Vioxx had three times the rate of heart attacks as patients on Celebrex, a competing COX-2 inhibitor made by Pfizer. Merck discounted this finding, say- ing that studies of patient records were less reliable than double blind clinical studies.40 Dr. Graham later charged that his superiors at the FDA had “ostra- cized” him and subjected him to “veiled threats” if he did not qualify his criticism of Vioxx. The FDA called these charges “baloney.”41

APPROVe: In order to examine the possibility that Vioxx posed a cardiovascular risk, Merck de- cided to monitor patients enrolled in a clinical trial called APPROVe to see if they those taking Vioxx had more heart attacks and strokes than those who were taking a placebo (sugar pill). This study had been designed to determine if Vioxx reduced the risk of recurrent colon polyps (a precursor to colon can- cer); Merck hoped it would lead to FDA approval of the drug for this condition. The APPROVe study was planned before the VIGOR results were known.

Merck Recalls the Drug On the evening of Thursday, September 23, 2004, Dr. Peter S. Kim, president of Merck Research Labs, received a phone call from scientists monitoring the colon polyp study. Researchers had found, the sci- entists told him, that after 18 months of continuous use individuals taking Vioxx were more than twice as likely to have a heart attack or stroke than those taking a placebo. The scientists recommended that the study be halted because of “unacceptable” risk.42

Dr. Kim later described to a reporter for The New York Times the urgent decision-making process that unfolded over the next hours and days as the company responded to this news.

On Friday, I looked at the data with my team. The first thing you do is review the data. We did that. Second is you double-check the data, go through it and make sure that everything is O.K. [At that point] I knew that barring some big mistake in the analysis, we had an issue here. Around noon, I called [CEO] Ray Gilmartin and told him what was up.

The retail price of Vioxx was around $3.00 per pill, compared with pennies per pill for older anti- inflammatory drugs like aspirin and Advil. Of course, Vioxx was often covered, at least partially, under a user’s health insurance, while over-the-counter drugs were not.

Safety Warnings Even before the drug was approved, some evidence cast doubt on the safety of Vioxx. These clues were later confirmed in other studies.

Merck Research: Internal company e-mails sug- gested that Merck scientists might have been worried about the cardiovascular risks of Vioxx as early as its development phase. In a 1997 e-mail, reported in The Wall Street Journal, Dr. Alise Reicin, a Merck scientist, stated that “the possibility of CV (cardio- vascular) events is of great concern.” She added, ap- parently sarcastically, “I just can’t wait to be the one to present those results to senior management!” A lawyer representing Merck said this e-mail had been taken out of context.36

VIGOR: A study code-named VIGOR, com- pleted in 2000 after the drug was already on the market, compared rheumatoid arthritis patients taking Vioxx with another group taking naproxen (Aleve). Merck financed the research, which was designed to study gastrointestinal side effects. The study found—as the company had expected—that Vioxx was easier on the stomach than naproxen. But it also found that the Vioxx group had nearly five times as many heart attacks (7.3 per thousand per- son-years) as the naproxen group (1.7 per thousand person-years).37 Publicly, Merck hypothesized that these findings were due to the heart-protective effect of naproxen, rather than to any defect inherent in Vioxx. Privately, however, the company seemed wor- ried. In an internal e-mail dated March 9, 2000, un- der the subject line “Vigor,” the company’s research director, Dr. Edward Scolnick, said that cardiovas- cular events were “clearly there” and called them “a shame.” But, he added, “there is always a hazard.”38 At that time, the company considered reformulat- ing Vioxx by adding an agent to prevent blood clots (and reduce CV risk), but then dropped the project.

The FDA was sufficiently concerned by the VIGOR results that it required Merck to add addi- tional warning language to its label. These changes appeared in April 2002, after lengthy negotiations

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On Thursday, September 30, Merck issued a press release, which stated in part:

Merck & Co., Inc. announced today a voluntary withdrawal of VIOXX®. This decision is based on new data from a 3-year clinical study. In this study, there was an increased risk for cardiovascular (CV) events, such as heart attack and stroke, in patients taking VIOXX 25 mg compared to those taking pla- cebo (sugar pill). While the incidence of CV events was low, there was an increased risk beginning af- ter 18 months of treatment. The cause of the clinical study result is uncertain, but our commitment to our patients is clear . . . Merck is notifying physicians and pharmacists and has informed the Food and Drug Administration of this decision. We are taking this action because we believe it best serves the in- terests of patients. That is why we undertook this clinical trial to better understand the safety profile of VIOXX. And it’s why we instituted this voluntary withdrawal upon learning about these data. Be as- sured that Merck will continue to do everything we can to maintain the safety of our medicines.

He said, ‘Figure out what was the best thing for patient safety.’ We then spent Friday and the rest of the weekend going over the data and analyzing it in different ways and calling up medical experts to set up meetings where we would discuss the data and their interpretations and what to do.43

According to later interviews with some of the doctors consulted that weekend by Merck, the group was of mixed opinion. Some experts argued that Vioxx should stay on the market, with a strong warning label so that doctors and patients could judge the risk for themselves. But others thought the drug should be withdrawn because no one knew why the drug was apparently causing heart attacks. One expert commented that “Merck prides itself on its ethical approach. I couldn’t see Merck saying we’re going to market a drug with a safety problem.”44

On Monday, Dr. Kim recommended to Gilmartin that Vioxx be withdrawn from the market. The CEO agreed. The following day, Gilmartin notified the board, and the company contacted the FDA.

Endnotes

1 By Anne T. Lawrence, San Jose State University. Copy- right © 2006 by the author. All rights reserved. An ear- lier version of this case was presented at the Western Casewriters Association Annual Meeting, Long Beach, California, March 30, 2006. This case was prepared from publicly available materials.

2 “Justice Dept. and SEC Investigating Merck Drug,” New York Times, November 9, 2004.

3 “Opening Statement of U.S. Senator Chuck Grassley of Iowa,” U.S. Senate Committee on Finance, Hearing— FDA, Merck, and Vioxx: Putting Patient Safety First?” November 18, 2004, online at http://finance.senate.gov.

4 A history of Merck may be found in Fran Hawthorne, The Merck Druggernaut: The Inside Story of a Phar- maceutical Giant (Hoboken, NJ: John Wiley & Sons, 2003).

5 Merck received the 1991 Business Enterprise Trust Award for this action. See Stephanie Weiss and Kirk O. Hanson, “Merck and Co., Inc.: Addressing Third World Needs” (Business Enterprise Trust, 1991).

6 Hawthorne, op. Cit., pp. 17–18. 7 Hawthorne, op. Cit., p. 38. 8 “FDA Failing in Drug Safety, Official Asserts,” New

York Times, November 19, 2004. The full transcript of the hearing of the U.S. Senate Committee on Finance, “FDA, Merck, and Vioxx: Putting Patient Safety First?” is available online at http://finance.senate.gov.

9 “Despite Warnings, Drug Giant Took Long Path to Vioxx Recall,” New York Times, November 14, 2004.

10 A history of the FDA and of its relationship to business may be found in Philip J. Hilts, Protecting America’s Health: The FDA, Business, and One Hundred Years of Regulation (New York: Alfred A. Knopf, 2003).

11 Marcia Angell, The Trust About the Drug Companies (New York: Random House, 2004), Ch. 2.

12 Merrill Lynch data reported in “A World of Hurt,” For- tune, January 10, 2005, p. 18.

13 U.S. General Accounting Office, Food and Drug Admin- istration: Effect of User Fees on Drug Approval Times, Withdrawals, and Other Agency Activities, September 2002.

14 “Postmarketing Surveillance—Lack of Vigilance, Lack of Trust,” Journal of the American Medical Association 92(21), December 1, 2004, p. 2649.

15 “FDA Lax in Drug Safety, Journal Warns,” www.sfgate .com, November 23, 2004.

16 2002 Survey of 846 FDA scientists conducted by the Office of the Inspector General of the Department of Health and Human Services, online at www.peer.org/ FDAscientistsurvey.

17 “Postmarketing Surveillance,” op. Cit. 18 “Big PhRMA’s Stealth PACs: How the Drug Industry

Uses 501(c) Non-Profit Groups to Influence Elections,” Congress Watch, September 2004.

19 “Drug Industry and HMOs Deployed an Army of Nearly 1,000 Lobbyists to Push Medicare Bill, Report Finds,” June 23, 2004, www.citizen.org.

20 Data available online at www.publicintegrity.org.

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on R&D?” Ch. 3 in Marcia Angell, op. Cit., and Merrill Goozner, The $800 Million Pill: The Truth Behind the Cost of New Drugs (Berkeley: University of California Press, 2004).

36 “E-Mails Suggest Merck Knew Vioxx’s Dangers at Early Stage,” Wall Street Journal, November 1, 2004.

37 “Comparison of Upper Gastrointestinal Toxicity of Rofecoxib and Naproxen in Patients with Rheumatoid Arthritis,” New England Journal of Medicine, 2000: 323.

38 “E-Mails Suggest Merck Knew Vioxx’s Dangers at Early Stage,” Wall Street Journal, November 1, 2004.

39 At one of the early Vioxx trials, the plaintiff introduced a Merck internal memo that calculated that the company would make $229 million more in profits if it delayed changes to warning language on the label by four months (New York Times, August 20, 2005). The FDA did not have the authority to dictate label language; any changes had to be negotiated with the manufacturer.

40 “Study of Painkiller Suggests Heart Risk,” New York Times, August 26, 2004.

41 “FDA Official Alleges Pressure to Suppress Vioxx Find- ings,” Washington Post, October 8, 2004.

42 “Painful Withdrawal for Makers of Vioxx,” Washington Post, October 18, 2004. Detailed data reported the fol- lowing day in The New York Times showed that 30 of the 1287 patients taking Vioxx had suffered a heart attack, compared with 11 of 1299 taking a placebo; 15 on Vioxx had had a stroke or transient ischemic attack (minor stroke), compared with 7 taking a placebo.

43 “A Widely Used Arthritis Drug is Withdrawn,” New York Times, October 1, 2004.

44 “Painful Withdrawal for Makers of Vioxx,” Washington Post, October 18, 2004.

21 “Rep. Billy Tauzin Demonstrates that Washington’s Revolving Door is Spinning Out of Control,” Public Citizen, December 15, 2004, press release.

22 “The Waning of the Blockbuster,” Business Week, October 18, 2004.

23 “A World of Hurt,” Fortune, January 10, 2005, p.20. 24 In 2005, 90,000 sales representatives were employed by

the pharmaceutical industry, about one for every eight doctors. The New York Times revealed in an investiga- tive article (“Give Me an Rx! Cheerleaders Pep Up Drug Sales,” November 28, 2005) that many companies made a point of hiring former college cheerleaders for this role.

25 The influence of the drug industry on the medical profes- sional is documented in Katharine Greider, The Big Fix: How the Pharmaceutical Industry Rips Off American Consumers (New York: Public Affairs, 2003).

26 “Drug Pullout,” Modern Healthcare, October 18, 2004. 27 “Marketing of Vioxx: How Merck Played Game of

Catch-Up,” New York Times, February 11, 2005. 28 “E-Mails Suggest Merck Knew Vioxx’s Dangers at Early

Stage,” Wall Street Journal, November 1, 2004. 29 IMS Health estimate reported in: “Will Merck Survive

Vioxx?” Fortune, November 1, 2004. 30 “With or Without Vioxx, Drug Ads Proliferate,” New

York Times, December 6, 2004. 31 “A ‘Smart’ Drug Fails the Safety Test,” Washington Post,

October 3, 2004. 32 “A World of Hurt,” Fortune, January 10, 2005, p. 18. 33 “Medicine Fueled by Marketing Intensified Troubles for

Pain Pills,” New York Times, December 19, 2004. 34 “New Scrutiny of Drugs in Vioxx’s Family,” New York

Times, October 4, 2004. 35 This estimate was hotly debated. See, for example, “How

Much Does the Pharmaceutical Industry Really Spend

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CASE 31 Nike: Sweatshops and Business Ethics

Introduction Nike is in many ways the quintessential global cor- poration. Established in 1972 by former University of Oregon track star Phil Knight, Nike is now one of the leading marketers of athletic shoes and apparel on the planet. The company has $10 billion in annual revenues and sells its products in some 140 coun- tries. Nike does not do any manufacturing. Rather, it designs and markets its products, while contract- ing for their manufacture from a global network of 600 factories scattered around the globe that employ nearly 550,000 people.1 This huge corporation has made founder Phil Knight one of the richest people in America. Nike’s marketing phrase “Just do it!” and “swoosh” logo have become as recognizable in popular culture as the faces of its celebrity sponsors, such as Michael Jordan and Tiger Woods.

For all of its successes, the company has been dogged for more than a decade by repeated and persistent accusations that its products are made in “sweatshops” where workers, many of them chil- dren, slave away in hazardous conditions for below- subsistence wages. Nike’s wealth, its detractors claim, has been built upon the backs of the world’s poor. To many, Nike has become a symbol of the evils of glo- balization: a rich Western corporation exploiting the world’s poor to provide expensive shoes and apparel to the pampered consumers of the developed world. Nike’s Niketown stores have become standard tar- gets for anti-globalization protestors. Nike has been the target of repeated criticism and protests from several nongovernmental organizations, such as San Fransisco–based Global Exchange, a human-rights organization dedicated to promoting environmental, political, and social justice around the world.2 News media have run exposés on working conditions in foreign factories that supply Nike. Students on the campuses of several major U.S. universities with which Nike has lucrative sponsorship deals have

protested against the ties, citing Nike’s use of sweat- shop labor.

For its part, Nike has taken many steps to counter the protests. Yes, it admits, there have been problems in some overseas factories. But the company has signaled a commitment to improving working conditions. It requires that foreign subcontractors meet minimum thresholds for working conditions and pay. It has ar- ranged for factories to be examined by independent auditors and terminated contracts with factories that do not comply with its standards. But for all this effort, the company continues to be a target of protests.

The Case Against Nike CBS 48 Hours aired a news report on October 17, 1996 depicting a typical exposé against Nike.3 Reporter Roberta Basin visited a Nike factory in Vietnam. With a shot of the factory, her commentary began:

The signs are everywhere of an American invasion in search of cheap labor. Millions of people who are literate, disciplined, and desperate for jobs. This is Niketown near what used to be called Saigon, one of 4 factories Nike doesn’t own but subcontracts to make a million shoes a month. It takes 25,000 workers, mostly young women, to “Just Do It.”

But the workers here don’t share in Nike’s huge profits. They work 6 days a week for only $40 a month, just $0.20 an hour.

Baskin interviews one of the workers in the factory, a young woman named Lap. Baskin tells the listener:

Her basic wage, even as a sewing team leader, still doesn’t amount to the minimum wage. . . . She’s down to 85 lbs. Like most of the young women who make shoes, she has little choice but to accept the low wages and long hours. Nike says that it requires all subcontractors to obey local laws; but Lap has already put in much more overtime than the annual legal limit: 200 hours.

Charles W.L. Hill, University of Washington

This case is intended to be used as a basis for class discussion rather than as an illustration of either effective or ineffective handling of the situation. Reprinted by permission of Charles W. L. Hill.

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In another attack on Nike’s practices, Global Exchange published a report in September 1997 on working conditions in 4 Nike and Reebok sub- contractor’s factories in southern China.6 Global Exchange, in conjunction with two Hong Kong human-rights groups, had interviewed workers at the factories in 1995, and again in 1997. Accord- ing to Global Exchange, in one factory, a Korean- owned subcontractor for Nike, workers as young as 13 earned as little as $0.10 an hour and toiled up to 17 hours daily in enforced silence. Talking dur- ing work was not allowed, and violators were fined $1.20 to $3.60, according to the report. The practices were in violation of Chinese labor law, which states that no child under 16 may work in a factory, and the Chinese minimum-wage requirement of $1.90 for an 8-hour day. Nike condemned the study as “errone- ous,” charging that it incorrectly stated the wages of workers and made irresponsible accusations.

Global Exchange, however, continued to be a ma- jor thorn in Nike’s side. In November 1997, the orga- nization obtained and then leaked a confidential report by Ernst & Young of an audit that Nike had commis- sioned of a factory in Vietnam owned by a Nike sub- contractor.7 The factory had 9,200 workers and made 400,000 pairs of shoes per month. The Ernst & Young report painted a dismal picture of thousands of young women, most under age 25, laboring 10 1/2 hours a day, 6 days a week, in excessive heat, noise, and foul air, for slightly more than $10 a week. The report also found that workers with skin or breathing prob- lems had not been transferred to departments free of chemicals, and that more than half the workers who dealt with dangerous chemicals did not wear protec- tive masks or gloves. It claimed workers were exposed to carcinogens that exceeded local legal standards by 177 times in parts of the plant, and that 77% of the employees suffered from respiratory problems.

Put on the defensive yet again, Nike called a news conference and pointed out that it had com- missioned the report, and had acted on it.8 The com- pany stated that it had formulated an action plan to deal with the problems cited in the report, and had slashed overtime, improved safety and ventilation, and reduced the use of toxic chemicals. The com- pany also asserted that the report showed that Nike’s internal monitoring system had performed exactly as it should have. According to one spokesman:

“This shows our system of monitoring works. . . . We have uncovered these issues clearly before any- one else, and we have moved fairly expeditiously to correct them.”

Baskin then asks Lap what would happen if she wanted to leave, if she was sick or had to take care of a sick relative: could she leave the factory? Through a translator, Lap replies:

It is not possible if you haven’t made enough shoes. You have to meet the quota before you can go home.

The clear implication of the story was that Nike was at fault for allowing such working conditions to persist in the Vietnamese factory (which, inciden- tally, was owned by a Korean company).

Another example of an attack on Nike’s sub- contracting practices occurred in June 1996. It was launched by USA, a foundation largely financed by labor unions and domestic-apparel manufacturers that oppose free trade with low-wage countries. Ac- cording to Joel Joseph, chairman of the foundation, a popular line of high-priced Nike sneakers, the “Air Jordans,” were put together by 11-year-olds in Indo- nesia making $0.14 per hour. A Nike spokeswoman, Donna Gibbs, countered that this was false. Accord- ing to Gibbs, the average worker made 240,000 ru- piah ($103) a month working a maximum 54-hour week, or about $0.45 per hour. Moreover, Gibbs noted, Nike had staff members in each factory moni- toring conditions to make sure that they obeyed lo- cal minimum-wage and child-labor laws.4

Another example of the criticism against Nike is the following extracts from a newsletter published by Global Exchange:5

During the 1970s, most Nike shoes were made in South Korea and Taiwan. When workers there gained new freedom to organize and wages began to rise, Nike looked for “greener pastures.” It found them in Indonesia and China, where Nike started producing in the 1980s, and most recently in Vietnam.

The majority of Nike shoes are made in Indo- nesia and China, countries with governments that prohibit independent unions and set the minimum wage at rock bottom. The Indonesian government admits that the minimum wage there does not pro- vide enough to supply the basic needs of one person, let alone a family. In early-1997, the entry-level wage was a miserable $2.46 a day. Labor groups estimate that a livable wage in Indonesia is about $4.00 a day.

In Vietnam the pay is even less—$0.20 an hour, or a mere $1.60 a day. But in urban Vietnam, 3 sim- ple meals cost about $2.10 a day, and then of course there is rent, transportation, clothing, health care, and much more. According to Thuyen Nguyen of Vietnam Labor Watch, a living wage in Vietnam is at least $3 a day.

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refused to meet a 10.7% increase in the monthly wage, to $70.30, required by the Indonesian govern- ment in April 1997.11

On May 12, 1998, in a speech given at the Na- tional Press Club, Phil Knight spelled out in detail a series of initiatives designed to improve working conditions for the 500,000 people that make prod- ucts for Nike at subcontractor facilities.12 Among the initiatives Knight highlighted were the following:

We have effectively changed our minimum age limits from the ILO (International Labor Organization) standards of 15 in most countries and 14 in devel- oping countries to 18 in all footwear manufacturing and 16 in all other types of manufacturing (apparel, accessories and equipment). Existing workers legally employed under the former limits were grandfa- thered into the new requirements.

During the past 13 months we have moved to a 100 percent factory audit scheme, where every Nike contract factory will receive an annual check by PricewaterhouseCoopers teams who are specially trained on our Code of Conduct Owner’s Manual and audit/monitoring procedures. To date they have performed about 300 such monitoring visits. In a few instances in apparel factories they have found work- ers under our age standards. Those factories have been required to raise their standards to 17 years of age, to require 3 documents certifying age, and to redouble their efforts to ensure workers meet those standards through interviews and records checks.

Our goal was to ensure workers around the globe are protected by requiring factories to have no workers exposed to levels above those man- dated by the permissible exposure limits (PELs) for chemicals prescribed in the OSHA indoor air quality standards.13

These moves were applauded in the business press, but they were greeted with a skeptical response from Nike’s long-term adversaries in the debate over the use of foreign labor. While conceding that Nike’s policies were an improvement, one critic writing in the New York Times noted that:

Mr. Knight’s child labor initiative is . . . a smoke- screen. Child labor has not been a big problem with Nike, and Philip Knight knows that better than any- one. But public relations is public relations. So he announces that he’s not going to let the factories hire kids, and suddenly that’s the headline.

Mr. Knight is like a 3-card monte player. You have to keep a close eye on him at all times.

The biggest problem with Nike is that its over- seas workers make wretched, below-subsistence wages. It’s not the minimum age that needs raising, it’s the minimum wage. Most of the workers in Nike

Nike’s Responses Unaccustomed to playing defense, Nike formulated a number of strategies and tactics over the years to deal with the problems of working conditions and pay in subcontractor facilities. In 1996, Nike hired one-time U.S. ambassador to the United Nations, representative, and former Atlanta mayor Andrew Young to assess working conditions in subcontractors’ plants around the world. The following year, after a 2-week tour of 3 countries that included inspections of 15 factories, Young released a mildly critical report. He informed Nike it was doing a good job in its treatment of work- ers, though it should do better. According to Young, he did not see: “sweatshops, or hostile conditions. . . . I saw crowded dorms . . . but the workers were eating at least 2 meals a day on the job and making what I was told were subsistence wages in those cultures.”9

Young was widely criticized by human-rights and labor groups for not taking his own translators and for doing slipshod inspections, an assertion he repeatedly denied.

In 1996, Nike joined a presidential task force de- signed to find a way of banishing sweatshops in the shoe and clothing industries. The task force included industry leaders, representatives from human-rights groups, and labor leaders. In April 1997, they an- nounced an agreement for workers’ rights that U.S. companies could agree to when manufacturing abroad. The accord limited the work week to 60 hours, and called for paying at least the local minimum wage in foreign factories. The task force also agreed to estab- lish an independent monitoring association—later named the Fair Labor Association (FLA)—to assess whether companies were abiding by the code.10

The FLA now includes among its members the Lawyers Committee for Human Rights, the National Council of Churches, the International Labor Rights Fund, 135 universities (universities have extensive li- censing agreements with sports-apparel companies), and companies such as Nike, Reebok, and Levi Strauss.

In early 1997, Nike also began to commission in- dependent organizations such as Ernst & Young to audit the factories of its subcontractors. In September 1997, Nike tried to show its critics that it was in- volved in more than just a public-relations exercise when it terminated its relationship with 4 Indone- sian subcontractors, stating that they had refused to comply with the company’s standards for wage levels and working conditions. Nike identified one of the subcontractors, Seyon, which manufactured specialty sports gloves for Nike, saying that Seyon

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Against Sweatshops (USAS). The USAS argued that the Fair Labor Association (FLA), which grew out of the presidential task force on sweatshops, was an industry tool, and not a truly independent auditor of foreign factories. The USAS set up an alterna- tive independent auditing organization, the Work- ers Rights Consortium (WRC), which they charged with auditing factories that produce products under collegiate licensing programs (under which Nike is a high- profile supplier of products). The WRC is backed, and partly funded, by labor unions and re- fuses to cooperate with companies, arguing that do- ing so would jeopardize its independence.

By mid-2000, the WRC had persuaded some 48 universities to join, including all 9 campuses of the University of California systems, the University of Michigan, and the University of Oregon, Phil Knight’s alma mater. When Knight heard that the University of Oregon would join the WRC, as op- posed to the FLA, he withdrew a planned $30 mil- lion donation to the university.16 Despite this, in November 2000 another major northwest university, the University of Washington, announced that it too would join the WRC, although it would also retain its membership in the FLA.17

Nike continued to push forward with its own ini- tiatives, updating progress on its Website. In April 2000, in response to accusations that it was still hid- ing conditions, it announced that it would release the complete reports of all independent audits of its subcontractors’ plants. Global Exchange continued to criticize the company, arguing in mid-2001 that the company was not living up to Phil Knight’s 1998 promises and that it was intimidating workers from speaking out about abuses.18

factories in China and Vietnam make less than $2 a day, well below the subsistence levels in those coun- tries. In Indonesia the pay is less than $1 a day.

The company’s current strategy is to reshape its public image while doing as little as possible for the workers. Does anyone think it was an accident that Nike set up shop in human rights sinkholes, where labor organizing was viewed as a criminal activ- ity and deeply impoverished workers were willing, even eager, to take their places on assembly lines and work for next to nothing?14

Other critics question the quality of Nike’s audi- tors, PricewaterhouseCoopers (PwC). Dara O’Rourke, an assistant professor at MIT, followed the PwC au- ditors around several factories in China, Korea, and Vietnam. He concluded that although the auditors found minor violations of labor laws and codes of conduct, they missed major labor-practice issues, in- cluding hazardous working conditions, violations of overtime laws, and violation of wage laws. The prob- lem, according to O’Rourke, was that the auditors had limited training and relied on factory managers for data and for setting up interviews with workers, all of which were performed in the factories. The audi- tors, in other words, were getting an incomplete and somewhat sanitized view of conditions in the factory.15

Continued Controversy Fueled perhaps by the unforgiving criticisms of Nike that continued after Phil Knight’s May 1998 speech, a wave of protests against Nike occurred on many university campuses from 1998 to 2001. The moving force behind the protests was the United Students

Endnotes

1 From Nike’s corporate Website at www.nikebiz.com. 2 www.globalexchange.org. 3 “Boycott Nike,” CBS News 48 Hours, October 17,

1996. 4 D. Jones, “Critics Tie Sweatshop Sneakers to ‘Air Jor-

dan,’” USA Today, June 6, 1996, 1B. 5 Global Exchange Special Report: Nike Just Don’t Do It.

www.globalexchange.org/education/publications/ newsltr6.97p2.html#nike.

6 V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,” Seattle Times, September 21, 1997, A4.

7 S. Greenhouse, “Nike Shoeplant in Vietnam is Called Unsafe for Workers,” New York Times, November 8, 1997.

8 Ibid. 9 Quoted in: V. Dobnik, “Chinese Workers Abused Making

Nikes, Reeboks,” Seattle Times, September 21, 1997, A4.

10 W. Bounds and H. Stout, “Sweatshop Pact: Good Fit or Threadbare?” Wall Street Journal, April 10, 1997, A2.

11 Associated Press Reporter, “Nike Gives Four Factories the Boot,” Los Angeles Times, September 23, 1997, 20.

12 Archived at www.nikebiz.com/labor/speech_trans.shtml. 13 OSHA is the United States Occupational Safety and

Health Agency. 14 B. Herbert, “Nike Blinks,” New York Times, May 21, 1998. 15 Dara O’Rourke, Monitoring the Monitors: A critique of

the Pricewaterhousecoopers (PwC) Labor Monitoring. Department of Urban Studies and Planning, Mit.

16 L. Lee and A. Bernstein, “Who Says Student Protests Don’t Matter?” Business Week, June 12, 2000, 94–96.

17 R. Dee, “UW to Join Anti-sweatshop Group,” Seattle Post Intelligencer, November 20, 2000, B2.

18 Anonymous, “Rights Group Says Nike Isn’t Fulfilling Promises,” Wall Street Journal, May 16, 2001.

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http://www.nikebiz.com

http://www.globalexchange.org

http://www.globalexchange.org/education/publications/

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Glossary G1

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Glossary

absolute cost advantage a cost advantage that is enjoyed by incumbents in an industry and that new entrants cannot expect to match.

absorptive capacity the ability of an enterprise to identify, value, assimilate, and use new knowledge.

acquisition when a company uses its capital resources to purchase another company.

adaptive culture a culture that is innovative and encour- ages and rewards middle- and lowerlevel managers for taking the initiative to achieve organizational goals.

anticompetitive behavior a range of actions aimed at harm- ing actual or potential competitors, most often by using monopoly power, and thereby enhancing the long-run prospects of the firm.

availability error a bias that arises from our predisposition to estimate the probability of an outcome based on how easy the outcome is to imagine.

barriers to imitation factors that make it difficult for a com- petitor to copy a company’s distinctive competencies.

behavior control control achieved through the establish- ment of a comprehensive system of rules and procedures that specify the appropriate behavior of divisions, func- tions, and people.

brand loyalty preference of consumers for the products of established companies.

broad differentiators companies that have developed business-level strategies to better differentiate their prod- ucts and lower their cost structures simultaneously to of- fer customers the most value.

bureaucratic costs the costs associated with solving the transaction difficulties between business units and corpo- rate headquarters as a company obtains the benefits from transferring, sharing, and leveraging competencies.

business ethics accepted principles of right or wrong gov- erning the conduct of businesspeople.

business model the conception of how strategies should work together as a whole to enable the company to achieve competitive advantage.

business unit a self-contained division that provides a product or service for a particular market.

business-tobusiness (B2B) marketplace An industryspecific trading network established to connect buyers and sellers through the Internet to lower costs.

capabilities a company’s skills at coordinating its resources and putting them to productive use.

chaining a strategy designed to obtain the advantages of cost leadership by establishing a network of linked mer- chandising outlets interconnected by IT that functions as one large company.

code of ethics formal statement of the ethical priorities to which a business adheres.

cognitive biases systematic errors in human decision mak- ing that arise from the way people process information.

commonality some kind of skill or competency that when shared by two or more business units allows them to oper- ate more effectively and create more value for customers.

competitive advantage the achieved advantage over rivals when a company’s profitability is greater than the average profitability of firms in its industry.

corporate headquarters staff the team of top executives, as well as their support staff, who are responsible for over- seeing a company’s long-term multibusiness model and providing guidance to increase the value created by the company’s selfcontained divisions.

corruption corruption can arise in a business context when managers pay bribes to gain access to lucrative business contracts.

cost-leadership a business model that pursues strategies that work to lower its cost structure so it can make and sell products at a lower cost than its competitors.

credible commitment a believable promise or pledge to support the development of a long-term relationship be- tween companies.

customer defection rates (or churn rates) percentage of a company’s customers who defect every year to competitors.

customer response time time that it takes for a good to be delivered or a service to be performed.

devil’s advocacy a technique in which one member of a decisionmaking team identifies all the considerations that might make a proposal unacceptable.

dialectic inquiry the generation of a plan (a thesis) and a counterplan (an antithesis) that reflect plausible but con- flicting courses of action.

differentiation a business model that pursues business- level strategies that allow it to create a unique product, one that customers perceive as different or distinct in some important way.

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GlossaryG2

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diseconomies of scale unit cost increases associated with a large scale of output.

distinctive competencies firm-specific strengths that allow a company to differentiate its products and/or achieve sub- stantially lower costs to achieve a competitive advantage.

diversification the process of entering new industries, dis- tinct from a company’s core or original industry, to make new kinds of products for customers in new markets.

diversified company a company that makes and sells prod- ucts in two or more different or distinct industries.

divestment strategy when a company decides to exit an in- dustry by selling off its business assets to another company.

dominant design common set of features or design characteristics.

economies of scale reductions in unit costs attributed to a larger output.

economies of scope the synergies that arise when one or more of a diversified company’s business units are able to lower costs or increase differentiation because they can more effectively pool, share, and utilize expensive re- sources or capabilities.

employee productivity the output produced per employee.

environmental degradation occurs when a company’s ac- tions directly or indirectly result in pollution or other forms of environmental harm.

escalating commitment a cognitive bias that occurs when decision makers, having already committed significant resources to a project, commit even more resources after receiving feedback that the project is failing.

ethical dilemmas situations where there is no agreement over exactly what the accepted principles of right and wrong are, or where none of the available alternatives seems ethically acceptable.

ethics accepted principles of right or wrong that govern the conduct of a person, the members of a profession, or the actions of an organization.

experience curve the systematic lowering of the cost struc- ture, and consequent unit cost reductions, that have been observed to occur over the life of a product.

external stakeholders all other individuals and groups that have some claim on the company.

first-mover disadvantages competitive disadvantages asso- ciated with being first.

fixed costs costs that must be incurred to produce a prod- uct regardless of the level of output.

flexible production technology (or, lean production) a range of technologies designed to reduce setup times for com- plex equipment, increase the use of individual machines through better scheduling, and improve quality control at all stages of the manufacturing process.

focused cost leadership a business model based on using cost leadership to compete for customers by offering low- priced products to only one, or a few, market segments.

focused differentiation a business model based on using differentiation to focus on competing customers by mak- ing unique to customized products for only one, or a few, market segments.

format wars battles to control the source of differentiation, and thus the value that such differentiation can create for the customer.

fragmented industry an industry composed of a large num- ber of small- and medium-sized companies.

franchising a strategy in which the franchisor grants to its franchisees the right to use the franchisor’s name, reputa- tion, and business model in return for a franchise fee and often a percentage of the profits.

functional managers managers responsible for supervising a particular function, that is, a task, activity, or operation, such as accounting, marketing, research and development (R&D), information technology, or logistics.

functional structure grouping of employees on the basis of their common expertise and experience or because they use the same resources.

functional-level strategies strategy aimed at improving the effectiveness of a company’s operations and its ability to attain superior efficiency, quality, innovation, and cus- tomer responsiveness.

general managers managers who bear responsibility for the overall performance of the company or for one of its major self-contained subunits or divisions.

general organizational competencies competencies that re- sult from the skills of a company’s top managers that help every business unit within a company perform at a higher level than it could if it operated as a separate or indepen- dent company.

generic business level strategy a strategy that gives a com- pany a specific form of competitive position and advantage vis-à-vis its rivals that results in aboveaverage profitability.

geographic structure a way of grouping employees into dif- ferent geographic regions to best satisfy the needs of cus- tomers within different regions of a state or country.

global strategic alliances cooperative agreements between companies from different countries that are actual or po- tential competitors.

global standardization strategy a business model based on pursuing a low-cost strategy on a global scale.

greenmail a source of gaining wealth by corporate raiders who benefit by pushing companies to either change their corporate strategy to one that will benefit stockholders, or by charging a premium for these stock when the company wants to buy them back.

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Glossary G3

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growth strategy a strategy designed to allow a company to maintain its relative competitive position in a rapidly ex- panding market and, if possible, to increase it.

harvest strategy when a company reduces to a minimum the assets it employs in a business to reduce its cost structure and extract or “milk” maximum profits from its investment.

hierarchy of authority the clear and unambiguous chain of command that defines each manager’s relative author- ity from the CEO down through top, middle, to first-line managers.

hold-and-maintain strategy when a company expends re- sources to develop its distinctive competency to remain the market leader and ward off threats from other companies that are attempting to usurp its leading position.

holdup when a company is taken advantage of by another company it does business with after it has made an in- vestment in expensive specialized assets to better meet the needs of the other company.

horizontal integration the process of acquiring or merg- ing with industry competitors to achieve the competi- tive advantages that arise from a large size and scope of operations.

hostage taking a means of exchanging valuable resources to guarantee that each partner to an agreement will keep its side of the bargain.

illusion of control a cognitive bias rooted in the tendency to overestimate one’s ability to control events.

information asymmetry a situation where an agent has more information about resources they are managing than the principal has.

information distortion the manipulation of facts sup- plied to corporate managers to hide declining divisional performance.

information manipulation managers use their control over corporate data to distort or hide information in order to enhance their own financial situation or the competitive position of the firm.

inside directors senior employees of the company, such as the CEO.

intangible resources nonphysical entities such as brand names, company reputation, experiential knowledge and intellectual property, including patents, copyrights, and trademarks.

integrating mechanisms ways to increase communication and coordination among functions and divisions.

integrating roles managers who work in full-time posi- tions established specifically to improve communication between divisions.

internal new venturing the process of transferring resources to and creating a new business unit or division in a new industry to innovate new kinds of products.

internal stakeholders stockholders and employees, includ- ing executive officers, other managers, and board members.

intrapreneurs managers who pioneer and lead new ven- ture projects or divisions and act as inside or internal entrepreneurs.

just-in-time system of economizing on inventory holding costs by scheduling components to arrive just in time to enter the production process or as stock is depleted.

killer applications applications or uses of a new technology or product that are so compelling that customers adopt them in droves, killing the competing formats.

knowledge management system the company-specific in- formation system that systematizes the knowledge of all its employees and provides access to employees who have the expertise needed to solve problems as they arise.

leadership strategy when a company develops strategies to become the dominant player in a declining industry.

learning effects cost savings that come from learning by doing.

leveraging competencies the process of taking a distinctive competency developed by a business unit in one industry and using it to create a new business unit in a different industry.

localization strategy strategy focused on increasing profit- ability by customizing the company’s goods or services so that the goods provide a favorable match to tastes and preferences in different national markets.

location economies the economic benefits that arise from performing a value creation activity in an optimal location.

market concentration when a company specializes in some way and adopts a focus business model to reduce invest- ment needs and searches for a viable and sustainable com- petitive position.

market development when a company searches for new market segments for a company’s existing products to in- crease sales.

market penetration when a company concentrates on expanding market share to strengthen its position in its existing product markets.

market segmentation the way a company decides to group customers based on important differences in their needs to gain a competitive advantage.

marketing strategy the position that a company takes with regard to pricing, promotion, advertising, product design, and distribution.

market structure a way of grouping employees into sepa- rate customer groups so that each group can focus on satisfying the needs of a particular customer group in the most effective way.

mass customization the use of flexible manufacturing tech- nology to reconcile two goals that were once thought to be incompatible: low cost, and differentiation through prod- uct customization.

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GlossaryG4

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matrix structure a way of grouping employees in two ways simultaneously by function and by product or project to maximize the rate at which different kinds of products can be developed.

merger an agreement between two companies to pool their resources and operations and join together to better compete in a business or industry.

mission the purpose of the company, or a statement of what the company strives to do.

multidivisional company a company that competes in sev- eral different businesses and has created a separate self- contained division to manage each.

multidivisional structure a complex organizational design that allows a company to grow and diversify while it also reduces coordination and control problems because it uses self-contained divisions and has a separate corporate headquarters staff.

multinational company a company that does business in two or more national markets.

network effects the network of complementary products as a primary determinant of the demand for an industry’s product.

network structure a cluster of different companies whose actions are coordinated by contracts and outsourc- ing agreements rather than by a formal hierarchy of authority.

new-venture division a separate and independent division established to give its managers the autonomy to develop a new product.

niche strategy when a company focuses on pockets of de- mand that are declining more slowly than the industry as a whole to maintain profitability.

nonprice competition the use of product differentiation strategies to deter potential entrants and manage rivalry within an industry.

on-the-job consumption a term used by Economists to de- scribe the behavior of company funds by senior manage- ment to acquire perks (such as lavish offi ces, jets, etc.) that will enhance their status, instead of investing it to in- crease stockholder returns.

operating budget a blueprint that states how managers intend to use organizational resources to most efficiently achieve organizational goals.

opportunism seeking one’s own selfinterest often through the use of guile.

opportunistic exploitation unethical behavior sometimes used by managers to unilaterally rewrite the terms of a contract with suppliers, buyers, or complement providers in a way that is more favorable to the firm.

opportunities elements and conditions in a company’s en- vironment that allow it to formulate and implement strat- egies that enable it to become more profitable.

organizational culture the specific collection of values, norms, beliefs, and attitudes that are shared by people and groups in an organization and that control the way they interact with each other and with stakeholders outside the organization.

organizational design the process of deciding how a com- pany should create, use, and combine organizational structure, control systems, and culture to pursue a busi- ness model successfully.

organizational design skills the ability of the managers of a company to create a structure, culture, and control sys- tems that motivate and coordinate employees to perform at a high level.

organizational slack the unproductive use of functional re- sources by divisional managers that can go undetected un- less corporate managers monitor their activities.

organizational structure the means through which a com- pany assigns employees to specific tasks and roles and specifies how these tasks and roles are to be linked to- gether to increase efficiency, quality, innovation, and re- sponsiveness to customers.

output control the control system managers use to es- tablish appropriate performance goals for each division, department, and employee and then measure actual per- formance relative to these goals.

outside directors directors who are not full-time employees of the company, needed to provide objectivity to the moni- toring and evaluation of processes.

outside view identification of past successful or failed stra- tegic initiatives to determine whether those initiatives will work for project at hand.

parallel sourcing policy a policy in which a company enters into longterm contracts with at least two suppliers for the same component to prevent any problems of opportunism.

personal control the way one managers shapes and influ- ences the behavior of another in a face-to-face interaction in the pursuit of a company’s goals.

personal ethics generally accepted principles of right and wrong governing the conduct of individuals.

positioning strategy the specific set of options a company adopts for a product based upon four main dimensions of marketing: price, distribution, promotion and advertising, and product features.

price leadership when one company assumes the responsi- bility for determining the pricing strategy that maximizes industry profitability.

price signaling the process by which companies increase or decrease product prices to convey their intentions to other companies and influence the price of an industry’s products.

primary activities activities related to the design, creation, and delivery of the product, its marketing, and its support and after-sales service.

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Glossary G5

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principle of the minimum chain of command the principal that a company should design its hierarchy with the few- est levels of authority necessary to use organizational re- sources effectively.

prior hypothesis bias a cognitive bias that occurs when de- cision makers who have strong prior beliefs tend to make decisions on the basis of these beliefs, even when presented with evidence that their beliefs are wrong.

process innovation development of a new process for pro- ducing products and delivering them to customers.

product innovation development of products that are new to the world or have superior attributes to existing products.

product structure a way of grouping employees into sepa- rate product groups or units so that each product group can focus on the best ways to increase the effectiveness of the product.

product development the creation of new or improved products to replace existing products.

product differentiation the process of designing products to satisfy customers’ needs.

product proliferation the strategy of “filling the niches,” or catering to the needs of customers in all market segments to deter entry by competitors.

product-team structure a way of grouping employees by product or project line but employees focus on the devel- opment of only one particular type of product.

profit center when each self-contained division is treated as a separate financial unit and financial controls are used to establish performance goals for each division and mea- sure profitability.

profit growth the increase in net profit over time.

profitability the return a company makes on the capital in- vested in the enterprise.

public domain government- or association- set standards of knowledge or technology that any company can freely incorporate into its product.

razor and blade strategy pricing the product low in order to stimulate demand and pricing complements high.

reasoning by analogy use of simple analogies to make sense out of complex problems.

reengineering the process of redesigning business pro- cesses to achieve dramatic improvements in performance such as cost, quality, service, and speed.

related diversification a corporate-level strategy that is based on the goal of establishing a business unit in a new industry that is related to a company’s existing business units by some form of commonality or linkage between their value-chain functions.

representativeness a bias rooted in the tendency to gener- alize from a small sample or even a single vivid anecdote.

resources assets of a company.

restructuring the process by which a company streamlines its hierarchy of authority and reduces the number of levels in its hierarchy to a minimum to lower operating costs.

risk capital equity capital for which there is no guarantee that stockholders will ever recoup their investment or ear a decent return.

scenario planning formulating plans that are based upon “what-if” scenarios about the future.

self-contained division an independent business unit or di- vision that contains all the value chain functions it needs to pursue its business model successfully.

self-dealing managers using company funds for their own personal consumption, as done by Enron and Computer Associates in previous years.

self-managing teams teams where members coordinate their own activities and make their own hiring, training, work, and reward decisions.

share-building strategy a strategy that aims to build mar- ket share by developing a competitive advantage to attract customers by providing them with knowledge of the com- pany’s products.

shareholder value returns that shareholders earn from pur- chasing shares in a company.

share-increasing Strategy when a company focuses its re- sources to invest in product development and marketing to become a dominant industry competitor.

span of control the number of subordinates who report di- rectly to a particular manager.

stakeholders individuals or groups with an interest, claim, or stake in the company, in what it does, and in how well it performs.

standardization the degree to which a company specifies how decisions are to be made so that employees’ behavior become measurable and predictable.

stock options the right to purchase company stock at a predetermined price at some point in the future, usually within 10 years of the grant date.

strategic alliances long-term agreements between two or more companies to jointly develop new products or pro- cesses that benefit all companies which are a part of the agreement.

strategic groups the set of companies that pursue a sim- ilar business model and compete for the same group of customers.

strategic leadership creating competitive advantage through effective management of the strategy-making process.

strategic outsourcing the decision to allow one or more of a company’s value-chain activities to be performed by indepen- dent, specialist companies that focus all their skills and knowl- edge on just one kind of activity to increase performance.

strategy a set of related actions that managers take to in- crease their company’s performance.

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GlossaryG6

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strategy formulation selecting strategies based on analysis of an organization’s external and internal environment.

strategy implementation putting strategies into action.

substandard working conditions arise when managers un- der- invest in working conditions, or pay employees below- market rates, in order to reduce their production costs.

supply-chain management the task of managing the flow of inputs and components from suppliers into the company’s production processes to minimize inventory holding and maximize inventory turnover.

support activities activities of the value chain that provide inputs that allow the primary activities to take place.

sustained competitive advantage a company’s strategies en- able it to maintain above-average profitability for a num- ber of years.

switching costs costs that consumers must bear to switch from the products offered by one established company to the products offered by a new entrant.

SWOT analysis the comparison of strengths, weaknesses, opportunities, and threats.

takeover constraint the risk of being acquired by another company.

tangible resources tangible resources Physical entities, such as land, buildings, equipment, inventory, and money.

team Strategic control systems the mechanism that allows managers to monitor and evaluate whether their busi- ness model is working as intended and how it could be improved.

technical standards a set of technical specifications that producers adhere to when making the product, or a com- ponent of it.

technological paradigm shifts in new technologies that rev- olutionize the structure of the industry, dramatically alter the nature of competition, and require companies to adopt new strategies in order to survive.

threats elements in the external environment that could endanger the integrity and profitability of the company’s business.

total quality management increasing product reliability so that it consistently performs as it was designed to and rarely breaks down.

transfer pricing the problem of establishing the fair or “com- petitive” price of a resource or skill developed in one divi- sion that is to be transferred and sold to another division.

transferring competencies the process of taking a distinc- tive competency developed by a business unit in one in- dustry and implanting it in a business unit operating in another industry.

transnational strategy a business model that simultane- ously achieves low costs, differentiates the product offer- ing across geographic markets, and fosters a flow of skills between different subsidiaries in the company’s global net- work of operations.

two-boss employees employees who report both to a proj- ect boss and who report to a functional boss.

unrelated diversification a corporate-level strategy based on a multibusiness model that uses general organizational competencies to increase the performance of all the com- pany’s business units.

value chain the idea that a company is a chain of activities that transforms inputs into outputs that customers value.

values a statement of how employees should conduct themselves and their business to help achieve the company mission.

vertical integration when a company expands its operations either backward into an industry that produces inputs for the company’s products (backward vertical integration) or forward into an industry that uses, distributes, or sells the company’s products.

vertical disintegration when a company decides to exit in- dustries either forward or backward in the industry value chain to its core industry to increase profitability.

virtual corporation when companies pursued extensive strategic outsourcing to the extent that they only perform the central value-creation functions that lead to competi- tive advantage.

virtual organization a collection of employees linked by laptops, smartphones, and global video teleconferencing who may rarely meet face-toface, but who join and leave project teams as their skills are needed.

vision the articulation of a company’s desired achieve- ments or future state.

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(‘f’ indicates a figure; ‘t’ indicates a table)

A Absolute cost advantages, 52 Absorptive capacity, 106 Accenture, 489 Accounting terms, 101t Achieve Competitive Excellence (ACE)

program, 151, 349–350 Acquisitions, 311, 485–486

attraction of, 364–365 guidelines, 367–369 pitfalls, 365–367

Adaptive culture, 431 Adelaide News, 336 Advanced Micro Devices (AMD), 59 Affymetrix, 145 Age distribution, 73 Agency theory, 384–388 Airline industry, 45, 50, 51, 55, 67, 74,

307–308 Aluminum industry, 320 Amazon.com, 70, 134, 140, 147, 172,

180, 227, 228 AMD, 212, 214 American Airlines (AA), 307 Anheuser-Busch, 51, 196 Anticompetitive behavior, 399–400 AOL, 200, 201f, 202 Apple, 3, 6, 97, 103–104, 103f, 107, 142,

180, 244, 245, 260, 311, 326, 329 differentiation advantage, 177 profitability, 2f, 6

Archer Daniels Midland, 383 Arthur Andersen, 393 Artzt, Russell, 389 Athletic shoe industry, 161 Automobile component supply

industry, 58 Automobile industry, 89 Autonomous action, 22, 24 Availability error, 29 Average customer, business model, 163 Avon, 263–264, 265, 467, 468 “Azure,” 38

B Balanced scorecard model, 395–396, 395f Bargaining power, horizontal

integration, 315 Barnes & Noble, 70 Barriers to entry, potential competitors,

50–53

Barriers to imitation, 84, 102, 104, 247–248, 248t

Bartlett, Christopher, 278, 282 Bartz, Carol, 422 Beer industry, 48, 73 Behavior control, 427–428 Benchmarking, 110 Best Buy, 3, 195 Bethlehem Steel, 77 Bidding strategy, acquisitions, 368 BMW, 159, 174, 175 Board of directors, 390–391 Boeing, 311, 325–326, 383, 400 Book-selling industry, 70 Bowerman, Bill, 215–216 Brand loyalty, 51–52 Bravo, Marie, 92, 93 Breakfast cereal industry, 56 British Sunday Telegraph, 336 Broad differentiation, 180–181, 181f Brooks, Dede, 384 Brown, Justin, 173 Buffet, Warren, 45 Burberry, 92, 93 Bureaucratic costs, 418

diversification, 354–357 and functional structure, 437–438 new industry entrance, 463 vertical integration, 322

Burgelman, Robert, 22 Business defining, 14f Business ethics, 396–397 Business-level managers, 11 Business-level strategies, 19–20, 157

broad differentiation, 180–181, 181f and competitive positioning, 164–167 cost leadership, 168–170 declining industries, 218–222 differentiation, 174–176 embryonic and growth industries,

196–203 focused cost leadership,

170–172, 172f focused differentiation, 176–178 fragmented industries, 194–196 generic, 167–178 mature industries, 207–218

Business model, 7 articulation, 31 broad differentiation, 181f and competitive advantage, 98–100 and competitive positioning,

158–164, 165f distinctive competencies, 164 generic, 167–178, 171f

market segmentation, 161–164, 161f, 162f replication, 314–315

Business process, 451–452 Business-to-business (B2B) networks, 488 Business unit, 11 Buyers bargaining power, 57–58

C Cadillac, 160 Canon, 344 Capabilities

distinctive competencies, 84–85 sharing in diversification, 345–346, 346f

Capacity control strategies, 216–218 excess elimination, 315 factors in excess, 217 maintenance, 210 utilization, 127

Capital turnover, 101f, 101t, 102 Cardiac surgery learning effects, 123 Caterpillar, 92, 148, 254, 283 Cathode ray tubes (CRT), 322 CD players, 237, 239 Cellular phone industry, 270 Centralized authority, 420–421, 467, 468 Chaining, fragmented industry, 194–195 Chambers, John, 494 Chandler, Alfred D., 417 Charles Schwab, 23 Christensen, Clayton, 253, 254, 255–256 Christie’s, 384, 390 Chrysler, 105 Churchill, Winston, 30 Churn rates, 128 Cisco Systems, 132, 142, 244, 255, 494

and Fujitsu, 295 ClearVision, 273–274 Cloud computing, 37, 227–228 Coca-Cola, 47, 49, 53, 74, 105, 247, 267,

366, 484 global strategy, 286

Code of ethics, 403 of Dell, 404

Cognitive biases, 28 Commercialization, new venture, 362 Commitment, leader, 31 Commonalities, diversification, 343,

351, 351f Company differences, profit rates, 70 Company infrastructure

efficiency, 134, 135t in value chain, 93

Comparative cost economies, 241–242

Index

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IndexI2

Decentralized planning, 27–28 Decision-making

biases, 28–29 techniques, 29–30

Declining industries, 67 business-level strategies,

218–222, 220f intensity, 218–219, 219f

Delegation of power, 32 Dell, Michael, 1–3, 9, 31, 184, 404,

431, 442 Dell Computer, 2f, 7, 31, 61, 68, 103–104,

103f, 107, 169, 184, 281, 313, 332, 442–443

Demand and value creation, 88–89 and vertical integration, 323

Deming, W. Edwards, 136 Demographic forces, 73 Deregulation, 74 Development research, new venture, 363 Devil’s advocacy, 29 DHL, 173 Dialectic inquiry, 30 Differentiated products, 159 Differentiation

business-level strategy, 174–176 organizational design implementation,

441–443 Digital Equipment Corporation

(DEC), 109 Digital television broadcasts (DTV), 233 Direct contact, managers, 422–423 Diseconomies of scale, 121, 121f Disruptive technology, 253–255 Distinctive competencies, 84–86

business model, 164 capabilities, 84–85 global market entry, 291–293 resources, 84

Distribution channels, global markets, 278–279

Diversification, 342 limits, 352–357 related, 351 strategies, 357–360 unrelated, 352

Diversified company, 342 Divestment strategy, declining industry,

219, 222 Division, definition, 418 Dolby, 235, 236–237, 240 Dolby, Ray, 236 Dominant design, 231, 231f Donald, Jim, 31–32 Donohue, John, 327 Doz, Yves, 298 Druyun, Darleen, 383 Duplication of resources, horizontal

integration, 312 Durability, competitive advantage,

102–107 Dyment, Roy, 146

Corporate headquarters staff, 464, 465f Corporate-level managers, 10–11 Corporate-level strategies, 20

acquisitions, 364–369 cooperative relationships, 323–328 diversification, 342–357 horizontal integration, 310–316 joint ventures, 369–370 multibusiness model, 309–310 multidivisional structure, 470–473, 471t new ventures, 360–364 restructuring, 370 strategic outsourcing, 328–333 vertical integration, 316–323 web, 358–360, 358f

Corruption, 401 Cost conditions, 55 Cost economies, global volume, 272–273 Cost leadership

advantages and disadvantages, 170 decisions, 168–169 organizational design implementation,

440–441 Cost of goods sold (COGS), 101f,

101t, 102 Cost reductions

global market entry, 293 global markets, 276–277

Cost structure horizontal integration, 312 outsourcing, 331 vertical integration, 322

Costs/product variety tradeoff, 126f Cott Corporation, 53 Credible commitment, 326

strategic alliance, 325 Credit card industry, 129 Cross-selling, 313–314 Currency exchange rates, 72 Customer defection rates, 128 Customer focus, 146 Customer loyalty, 129, 129f Customer needs, and product

differentiation, 159–160 Customer-oriented business, 14 Customer response time, 98, 147–148 Customer responsiveness

and competitive advantage, 95f, 98 functional roles, 148t and market structure, 444–445 and strategic control, 424 superior, 145–148

Customer service, in value chain, 92 Customer switching costs, 52 Customization, 147 Cypress Semiconductor, 429, 435

D David, George, 151, 349–350 Davidge, Christopher, 384 Decentralization, 468 Decentralized authority, 420–421

Compatibility, demand growth, 202–203 Competencies, 85

competitor, 248, 248t, 249 leveraging in diversification, 344–345 transfer in diversification,

343–344, 343f Competitive advantage, 6–7, 83

analysis, 100–102 customer responsiveness, 95f, 98 distinctive competencies, 84–86 durability, 102–107 efficiency, 94–95, 95f failure avoidance, 107–111 and functional strategies, 119f innovation, 95f, 97–98 national, 267, 269–271, 269f superior quality, 95–97, 95f and value creation, 86–90 value creation cycle, 99f

Competitive bidding strategy, 324 Competitive chasm, 200, 201f Competitive positioning

broad differentiation, 180–181, 181f business-level strategy, 164–167, 165f and business model, 158–164 cost leadership, 168–170 definition, 158 dynamics, 178–180 failures, 183–185 and strategic groups, 181–183 and value creation, 167f

Competitive price, 160 Competitors, capability of, 105–106 Complementary assets, first mover

strategy, 246–247, 248, 248t Complementary products

and standards, 232 supply, 238

Complementors competence, 60 Complexity, demand growth, 202 Computer Associates, 388, 389 Computer industry, 47, 48, 48f, 59,

61, 197 Condit, Phil, 383 Conglomerates, 349, 352 Consistency, leader, 30–31 Consolidated industries, 54, 55, 194 Consumer surplus, 87 Consumer tastes, global markets, 277–278 Continuous improvement and

learning, 110 Control system, employee motivation, 416 Conversion activities, standardized, 428 Cooperation with competitors, 239 Cooperative relationships

long-term contracting, 324–325 short-term contracts, 324

Coordination diversification, 355, 355f, 357 with rivals, 218

Core business maintenance, outsourcing, 332

Corning, 145

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Index I3

Format licensing, 240 Format wars

in smartphone operating systems, 259–260

technical standards, 230, 233 winning, 237–240

Foster, Richard, 250, 252 Four Seasons, 146 Fragmented industries, 54

business-level strategy, 194–196, 195f Franchising

fragmented industry, 195 global market entry, 288–289, 292t

Free cash flow, 342 Fuji, 249, 250 Fujitsu

and Cisco Systems, 295 Function, definition, 417 Functional-level managers, 9 Functional-level strategies, 19, 118, 119f

control, 434–435 culture development, 435–437 grouping by function, 433–434

Functional managers, 11 Functional resource duplication,

multidivisional structure, 470 Functional structure, 434f

and bureaucratic costs, 437–438 Fung, Victor, 490 Fung, William, 490

G Gallo Wine, 206 Garriques, Ronald, 184 Gates, Bill, 31, 429–430 General Electric (GE), 10, 11, 132

appliance group, 27 General managers, 9 General Mills, 56 General Motors (GM), 16, 89, 89f, 90,

95, 98, 104, 106, 107, 142, 322, 324, 465

and Toyota, 298 General organizational competencies,

sharing in diversification, 347–350 Generally agreed-upon accounting

practices (GAAP), 386, 392 Geographic structure, organizational

design implementation, 445–446, 446f

Ghemawat, Pankaj, 105–106 Ghoshal, Sumantra, 278, 282 Glassman, David, 273, 274 Global area structure, 477f Global division structure, 478, 478f Global environment, 265–279

cost pressures, 275–277 entry modes, 284–293 expansion, 271–275 local responsiveness, 276f, 277–279 strategic alliances, 293–298 strategies, 279–284, 280f, 285f

Excavators, paradigm shift, 254 Excess capacity

factors, 217 maintenance, 210

Exercises competition, 76 competitive advantage, 113, 187–188 diversification, 372–373 global strategy, 300–302 identifying excellence, 150 industry environment, 224 organizational structure, 455, 493 paradigm shift, 258 stakeholder claims, 408 strategic planning, 35 vertical integration, 335

Exit barriers, 56–57 Experience curve, 123–125, 124f Exploratory research, new venture, 363 Exporting, global market entry, 285,

287, 292t Express mail, 98, 148

and parcel delivery industry, 57 External analysis, 17–19 External stakeholders, 379, 380f Extraordinary pay, senior

management, 386

F Face-to-face interaction, 425 Failure avoidance, 107–111

steps, 110–111 Federal Communications Commission

(FCC), standards, 233 Federal Trade Commission (FTC), 316 FedEx, 57, 173, 174, 245 Feedback loop, 21 Feigenbaum, A. V., 136 First Global Xpress (FGX), 173 First-movers

advantages, 244–245 disadvantages, 245–246 exploitation strategies, 246–249 high-tech industry, 243–244, 244f

Fixed costs, 120 high tech industry, 242

Flat organizational structure, 418–419, 419f

Flexible production technology, 126, 126f, 128

Flextronics, 332 Focused cost leadership, business-level

strategy, 170–172, 172f Focused differentiation, business-level

strategy, 176–178 Focused market segment, 161, 162f, 164 Focused narrow product line, 450–451 Ford, Henry, 197 Ford Motor Company, 127–128,

477, 481 Foreign sales organization, 477 Forest Labs, 62

E Early adopters, market share, 198,

199f, 200 Early majority, market share,

198–199, 199f eBay, 180, 327 Economies of scale, 51, 120–129, 121f,

122f, 124f, 126f horizontal integration, 312

Economies of scope, diversification, 345 Efficiency

achieving, 134, 135f in competitive advantage, 94–95, 95f economies of scale, 120–129, 121f, 122f experience curve, 123–125, 124f and learning effects, 121–123, 122f marketing, 128–129 multidivisional structure, 467 production systems, 125–128 and strategic control, 423

Eisner, Michael, 420, 431 Eli Lilly, 62 Ellison, Larry, 314, 348 Eloquence, leader, 30–31 Embryonic industries, 64–65

business-level strategies, 196–203 investment strategies, 204

Emergent strategies, 24–25, 24f Emotional intelligence, 32–33 Empathy, leader, 33 Employee productivity, 95 Employee stock ownership plans (ESOP),

381–382, 396, 435 Employee training, 131 Empowerment, 132 Enron, 393, 405 Enterprise resources planning (ERP)

system, 474 Entrepreneurial capabilities, 347–348 Entry by potential competitors, 50–53 Entry deterrence, 207–210, 207f Entry mode

exporting, 285, 287, 292t franchising, 288–289, 292t global market, 285, 291–293, 292t licensing, 287–288, 292t wholly owned subsidiaries,

290–291, 292t Environmental degradation, 401 Escalating commitment, 28 Ethical behavior, 402

decision-making, 403 ethics officer, 404 hiring and promotion, 402–403 moral courage, 405 organization culture and leadership, 403 strong corporate governance, 404–405

Ethical dilemma, 491 definition, 397 exercises, 33, 74, 111, 185, 222, 257,

299, 333, 371, 406 Ethics, and strategy, 396–406

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Infrastructure differences, global markets, 278

Innovation and competitive advantage, 95f, 99 exploitation strategies, 246–249, 248t failure rate, 142 failure reduction, 143–145 functional roles, 144t and strategic control, 424 superior, 141–145

Innovators, market share, 198, 199f Inputs, standardized, 427 Inside directors, 390 Intangible resources, 84 Integrating roles, multidivisional

structure, 472 Integration, acquisitions, 365, 368 Intel, 22, 59, 197, 212, 213, 214, 243–244

dominant design, 231, 233 Intended and emergent strategies,

24–25, 24f Inter-Continental Hotel Group (IHG),

224–225, 227 Interest rates, 71 Internal analysis, 19, 83

competitive advantage, 100–102 Internal new venturing, 360 Internal stakeholders, 379, 380f International strategy, 280f, 283–284 International trade and investment, 72 Internet retail industry, 134 Intrapreneurs, 481 Invested capital (IC), 100, 101t iPad, 177 iPhone applications, 177 iPod, 177 Isdell, Neville, 286 Ito, Yuzuru, 151 iTunes, 177 Iverson, Ken, 31 Ivester, Douglas, 286 “Ivory tower” planning, 27, 28

J Jet Blue, 50, 51, 189, 307, 308 Jobs, Steve, 177, 348, 362 John Deere, 254 Johnson & Johnson, 247 Joint ventures

global market entry, 289–290, 292t new industries, 369–370

Jones, Tim, 22 Jones, Reg, 354 Jung, Andrea, 263, 265, 467, 468 Juran, Joseph, 136 Just-in-time (JIT) inventory systems, 130

K Kahneman, Daniel, 30 Keiretsu system, Japanese carmakers, 325 Kelleher, Herb, 32, 308

Holdup outsourcing, 332–333 specialized assets, 319

Holiday Inns, 224–225 Home Depot, 195, 387, 392 Honda, 164, 173, 174, 489 Honda Motor Co., 25, 147 Horizontal integration, 311

benefits, 312–315 problems of, 315–316

Horizontal merger, fragmented industry, 196 Host government demands, 279 Hostage taking, strategic alliance,

325–326 Howard Schultz’s Second Act, 81–82 Human resources

efficiency, 131, 134, 135t in value chain, 93

Hydraulic systems, paradigm shift, 254

I Iacocca, Lee, 105 IBM, 15, 107, 108, 238, 452–453, 489

global strategy, 302–303 Icarus Paradox, The, 109, 110 Iger, Bob, 420 Illusion of control, 29, 30 Imitating capabilities, 105 Imitating resources, 104–105 Imitation, new products, 243 Immelt, Jeffrey, 10, 348 Industry

changing boundaries, 49 competitive structure, 54–55 definition, 47 demand, 55 differences and performance, 7–9, 8f dynamism, 106–107 five forces model, 49–60 innovation and change, 68–70 life cycle analysis, 64–68 macroenvironment impact, 70–74 market segments, 48–49, 48f and sector, 48, 48f strategic groups within, 60–64

Inertia and failure, 108 overcoming, 110–111

Information asymmetry, 385, 386 Information distortion, 469 Information gathering, leader, 32 Information loss, outsourcing, 333 Information manipulation, 399 Information processing and storage, 15 Information systems

efficiency, 132–134 in value chain, 93

Information technology and fragmented industry, 196 multidivisional structure, 473–474 strategic control, 428–429 strategic implementation, 487–488

Global forces, 72 Global-matrix structure, 480, 480f, 481 Global product-group structure, 479, 479f Global standardization strategy,

280–281, 280f Global strategic alliances, 293–298 Global strategies, 20, 280f, 476t

Avon Products, 263–264 changes over time, 284, 285f Dell, 281 international, 284, 475, 476t, 477–478 localization, 281–282, 475,

476–477, 476t multidivisional structure, 475–481 standardization, 280–281, 475, 476t,

478–479 transnational, 282–283, 475, 476t,

479–481 Goals, 16–17 Goizueta, Roberto, 286 Goldman Sachs, 377–378, 379, 397 Goleman, Daniel, 32 Google, 6, 21, 38, 209, 228, 260

cloud computing, 228 Gou, Terry, 329 Governance mechanisms, 388

auditing and statements, 392–393 board of directors, 390–391 employee incentives, 396 stock-based compensation, 391–392 strategic control systems, 394–396 takeover constraint, 393–394

Government regulations, 52–53 Greenmail, 394 Grove, Andrew, 22, 60 Growth industries, 65

business-level strategies, 196–203 investment strategies, 205

Growth strategies, 205

H Hai, Hon, 329 Hamel, Gary, 298 Hammer and Champy, 453 Handoffs, 417–418 Harvest strategy, declining industry, 206,

219, 221–222 Health consciousness, 73 Heavyweight project manager, 143 Hewlett Packard, 3, 61, 313

profitability, 2f Hewlett, Bill, 402 Hewlett-Packard (HP), 239, 256, 421, 485 Hierarchy of authority, 418 High market segment, 162, 162f High-technology industries, 229–230

costs, 240–242, 241f first-movers, 243–249 paradigm shifts, 249–256 standards and formats, 230–240

Hiring strategy, 131 Hold-and-maintain strategy, 206

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Index I5

Molson Coors, 51 Moore, Ann, 18 Moore, Geoffrey, 200, 201 Moral courage, and ethics, 405 Motivation, leader, 33 Multibusiness model, 309–310, 342

related diversification, 351 Multidivisional company

advantages, 466–467 implementation problems, 467,

469–470 organization, 9, 10f structure, 463–466, 465f

Multidivisional structure, 464 Multinational companies, 265

subsidiaries’ skills, 275 Murdoch, Rupert, 336–337 Mutual dependence, specialized

assets, 319 Mylan Labs, 62

N Nardelli, Bob, 387 National competitive advantage, 267,

269–271, 269f factor endowments, 270–271 local demand conditions, 270 rivalry, 270–271 supporting industries, 270

National Star, 336 Neiman Marcus, 174, 429, 446 Nelson, Martha, 18 Nestlé’s, 482, 484, 486 Net profit, 100, 101f, 101t Netflix, 228 Network effects, 233–234

new entrants, 254 Network structure, 488–491 New industry acquisition, 364–369 New ventures, 360–364, 481, 483

division, 483 guidelines, 363–364 pitfalls, 361–363

New York Post, 336 News Corp., 336–337 NeXT, 177 Niche strategy, declining industries, 219,

220–221 Nike, 215–216, 328, 331, 398, 400,

489–491 Nokia, 260, 268, 270, 326,

461–462, 463 product structure, 444f

Nonprice competition, 212–213, 213f Nonprofit enterprises, performance

goals, 8–9 Nordstrom, 166, 174 North American Free Trade Agreement

(NAFTA), 274 Nucor Steel, 16, 31, 78, 85, 121,

132, 172 Nvidia, 212, 214

global forces, 72 political and legal forces, 74 social forces, 73–74 technological forces, 73

Macy’s, 196 Management by objectives, 435 Manufacturing, functional strategy,

435–436 Marginal costs, high-tech industry,

241, 241f Market concentration, 205 Market demand, 197–200, 198f

and standards, 233 Market discipline, strategic alliance,

326–328 Market penetration, 213 Market saturation, 198 Market segmentation, 48–49, 48f,

161–164, 161f, 162f Market structure, organizational design

implementation, 444–445 Marketing

efficiency, 128–129, 135t strategy, definition, 128 in value chain, 91–92

Markets global, 266–267 growth rates, 201–203

Marks & Spencer, 105, 129 Mass customization, 126, 127 Mass market vs. premium beer segment,

48–49 Materials management

efficiency, 129 in value chain, 93

Matrix structure, 447–449, 447f global, 480, 480f

Matsushita, 151, 234–235, 240, 245 Mature industries, 66–67

business-level strategies, 207–218 investment strategies, 206

Maucher, Helmut, 482 McComb, William, 456–457 McDonald’s, 114, 195, 199, 275, 310, 321

vertical integration, 321 Mercedes-Benz, 159, 160, 174, 477 Merck, 62, 311, 422, 485–486 Merrill Lynch, 409–410, 421 Microsoft, 20, 21, 37–39, 61, 76, 120,

197, 233, 272, 430, 485 cloud computing, 228 dominant design, 231, 235 paradigm shifts, 250 Windows Azure, 228

Miller, Danny, 109 Miller Brewing Co., 73, 343, 344 Mini-mills, 77 Minimum chain of command, 419–420 Minitel, 246 Mintzberg, Henry, 24–25 Mission, definition, 14 Mission statement, 14–16 Mobility barriers, 63–64

Kellogg, 56 Kennedy, John F., 30 Killer applications, 238 Kindler, Jeffrey, 356 King, Martin Luther, 30 Knight, Phil, 215, 216, 398 Knowledge management system, 488 Kodak, 14, 15, 249, 250, 354–355 Kraft Foods, 56 Krispy Kreme Doughnuts, 165 Kroc, Ray, 114 Kroger, 56, 196 Kumar, Sanjay, 389

L Laggards, market share, 199, 199f Lands’ End, 126, 127, 146 Late majority, market share, 199, 199f Law of diminishing returns, 241 Lay, Ken, 402 Leadership strategy, declining industry,

219, 220 Learning effects, 121–123, 122f Lee Kun-hee, 374 Legal forces, 74 Leveraging competencies, 344–345 Lewis, Ken, 409–410 Lexus, 160 Li & Fung, 490 Liaison roles, mangers, 423 Licensing, global market entry,

287–288, 292t Licensing format, 240 Life cycle, investment strategies, 203–206 Life cycle analysis, 64–68, 65f

embryonic stage, 64–65 growth stage, 65 limitations, 68 shakeout stage, 66

Lincoln, 160 Lipitor, 356 Liz Claiborne, 456–457 Local responsiveness, 276f, 277–279, 280f Localization strategy, 280f, 281–282 Location economies, 273–274 Logistics

efficiency, 129–130 in value chain, 93

Long-run growth, multidivisional structure, 466–467

Long-term cooperative relationships, 325 Long-term goals, 17 Low-priced products, 159 Luck, and competitive success, 111

M Mackay, Martin, 356 Macroeconomic forces, 71–72 Macroenvironment, 70–74, 71f

demographic forces, 73 economic forces, 71–72

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IndexI6

Production efficiency, 125–128, 135t globalization, 266–267 in value chain, 91

Profit center, 466 Profit growth, 5f, 6 Profitability, 5f, 6

and competitive advantage, 86–90 different industries, 8, 8f and diversification, 342–350 and flexible production

technology, 128 global expansion, 271–275 and goals, 17 multidivisional structure, 466 new venture scale of entry, 362f and organizational design, 439f revenue growth rates, 387f, 388 and stakeholders, 382–384 of U.S. computer companies

2001–2010, 2f vertical integration, 318–321

Profitable growth, 6 and goals, 17

Property, plant and equipment (PPE), 101f, 101t, 102

Public domain, 233 Punctuated equilibrium, 69, 69f

Q Quality

and competitive advantage, 95–97, 95f, 96f

as excellence, 134, 139–141 and strategic control, 424

QWERTY format, 230, 233

R R&D skills, 248 Rawls’s theory of justice, 403 Razor and blade strategy, 239 “Razor and razor blades” business

model, 20 Reasoning by analogy, 29 Reengineering, 451–453 Related diversification, 351, 357

multidivisional structure, 473 Relational capital, 298 Relative advantage, customer

demand, 202 Reliability, 95, 96, 96f, 97

functional roles, 138t methodologies, 138–139 superior, 134–135

Representativeness, 29 Research and development (R&D), 91,

101f, 101t, 102 efficiency, 130–131, 135t functional strategy, 435–437 new venture, 363–364 value chain, 91

Planned strategies combined with emergent, 26 criticism, 21, 22

Planning process, strategy making, 12, 13f Political forces, 74 Porsche, 159, 178 Porter, Michael E., 49–50, 69, 269,

270–271 Porters Five Forces Model, 49–50, 50f,

60, 170 buyers bargaining power, 57–58 complementors impact, 60 entry by potential competitors, 50–53 macroenvironment impact, 70 rivalry of established companies,

53–57 substitute products, 59–60 suppliers bargaining power, 58–59

Positioning strategy, 142 Positive feedback, standard impact, 234f Potential competitors

barriers to entry, 50–51 definition, 50

Power, astute use of, 32 Prahalad, C. K., 298 Pratt & Whitney, 151, 152 Preacquisition screening, 367 Preempting rivals, 217 Preferences, global markets, 277–278 Premium pricing, 159 Price cutting, 207f, 210 Price inflation/deflation, 72 Price leadership, 212 Price signaling, 211–212 Pricing

and format demand, 239 and value creation, 87, 88, 88f, 89

Primary activities, value chain, 91–92 Principal-agent relationships, 385 Prior hypothesis bias, 28 Prior strategic commitments, and

failure, 108 Private clouds, 38 Process innovation, 97 Procter & Gamble, 174, 181, 345, 346f

global strategies, 272, 281, 284 Prodigy, 200, 201f, 202 Product attributes, 95, 140t Product bundling, 313, 346–347 Product development, 213–214

cross-functional teams, 143 Product differentiation, 159–160

horizontal integration, 312–314 outsourcing, 332

Product innovation, 97 Product-oriented business, 15 Product proliferation, 208–209, 208f,

215–216 Product quality enhancement, vertical

integration, 320–321 Product structure, organizational design

implementation, 443–444 Product-team structure, 449–450, 450f

O Office Live, 38 Olson, Ken, 109 On-the-job consumption, 386 O’Neal, Stan, 409 Operating budget, 427 Operating responsibility, multidivisional

structure, 464 Opportunism, 296 Opportunistic exploitation, 400 Opportunities, 46, 67 Oracle Corporation, 314 Organizational culture, 16, 416, 416f,

429–430 leadership, 430–431 traits, 431–433

Organizational design, 415–417, 416f implementation, 439–451 skills, 348

Organizational slack, 467 Organizational socialization, 430 Organizational structure, 415–416,

417–418 authority and responsibility, 418–421 functions, divisions and tasks, 417–418 integration, 421–423

Otis Elevator, 151 Output control, 426–427 Outputs, standardized, 428 Outside directors, 390 Outside view, and cognitive biases, 30 Outsourcing, 328–333, 438–439,

488–491 Overcapacity, 217

P Packard, David, 402 Page, Larry, 209 Palm, 244, 245 Palmisano, Sam, 302–303 Paradigm shifts, 249–250

established companies, 250–256 new entrants, 256

Parallel sourcing policies, 328 Pascale, Richard, 25 Paulson, John, 377, 378 Pay for performance, 132 Pay-per-click business model, 21 Pearson, William, 23 PepsiCo, 53, 74, 105 Perot Systems, 3 Perrier, 91–92 Personal computer industry, 61 Personal control, 425 Personal ethics, 401 Peters, T. J., 431 Pfeffer, Jeffery, 32 Pfizer, 62, 141, 356 Pharmaceutical industry, 62, 62f Philip Morris, 73, 343, 343f, 344 Pixar, 177

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Index I7

Strategic leadership, 4, 30–33 Strategic managers, 9–11

sharing in diversification, 348, 350 Strategic outsourcing, 328

benefits, 331–332 risks, 332–333

Strategic planning, 26–28 exercise, 35

Strategic responsibility, multidivisional structure, 464

Strategy definition, 4 as emergent process, 21–25 feedback loop, 13f, 21 implementation, 4, 13f, 20 resources, capabilities and competencies,

85–86, 85f Strategy formulation, 4, 11–12, 13f

external analysis, 17–19 goals, 16–17 internal analysis, 19 mission statement, 14–16 planning process, 12, 13f SWOT analysis, 19–20

Stringer, Sir Howard, 359–360 Substandard working conditions, 400 Substitute products, 59–60 Successor technologies, 252,

252f, 253f The Sun, 336 Sun Microsystems, 367, 484 Sunday Times, 336 Superior performance, 4, 5–6

broad differentiation, 180–181 nonprofit enterprises, 8–9

Suppliers bargaining power, 58–59 Supply-chain management, 130 Support activities, value chain, 93 Sustained competitive advantage,

7, 83 Switching costs, 52, 235, 239 SWOT (strengths, weaknesses,

opportunities, threats) analysis, 19–20

acquisitions, 367

T Tacit price coordination, 315 Taiwan Semiconductor Manufacturing

Company (TSMC), 325 Takeover constraint, 393–394 Tall organizational structure,

418–419, 419f Tangible resources, 84 TCP/IP standard, 231, 233 Teams, integration mechanism, 423 Technical standards. See also Standards

computers, 231f definition, 230 format wars, 230

Technological forces, 73 Technological paradigm shifts, 249–256

Serendipity, 23–24 Shakeout, strategies, 205–206 Shakeout stage, 66 Share-building strategy, 204 Share-increasing strategy, 205 Shareholder value, 5

determinants, 5f Sharp, 245 Six Sigma quality improvement

methodology, 135, 137, 138 Sloan, Alfred, 465–466 Smartphones

format war in, 259–260 market, 326

Smith Corona, 15 Social forces, 73–74 Social skills, leader, 33 Soft drink industry, 47, 49

barriers to entry, 53 Sony, 141, 142, 166, 358, 359–360

format war, 232, 234, 235, 238 Southwest Airlines, 3, 32, 85, 172,

188–189, 307–308 Specialized asset investment, 318–320 Stakeholders, 381–382

and corporate performance, 379–380 impact analysis, 380–381 and profitability, 382–384

Standardization, control system, 427 Standards. See also Technical standards

benefits, 231–232 establishment, 233 examples, 230–231

Staples, 97, 195 Starbucks, 22, 32, 81–82, 83, 84, 228 Steel industry, 77–78, 125

Switzerland, 270 Stock-based compensation, 391–392 Stock options, 391 Stockbrokerage industry, 70 Strategic alliances

corporate-level strategy, 324 long-term contracting, 324–325

Strategic alliances (global) advantages, 293–294 disadvantages, 294–295 managing, 297–298 partner selection, 296 structure, 296–297, 297f

Strategic control, multidivisional structure, 466

Strategic control systems, 394–396, 423–425

design steps, 425f levels, 424–425, 426f types, 425–428

Strategic decision making, 28–30 Strategic groups

competition, 63 competitive positioning, 181–183 implications of, 63 within industries, 60–64, 62f mobility barriers, 63–64

Resources distinctive competencies, 84, 85 sharing in diversification, 345–346, 346f

Restructuring, 370, 451 Retail industry, 63, 179 Return on sales (ROS), 101f, 101t, 102 Revenue growth rates, 387f, 388 Reward systems, 429 Richardson Electronics, 220, 221 Risk capital, 5, 381 Rivalry management strategies,

210–218, 211f Rivalry of established companies, 53–57

cost conditions, 55 exit barriers, 56–57 industry competitive strategy, 54–55 industry competitive structure, 54–55 industry demand, 55

Rivalry reduction, horizontal integration, 315

Rodgers, T. J., 429, 435 ROIC (return on invested capital), 5f, 40,

101f, 101t different industries, 8 diversification, 342 multidivisional structure, 466, 471, 472 profitability, 100, 101f, 382 targets, 427

Rolex, 95 Roll, Richard, 29 Royal Dutch Shell, 26, 388 Rumelt, Richard, 70 Ryanair, 171

S S-curve, 250 Sales, functional strategy, 436–437 Sales, general and administrative expenses

(SG&A), 101f, 101t, 102 Samsung Electronics (SE), 326, 374–375 San Antonio Express, 336 SAP, 474 Sarbanes-Oxley Act (2002), 391, 393 SBA-Miller, 51 Scale of entry, new ventures, 361, 362f Scenario planning, 26–27, 27f Scheduling improvement, vertical

integration, 321 Schmidt, Eric, 209 Schultz, Howard, 81, 83 Schwab, Charles, 22, 23 Sears, Roebuck, 25, 28 Sears, Mike, 383 Securities and Exchange Commission

(SEC), 36, 378, 392 Self-awareness, leader, 33 Self-contained division, 464 Self-dealing, 389, 399, 405 Self-managing teams, 131, 132 Self-regulation, leader, 33 Semiconductor chips industry, 251 Sequential resource flow, 472

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IndexI8

W Walmart, 3, 6, 163, 381

business model, 99–100 competitive positioning, 169 global expansion, 273, 277, 479 innovation, 68 inventory control, 130 “Sam’s Choice,” 53 supermarket industry entry, 315

Walt Disney Company, 86, 420, 430

Walton, Sam, 30, 31, 431, 432, 435 Wang, Charles, 389 Wang, Jerry, 422 Waterman, R. H., 431 Watson Pharmaceuticals, 62 Welch, Jack, 31 Wheeling-Pittsburg, 77 Whitman, Meg, 327 Wholly owned subsidiaries,

290–291, 292t Wilson, Kemmons, 224 Windows, 37 Wintel standard, 231, 231f, 232,

233, 237 Wiseman, Eric, 339 Work-in-progress reductions, 127 Working capital, 101f, 101t, 102 Wrapp, Edward, 32 Wyman, Oliver, 89

X Xerox, 244, 245, 283–284

and Fuji, 297

Y Yahoo!, 422 Yamaha, 147 Yoon-Woo Lee, 374

Z Zara, 93, 94, 98, 179 Zynga Inc., 155–157

U.S. computer companies 2001–2010 profitability of, 2f

Utility value, 86, 87

V Vacuum tube industry, 219, 221 Value-added, vertical integration, 317,

317–318f Value chain

customer service, 92 description, 90, 90f marketing, 91–92 outsourcing, 328 production, 91 related diversification, 351 research and development, 91 support activities, 93

Value creation, 86–90 competitive positioning, 167f cycle, 99f efficiency achievement, 134, 135f frontier, 167 generic business models, 171f outsourcing, 328, 330f pricing options, 88f per unit, 87, 87f

Values, company, 15–16 VCR technology, 234 Verizon, 346 Vertical integration

corporate level-strategy, 316 limits, 323 multidivisional structure, 472–473 problems, 322–323 profitability increase, 318–321 stages, 317, 317f

VF Corp., 339–341 Viral model of infection, demand

growth, 203 Virgin America, 50, 51 Virtual corporation, 331 Virtual organization, 488, 489 Vision

company, 15 leader, 30–31

Volvo, 141

Technology, 229–230. See also High- technology industries

S curve, 250, 251f, 252, 252f, 255 and vertical integration, 322–323

Telecommunications industry, 49 Texas Instruments, 109, 131 Thain, John, 409–410 Thatcher, Margaret, 30 Threats, 47, 67 3M, 23–24, 141–142, 347, 361, 483 Time, Inc., 18, 19, 21 The Times, 336 Tit-for-tat price signaling strategy, 211 Tobacco industry, 74 Toshiba, 232 Total quality management (TQM), 96,

135–136, 435, 440, 452 Toyota, 84, 89, 89f, 90, 96, 97, 105, 122,

160, 173, 174, 215, 481, 489 Toys R Us, 68 Traditional practices, global markets, 278 Transfer prices, 322 Transfer pricing system

multidivisional structure, 466, 469 Transferring competencies, diversification,

343–344, 343f Transnational strategy, 280f, 282–283 TRW, 297 Tyco International, 368–369, 388

U Ultrasound technology, 243 Uncertainty, and planning, 21 Unethical behavior, 401–402 Unethical leadership, 402 Unilever, code of ethics, 403, 405 Union Pacific (UP), 422 United Airlines, 3 United States steel industry, 77–78 United Technologies Corporation (UTC),

151–152, 349–350 Unrelated diversification, 352, 357

multidivisional structure, 471–472 UPS, 57 U.S. airline industry, 45, 50, 51,

307–308

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